Tuesday, March 13, 2007

Applied Materials (AMAT) Slowdown

Applied Materials (AMAT) makes the equipment that makes electronic semiconductor devices (chips). In a sense they compete in the most basic industry of the modern electronics industry.

In AMAT’s last analyst conference they reported a 10% sequential decrease in quarterly revenues for the quarter ending January 28, 2007, but they were still up 23% from the quarter ending January 28, 2006. Asked to explain themselves, they said the main factor causing the sequential decline was decreased spending by display manufacturers. A seasonal slowdown in demand for chips also meant that semiconductor manufacturers were able to slow the pace of equipment purchases.

That makes sense given reports from the rest of the electronics industry. While large flat-panel displays are becoming commodity items, partly this was due to remarkable price reductions going into the holiday season of 2006. This cut into profit margins at retailers like Walmart, Best Buy and Circuit City; it also cut into the margins of the manufacturers of the displays, from high-end players like Sony to low-end players that are running full tilt trying to gain market share in this booming market. If margins are low one elective expense to cut back on is production machinery. Since demand is expanding it is not a matter of purchases of machinery going to zero. Instead excess capacity is minimized and machines are purchased only when they are really needed to meet new demand.

The same basic scenario is true of semiconductor makers. In the spring of 2006 there looked like there might be supply constraints. The people who put the chips into the boards that go in everything from cell phones to toys beefed up their inventories rather than risking being unable to meet demand in the holiday season. But then with the holiday build finished, they looked at 2007. The outlook was unclear. Even with demand good they were able to cut inventories. This meant chip manufacturer’s inventories started climbing (some more than others). So no need to purchase machines to make more chips. Again, it is not that demand went to zero. If you look at their capital budgets they kept spending; at their analyst conferences they all gave numbers for further capital spending in 2007 (which analysts use to try to predict the future for firms like Applied Materials).

A key to understanding the chip equipment makers is the transition question. Right now the leading edge is getting ready to change from the 65 nm process to the 45 nm process. But most cutting edge firms, like AMD, are still transitioning production to 65 nm. Many chips are still produced on older processes like 90 nm or larger (nm is nanometer; less nanometers mean smaller chips or more circuits on the same sized chip). Equipment makers are constantly getting ready for the next big thing, selling the cutting edge stuff, and continuing to sell the less expensive older machines. Older machines get sold off to foundries that make low-end chips.

What are the general categories of equipment that AMAT makes? Deposition processes add a thin, sometimes single-atom, layer to a substrate. Planarization makes silicon perfectly flat. Etching removes unwanted materials to create a circuit pattern. Inspection and measurement systems assure quality throughout the fabrication process. Ion implanting changes the electrical characteristics of a substrate. Thermal processes are used to change physical and electrical properties of substances and for some deposition processes. Cleaning equipment is needed to assure perfect inputs to the various other fabrication processes.

One of AMAT’s competitors is Varian Semiconductor (VSEA), which sold about $794 million in equipment in 2006. Its stock price is today over $50 per share, almost double what it was a year ago. Varian specializes in ion deposition.

AMAT sold $9.1 billion of equipment in 2006 and had profits of over $1.7 billion or $1.17 per share. Even with the Q4 sequential decrease they made $403 million in net profit.

AMAT can continue to grow as the semiconductor industry grows. With a price to earnings ratio of 15.75, or a 6.35% earnings return if you buy at today’s stock price, it is a pretty safe bet. It also yields over 1% in dividends.

With upside potential driven at base by growing demand for electronic goods in developing nations, the only downside risk in the short-to medium run for AMAT would be a global recession. Around April the consumer electronics manufacturers will need to place their bets. They will try to predict demand just right, balancing the risk of not having enough product with the risk of overestimating demand. Those decisions will be passed down the chain to chip makers and eventually to chip equipment makers like AMAT.

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