Applied Materials (AMAT)
Under the Hood

September 3, 2009

Applied Materials makes capital equipment, which is equipment used to manufacturer further equipment or goods. In Applied Materials' case it manufactures the machines used to make semiconductors and related electronic equipment. It has four major segments: semiconductor; display; solar; and services.

Capital equipment can be a bad place to be in a down cycle. With demand slack, manufacturers don't need to expand their capacity. Even after the macroeconomic cycle has hit bottom it may take months or years for capacity to become constrained enough to force businesses to make significant investments in new capital equipment.

Each type of capital equipment, however, has its own quirks. The main quirk to be aware of in the semiconductor industry is that the expansion of capabilities of logic and memory chips is dependent on ever-shriking circuit elements. In the industry the vocabulary is in "process technologies" measured in nanometers (nm). For instance, not that long ago the cutting edge was 90 nm; today it is 45 nm; 33 nm is expected shortly.

So while the 2008-2009 recession left manufacturers with plenty of capacity, much of it is now the wrong capacity. For a specific NAND (Flash) memory chip, for instance, the oldest manufacturing capacity may no longer cost effective because the prices for the chips have dropped so dramatically. To keep up to pace, smaller process technologies must be used.

While semiconductor making equipment sales dropped sharply for AMAT during the recession, they did not drop to zero. Part of this was because orders had been made long in advance. Partly it was because some confident, well-funded manuacturers continued to buy the newest equipment in order to be set to have better profit margins than competitors.

When will the need for new equipment compensate for the decreased overall end demand? It has not happened yet. For Q2, semiconductor segment revenue ramped from Q1 to $498 million, but was down 34% from $756 million in Q2 2008, which itself was a soft quarter. Management said orders picked up significantly in the June.

The most likely scenario is that 2010 will be a good year for Applied Materials. Between the ongoing shift to smaller process technologies and the shift in computer memory to DDR3, a lot of new equipment is going to be required. Whether the ramp up will be strong in the second half of 2009, however, is an open question.

Applied Materials has also invested heavily to develop technologies for manufacturing solar cells. Several solar cell factories are now operating that use Applied equipment. Financing restraints have cut back planned equipment purchases, but this is likely to be a temporary effect. When the global economy revives and oil prices start heading up again, there will be another rush to solar. This time Applied Materials will be ready with perfected manufacturing processes.

In display, which is flat panel displays, demand in the China market is breathing life back into the market. There was plentiful capacity in mid 2008, so most manufacturers paused their equipment purchases. Now, while prices are still low, unit sales globally have ramped to the point that factories are nearing their capacity constraints. So expect new equipment orders, especially in 2010.

Applied Materials did a pretty good job cutting back on expenses during the difficult times. As a result, in Q2 GAAP its GAAP loss was $55 million, but cash flow from operations was $194 million.

Applied Materials is predicting to at least break even on a GAAP basis in Q3.

The usual business risks from competition and shifting demand patterns remain present.

So keep diversified!

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