Why Applied Needn’t Worry About The Current Slowdown In Foundry Spending

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Applied Materials

Recent macro headwinds have led to a slowdown in foundry spending, as customers are managing excess inventory, improving their yields, and reusing equipment. The slowdown in foundry investment has a negative impact on Applied Materials’ (NASDAQ:AMAT) ‘Silicon Systems Group’ business, which accounts for approximately 65% of its revenue and 60% of its valuation. While 2015 is expected to be a slow year for foundry investment, the industry is seeing (and the trend is expected to continue) strong investment in memory capacity. Additionally, foundry demand is expected to pick up again in 2016. Applied is the largest maker of chip equipment, and has a strong position in both foundry and memory segments, and thus we believe that its long-term potential remains intact, despite recent trends to the contrary.

While Applied’s top line continues to grow, a weaker-than-expected growth rate, unpredictable near-term demand for nanomanufacturing equipment, and the lumpy Display segment have all weakened investor sentiment around the company. Year-to-date the company’s stock is down almost 40%. Changes in the business environment over the past few months have created some near-term headwinds for Applied. Nevertheless, Applied reported a relatively decent fiscal Q3 2015.  While its Q3 2015 revenue fell marginally short of analyst expectations, the company reported its highest quarterly earnings in the past three years. (Read Our Q3’15 Earnings Article)

Our $19 price estimate for Applied Materials is at an approximate 30% premium to the current market price.

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See our complete analysis of Applied Materials here

Factors That Led To A Slowdown In Foundry Spending; Fab Equipment Spending Will Increase In 2015 & 2016

The semiconductor manufacturing equipment market is cyclical in nature, with two years of growth usually followed by two years of slump in demand. During a growth phase, the increase in demand results in higher sales for equipment makers, such as Applied. Because of the exorbitant cost of building, equipping and producing chips, it is essential for manufacturers to operate close to full capacity in order to remain profitable. Thus, when the demand for devices nears saturation, manufacturers delay investing in new equipment and instead recycle and reuse the existing equipment.

The demand for semiconductors have slowed down in the last few months, mainly on account of greater than expected decline in PC sales, weakness in tablets and a slowdown in smartphone sales. This, in turn, has impacted foundries’ demand for new equipment. Since memory and logic have comparatively broader applications across markets, these product categories continue to see strong growth.

The ongoing macro weakness forced TSMC and Intel, two of Applied’s key customers to cut their capex targets for 2015 by close to $1 billion each. While TSMC cited improvements in capital efficiency and a faster-than-expected migration to its leading-edge 16nm process technology, Intel attributes the downward revision in its capex goal for 2015 to manufacturing efficiency and changes in timing for purchases. The company has pushed out the launch of it 10 nm products to 2017.

We expect Intel, TSMC and Samsung (another key customer for Applied) to increase their fab equipment spending in 2016 to support the expansion of new technology transitions.

As per the most recent edition of the SEMI World Fab Forecast, front end fab equipment spending (including new, used, and in-house) is projected to increase 5% in 2015 (to US$ 37.0 billion) and another 6.6% in 2016 (to $39.4 billion). Foundry is expected to decline by 3% this year but will gain momentum in 2016, with a projected growth of 14%. While memory equipment spending is estimated to grow by 16% in 2015, it is forecast to drop by 1% in 2016.

World_Fab_chart_0915

Major Technology Inflections (FinFEt & 3D NAND) To Drive Applied’s Future Growth

Major technology inflections, like FinFET circuit structures and 3D NAND represent unprecedented technology advances that are enabled by materials innovation. Applied notes that the industry is still in the early stages of these inflections and as they play out over the next several years, they create great, long-term growth opportunities for the company. Applied claims to address more inflections than any other equipment company. [1]

Applied believes that FinFET technology adoption is the most attractive opportunity in foundry spending. It views the use of more advanced materials in FinFET production as an important growth driver, as devices using the FinFET technology are notable both in terms of power consumption and processing speed, important features for today’s computing devices. Applied claims to be in a strong position to gain from the adoption of the FinFET technology, as it has a high market share in EPI tools, an upgraded version of which will be extensively used for the technology. The FinFET technology can increase Applied’s addressable market by around 35%, in management’s view. [2]

Despite the short-term pause in capacity additions, Applied claims that the leading foundries are still aggressively pursuing 1o nm technology and expects this to become a key battleground in 2016 with the buildout of pilot production. The 10 nm node expands the available market for Applied and plays to the strengths of its businesses.

Applied also remains increasingly optimistic about the pace of the transition from planar to 3D NAND, with the buildout of the 3D NAND technology broadening and accelerating. It expects 3D NAND installed capacity to surpass 150,000 wafer starts per month by the end of calendar 2015. While this number is higher than anticipated at the start of the year, it only represents around 15% of total NAND capacity. Thus, 3D NAND offers tremendous opportunity of growth to Applied. As the adoption of 3D NAND accelerates, it will become a more meaningful driver of Applied’s growth. 3D NAND is also enabling the company to expand the available market for its Epitaxial products by 5% to 10%.

Applied’s focus on technology inflections and new products produce strong revenue and share growth opportunities for the company in the long-run, in our view.

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Notes:
  1. Applied’s 2015 Analyst Meeting Presentation []
  2. Applied Material’s Management Presents at Citi Global Technology Conference – (Transcript), Seeking Alpha, September 4, 2013 []