How Semiconductor Business Could Significantly Impact Applied Materials’ Valuation

Owing to a surge in major technology transitions in semiconductor and display manufacturing, and high growth in Applied Global Services (AGS), Applied Materials (NASDAQ:AMAT) delivered its highest quarterly revenue in the past year in fiscal Q2, up 4% both quarter-over-quarter and year-over-year. High Wafer Fab Equipment (WFE) spending driven by increased investment in 3D NAND and the transition to FinFET by its customers, such as TSM and Samsung (SSNLF), led to increased DRAM spending. The above factors have helped Applied continuously expand its top line in the last few quarters. 

By increasing investment in key areas, Applied claims to have created a pipeline of differentiated products that will accelerate the company’s growth. Major inflections, like FinFET and 3D NAND in semiconductors and OLEDs in new displays, represent unprecedented technology advances that are enabled by materials innovation. Applied claims that the industry is still in the early stages of these inflections and, as they play out over the next several years, they create long-term growth opportunities for the company.

Applied remains gloomy regarding the risks it is exposed to as a result of ongoing changes specific to the semiconductor industry and competition created by small and highly specialized players. Nevertheless, the company believes that its unique position in precision materials engineering will help it outgrow the industry in the future. Applied spends more than $1 billion in R&D, which gives the company an edge over small-funded enterprises.

Our price estimate of $22 for Applied Materials is about 10% higher than the current market price. In this article, we look at certain scenarios where our valuation for the company could change significantly.

See our complete analysis of Applied Materials here

Global Semiconductor Equipment Market Size Increases To $55 Billion (~10% Upside)

Worldwide sales of semiconductor manufacturing equipment totaled $38 billion in 2014, representing a year-over-year increase of 18%. 2014 saw expansions in all major categories — Wafer Processing equipment increased 15%, while the Assembly and Packaging and Test equipment segments grew 32% and 31%, respectively. The Other Front-End segment (Other Front End includes Wafer Manufacturing, Mask, and Fab Facilities equipment) increased 15%.

2014 was a much welcomed year for equipment and material suppliers, as device manufacturers easily exceeded revenues of $300 billion. Even with the weakened Yen, both the semiconductor and equipment segments experienced growth. 2015 is promising to be another growth year for the entire market with device, materials and equipment suppliers poised to experience increases for the year. ^[1] The robust growth in semiconductor manufacturing equipment in 2014 implies strong growth in overall semiconductor capital expenditures.

The accelerated changes in device technology and the adoption of new materials in the industry are expected to re-accelerate demand for semiconductor equipment in the next two years. The advance of digitization and the Internet-of-Things (IoT) will further increase demand for semiconductor products. Taken together, these factors will drive solid growth for the global semiconductor equipment market over the next five years. Gartner estimates that capital equipment spending in the semiconductor industry will increase by 11% in calendar year 2015. Rising mobile shipments, a recovering DRAM market, growing NAND demand and the pending technology transitions (22nm and 16 nm, FinFET, and 3D NAND) are key factors driving demand for semiconductor equipment.

However, the semiconductor equipment industry has shown strong cyclical behavior historically. During a typical upturn of one to two years, most companies generate profits, which they use to sustain their operations during the downturn. But precisely because investment runs ahead of market demand in the upturn, the period is followed by a longer downturn or a very slow growth period. So, the rise in the sale for semiconductor equipment market might get hindered somewhat in the long run due to stagnation in the market.

We currently forecast the global semiconductor equipment market to increase from $38 billion in 2014 to $46.3 billion by the end of our forecast period. However, as a result of strong growth owing to technological advancements, the global market could gain at a much faster pace.  If the global semiconductor equipment market increases to $55 billion, keeping our market share forecast for the company constant, it would lead to a 10% increase in our valuation for the company.

Applied’s Market Share In Semiconductor Equipment Segment Declines To 10% (~15% Downside)

Applied saw strong growth in its Silicon Systems Group (SSG) segment last quarter with net sales of $1.6 billion, which came in above the high end of company guidance and increased 8% sequentially. According to Applied, WFE spending for calendar 2014 was approximately 15% higher than 2013. The company believes the market could grow another 5% or more in calendar 2015. Over the past two years, Applied has gained a share of 1.5 points in WFE while delivering innovative solutions and enabling new products to customers.

But Applied’s confidence is supported by its three major customers in the WFE segment. These three customers accounted for approximately 54% of net sales and 75% of new orders in this segment in fiscal 2014. A decline in business from any one of these customers could be a great setback for Applied, and could lead to a major fall in the company’s SSG market share.

The semiconductor industry has been increasingly driven by consumer demand for lower-cost electronic products with increased capability, particularly mobility devices such as smartphones and tablets. As a result, products within the SSG segment are subject to significant changes in customer requirements, including transitions to smaller dimensions, new materials and an increasing number of applications. While certain existing technologies may be adapted to new requirements, some applications create the need for an entirely different technological approach. The rapid pace of technological change can quickly diminish the value of current technologies and products and create opportunities for existing and new competitors. This could lead to a significant loss in Applied’s market share.

We currently forecast Applied’s SSG market share to reach 15.6% by the end of our forecast period. However, there is a possibility that we are overestimating Applied’s potential gains from the WFE segment mentioned above, underestimating the competition in the industry and the cyclical nature of the industry. If Applied’s SSG market share declines to 10% over our forecast period, our valuation for the company would decline by as much as 15%.

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1. 2014: A year in review [↩]