What’s Behind Applied’s $12 Valuation?

Applied Materials (NASDAQ:AMAT) provides manufacturing equipment, services and software to semiconductor manufacturers. It is the world’s largest semiconductor fabrication equipment supplier based on revenue. It is also a leading supplier of LCD fabrication equipment to the flat panel display industry and solar PV manufacturing systems to the solar industry.

Applied’s top-line has taken a hit on account of the slowdown in the semiconductor industry as many semiconductor manufacturers have reduced their capital spending on account of lower end-demand. While we continue to have a positive outlook on Applied’s long-term prospects, we believe the macro headwinds could impact its short term growth. At $12.02, our current price estimate for Applied Material is in-line with the current market price.

In this article we provide a snapshot of the important business segments and key trends that contribute to Applied’s growth.

See our complete analysis of Applied Materials here

What are the key markets and customers for Applied Material? What are the most important segments that contribute to its growth?

Applied Materials’ customers include manufacturers of semiconductor wafers and chips, flat panel liquid crystal displays (LCDs), solar PV cells and modules, and other electronic devices. Its customers either use the manufactured products in their own end products or sell the same to other companies for use in advanced electronic components.

Applied generated $10 billion revenue in 2011 and earned 47% gross profit on the same. Its business can be broken down into four key segments:

1. Silicon Wafer Fab Equipment – Applied develops, manufactures and sells a wide range of manufacturing equipment used to fabricate semiconductor chips, also referred to as integrated circuits (ICs). It offers systems that perform most of the primary processes used in chip fabrication. Applied’s semiconductor manufacturing systems are used by semiconductor manufacturers and foundries to build and package memory, logic and other types of chips.

The silicon wafer fab equipment segment contributes close to 53% to Applied revenue. It generates around 51% gross profit which makes it the most profitable division in the company’s portfolio.

Weak market conditions in the second half of 2011 caused pullbacks in expansion plans throughout the industry as manufacturers adjusted their production levels to match end-user demand. The conditions persisted in 2012 as well with Applied witnessing weaker than expected demand in its semiconductor equipment business, primarily among foundry customers.

Research firm Gartner estimates the worldwide semiconductor manufacturing equipment spending to have totaled 38.9 billion in 2012, a 11.6 % decline from 2011. ^[1] However, with increasing stability in economic conditions and a rebound in the global PC market, we expect to witness an increase in utilization levels to support the growing demand.

With a broad portfolio of products and global reach, we forecast Applied to retain its market share at around 13% for the rest of our forecast period. Additionally, we anticipate no significant change in Applied’s pricing policy and forecast the margins to remain more or less around the current level.

2. Applied Global Services – Applied’s global services segment offers product and services designed to improve performance and productivity and reduce the environmental impact of the fab operations of semiconductor, LCD and solar PV manufacturers. Applied offers a portfolio of fab operation services to maintain and optimize customers’ fabrication facilities.

Applied Materials generates 24% of its revenue and makes 44% gross profits from its applied global services segment. We forecast revenues from this segment to almost double by 2019. Apart from expenditure on purchasing manufacturing equipment, there is an increasing focus on improving overall utilization and reducing the total cost of ownership of the material.

3. Energy & Environmental Solutions (EES) – To increase conversion efficiency and yields from solar PV devices, Applied offers manufacturing solutions for wafer-based crystalline silicon (c-Si) and glass-based thin film applications. The EES segment contributes 17% to Applied’s overall revenue.

The solar equipment market is dependent on sales of solar PV and thin-film products to solar energy companies and currently the industry is suffering from low demand coupled with excess manufacturing capacity. Revenue from Applied’s energy and environmental solutions division registered a significant decline in 2012. The decrease in solar orders last quarter point toward a slower than anticipated revival in the solar market.

While there was a significant decline in the solar PV equipment market in 2012, we remain optimistic on the long-term prospects of this segment. With growing awareness about the benefits of renewable energy combined with declining costs, there is bound to be an increase in demand for solar power use.

Witnessing a steep decline in orders, Applied announced a restructuring plan for its Energy and Environmental Solutions (EES) business to lower its cost structure and the operating breakeven level to approximately $500 million at the start of 2012. The company also announced its workforce restructuring plan by implementing a voluntary retirement program & other workforce reduction action. It projects to save $140 – $190 million annually through this plan which it intends to invest in future key initiatives.

Thus, we estimate the EES division to return to profitability this year onward.

4. Display – Applied’s display segment designs, manufactures and sells equipment to fabricate thin film transistor LCDs for televisions, computer displays and other consumer-oriented electronic applications such as mobile devices. The company earns 6% of its revenue from the display division and makes round 42% gross profit on the same. We forecast revenue to steadily increase in the future and believe that Applied has strong fundamentals to sustain its current display gross margins.

We estimate the rapid growth in smartphones and tablets to be an important driving force for Applied’s display segment. With the current slowdown in growth of global PC shipments, the increasing adoption of smartphones and tablets is expected to fuel future growth in the semiconductor industry.

The global appetite for mobile devices with new features, longer battery life and brighter, higher resolution displays continues to strengthen. As these devices drive demand for leading-edge foundry capacity, the market leaders are aggressively accelerating ramps at advanced nodes.

Applied Materials has a significant presence in the smartphone and tablet market. It expects to generate more than $250 million revenue from products that serve new applications in this area in the future.

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1. Gartner Says Worldwide Semiconductor Manufacturing Equipment Spending to Decline 11.6 Percent in 2012, Gartner Press Release, March 21, 2012 [↩]