The U.S. Senate is working on getting the Chips Act passed to help boost American manufacturing of semiconductors. The act would give some $52 billion in subsidies for chip makers, welcome news for the economy after struggling with two years of chip shortages.
With or without that help, though, global semiconductor demand is poised to keep running higher for the rest of this decade. Some estimates point to upwards of $1 trillion in global spending by 2030 (up from about $600 billion in 2021). With all of those new chips needed in the coming years, chip fab equipment company Applied Materials (AMAT 1.21%) could be a great broad-based play on the industry.
It all starts with fabricating equipment
Fabricating chips is arguably the most complex manufacturing process there is. Semiconductors are an amalgam of specialty materials layered atop each other in sometimes-close-to-microscopic arrangements of electricity-conducting circuits. Advanced and very expensive equipment is needed for these fabrication processes. That's where a company like AMAT comes in.
AMAT and a handful of peers specialize in the design of advanced chip fabricating equipment. The company reports its revenue in three segments: semiconductor systems (the equipment sold to fabs that produce chips, which is further divided into foundry logic and other, and memory chips), global services (consisting of service fees related to the operation of fabricating equipment already installed and in use), and display and adjacent markets (including LCD and OLED screen making equipment).
AMAT is far from the fastest growing company in the semiconductor industry. Even during the height of the chip shortage in 2021, revenue was growing in the mid-30% and low-40% year-over-year range -- a sizzling pace for AMAT and the fab equipment industry overall, which was benefiting from the depressed sales of 2020 when the pandemic began. By comparison, top chip designers like Nvidia and Advanced Micro Devices were close to doubling sales during that time.
Additionally, AMAT and other fabricating equipment makers have cyclical business models, as is often the case with any company in the manufacturing space. Spurts of growth tend to come in waves as chip fabricators scramble to upgrade their equipment, especially whenever there's a new technology needed to make the latest and greatest silicon devices. The result is a company that generates swells in revenue and net income, but overall generates gradual growth over time.
Buy now on a cyclical "downturn"?
The fact that the semiconductor industry is cyclical in nature is a loudly broadcasted risk. And that's exactly what has been eating AMAT stock as of late. Consumer spending on electronics is cooling off, and some think the chip shortage could end as early as 2023. Chip stocks tend to decline well in advance of any downturn actually occurring, and then rally while still in the midst of a downturn on expectations of the next cyclical run higher.
Fraught with global supply chain issues, AMAT has been reporting progressively slower revenue growth in recent quarters. In May 2022, it said its fiscal 2022 Q2 sales increased "only" 12% year-over-year. The company provided an outlook for sales to decline as much as 6% or be up as much as 7% year-over-year in Q3. It appears the company could indeed be in the early stages of a cyclical downturn. Shares of AMAT have been punished because of this, and are down 35% so far in 2022 as of this writing -- compared to a 24% drop for the Nasdaq composite.
But buying on these cyclical declines can pay off big time for AMAT shareholders. This is a highly profitable company that generates operating margins of upwards of 30% during good times (with quick rebounds in depressed operating margins during bad times). The reason? The sale of chip fabricating equipment is resilient as old machines need to be replaced and newer and better machines are needed to make the latest and greatest microchips.
Best of all, as a mature business, AMAT returns excess cash to shareholders via a rising dividend payout and share repurchases. The dividend currently yields just 1.1% a year, but the current payout of $1.04 per year is up nearly 200% in the last decade. Share repurchases have also already totaled $3.6 billion through the first half of fiscal 2022, which represents 4.4% of AMAT's current enterprise value. That's an incredibly generous return of value to shareholders.
As of this writing, Applied Materials stock trades for just 16 times trailing 12-month free cash flow and just 12 times current-year expected earnings. If you're looking for a way to benefit from the semiconductor industry's gradual growth over the next decade, this dividend-paying and share-repurchasing cash machine is a fantastic investment right now.