1 Company With All the Materials for Greatness

With increasing research spending and a promising merger with Tokyo Electron, Applied Materials has a bright future for growth even in the highly competitive semiconductor manufacturing industry.

Jun 5, 2014 at 8:45PM

In the past month, Applied Materials (NASDAQ:AMAT), one of the largest producers of semiconductor chip-manufacturing equipment, has surged over 10% following positive earnings growth and news of its pending merger with Tokyo Electron. Overall, 2014 has been a disappointing year for the semiconductor manufacturing industry, with ASML Holding NV, a large manufacturer of photolithographic devices, reporting earnings significantly below estimates. In addition, three of the largest customers in this industry, Samsung, Intel, and Taiwan Semiconductor, announced that their year-over-year chip capital expenditures would stay constant from 2013 to 2014. Despite slowing industry growth in 2014, Applied Materials seems well-positioned for future success.

Revenue stream 
Applied Materials has four different business segments that generate revenue: silicon systems group, applied global services, display, and energy and environmental solutions. Silicon systems group, which researches, builds, and sells equipment for integrated circuit manufacturing, is its largest source of revenue, generating 64% of total revenue in 2013 and 2012. The silicon systems group creates a diverse range of devices for many complex steps in the fabrication of semiconductor chips such as etching, deposition, and ion implantation. Most of its competitors in these fields are smaller, more specialized companies that only focus on making devices for a single step in the production process.

The applied global services division helps companies create integrated systems for the entire semiconductor chip-manufacturing process, along with automation software and maintenance of existing equipment. In 2013, this segment of Applied Materials accounted for 27% of the company's total revenue.

Applied Materials' display segment creates equipment to manufacture LCD and OLED screens. This segment's total revenue has remained rather constant at around 7% over the past few years, due to decreasing popularity of LCD TVs. However, Samsung, one of Applied Materials' largest customers, has introduced a curved OLED TV that will require many new systems to efficiently increase production, especially if these TVs grow in popularity.

The final 2% of Applied Materials' revenue comes from the energy and environmental solutions segment, which manufactures and sells equipment used to produce semiconductors for solar panels. This segment once accounted for around 20% of the company's revenue and has the potential to grow again, in light of recent announcements by several large companies, including Google and Walmart, of plans to purchase solar technology.

Competitive advantage
Applied Materials consistently increased spending on research and development year after year, most recently spending $1.38 billion in 2013, and is on track to spend over $1.4 billion in 2014. Although this is approximately 15%-20% of net sales -- a very significant portion -- it ensures that Applied Materials will remain at the technological forefront with every product it offers. Companies with plans to make semiconductor products can purchase almost all the equipment needed from Applied Materials, who will set up the whole system to run as an automated unit. This benefits customers and provides Applied Materials with very large orders.

Tokyo Electron merger
Applied Materials' merger with Tokyo Electron will provide the combined companies with a 25% market share, giving them an edge over small and highly specialized competitors. The merger will also allow the companies to combine their product lines, giving customers more options to find the optimal product for their specific needs. In addition, the two companies' combined research and scale should allow them to be forerunners in the newest lines of semiconductors and create ways to efficiently manufacture smaller, faster devices. 

Customers and demand
Applied Materials is growing its customer base while maintaining the loyalty of its largest clients. Although its three largest customers, Samsung, Intel, and Taiwan Semiconductor Manufacturing Company, have kept spending on chip manufacturing equipment flat, Applied Materials has been able to increase revenue by 19% quarter over quarter in 2014 due to growth in orders from smaller customers. In addition to growing revenue from orders, Applied Materials' order backlog increased almost 50% from 2012-2013, growing to $2.3 billion and guaranteeing at least that much revenue for the next 12 months.

Bottom line
Over the last few years, Applied Materials has shown steady growth and established good relationships with many large customers while continuing to develop new and improved products. Applied Materials' large line of integrated circuit equipment has allowed it to provide companies with full systems for semiconductor chip manufacturing. As integrated circuits improve, the manufacturing process will become more complex and specialized, which will compel companies to buy new Applied Materials products if they wish to continue manufacturing state-of-the-art chips.

Between high research and development spending and a merger with Tokyo Electron, Applied Materials will be able to continue producing high-quality devices for its expanding customer base, making the stock an appealing buy. Of course, it does not come without risk, as Applied Materials' success is dependent on the success of Intel, Samsung, and Taiwan Semiconductor Manufacturing Company.

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