A global shortage of semiconductors -- basic building blocks for everything from high-tech services to autos to household appliances -- is reverberating through the economy. For semiconductor manufacturing equipment providers like Applied Materials (AMAT -1.43%), it's a good time to be in business. Chip fabricators are scrambling to keep up with orders and are trying to expand their production, which means strong demand for equipment. In fact, Applied Materials just posted record quarterly sales and signaled growth will continue at a torrid pace this year -- and could stay strong well beyond 2021. Here's why.
1. "Just-in-time" supply failed during the pandemic
As with all businesses related to manufacturing, managing supply of basic commodities is of utmost concern. While circuitry is a basic commodity used in the manufacture of all sorts of devices these days, it isn't exactly a cheap product to keep large inventories of. On the contrary, some high-end chips are quite expensive.
To manage costs, many companies keep only a short supply of chips they need on hand, and the chip fabrication industry has adapted to this "just-in-time" strategy. It's worked well, at least up until the pandemic. Factories around the globe have been shuttered at times due to the pandemic, and chip customers opted to work with the limited inventory they had last year to manage cash flow. But the sudden resurgence in demand for tech hardware means there's now a shortfall in supply in some sectors of the economy (like autos and some consumer electronics).
On the Q2 fiscal 2021 earnings call (for the three months ended May 2, 2021), Applied Materials CEO Gary Dickerson said that "the highly efficient, just-in-time supply chains that have served the semiconductor industry well for the past two decades may not be the most effective strategy going forward." Fabs and their customers are now looking to expand production to create a more flexible supply chain. The result? More chip fab equipment will be needed, which plays right into the company's hands.
2. A push to increase regional manufacturing
Similar to the above initiative to increase chip production capacity, Dickerson also alluded to a global competition for more localized manufacturing. Semiconductor fabrication is a complex process, with the most advanced systems taking hundreds of steps to build. As a result, chip manufacturing hubs have been created that specialize in the process. Taiwan Semiconductor (TSM -0.33%) is the largest player here, with the bulk of its operations located in Taiwan.
But various countries (most notably the world's two largest economies, the U.S. and China) are pushing for more localized production to more directly supply their silicon-hungry consumers. For example, Taiwan Semiconductor is expanding its facilities in Arizona, and rival Intel (INTC -1.01%) is planning an additional two in the state. Similar initiatives supported by government agencies are underway elsewhere.
For Applied Materials, this is great news. Constructing new facilities like this takes years, which will help underpin its recent surge in sales for the foreseeable future. In Q2 fiscal 2021, revenue was up 41% from a year ago to $5.58 billion. Free cash flow was up 74% to $983 million. The outlook for Q3 is even better. Revenue is expected to be $5.92 billion at the midpoint of guidance (up 6% sequentially and up 35% year over year). Given the big expected jump in sales and profits this year, shares look like a reasonable long-term value at 28 times trailing-12-month free cash flow.
3. Secular change in technology
Longer term, Applied Materials is benefiting from more than just a global chip shortage and government interest in boosting localized manufacturing. Technology itself is evolving. According to Dickerson on the earnings call:
Digital transformation is driving exponential growth in data generation, which leads to the second major inflection, AI computing. New computing approaches are needed to create value from these massive volumes of data. AI computing works best with workload-specific software and hardware built from customized and entirely new types of silicon.
New types of chips designed for AI and other custom-built applications are putting new stress on the semiconductor industry. Chip fabs are purchasing new equipment to keep up with new demands for customized circuitry, but again this is a process that takes time -- in this case, perhaps a decade of rapid adoption of AI and related business processes. Demand for the fab equipment that Applied Materials supplies will ebb and flow along with manufacturing, but sales are expected to continue averaging up over time, just as they have over the last couple of decades.
Applied Materials stock is flying high right now, up over 130% through the last 12 months. However, the global chip shortage and new technology is placing new demands on the industry. A key supplier of equipment for chip fabs around the globe, Applied Materials still looks like a quality business worth owning for the long haul.