Should one consider Purchasing Applied Materials?
Applied Materials (AMAT, decreased by 3.78%) has been a remarkable performer in the stock market, but it has taken a significant step back from its peak values.
Applied is the top semiconductor equipment company in terms of revenue and has the broadest market reach. Despite the surge in artificial intelligence (AI), requiring vast quantities of advanced chips and high-speed DRAM memory, which Applied's equipment aids in manufacturing, investors have still observed a 32% drop from the all-time highs that occurred in July.
Now trading at a reduced valuation and with AI-driven technologies still on the horizon, is this consistent long-term achiever a compelling investment opportunity?
Advantages of Applied Materials
The semiconductor equipment industry is highly specialized and mostly controlled by a limited number of major players. This means that for each stage of semiconductor production, there are typically only a couple of options available. This offers a considerable competitive edge to all semiconductor companies, resulting in high profit margins and returns on capital investment.
In addition to these advantages, the semiconductor industry has consistently outpaced the economy's growth rate. This is due to the increasing use of semiconductors in numerous consumer and enterprise-related devices every year. With AI expected to further amplify this trend, the demand for semiconductors is anticipated to continue growing.
Furthermore, as the complexity of advanced semiconductor manufacturing has increased, capital intensity has also risen. This situation benefits semiconductor equipment producers like Applied Materials, as their superior growth and high returns on capital have been key factors in their outstanding market performance.
Reasons for Applied Materials' recent downgrade
Early this month, analysts at Morgan Stanley reduced their assessment of Applied Materials, leading to a decline in the stock price to its lowest point this year.
Why the downgrade? The analysts from Morgan Stanley raised several concerns. The first issue is China. Over the past two years, Chinese chip producers of logic and DRAM have accelerated their orders for equipment, seemingly attempting to overcome potential sanctions, despite the weak Chinese economy.
This accelerated demand has helped maintain Applied's revenue and earnings per share (EPS) over the past few years, despite reduced demand for semiconductor equipment from other suppliers. However, with new sanctions recently implemented, analysts expect Chinese demand to decrease in the coming year, as customers process their existing purchases.
Additionally, while AI chips and HBM memory are currently gaining popularity, the more conventional portions of chip production are still struggling to recover as much as anticipated. As a result, growth objectives beyond Taiwan Semiconductor Manufacturing (TSM) have been scaled back, which continues to bolster TSMC's position in the AI-related market. In particular, Samsung, which was aiming to challenge TSMC, has experienced technological execution issues, limiting its demand for new equipment.
In summary, the Morgan Stanley team forecasts a "transitional" year for Applied Materials in 2025, with the semiconductor fabrication equipment industry as a whole predicted to decrease by 6%.
However, this sell-off might be an opportunity
Given its current valuation and a potential decrease in equipment sales, Applied Materials appears to offer excellent value at this point in time. Despite the perceived slowdown in projected equipment sales for the next year, Applied may perform better than the industry average.
Applied has also gained market share in recent years, and its services business, tied to its installed base, is projected to grow every year. This growth in services could offset a potential mid-single-digit decline in new equipment sales, even if this decline does materialize.
In the event of a decline, EPS could remain stable or even increase thanks to stock buybacks. Applied will likely continue to buy back shares at a steady rate, given its high profit margins and cash generation. Furthermore, Applied has a substantial cash reserve of over $8 billion, compared to approximately $6 billion in debt.
Although Morgan Stanley may express pessimism, this view may be relatively uncommon on Wall Street. The overall consensus still anticipates Applied's EPS growing to $9.50 per share during this fiscal year, up from $8.65 in the previous fiscal year 2024. This would place the stock at just 18 times next year's forecasted EPS, which is a comparatively low multiple.
Even in its recent downgrade, the Morgan Stanley analysts acknowledges that "the long-term drivers of [wafer fab equipment] market growth remain intact, as supply chain diversification continues to be a top priority, and semiconductor capital intensity is not decreasing."
Thus, while Morgan Stanley views its assessment as short-term, the company still believes in the long-term trends of AI, more complex chip architectures, countries aiming for localized leading-edge production, and Applied's strong market position. Consequently, investors might consider this as an opportunity to acquire shares for the long term.
Despite the recent downgrade from Morgan Stanley, the long-term trends in AI, complex chip architectures, and localized semiconductor production still make Applied Materials an attractive investment opportunity for those with a long-term perspective. Given the company's high profit margins, strong cash reserves, and continued growth in its services business, a potential mid-single-digit decline in new equipment sales may not significantly impact its earnings per share due to stock buybacks.
