We've been on a theme in the Rule Maker lately regarding risk, value, and finding the right kinds of companies.

More than ever I think it's possible for investors that follow the Rule Maker strategy to identify top companies trading at reasonable prices, provided investors are patient and choosy. I think Applied Materials (Nasdaq: AMAT), which makes machines that make computer chips, is a top candidate.

Over the last 25 years the company's revenue has grown at a compound annual growth rate of 30%; over the last 10 years it has generated average annual returns just shy of 50%, and its share of the wafer fabrication equipment (WFE) market jumped to almost 29% last year, up from 18.1% in 1998, according to data provided by the Semiconductor Equipment Materials Industry, a trade association.

There's no question that Applied Materials is the dominant supplier of front end capital equipment to the semiconductor industry. Here's a look at how the company stacks up against the Rule Maker's quantitative criteria using the latest available figures:

Fiscal 2000
Sales growth: 88%
Gross margins: 50.7%
Net margin: 21.5%
Cash to total debt: 6.2
Foolish Flow Ratio: 1.73
Cash King Margin: 13.3%

With the exception of the Flow Ratio, Applied Materials easily makes the grade as a Rule Maker. It's important to note, however, last year was an above-average year in the chip equipment industry, with sales rocketing as companies like Intel (Nasdaq: INTC) started transitioning to 300 millimeter wafers, a money saving technology that will allow the microprocessor giant to produce more chips per wafer. In this cyclical industry, there will be years when Applied misses the mark. In 1997, 1998, and 1999, its Cash King Margin came in at 8.8%, 9%, and 15%, respectively.

If you really want to get a feel for a company's metrics you need to pull figures from more than one year. Three years would be better, five would be great, and 10 would really give you a feel for how a company performs within a broader range of climates. I can give you some of the basic numbers over a five-year period:

Gross margins: 46.7%
Sales growth: 27.5%
Profit margins: 12.5%

As for the company's flow ratio, it runs high for Applied Materials, ranging from 1.73 in 2000 to 1.41 the year before. Considering the ramp up in demand for machines -- especially last year -- I'm not too surprised to see where it is. Last year sales grew slightly faster than receivables, 88% vs. 85%, and slower than inventories, 88% vs. 107%. Considering the major transitions underway in the chip equipment industry -- the shift to 300 mm wafers, the shift to smaller geometries (more transistors per chip), and the shift to better conducting materials -- I think I'd give the company some leeway managing its inventory. Nevertheless, that's a strike against it.  

Transitions in the chip industry lead us to the second phase of the analysis. Where is Applied Materials headed? We want to understand what kind of growth opportunities remain for this large company.

For starters, James Morgan, the company's chief executive, expects Applied Materials to be a $20 billion company in 2004. That's an aggressive goal for a $10 billion company. Here's a look at growth expectations for the portion of the chip equipment industry Applied Materials competes in, according to SEMI. The numbers in the first row represent sales in billions.

           '99     '00    '01    '02    '03
WFE*       16.8    31.2   38.7   42.9   45.8
% growth    -      85.6%  24.1%  10.8%  6.9%

WFE -- Wafer fabrication equipment

Basically, SEMI expects the WFE market to grow about 13.6% annually over the next three years, or about 47% total. Applied Materials expects to double its sales in this period, meaning it expects to grow much faster than the market. In addition to selling new front end equipment, Applied Materials expects to boosts sales by increasing services, consulting, and selling of replacement parts. There's plenty of growth opportunity for Applied, based on its position and ability to grab market share, though industry growth rates are slowing.

Beyond 2003, however, there is plenty left to accomplish in the chip equipment business. Consider that companies such as Intel are just now making the transition to 300 millimeter wafers, yet by 2008 (probably sooner) wafer sizes should jump to 450 millimeters, according to SEMI. Also consider that Intel just made the switch to 0.18 micron technology in 1999 and recently unveiled prototype technology that could make 0.03 micron technology possible as early as 2005. (A micron is one-millionth of a meter and is used to measure the line width of transistors on a microchip. Thinner line widths save space, which cuts waste, improves efficiency, and improves speed because signals don't have to travel as far.)

Such transitions require new machines, and Applied Materials is the dominant supplier in nine of the 13 major areas it competes in, according to a recent company presentation. The industry growth curve isn't straight up anymore, and the years of 88% annual sales growth are probably behind Applied Materials forever, but I see plenty of growth in the coming years.

Even better, Applied Materials makes chip machines for companies across the industry, which provides some safety if users start buying fewer computers and more personal digital assistants and cellphones. Regardless of whether the PC remains the center of the computer industry, Applied Materials is well positioned to provide the machines that make the chips.

Finally, because of the cyclicality of the chip industry, Applied Materials is a very volatile stock. For academic folks this means Applied Materials is risky -- its share price swings high and low. We're not worried about volatility in the Rule Maker portfolio since we aren't looking to report our returns on a monthly or quarterly basis. We just want to sign up with companies suited to perform well over the long term. This gives us the opportunity to purchase a stock when the market places it on sale.

Currently, the market has a pretty dour view of the chip equipment industry, which is why Applied Materials trades at more than a 50% discount to its 52-week high. At a price of about $44, the stock trades at about 40x trailing free cash flow. That isn't cheap, but the market knows Applied Materials is a champ. Based on expected growth rates and the company's entrenched position with customers, this is a reasonable price to pay for a company that could be generating $2.6 billion in free cash flow in 2004. That would represent roughly 20% growth in annual free cash flow.

This isn't to say there isn't risk associated with Applied Materials. Forecasting its free cash flow growth is very difficult, and understanding the chip equipment industry isn't easy. But this is the kind of company the Rule Maker Portfolio should examine. It has an established market position, a strong track record of performance, room to grow, leading market share, a stable and proven management team, and it's producing solid cash flow.

What do you think? Post your thoughts on the Rule Maker Strategy Discussion Board.