Applied Materials: Trading Near Fair Value After Recent Run Up (NASDAQ:AMAT)

Executive Summary

Applied Materials, Inc. (NASDAQ:AMAT) stands as a strong player in the Semiconductor Services Sector, particularly against the backdrop of rapid growth in the semiconductor industry, primarily fueled by advancements in Artificial Intelligence (AI). Considering the recent surge in AMAT’s stock price, reflecting these industry dynamics and AI-driven growth potentials, my analysis leads to a recommendation of a Hold rating. This stance is based on a calculated intrinsic value of $173.17 per share, which, for practical purposes, can be approximated to $173. This rating underscores AMAT’s solid market position and growth prospects while acknowledging that the recent stock price movement may have captured much of its near-term potential, aligning its current valuation closely with the firm’s underlying intrinsic value.

Company Overview

Applied Materials, Inc., headquartered in Santa Clara, California, is a leading provider in the global semiconductor industry. Founded in 1967, the company has established itself as a pivotal player in developing, manufacturing, and selling equipment, services, and software for the fabrication of semiconductor chips. Applied Materials serves a crucial role in enabling the production of virtually every new chip and advanced display worldwide.

The company operates through three primary segments, each contributing significantly to its revenue stream and overall business strategy:

1. Semiconductor Systems: This segment involves the development, manufacture, and sale of a broad range of manufacturing equipment used to fabricate semiconductor chips. It includes systems for depositing thin film layers, etching patterns, adding dopants, modifying film properties, and cleaning wafer surfaces.

2. Applied Global Services (AGS): This segment provides integrated solutions to optimize equipment performance and yield of semiconductor fabs. AGS offers a range of services including equipment installation, maintenance, upgrade, and repair. It focuses on improving the output and efficiency of clients’ semiconductor manufacturing processes.

3. Display and Adjacent Markets: This segment involves the production of equipment used to fabricate thin-film transistor LCDs, organic light-emitting diodes (OLEDs), and other display technologies. It also covers equipment for coating and developing photomasks, solar cells, and other coating technologies.

Applied Materials’ revenue generation is predominantly driven by the sale of semiconductor manufacturing equipment, but it also earns significant income from service and support operations. The company’s business model focuses on delivering high-precision engineering solutions, enabling it to capitalize on the ever-increasing demand for semiconductor chips used in various electronic devices, from smartphones to complex computing systems.

Under the leadership of Gary Dickerson, President and CEO, Applied Materials has been steering towards innovation and strategic partnerships to further strengthen its market position. The company’s approach to revenue generation is multifaceted, involving direct sales of equipment and services, long-term service agreements, and a focus on continuous innovation to meet the evolving demands of the semiconductor and display industries.

Applied Materials’ commitment to innovation, coupled with its expansive portfolio of products and services, positions it as a key enabler in the semiconductor and display manufacturing sectors, driving technological advancements and supporting the proliferation of electronic devices globally.

Recent Financial Performance

AMAT concluded Fiscal Year 2023 with record achievements in terms of earnings, revenue, and cash flow for both the fourth quarter and the entire year.

In the Semiconductor Systems segment, AMAT reported mid-single-digit growth for the fiscal year. This marks the fifth consecutive year of outperforming the wafer fabrication equipment market. The past 12 months have been significant for various business units, setting new records and milestones. Notably, the company surpassed 10,000 shipments in etch chambers and released new products, securing incremental production tools of record positions in several key areas, including Gate-All-Around, advanced DRAM, high-bandwidth memory, and heterogeneous integration. The Integrated Circuit, Aggregates, Photonics, and Sensors (ICAPS) business also saw growth, serving a range of sectors from IoT to automotive power and sensors.

The Services segment achieved low single-digit revenue growth in FY2023, overcoming challenges such as lower fab utilization rates and trade restrictions. Notably, the total installed base of process chambers increased by 5%, now more than double that of the nearest competitor. The company also expanded the number of tools under long-term subscription agreements, now accounting for 63% of total parts and service revenues.

Operational and supply chain focus remained a priority in 2023, with significant and sustainable improvements made. AMAT improved customer delivery and shipment quality while normalizing inventory levels, positioning the company for scalable growth as the industry expands.

Financially, year-over-year revenue grew nearly 3% to a record $26.5 billion. Non-GAAP gross margin improved by 20 basis points to 46.8%, offsetting the impact of inflation through value-based pricing and cost improvement actions. Non-GAAP EPS saw a 4.5% increase to $8.05 per share. The company also reported a record operating cash flow of $8.7 billion and a record free cash flow of $7.6 billion.

Shareholder distributions totaled approximately $3.16 billion, including $975 million in cash dividends and approximately $2.2 billion used for repurchasing 18 million shares at an average price below $123 per share. This aligns with the company’s commitment to returning 80% to 100% of FCF to shareholders, with a return of 87% over the past three years.

Segment-wise, the Semi Systems revenue declined 3% year-over-year to $4.88 billion, but the full year saw a 5% growth, achieving record net sales in foundry-logic, implant packaging, metal deposition, and chemical vapor deposition (CVD). The Applied Global Services segment reported a 4% year-over-year growth in Q4 to a record $1.47 billion, with an improved operating margin. The Display segment’s revenue also increased to $298 million in Q4, with an operating margin of 22.5%, and the company anticipates modest improvements in this segment in 2024.

In terms of cash flows, nearly $1.6 billion in operating cash flow and nearly $1.25 billion in FCF were generated in Q4. Shareholders received nearly $968 million, including dividends and buybacks. These results reflect AMAT’s robust financial health and its strategic positioning for sustained growth and shareholder value creation.

The yearly results, in my opinion, are strong and continue to showcase AMAT’s strong market position and customer relationships. I see this as the early formation of a “moat,” around this entrenched firm, a strong position to hold as the industry faces increasing consolidation.

Industry Overview

The semiconductor industry, a critical input of modern technology, is poised for substantial growth and transformation in the coming year and also faces the threat of further consolidation as noted above. This overview is primarily informed by online research, complementing insights from IBISWorld Industry Reports, the Global Semiconductor Industry Report via KPMG, and the recent financial performance of AMAT.

In 2024, the global semiconductor market is forecasted to witness a strong growth rate. According to World Semiconductor Trade Statistics (WSTS), the market is expected to rebound with a 13.1% growth, driven significantly by the memory sector. This surge in growth is attributed to various factors, including regional market expansions, particularly in the Americas and Asia Pacific, which are anticipated to demonstrate significant double-digit year-over-year growth. International Data Corporation (IDC) echoes this sentiment, projecting an impressive 20% annual growth rate for the semiconductor sales market in 2024.

Several key trends are shaping the industry’s future:

1. Automotive and AI Integration: Advanced Driver Assistance Systems (ADAS) and infotainment are becoming increasingly crucial in driving the automotive semiconductor market. With a compound annual growth rate (CAGR) of 19.8% expected for ADAS by 2027, this segment is set to account for a significant portion of the market.
2. AI Expansion: The integration of AI in data centers requiring higher computing power is expanding to personal devices, which is expected to increase semiconductor demand, also according to IDC.
3. Foundry Industry Growth: The foundry industry is anticipated to experience a rebound, especially in advanced processes, due to rising demand for consumer electronics and AI.
4. Innovations in Packaging Technologies: IDC forecasts that the 2.5/3D packaging market will experience significant growth, with a CAGR of 22% from 2023 to 2028. This growth is attributed to the evolving functionality and performance requirements of semiconductor chips, which necessitate advanced packaging technologies. The increasing importance of these technologies is indicative of the semiconductor industry’s ongoing advancement and the growing need for sophisticated packaging solutions.

The U.S. semiconductor manufacturing industry, in particular, is expected to benefit from the expected re-shoring of semiconductor manufacturing within the United States. This resurgence is poised to positively impact American producers of parts and services essential for semiconductor manufacturing. As companies like AMAT continue to innovate and provide integral equipment, services, and software, they are well-positioned to capitalize on this growth. The company’s recent performance, including record earnings and revenue in FY2023, underscores its robust position in an expanding market. As noted in their recent earnings call, Waterfab demand, in particular, is poised to see strong growth.

Moreover, the U.S. government’s focus on bolstering semiconductor manufacturing domestically, through policies and incentives, aligns with the industry’s growth trajectory.

Intrinsic Valuation Overview

As a part of my analysis, I also conducted an intrinsic valuation using the Discounted Cash Flow (DCF) method for AMAT. This was based on detailed financial forecasts extending from 2024 to 2028 and incorporates a blend of current trends and future expectations within the semiconductor industry. This analysis uses a Weighted Average Cost of Capital (WACC) of 11.1% and a terminal multiple of 20x to calculate the company’s valuation (more information on this multiple below). Once completed, these projections were weighed against current analyst expectations.

I project that AMAT’s revenues are expected to show a steady upward trajectory over the next few years. In 2024, the revenue is projected at $26,097.0 million, followed by an increase to $28,695.0 million in 2025. The growth trend continues with revenues expected to reach $30,943.0 million in 2026, $32,490.2 million in 2027, and finally $34,114.7 million in 2028. Alongside revenue growth, the company’s EBITDA is also forecasted to rise consistently, starting from $8,090 million in 2024 to $10,576 million by 2028.

The DCF model calculates the present value of these future cash flows, taking into account the company’s cost of capital. The terminal value, a crucial aspect of this analysis, is derived using a 20x EBITDA multiple. This reflects an expectation of slight multiple expansion (as has already occurred throughout the last week), particularly driven by the growing interest in AI technology and its impact on the semiconductor sector. To be clear, the firm trades above fair value at its current EV/EBITDA multiple.

The outcome of this analysis is a per-share valuation of approximately $173.17, which is rounded off to $173 per share:

This target price falls slightly lower than current analyst expectations, most of which fall within the price range of $175-$185 a share:

Within the context of AMAT’s performance within the last week, however, the average price ($180) only represents a slight upside to the current share price (roughly 7.5%).

Recent Stock Price Performance

The semiconductor industry witnessed a notable shift in the stock market this past week, largely influenced by the ripple effect of Taiwan Semiconductor Manufacturing’s (TSM) encouraging quarterly results.

The resulting upswing represented a nearly 10 percent rise in AMAT’s stock price, closing around $153 a share on Jan 17th and then finishing the week over $167.

I feel strongly that this removed most of the near-term upside in the stock, as it is now trading only slightly lower than its intrinsic value. Furthermore, AMAT’s present P/E ratio, trading at 19x, is closely approaching its five-year peak of 20x earnings, last seen in 2021. There could be further expansion based on this news, but further price increases could result in a disconnect from AMAT’s fundamental value.

Risk Analysis

The risk analysis for AMAT involves several critical factors that could potentially impact the investment thesis. These risks are essential to consider for a balanced and comprehensive understanding of the investment landscape.

1. Investigation into China Exports: A significant risk for AMAT stems from the ongoing investigation into its exports to China. This investigation could lead to potential regulatory actions, impacting AMAT’s business operations and reputation. Given that a large portion of AMAT’s sales come from China, any adverse outcomes from this investigation could significantly affect the company’s revenue and growth prospects. This risk is further exacerbated by the current geopolitical climate, where tensions between the U.S. and China could lead to stricter export controls or tariffs, affecting AMAT’s ability to operate effectively in this key market.

2. Dependence on Multiple Expansion and Qualitative Factors in Valuation Thesis: The investment thesis hinges on the assumption of multiple expansion, driven by the increased demand for semiconductors due to the focus on AI. While this presents a strong growth potential, it also introduces a significant risk. If the expected multiple expansion does not materialize, or if the market does not recognize the value of AMAT’s positioning in the AI-driven semiconductor space as anticipated, the valuation could be affected. This risk is notable, particularly since the current valuation suggests that the firm is fairly priced without considering an expansion beyond historical levels.

3. Market Volatility and Technological Shifts: The semiconductor industry is characterized by rapid technological changes and intense competition. Any shifts in technology that render current methodologies obsolete or any significant advancements by competitors could impact AMAT’s market position. Additionally, the cyclical nature of the semiconductor industry means that AMAT is subject to market volatility, which could lead to fluctuations in demand and pricing, impacting revenue and profitability.

4. Supply Chain and Operational Risks: Given the complex nature of semiconductor manufacturing, AMAT faces operational risks related to supply chain disruptions. Issues such as shortages of raw materials, logistical challenges, or production delays can significantly impact AMAT’s ability to meet customer demand. This risk is heightened by the global nature of AMAT’s supply chain, making it susceptible to geopolitical tensions and global economic fluctuations.

5. Regulatory and Compliance Risks: The semiconductor industry is heavily regulated, and changes in regulations, particularly related to environmental, health, and safety standards, could impact AMAT’s operations. Compliance with these evolving regulations requires ongoing investment and adaptation, which could affect the company’s cost structure and operational efficiency.

Conclusion

To summarize, within my analysis of Applied Materials, Inc., it’s evident that the company stands as a formidable entity in the Semiconductor Services Sector, backed by strong performance and strategic positioning in an industry driven by rapid technological advancements, particularly in Artificial Intelligence.

The recent surge in AMAT’s stock price, especially following Taiwan Semiconductor Manufacturing’s positive quarterly results, indicates a market acknowledgment of AMAT’s growth prospects and operational strengths. However, this appreciation in stock value also suggests that AMAT is currently trading closer to its intrinsic value, leading to my recommendation of a “Hold” rating with a target price of $173.17, rounded to $173.