The market was quick to bring out the knives after Applied Materials (NASDAQ:AMAT) released mixed-bag fiscal second-quarter results in mid-May. Investors apparently ignored the company's terrific top- and bottom-line growth, while letting concerns about slowing smartphone sales and the company's tepid guidance dent their confidence.

However, on taking a closer look at Applied Materials' results and outlook, it becomes clear that the market is missing the bigger picture.

Processor on an integrated circuit.

Image Source: Getty Images.

Slowing smartphone sales shouldn't rock the boat

Applied Materials CEO Gary Dickerson said during the quarterly conference call with investors that smartphone sales, especially sales of high-end models, have been tracking below expectations. As such, demand for critical smartphone equipment such as displays has been waning, forcing chipmakers that buy fabrication equipment from Applied Materials to put their investments on hold.

According to Godlman Sachs, the slow uptake of high-end smartphone models equipped with OLED displays has pushed out the capacity addition of related equipment from 2021 to 2023. As a result, Applied Materials' display-equipment sales are expected to drop 15% to 20% next year, a sharp decline compared to this year's expectation of a 30% jump.

There's no doubt that this will weigh on the company's finances in the near-term. But it shouldn't rock the boat much from a longer-term perspective, as display equipment accounted for just over 13% of Applied Materials' total sales last quarter. Instead, it's important to focus on the elephant in the room: the company's semiconductor systems business, which supplies nearly two-thirds of its total revenue.

The big play

Applied Materials' semiconductor systems revenue shot up nearly 25% in the latest quarter thanks to multiple catalysts. The company supplies fabrication equipment to key verticals, including foundries that manufacture chips, DRAM (dynamic random access memory), and flash memory, and all of these products are on the cusp of rapid long-term growth.

For instance, NAND flash demand and DRAM memory demand are forecast to increase at an annual rate of 35% and 20%, respectively, for the next three years, driven by emerging tech trends such as the Internet of Things (IoT), artificial intelligence (AI), and the proliferation of data centers.

Data centers, in fact, could become a bigger market for DRAM than smartphones. Applied Materials estimates that server-driven DRAM demand is increasing 75% faster than mobile-related demand, so it could become the largest DRAM segment in the next three to five years. Not surprisingly, DRAM manufacturers have been stepping up capital investments to meet the surge in demand.

Samsung, for instance, is reportedly going to spend $12 billion to add a new DRAM production line in South Korea's Pyeongtaek. Micron is also ramping capacity with a new Singapore facility that recently broke ground.

Looking ahead, Applied Materials' foundry customers can be expected to spend more money on capital equipment as they work to meet the IoT and automotive-driven chip demand. Grand View Research estimates that demand for automotive chips will increase at a steady annual pace of 10.7% through 2025, while IoT chip demand will rise at a much faster annual rate of 15% for the next five years.

As such, investors need not be fixated on slowing smartphone demand, as there are other catalysts that could step in.

An enticing bet

The solid prospects of Applied Materials' semiconductor systems business will boost its bottom line in the long run thanks to a higher margin profile. The segment's non-GAAP operating margin shot up 170 basis points year over year last quarter to 37.2%, way higher than the non-GAAP operating margins of its other two segments, which were sub-30%.

Not surprisingly, the consistent growth of semiconductor systems has been a boon for Applied Materials' earnings over the quarters.

Period

Q1 2017

Q2 2017

Q3 2017

Q4 2017

Q1 2018

Q2 2018

Net income (in $millions)

$732

$861

$927

$1,005

$1,135

$1,273

Semiconductor Systems operating margin

34.2%

35.5%

36.3%

34.8%

36.6%

37.2%

Data source: Applied Material.

Analysts expect Applied Materials' earnings to increase at a compound annual growth rate of over 18% for the next five years. What's more, investors can enjoy this anticipated growth without having to pay too much, as the stock trades at just 11 times forward earnings, which is less than half of the 23.7x industry average.

Harsh Chauhan has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.