One Apple (NASDAQ: AAPL) supplier I follow closely is Taiwan Semiconductor Manufacturing Company (NYSE:TSM). TSMC has profited handsomely over the years as it has managed to win the contract manufacturing orders for Apple's A8, A10, and A11 applications processors and is widely believed to have won the orders for the upcoming A12 chip, too. The A12 chip, which Bloomberg says is now in mass production, is said to be built using TSMC's latest 7nm technology.

Although TSMC is an obvious beneficiary from the production of the A12 chip, there's another company that's poised to profit handsomely as Apple and other companies start building chips using TSMC's (as well as other companies') 7nm technologies: Applied Materials (NASDAQ:AMAT).

A wafer of chips.

Image source: Applied Materials.

Who supplies the supplier?

Most chip design companies outsource the production of their chip designs to third-party contract chip manufacturers because the technological and financial barriers associated with manufacturing chips in-house is simply too great.

It costs billions of dollars to develop the manufacturing techniques to build chips, and companies generally need to invest billions of dollars in the capital equipment with which to apply those techniques to build chips. Applied Materials is one of the key suppliers of that expensive equipment to chip manufacturers. 

Over the last several generations, the capital intensity required to manufacture chips using the latest chip manufacturing technologies has grown significantly. This is due to the fact that new manufacturing technologies require more processing steps than older-generation technologies. That increase in chip manufacturing complexity makes life tougher for chip manufacturers and their clients, but it's music to the ears of capital equipment makers like Applied Materials.

For some context, during the company's fiscal year 2017, 41% of the company's $9.52 billion in revenue came from sales of equipment to contract chip manufacturers. That figure was up 100 basis points from fiscal year 2016, but Applied Materials' overall revenue grew from $6.87 billion to $9.52 billion, so the absolute dollar increase was around 42%. 

The overall foundry industry isn't seeing its revenues or unit shipments grow anywhere close to 42% year over year -- TSMC, for example, said that industrywide foundry revenue grew by 8% year over year in calendar year 2017 -- so what this tells us is that the industry-wide increase in capital intensity for advanced manufacturing technologies is benefiting Applied Materials handsomely.

Applied Materials eyes big bucks from 7nm production

During its analyst day presentation last year, Applied Materials told investors that the capital intensity required to build a wafer of chips using 7nm technologies is twice that required to build chips using 28nm technology. For some context, 28nm technologies started going into mass production during 2011 and are still in broad use today (TSMC reported that 20% of its revenue last quarter came from 28nm shipments). 

Now, to be sure, a doubling in capital intensity in going from 28nm to 7nm doesn't necessarily mean chip equipment vendors like Applied Materials will see their revenue double over that time. Keep in mind that one of the key design goals for new manufacturing technologies is to shrink transistor sizes (transistors are the basic building blocks of computer chips), so while the capital intensity per wafer of chips produced goes up, chip sizes should generally come down, reducing the number of wafers required to satisfy chip demand.

For some perspective, TSMC says its 7nm technology offers 0.43X chip area scaling over its prior 16nm technology, and its 16nm technology provided a rough doubling in transistor density over its 28nm counterpart (though it's hard to find a precise figure). The point, though, is that not all of the increase in per-wafer capital intensity will translate directly into more revenue for Applied Materials and its peers.

Nevertheless, Applied Materials did say at its analyst day that the 7nm manufacturing technology could be the "largest" manufacturing technology in history driven by "increasing content in smartphones [and] edge [devices]" as well as "high performance computing [plus] accelerators for [artificial intelligence]/machine learning."

Investor takeaway

The new reality is that as chip manufacturing companies aim to build faster, more efficient chips, they'll have to keep developing new technologies that push the limits in terms of both area scaling as well as the performance and efficiency of their technologies. These innovations will require significant ingenuity on the part of the chip manufacturers themselves, and the companies that successfully deliver should be able to ride the current demand trends for more powerful computer chips, but those technologies will also require increasingly expensive tools and equipment, which Applied Materials will be all too happy to provide.

Ashraf Eassa has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Apple. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.