This Tech Giant’s Too Cheap to Ignore

05/18/2011 3:23 pm EST


Paul Larson

Editor, Morningstar StockInvestor

Leading chip-making tools supplier Applied Materials is undervalued by about a third amid a semiconductor boom, write Paul Larson and Andy Ng inMorningstar StockInvestor.

Applied Materials (AMAT) is the behemoth of the semiconductor equipment industry, with unmatched scale and a broad product portfolio.

With a strong competitive position and a share price meaningfully below its fair value estimate, this is the stock we have been looking at the most in recent weeks.

The firm has steadily been establishing its solar-equipment business in an effort to drive growth. An upturn in the semiconductor-equipment market has also been providing a boost for Applied in recent quarters.

Applied is the closest thing to a one-stop shop for chip manufacturers, as competitors are usually specialists in their respective segments. In 2009, the firm had a commanding 15% share of a $17 billion market, according to Gartner.

Applied enjoys big competitive advantages. Its installed base has expanded to more than 22,000 tools, and the firm has engineers in nearly every chip-manufacturing facility in the world.

Applied’s scale and trusted name have allowed it to develop close relationships with customers, giving the firm insight into current and future customer technology needs. Further, Applied’s substantial resources allow it to compete successfully in various market segments, in aspects ranging from pricing and marketing to research and development.

Few firms can rival Applied’s roughly $1 billion annual R&D budget. A strong balance sheet gives the company flexibility in a deeply cyclical industry, and allows it to enter new markets with relative ease, either through internal development or acquisitions.

Applied also benefits from capacity expansion as chip devices become increasingly prevalent in everyday electronics. Advances in semiconductor technology are also growth drivers for the firm.

As chip circuitries increase in complexity, semiconductor fabrication requires more process steps and new manufacturing technologies. Applied provides cutting-edge equipment to chipmakers, which allows them to produce state-of-the-art chips.

Beyond semiconductors, Applied has been building a foundation for its emerging solar-equipment business. Applied’s core technology expertise is extendable to solar-cell manufacturing tools, which has allowed the company to enter this adjacent market. The firm has made several acquisitions to bolster its competitive position in the solar-equipment market, and has shown signs of early success.

After a severe cyclical downturn in 2008 and 2009, the semiconductor equipment industry has seen business conditions rebound in recent quarters—and is now in the midst of an upturn, thanks to robust capital spending by chipmakers. We expect the boom in business conditions to continue for the foreseeable future, which should provide tailwinds for Applied’s main chip equipment business.

Our fair value estimate is $22 per share. [Shares traded near $14.50 Wednesday, 34% below that target—Editor.]

After revenue jumped 90% in fiscal 2010, we forecast sales will rise 8% in fiscal 2011, followed by a decline of 12% in fiscal 2012 as we project another downturn. In the long run, we expect average revenue growth to run in the
10% range.

Applied has done a good job of increasing operational efficiency and reducing costs, particularly in its core semiconductor-equipment segment. After a loss in fiscal 2009, the firm posted an operating margin of 15% in fiscal 2010, thanks to improved business conditions.

We anticipate an operating margin of 23% in fiscal 2011 and forecast that operating margins will run in the low 20s over the longer term.

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