A great growth stock typically involves a well-run business capitalizing on an emerging trend that will change the world. Two such early stage trends with that world-changing potential are artificial intelligence (AI) and the Internet of Things (IoT).
We tend to think about these trends in terms of consumer-facing products like Apple's iPhone. But who is behind the scenes making production possible? Two such companies are Universal Display (NASDAQ:OLED) and Applied Materials (NASDAQ:AMAT). Which of these two is better positioned to benefit from these trends, and is therefore the better buy?
The first iPhone used an LCD screen, and this technology was fine for millions of phones over the years. But these days, OLEDs (for organic light emitting diodes) are increasingly replacing LCDs due to slimmer design, lower power consumption, and better picture quality. Top phones like Google's Pixel 4 and Apple's iPhone 11 Pro Max all sport the latest in OLEDs.
Universal Display makes its money by licensing its OLED manufacturing patents and selling the materials needed for making the displays. It doesn't actually do the manufacturing or come up with consumer-facing products. This means it's not a cash intensive business. Indeed, so far this year, Universal Display has a 37% net profit margin, bringing in over $111 million in net income. This lean business model is reflected in the company's balance sheet of over $235 million in cash and zero debt.
The company's biggest expense is research and development, costing over $51 million so far in 2019. And that makes sense. Since a major part of Universal Display's revenue comes from licensing intellectual property, it must continue to solve problems and obtain patents, lest it get disrupted -- just as it disrupted the LCD market. Indeed, several companies are currently experimenting with micro-LED screens, a threat to Universal Display's entire business.
Let's say you came up with a design for the greatest AI computer chip in the world. Unless you also come up with a machine to build that chip, it's not much use. That's where Applied Materials comes in.
It builds the equipment that can manufacture the semiconductor components that will power trends like AI, big data, and the IoT. Semiconductor companies depend on companies like Applied Materials, which led CEO Gary Dickerson to say in one interview, "Applied will win no matter who ends up winning."
To be clear, Applied Materials also generates revenue by manufacturing displays, servicing machines, and offering consulting. But the bulk of its business -- 62% of net sales -- is in semiconductor equipment. This industry is famously cyclical, with occasional oversupply problems. Weakened semiconductor demand and the tariff war between the U.S. and China (where many chips are made) has caused the entire semiconductor industry to slump over the last two years.
But demand may be picking up again. In Applied Materials' fourth quarter, the company reported revenue of $3.75 billion, exceeding its own guidance of $3.7 billion. In the earnings call, Dickerson credited increased semiconductor demand as the reason the company performed so well. Management underlined this by raising revenue guidance for the first quarter of 2020 to $4.1 billion -- potentially 9% year-over-year growth.
The better buy?
I love investing in companies with pristine balance sheets, and Universal Display has one. It also holds all the cards in a high-demand global product. I wouldn't be surprised to see this company generate lots of cash over the next several years as its OLED products continue to be the solution of choice for smartphones, TVs, and (increasingly) lighting.
But in the end, Universal Display relies entirely on OLED technology, and could be disrupted overnight. For that reason, while I like the company, I like Applied Materials a little bit more. No matter which direction semiconductor technology goes, Applied Materials has an opportunity to provide the equipment solutions needed. The semiconductor industry may be cyclical, but if it's true that the AI, big data, and IoT trends are at an inflection point, long-term demand will continue to swing higher and higher.