Shares of Applied Materials (AMAT 2.98%) have been on a tear this year and are approaching all-time highs last reached in late 2021. Investors have been drawn in by the company's winning strategy of steady growth even in a down year for the critical semiconductor-manufacturing equipment niche of the chip market. A big dividend increase announced earlier this year doesn't hurt either.
However, there's another key reason to be optimistic about Applied's prospects. The company's recent earnings update is the latest sign that a nasty downturn in the semiconductor market (driven by falling consumer electronics sales after the pandemic, which led to excess inventory of some chips) is finally coming to an end. Here's what investors need to know.
A ho-hum quarter... or was it?
Applied Materials Q3 fiscal 2023 (the three months ended in July 2023) looked pretty pedestrian. Revenue was $6.4 billion, down 1% from the year prior. Earnings per share (EPS) were flat from last year at $1.85, or down 2% year over year to $1.90 on an adjusted basis.
One key financial metric was a standout, though. Free cash flow, which can be highly variable from one quarter and one year to the next, was $2.3 billion. That was up 85% from Q3 fiscal 2022 as past investments into next-gen chip-manufacturing equipment began to pay off.
But what of this semiconductor industry downturn, including for Applied Materials, and the manufacturing-equipment industry's overall decrease in sales in 2023? Applied had some good news tied up in its Q4 outlook (the quarter that will end in October 2023). Management expects revenue to be $6.51 billion, plus or minus $400 million, and adjusted EPS to be $1.82 to $2.18. At the midpoint, that implies a 2% and 5% quarter-over-quarter rise in revenue and adjusted EPS, respectively.
Things heat up starting in 2024
Business should start to get really interesting starting in 2024. Applied has largely outperformed its peers this year thanks to its pivot to address what it calls ICAPS -- end markets for chips for electric vehicles, industrial automation, solar and wind, and smart-energy infrastructure.
Dozens of new fabs are under construction or retooling right now. Applied, the longtime chipmaking-equipment generalist, will likely sell at least a little equipment to most or all of them. Many of these fabs are for ICAPS but also for advanced logic and memory chips (think PC, smartphone, and data center AI chips). All three of Applied's revenue segments -- Semiconductor Systems (sale of equipment), Applied Global Services (or AGS, equipment leases and servicing, software subscriptions), and Display and Adjacent Markets (LED and OLED display manufacturing equipment) -- are expected to return to strong growth in the coming quarters.
AGS is a good proxy for the trajectory of the business overall, since sales tend to be more stable given the subscription-based model that smooths out the peaks and valleys. CEO Gary Dickerson said on the earnings call that "we believe we're on track to achieve low double-digit AGS growth in the coming years."
Who should be interested in Applied Materials?
Applied is giving a strong signal that the semiconductor industry's broad-based next run higher is right around the corner. If that transpires in 2024, Applied won't be the fastest-growing business. This is more of a slower-and-steady stock play.
That certainly doesn't mean Applied is a boring stock, though. This company has a long track record of increasing shareholder returns. It raised its quarterly dividend by 23% earlier this year (the dividend currently yields 0.9% a year). Share repurchases have declined in 2023 ($1.5 billion through the first nine months of fiscal 2023 versus $4.6 billion in 2022), but I'm OK with that since the stock was depressed during the 2022 bear market. A shift to more dividend payout instead looks like good capital allocation to me.
As a result of that cash-allocation adjustment, Applied's balance sheet has been replenished and is ready for the next round of tech investment in the coming years. Cash and short-term investments totaled $6.5 billion at the end of July (plus another $2.2 billion in long-term investments) versus just $2.6 billion in cash and short-term investments at the end of fiscal 2022 last October. Debt remains stable at $5.5 billion.
Applied Materials stock still looks attractively valued to me at just shy of 20 times trailing-12-month EPS, or 17 times free cash flow. This remains one of my top semiconductor stocks as the industry approaches its next bull market and could be a good long-term pick for investors seeking growth and income.
