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Morningstar | Following Recent Sell-Off, Shares of Wide-Moat Applied Materials Look Attractive Relative to $49 FVE

We are adding wide-moat Applied Materials to the Best Ideas list, as we remain positive on the wafer fabrication equipment, or WFE, market heading into 2019. Applied has benefited greatly from the sharp rise in spending by memory and display customers over the past few years, though recent customer commentary suggests a near-term pullback in spending for each sub-segment (especially in 3D NAND and OLED). Although we think total WFE spending will be modestly lower in 2019, we foresee Applied leveraging the breadth of its product portfolio and services business to successfully navigate a softer WFE demand environment. Shares of Applied offer a compelling margin of safety versus our fair value estimate of $49, as we think the recent sell-off was overdone.

Applied is the leading vendor of semiconductor fabrication tools. While competitors tend to specialize in a single core competency, Applied competes in almost every key equipment segment with the exception of photolithography. As a result, all major chipmakers develop strong relationships with Applied that span multiple process steps of their chip production. The firm is the dominant player in the material deposition and removal areas, among others, and boasts an impressive global presence with an installed base of more than 30,000 tools and customer engineers stationed in nearly every chip-manufacturing facility in the world. With semiconductor fabrication becoming increasingly complex, resulting in more process steps and new manufacturing technologies, collaboration between chipmakers and equipment providers is set to reach unprecedented levels.

Applied has also expanded its global services business fairly significantly, which provides a stable revenue stream distinct from tool purchases. What began as simply a corrective maintenance and spares provider has evolved into the on-site presence of roughly 3,000 customer engineers that collaborate with chipmakers to troubleshoot high-value problems to improve yields and output, ultimately driving productivity and reducing cost. As traversing the path prescribed by Moore’s law becomes increasingly difficult, we believe this part of the firm will help entrench Applied’s installed base of tools in customers’ chip-manufacturing facilities.

We attribute the recent weakness in semiconductor stocks to an assortment of factors including macro-related concerns such as tariffs, the escalating trade war between the U.S. and China, inventory builds, and memory price declines. However, the end-market diversity beyond PC and smartphones for semis, which includes the shift to the public cloud, rise in automotive chip content, investments in 5G, and Artificial Intelligence should collectively allow for less cyclical behavior for overall WFE patterns, in our view. We think memory customers are better equipped to navigate “downturns” with greater cash cushions and profitability levels from the recent memory upswing, thanks to more rational behavior from a supply/demand standpoint. As such, short-term delays in equipment spending by Samsung and Micron shouldn’t last nearly as long as past downturns, which bodes well for Applied and its peers.