Applied Materials: Sanding Atoms

Sector

Semiconductors

Background

Dylan Patel is the author and Chief Analyst of SemiAnalysis. We cover the geopolitical factors impacting the semiconductor industry, how the rise of AI is fueling growth in demand for semis, and compare Applied's business model to its more cyclical competitors.

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Date

July 5, 2023

Episode Number

118

Background and Overview

Founded in 1967, Applied Materials has evolved into the leading supplier of semiconductor manufacturing equipment, headquartered in Santa Clara, California. The company serves major foundries like TSMC, Samsung, and Intel, providing tools for producing advanced chips (e.g., 5-nanometer nodes). Unlike ASML, which specializes in lithography equipment, Applied Materials boasts a broad portfolio spanning multiple equipment types, including chemical mechanical planarization (CMP), deposition, etching, and ion implantation. With approximately 34,000 employees and a portfolio of 17,300 patents, the company invests heavily in innovation, spending $3 billion annually on R&D.

Historically, Applied Materials grew through mergers and acquisitions (M&A), consolidating its position across various equipment categories. However, after a failed attempt to merge with Tokyo Electron in 2014 due to regulatory hurdles, the company shifted focus to organic growth, emphasizing R&D and operational excellence. Its business model is characterized by a mix of high-margin equipment sales and a growing services segment, which includes maintenance, spare parts, and upgrades, reducing exposure to industry cyclicality.

Ownership and Valuation

Applied Materials is publicly traded (NASDAQ: AMAT) with an enterprise value exceeding $100 billion, up from $30 billion five years ago. While specific ownership details (e.g., private equity or sponsor involvement) are not provided, its valuation reflects strong market confidence in its growth trajectory and resilience. The company’s market cap growth aligns with the semiconductor industry’s increasing importance, driven by demand for advanced chips in AI, mobile, and cloud computing. No specific transaction multiples are mentioned, but the enterprise value growth suggests a premium valuation, likely trading at a multiple of 15-20x EBITDA, consistent with high-growth, capital-light tech equipment firms.

Key Products, Services, and Value Proposition

Applied Materials’ core value proposition lies in providing highly specialized, precision-engineered equipment essential for semiconductor fabrication. Its products are critical for achieving the nanometer-scale precision required in modern chip manufacturing, where billions of transistors are arranged with sub-nanometer accuracy. The company’s portfolio includes:

1. Equipment Sales (75% of revenue):
• Chemical Mechanical Planarization (CMP): Polishes wafers to sub-nanometer precision, a niche where Applied Materials holds a near-monopoly for advanced nodes (90% market share in 5-nanometer CMP tools). Represents ~3% of fab equipment spend.
• Deposition (e.g., PVD, CVD, ALD): Deposits thin films of materials onto wafers, critical for transistor and wiring layers.
• Etching: Removes material to create precise patterns on wafers.
• Ion Implantation: Embeds ions to alter electrical properties of silicon.
• Epitaxial Growth, RTP, Annealing: Supports advanced transistor structures and thermal processes.
• Pattern Engineering: A new tool aimed at competing with lithography in specific process steps, potentially capturing market share from ASML.
2. Services (25% of revenue):
• Maintenance, calibration, spare parts, and equipment upgrades, ensuring high yields and longevity of installed equipment.
• Higher-margin than equipment sales, contributing to operating margin stability.

The value proposition is rooted in:

• Precision and Reliability: Equipment achieves beyond Six Sigma quality, critical for high-yield chip production.
• Co-engineering: Close collaboration with customers (e.g., TSMC) to develop next-generation tools, embedding Applied Materials in the R&D process.
• Broad Portfolio: Unlike ASML’s lithography focus, Applied Materials’ diverse offerings make it a one-stop shop for foundries, reducing dependency on multiple suppliers.

Segments and Revenue Model

Applied Materials operates two primary economic units:

1. Semiconductor Equipment: Tools sold to foundries for chip fabrication, generating ~75% of revenue.
2. Services: Recurring revenue from servicing installed equipment, contributing ~25% of revenue.

Revenue Model:

• Equipment Sales: Revenue is driven by unit sales of high-cost equipment (priced in the millions per tool), with pricing tied to technological complexity and node size (e.g., 5-nanometer tools command premium pricing). Volume depends on foundry CapEx cycles, influenced by end-market demand (e.g., AI, mobile, cloud).
• Services: Recurring revenue from long-term service contracts, spare parts, and upgrades. This segment is stickier, as equipment requires ongoing maintenance to maintain yields. Services are higher-margin due to lower variable costs and customer lock-in.

Revenue Drivers:

• Pricing: Premium pricing for advanced tools reflects mission-criticality and lack of substitutes. Pricing is stable due to oligopolistic market structure and mutual respect among players (no race to the bottom).
• Volume: Driven by foundry CapEx, which correlates with semiconductor demand. AI-driven demand for 3- and 2-nanometer chips increases process steps by 30%, boosting equipment needs.
• Aftermarket Services: The installed base of equipment generates predictable, high-margin service revenue, akin to “power by the hour” models in aerospace. Services are sticky due to the complexity of equipment and customer reliance on Applied Materials’ expertise.
• Geopolitical Subsidies: Government incentives (e.g., U.S. CHIPS Act: $52 billion + $30 billion tax credit, Japan: $30-40 billion, China: $200-250 billion) drive foundry CapEx, indirectly boosting equipment demand.

Splits and Mix:

• Customer Mix: High concentration, with 20-30% of revenue from TSMC, Samsung, and Intel. These relationships are deeply collaborative, involving co-engineering for next-generation nodes.
• Geo Mix: Significant exposure to Asia (Taiwan, South Korea, China), where most advanced fabs are located. China accounts for 25-30% of new fab construction, posing both opportunity and risk.
• Product Mix: Diverse portfolio across CMP, deposition, etching, etc., with no single category dominating revenue. CMP is a monopoly-like franchise, while others face competition from Lam Research or niche players.
• Channel Mix: Direct sales to foundries, with no intermediaries. Services are sold alongside equipment, often bundled into long-term contracts.
• End-Market Mix: Exposure to mobile (e.g., Apple), AI (e.g., NVIDIA), cloud (e.g., Amazon, Google), and legacy chips (e.g., automotive, IoT).

Historical Mix Shifts:

• Services have grown from ~20% to 25% of revenue over the past decade, reducing cyclicality.
• Advanced node equipment (5-nanometer and below) has increased as a share of equipment sales, driven by AI and mobile demand.
• China’s share of revenue has risen due to rapid fab expansion, but this introduces geopolitical risk.

Headline Financials

Applied Materials’ financial profile is robust, characterized by strong revenue growth, high margins, and significant FCF generation. Below are the key metrics:

Revenue Trajectory:

• Long-term revenue CAGR of 10%, accelerating to 15% over the last five years, outpacing the semiconductor industry’s growth (5-7% CAGR).
• Growth drivers: Increasing chip complexity (30% more process steps from 5- to 3-nanometer), rising foundry CapEx, and geopolitical subsidies.
• Services revenue is less cyclical, providing stability during downturns (e.g., 2008: 35% revenue drawdown, 2018: 20% drawdown).

Cost Structure and Operating Leverage:

• Variable Costs (~55% of revenue):
• Cost of goods sold (COGS) for equipment manufacturing, including raw materials and labor.
• Services have lower variable costs (e.g., technician labor, spare parts), contributing to higher margins.
• Drivers: Raw material inflation, labor costs, and supply chain efficiency. Applied Materials benefits from bulk purchasing and economies of scale.
• Fixed Costs (~30% of revenue):
• R&D ($3 billion, 13-14% of revenue) is the largest fixed cost, critical for maintaining technological leadership.
• SG&A, facilities, and overhead are relatively low, enabling operating leverage as revenue scales.
• During downturns, R&D remains stable (15-20% of revenue), ensuring long-term competitiveness.
• Operating Leverage: Fixed costs (R&D, SG&A) are spread over growing revenue, driving operating margins from 20% in troughs to 30% in peaks. Incremental margins are high, reflecting strong scalability.

Profit Margins:

• Gross margin: ~45%, stable due to pricing power and high-margin services.
• Operating margin: 20-30%, with services and operating leverage boosting profitability in upcycles.
• EBITDA margin: Not explicitly stated but estimated at 25-35%, reflecting low CapEx and high operating margins.

Capital Intensity and FCF:

• CapEx: Sub-15% of revenue, low for a manufacturing business, as Applied Materials focuses on R&D over physical assets.
• NWC: Efficient cash conversion cycle due to upfront payments from customers and low inventory requirements. No significant NWC cycles mentioned.
• FCF: ~80% of operating cash flow is converted to FCF, driven by high margins and low CapEx. FCF grows faster than revenue (15-20% CAGR), supporting capital returns.
• Capital Allocation:
• Share Buybacks: Aggressive repurchasing during downturns (e.g., 5-7% of float in 2008, 2017-18, 2022), reducing shares by 30% over eight years. This enhances EPS growth (20% CAGR).
• Dividends: Not emphasized but likely a smaller component of capital returns.
• M&A: Limited since the failed Tokyo Electron merger, with a focus on organic growth.
• R&D: $3 billion annually ensures technological leadership, a defensive investment to maintain market share.

Value Chain Position

Applied Materials operates upstream in the semiconductor value chain, supplying equipment and services to foundries (e.g., TSMC, Intel, Samsung). The value chain flows as follows:

1. Raw Materials: Silicon wafers, chemicals, and gases from niche suppliers (e.g., Japanese chemical firms).
2. Equipment Manufacturers: Applied Materials, ASML, Lam Research, etc., provide tools for wafer fabrication.
3. Foundries: TSMC, Intel, Samsung fabricate chips using equipment.
4. Chip Designers: NVIDIA, Apple, Qualcomm design chips for specific applications.
5. End Products: Chips are integrated into devices (e.g., iPhones, AI servers).

Position: Applied Materials is a critical enabler of foundry operations, providing tools that dictate chip quality and yield. Its equipment is mission-critical, with no viable substitutes for advanced nodes (e.g., CMP for 5-nanometer chips). The company is backward-integrated into R&D and co-engineering, collaborating with foundries to develop next-generation tools.

GTM Strategy:

• Direct Sales: Equipment is sold directly to foundries, often through multi-year contracts tied to CapEx cycles.
• Service Contracts: Bundled with equipment sales, ensuring recurring revenue and customer lock-in.
• Co-engineering: Deep collaboration with customers in research fabs, embedding Applied Materials in the development process.

Competitive Advantage:

• Precision Engineering: Equipment achieves sub-nanometer precision, critical for advanced nodes.
• Broad Portfolio: Unlike ASML’s lithography focus, Applied Materials’ diverse offerings reduce dependency on any single process step.
• Customer Entrenchment: Co-engineering and service contracts create high switching costs, as replacing equipment requires years of re-engineering.

Customers and Suppliers

Customers:

• Concentration: 20-30% of revenue comes from TSMC, Samsung, and Intel, reflecting the oligopolistic nature of the foundry market.
• Relationship: Deeply collaborative, involving years of co-engineering in research fabs to develop next-generation tools. Customers rely on Applied Materials for yield optimization and process innovation.
• Switching Costs: Extremely high due to equipment specialization and co-engineering history. Replacing a CMP tool, for example, would require retraining engineers and revalidating processes, costing years and millions.

Suppliers:

• Concentration: Limited suppliers for critical components (e.g., precision optics, chemicals), often niche players in Japan or Europe.
• Dependency: Suppliers are specialized, but Applied Materials’ scale provides bargaining power (e.g., bulk purchasing).
• Risk: Geopolitical disruptions (e.g., a Japanese chemical plant explosion in the 1990s halted 80% of industry production) highlight supply chain vulnerability.

Pricing

Contract Structure:

• Equipment: Sold on a per-unit basis, with prices in the millions per tool. Contracts are tied to foundry CapEx cycles, often spanning multiple years.
• Services: Long-term contracts for maintenance, upgrades, and spare parts, providing predictable revenue.
• Visibility: High visibility due to customer concentration and long-term CapEx plans. Foundries share multi-year roadmaps, enabling Applied Materials to forecast demand.

Pricing Drivers:

• Mission-Criticality: Equipment is essential for high-yield chip production, justifying premium pricing.
• Oligopolistic Market: Limited competition (1-2 suppliers per process step) prevents price wars. Mutual respect among players maintains stable pricing.
• Technological Complexity: Advanced nodes (e.g., 3-nanometer) require more complex tools, commanding higher prices.
• Customer Willingness to Pay: Foundries prioritize yield and performance over cost, as a 5% yield improvement can generate millions in additional revenue.

Price Sensitivity:

• Low, as equipment represents ~80% of foundry CapEx ($30 billion annually for TSMC), but individual tools (e.g., CMP) are a small fraction (3-5%). Customers prioritize reliability over price.

Bottoms-Up Drivers

Revenue Drivers:

• Equipment Sales:
• Volume: Driven by foundry CapEx, which grows with semiconductor demand (5-7% CAGR). AI increases process steps by 30%, boosting equipment needs.
• Pricing: Stable due to oligopolistic structure and high switching costs. Advanced node tools command premiums.
• Mix: Shift toward advanced nodes (5-, 3-, 2-nanometer) increases revenue per tool.
• Services:
• Volume: Grows with the installed base, as equipment requires ongoing maintenance.
• Pricing: Higher-margin due to lower variable costs and customer lock-in.
• Mix: Services rising to 25% of revenue, reducing cyclicality.
• Geopolitical Subsidies: $300-400 billion in global subsidies (U.S., Japan, China, Europe) drive foundry CapEx, increasing equipment demand.
• End-Market Growth: AI, cloud, and mobile drive demand for advanced chips, outpacing GDP growth.

Cost Drivers:

• Variable Costs:
• COGS (~55% of revenue) includes raw materials, labor, and manufacturing. Services have lower COGS (e.g., spare parts vs. equipment production).
• Drivers: Supply chain efficiency, raw material inflation, and labor costs. Scale provides cost advantages.
• Fixed Costs:
• R&D ($3 billion, 13-14% of revenue) is the largest fixed cost, critical for technological leadership.
• SG&A and overhead are low, enabling operating leverage.
• Drivers: R&D intensity, facility costs, and administrative efficiency.
• Operating Leverage: Fixed costs are spread over growing revenue, driving margin expansion (20% to 30% in upcycles).

FCF Drivers:

• Net Income: High operating margins (20-30%) drive strong profitability.
• CapEx: Low (<15% of revenue), as the business is R&D-intensive rather than capital-intensive.
• NWC: Efficient due to upfront payments and low inventory needs.
• Cash Conversion: ~80% of operating cash flow converts to FCF, supporting buybacks and dividends.

Capital Deployment:

• Buybacks: Aggressive during downturns (5-7% of float), reducing shares by 30% over eight years, boosting EPS (20% CAGR).
• R&D: $3 billion annually ensures technological leadership.
• M&A: Limited, with a focus on organic growth post-2014.
• Dividends: Secondary to buybacks but likely present.

Market Overview and Competitive Landscape

Market Size and Growth:

• Total Addressable Market: The semiconductor equipment market is ~$100 billion annually, with fab CapEx ranging from $90-100 billion (down slightly due to macro issues).
• Growth: Long-term growth of 5-10% CAGR, driven by:
• Volume: Increasing chip demand (AI, mobile, cloud) and more process steps (30% increase from 5- to 3-nanometer).
• Price: Stable pricing due to oligopolistic structure, with premiums for advanced tools.
• Subsidies: $300-400 billion in global incentives boost CapEx.
• Industry Growth Stack:
• Semiconductor industry: 5-7% CAGR, faster than GDP.
• Equipment market: 7-10% CAGR, faster than semiconductors due to process complexity.
• Applied Materials: 10-15% CAGR, outpacing the equipment market due to market share gains and services growth.

Market Structure:

• Oligopolistic: 8-9 companies sell >$1 billion in equipment annually, with Applied Materials (20% share), ASML (20%), and Lam Research (~15%) dominating.
• Minimum Efficient Scale (MES): High MES due to R&D intensity ($3 billion annually) and technological complexity, limiting new entrants.
• Competitors: ASML (lithography), Lam Research (etch, deposition), KLA (inspection), Tokyo Electron (various). Competition is niche-specific, with little overlap (e.g., Applied Materials and ASML rarely compete).
• China Risk: Chinese firms (e.g., Naura, ACMR) are gaining share in less advanced segments (e.g., cleans), potentially disrupting pricing if subsidies enable aggressive competition.

Competitive Positioning:

• Matrix: Applied Materials competes on technological leadership and breadth, targeting advanced foundries (TSMC, Samsung, Intel) with premium tools.
• Market Share: Stable at ~20%, with gains in monopoly-like niches (e.g., CMP: 90% share in 5-nanometer).
• Relative Growth: Revenue growth (10-15% CAGR) exceeds the equipment market (7-10% CAGR), reflecting share gains and services expansion.

Porter’s Five Forces and Hamilton’s 7 Powers:

1. Threat of New Entrants (Low):
• Barriers: High R&D costs ($3 billion), co-engineering relationships, and customer lock-in (switching costs). Subsidized Chinese entrants are a risk but lag in advanced nodes.
• 7 Powers: Economies of scale (R&D spread over $26 billion revenue), switching costs (co-engineered tools), cornered resource (17,300 patents), process power (sub-nanometer precision).
2. Threat of Substitutes (Low):
• No viable substitutes for advanced equipment (e.g., CMP for 5-nanometer). Customers prioritize yield over cost.
• 7 Powers: Switching costs, process power.
3. Supplier Power (Moderate):
• Niche suppliers (e.g., Japanese chemicals) have some power due to concentration, but Applied Materials’ scale mitigates this.
• 7 Powers: Economies of scale.
4. Buyer Power (Moderate):
• High customer concentration (20-30% from TSMC, Samsung, Intel), but mutual dependency and co-engineering limit buyer power. Foundries prioritize yield over price.
• 7 Powers: Switching costs, counter-positioning (broad portfolio vs. ASML’s focus).
5. Industry Rivalry (Low to Moderate):
• Oligopolistic structure with stable pricing and niche competition. Chinese entrants could increase rivalry if they scale.
• 7 Powers: Branding (reputation for reliability), counter-positioning.

Strategic Logic:

• CapEx Cycles: Defensive R&D investments ($3 billion) maintain technological leadership, while buybacks during downturns enhance EPS.
• Economies of Scale: High MES (R&D, manufacturing) creates a defensible position, but over-expansion risks diseconomies (e.g., bureaucracy).
• Vertical Integration: Limited, with focus on equipment and services rather than backward (raw materials) or forward (chip fabrication) integration.
• Horizontal Expansion: New tools (e.g., pattern engineering) target adjacent markets (e.g., lithography), potentially capturing share from ASML.

Risks and Bear Case

1. China Risk:
• Chinese equipment firms (e.g., Naura, ACMR) could gain share in less advanced segments, disrupting pricing with subsidized, lower-cost tools.
• U.S. export restrictions may limit Applied Materials’ access to China (25-30% of new fabs).
2. Cyclicality: Despite services growth, revenue can drop 20-35% in downturns, impacting EPS and valuation.
3. Technological Disruption: Failure to innovate in new process steps (e.g., gate-all-around transistors) could cede share to competitors like Lam Research.
4. Customer Concentration: Reliance on TSMC, Samsung, and Intel (20-30% of revenue) exposes the company to their CapEx decisions.

Key Takeaways and Unique Dynamics

Applied Materials’ business model is a masterclass in navigating a cyclical, high-stakes industry with precision and resilience. The following dynamics stand out:

1. Broad Portfolio as a Competitive Moat:
• Unlike ASML’s lithography focus, Applied Materials’ diverse offerings (CMP, deposition, etching, etc.) make it a one-stop shop for foundries. This breadth reduces dependency on any single process step and enhances customer stickiness, as replacing multiple tools is impractical.
2. Co-engineering and Switching Costs:
• Deep collaboration with customers (e.g., TSMC) in research fabs embeds Applied Materials in the R&D process, creating high switching costs. For example, replacing a CMP tool requires revalidating years of process tweaks, costing millions and diverting engineering resources from yield optimization.
3. Services as a Cyclicality Buffer:
• The services segment (25% of revenue) is a high-margin, recurring revenue stream that stabilizes earnings during downturns. Unlike equipment sales, services are non-discretionary, as foundries must maintain installed equipment to preserve yields. This mirrors John Deere’s maintenance model, reducing exposure to CapEx cycles.
4. Capital Allocation Excellence:
• Aggressive buybacks during downturns (5-7% of float) capitalize on cyclicality, reducing shares by 30% over eight years and boosting EPS (20% CAGR). This disciplined approach contrasts with over-leveraged M&A strategies, focusing on organic growth and shareholder returns.
5. Geopolitical Tailwinds and Risks:
• Global subsidies ($300-400 billion) drive foundry CapEx, boosting equipment demand. However, Chinese competition, fueled by $200-250 billion in subsidies, threatens market share in less advanced segments, introducing pricing risk.
6. AI-Driven Growth:
• AI’s compute demands drive demand for 3- and 2-nanometer chips, increasing process steps by 30% and requiring more equipment. Applied Materials benefits disproportionately due to its monopoly-like niches (e.g., CMP) and new tools (e.g., pattern engineering).

Unique Dynamics:

• Monopoly-Like Niches: Applied Materials dominates specific process steps (e.g., CMP: 90% share in 5-nanometer), where competitors are either absent or inferior. This creates pricing power and customer lock-in.
• R&D as a Defensive Moat: $3 billion in annual R&D ensures technological leadership, critical in an industry where yields are the lifeblood. This contrasts with Intel’s hubris in under-leveraging equipment suppliers, leading to yield failures.
• Oligopolistic Stability: Mutual respect among players (Applied Materials, ASML, Lam Research) maintains stable pricing, avoiding margin compression. However, Chinese entrants could disrupt this equilibrium.

Lessons for Investors and Operators:

• Long-Term Focus in Cyclical Industries: Applied Materials’ consistent R&D investment (13-14% of revenue, rising to 20% in downturns) ensures competitiveness, a model for firms in volatile sectors.
• Customer Entrenchment: Co-engineering and services create sticky relationships, a strategy applicable to B2B firms with concentrated customers.
• Capital Allocation: Buybacks during downturns amplify shareholder value, a tactic for cash-rich firms in cyclical markets.
• Service Models: Recurring, high-margin services can transform cyclical businesses, as seen in John Deere and software firms.

Conclusion

Applied Materials is a linchpin in the semiconductor ecosystem, leveraging a broad portfolio, co-engineering relationships, and a growing services segment to maintain leadership. Its financial profile—10-15% revenue CAGR, 20-30% operating margins, and ~80% FCF conversion—reflects strong operating leverage and disciplined capital allocation. The company’s monopoly-like niches, high switching costs, and R&D intensity create a defensible moat, while services buffer cyclicality. However, Chinese competition and geopolitical risks loom as challenges. The business model exemplifies how specialization, customer entrenchment, and strategic capital deployment can thrive in a complex, cyclical industry.