Applied Materials: Leader In Materials Engineering Solutions With A Big Discount

Applied Materials, Inc. (AMAT) is one of the most appealing stocks for value investors within the semiconductors sector because of its good value with a proven track record. With revenue up almost 30% from the same period a year ago, 2018 is off to a great start. Besides, I am certain that Applied can convey solid twofold digit growth over the Semiconductor, Display, and Service businesses. I see a feasible quality in its markets as new demand drivers, including IoT, big data, and AI layer on top of traditional computing and mobility. In spite of these solid fundamentals, it trades at an attractive discount of 31.18%.

Company Overview

Applied Materials (also called Applied) provides manufacturing equipment, services, and software to the semiconductor, display, and related industries. Applied’s clients incorporate makers of semiconductor wafers and chips, liquid crystal and organic light-emitting diode (OLED) displays, and other electronic gadgets. These clients may utilize what they manufacture in their own end products or sell the items to different companies for use in cutting-edge electronic parts.

Applied functions in three reportable divisions: Semiconductor Systems, Applied Global Services, and Display and Adjacent Markets.

Applied’s outcomes are driven essentially by client spending on capital hardware and services to help key innovation transitions or to expand production volume in light of global demand for semiconductors and displays. While certain current technologies might be adapted to new requirements, a few applications create the need for an entirely different technological approach.

Some of the biggest players in the sector are Intel Corporation (INTC), NVIDIA Corporation (NVDA) and Texas Instruments Incorporated (TXN).

Company Dynamic

With revenue up about 30% from the same period a year ago. 2018 as of now looks like another awesome year, and I expect every one of Applied’s three major business divisions to convey solid twofold digit growth. There is a tremendous dynamic across the company and I am certain this dynamic is maintainable for two reasons.

To begin with, I see an extending set of market drivers as the ever-increasing number of industries are disrupted by developing technologies, from retail to entertainment, healthcare, assembling, and transportation. The way companies create value and contend progressively relies on their capacity to capture, store, and comprehend tremendous measures of information. The general market for electronics is expanding, and as those gadgets get astute, semiconductor and display content grows considerably faster.

Second, Applied is in an extraordinary position to outpace its business sectors. Applied is transforming its investments into a solid pipeline of differentiated products, and it is utilizing an expansive set of abilities to put up very empowering new technologies to market faster than any time in my memory.

Major Trends Driving Tenable Progress

This is an unfathomably energizing time in the electronics industry since many companies are toward the beginning of another period of development. The Internet of Things, big data, and artificial intelligence will change the economy throughout the following decade. Thus, an expansive range of companies is making considerable interests in these advances to position themselves for what’s to come.

While these are only the beginning periods of AI and big data, there are, as of now, applications that have noteworthy footing and are beginning to scale. The principal case is AI Natural Language Processing which is being coordinated with more gadgets and driving silicon content at the edge and in the cloud.

Voice assistants are quickly turning into the centre point for home robotization. An average voice assistant has around 30 chips and a sum of 200 square millimetres of silicon, that is about double the area of a cell phone application processor. Language processing is compute-intensive and the outstanding companies are building dedicated data centres to support it.

These AI tasks demand new server architectures that have up to 8 times more logic and 4 times more memory content by area than traditional enterprise servers. Another critical AI progress for 2018 is neural processing units in cell phones. This is an incredible case of AI at the edge, where machine learning is utilized to empower a telephone’s camera to recognize and respond to what it’s seeing.

The third illustration is self-driving autos. It’s accounted that $80 billion has just been invested in technology companies and traditional automakers race to get Level 4 vehicles to the market. I believe Level 4 vehicles will have around 8 times more silicon content than a standard auto has today. These powerful rising patterns layer on top of traditional demand drivers, for example, cell phones, data centres, and storage, which continue to develop and advance. We see outstanding cloud service providers declaring significant increments in their capital investments to grow data centre limit.

Financial Overview

Applied conveyed its eighth consecutive quarter of year-on-year growth in both revenue and non-GAAP EPS, which was $1.06, or $1.02 when barring a $0.04 tax benefit. On a year-over-year non-GAAP basis, it expanded gross margin by 1.3 points, decreased OpEx as a percent of sales by 2.3 points and increased operating margin by 3.6 points.

Turning to the divisions, Applied conveyed record revenue and operating profit in both semi equipment and services. In semi equipment, it increased revenue by 32% year-on-year and conveyed the most noteworthy operating margin in over seven years. I’m especially awed by the growth of its services business. AGS increased revenue by 30% year-over-year, which was over my anticipation for the most part because of higher-than-expected spare parts demand. AGS additionally conveyed record operating margin.

In Display, revenue and operating margin were both lower sequentially following a record Q4, which I expected because of the knottiness of the business. I anticipate Display revenue and operating margin to increase higher in the balance of the year.

5-year cash flow forecast

2018 2019 2020 2021 2022
Levered FCF (USD, Millions) $4,243.43 $4,731.50 $5,171.00 $5,930.53 $6,801.62
Present Value Discounted (@10.19%) $3,851.07 $3,896.97 $3,865.16 $4,023.00 $4,187.30
Present value of next 5 years cash flows $19,824

Present value of terminal value: $55,591

Equity Value = Present value of next 5-year cash flows + terminal value
$75,415 = $19,824 + $55,591

Value per share = Total value/Shares Outstanding

$71.78 = $75,415 / 1,051

Current discount (share price of $49.40): 31.18%

Source: SEC Filings Data

Applied 5 years Stock Price & ROE, ROA, PE ratio

Price Based on Past Earnings and Expected Growth

$AMAT US Semiconductor US market
P/E ratio 18.4x 24.6x 18.4x
PEG ratio 1.0x

Source: SEC Filings Data

My analysis model shows that Applied currently is below its future cash flow value at a 31.18% discount and is good value (1) based on earnings compared to the US Semiconductor industry average and the US market (2) based on expected growth next year. I also expect Applied to efficiently use shareholders’ funds in the future 3 years ($AMAT ROE 43.1% vs. semiconductors average ROE 12.8%).

Applied’s year on year earnings growth rate has been positive over the past 5 years. Its 1-year earnings growth exceeds its 5-year average (34.3% vs. 18.2%). Besides, its earnings growth has exceeded the US Semiconductor industry average in the past year (34.3% vs. 27.5%).

Performance Last Year

$AMAT US Semiconductor
Return on Equity 34.0% 12.8%
Return on Assets 15.0% 7.4%
$ AMAT $AMAT (3 years ago)
Return on Capital Employed 27.0%

15.0%

Source: SEC Filings Data

Applied Materials has efficiently used shareholders’ funds last year (Return on Equity greater than 20%). Applied Materials also used its assets more efficiently than the US Semiconductor industry average last year based on Return on Assets. It has significantly improved its use of capital last year versus 3 years ago (Return on Capital Employed).

In the viewpoint of financial health, Applied Materials is able to meet its short-term (1-year) commitments with its holdings of cash and other short-term assets. Its cash and other short-term assets are able to cover its long-term commitments. Besides, its debt is well covered by operating cash flow (80.7%, greater than 20% of total debt) and its interest payments on debt are well covered by earnings (EBIT is 30.6x coverage).

In the viewpoint of dividend, Applied Materials’ dividends per share have been stable in the past 10 years and increased over the past 10 years. Its dividends paid are thoroughly covered by net profit (6.7x coverage) and I expect its dividends after 3 years to be well covered by net profit (5.9x coverage).

Risks

The industries that Applied Materials serves can be unstable and hard to foresee.

Applied Materials is exposed to risks related to an uncertain global economy.

Applied Materials is exposed to risks because of continuous changes in the different businesses in which it functions.

Conclusion

Applied Materials has a favourable business outlook, and regardless of the solid profile, its valuation is appealing given that it is trading at 31.18% discount below future cash flow value. Additionally, its ROE, ROA, and ROCE are showing that Applied Materials is good value (1) based on earnings compared to the US Semiconductor industry average and the US market (2) based on expected growth next year, besides the fact that Applied is also undervalued based on its cash flows. It has substantial upside potential (target price $71.78 per share) to climb to the average of its competitors or trades at a slight premium.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.