Chit Chat Stocks - Applied Materials (AMAT) | Not So Deep Dive

Episode Date: March 22, 2022

Applied Materials provides manufacturing equipment, services, and software to the semiconductor industry. The company sells primarily to chip manufacturers and display companies. Listen closely as Ian, Brett, and Ryan go through the history, financials, and future prospects of Applied Materials. Enjoy the show! This episode is sponsored by Commonstock, a social network for smart money investors. Check-out the platform here: https://commonstock.com/ Want updates on future shows and projects? Follow us on Twitter: https://twitter.com/chitchatmoney Subscribe to 7investing with the code "CCM" and get $10 off: https://7investing.com/subscribe/aff/4/ Interested in more of Ian's work? Follow him on Twitter: https://twitter.com/IanGrayLive  Contact us: [e-mail] Timestamps Company Background | (3:43) Industry | (8:43) Management & Ownership | (11:06) Valuation | (12:59) Earnings | (16:36) Balance Sheet | (19:10) Our Analysis | (22:19) Disclosure: Chit Chat Money hosts and guests are not financial advisors, and nothing they say on this show is formal advice or a recommendation. Brett Schafer and Ryan Henderson are general partners and portfolio managers at Arch Capital. Arch Capital and its partners may hold securities discussed on this show. Learn more about your ad choices. Visit megaphone.fm/adchoices Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Chit Chat Money. On this show, hosts Ryan Henderson and Brett Schaefer interview industry experts and riff on the world of investing. As a quick reminder, Chit Chat Money is a CCM Media Group podcast. Ryan and Brett are also general partners at Arch Capital, and Arch Capital may have positions in the securities discussed in this podcast. Anything discussed on Chit Chat Money by Ryan or Brett or any other podcast guests is not formal advice or a recommendation. Now, please enjoy this episode. Welcome in. This is the Tuesday Not-So-Deep-Dive episode on Chitchat Money. We have Ian Gray joining us today. We're talking Applied Materials, which is a company a lot of

people, well, not a lot of people, anyone that's used any sort of computing device before has interacted with, but they just don't know about it yet. And Ryan's going to introduce what they are. But first, I got to ask everyone, I think we already discussed this before. Have either of you guys heard of this company before, Ian? I don't think I'd really heard of this one, maybe in some Twitter threads or stuff like that, but I hadn't ever, I didn't really know what they did. All right, Ryan. No, I did not. And the industry in general is something I haven't looked at. So you gave us quite the homework assignment for this week. Yeah. Well, you know, we got to, what do they call it? Eat the veggies. This is good work

because eventually maybe 10 years from now, we'll understand all these companies properly. Just some baby steps here. And I'll let Ryan introduce and talk about what Applied Materials does. But first we have to talk about our sponsor today. And that is CommonStock, a social network for smart money investors. So CommonStock is a platform where you can message and long form and write posts, link to posts, all that good stuff, but more fundamental analysis based. It's more of a less chaotic form of how Twitter works. And you can also follow people similar to how Twitter works, but you can see how big someone's followers assets are. And you can connect your brokerage accounts to that without actually having to have a brokerage

account. So you can connect your Robinhood, your Schwab, whatever it is, all those connected to that, see all your watch lists. And then for people that follow you, you can see how much in a dollar amount your follower assets are. So it's very fun in that regard. And it's a lot better for actually reading about a company, reading some analyst analysis. For example, I put something out on there on Match Group. It's not as formal as, say, a written research report, but you can do a lot more than, say, the 280 characters limited on Twitter. And we all know how chaotic that can be. So it's really a Bloomberg terminal for main street. It's really focused on individual investors analysis without getting into the crazy, you know, data you get

from Bloomberg. It's for someone that wants, you know, even if it's just your hobby, uh, and you want to follow, follow some analysts or, you know, someone like Ian, he's on there a lot writing about stuff. Um, Ian, what, what did you were doing something with the common stock? What was that the other day? Yeah, I was writing a little bit about Wix trying to ask some questions. I'd say one of the best things about common stock is every time I post on there, I know that I'm going to get some thoughtful questions and responses. So it has some kind of longer form dialogue back and forth in a way that I don't typically get on Twitter. All right. And yeah, the most important thing is that it's trusted and transparent insights where you can see what people own if

they want to and all that good stuff. Great analysis over there. I'd recommend you download or go to commonstock.com. If you search it in Google, it'd be very easy to find. Sign up. It's free. All right, Ryan, do you want to introduce Applied Materials? Probably the hardest part of the show right here is describing what they do. Yeah. So I'll give the one-liner and then I'll try to break it down into maybe a simpler definition, but Applied Materials provides manufacturing equipment, services, and software to the semiconductor and display industries. And so the way I understand it is that Applied Materials is one of the, if not the world's leading material engineering firms and material engineering is basically just the science

of creating and modifying materials. I had to watch a lot of YouTube videos to kind of grasp, to actually grasp what they do. And if you're not familiar with the space, I recommend starting there. Don't start on the 10K because there's going to be a lot of terminology that you're probably not used to. I'm not used to it. But it's actually really fascinating the way it works. Basically, my understanding is that they are manipulating materials on an atomic level, but at an industrial scale. And they do it through a bunch of different processes. And Brett's an engineer, so maybe he can add something here. But the processes include, they talked about this one a lot, deposition or deposition, removal, modification, and analysis.

and I can't really do the process justice in terms of like defining it or explaining it in the right way. So I recommend, like I said, going to YouTube. But on the business side, Applied Materials sells primarily to chip manufacturers or display companies. So their two largest customers are Samsung and Taiwan Semiconductor and Applied Materials breaks its revenue down into three segments. So there's Semiconductor Systems, Applied Global Services and display and adjacent markets and so like i talked about the two big ones are pretty much semiconductor and then display and adjacent um and when i say display think like high-tech display screens like tvs or augmented reality or virtual reality screens basically they're making

uh the manufacturing equipment to provide to end manufacturers i know i'm probably kind of going in loops here. Brett, am I missing anything on that? Yeah. I mean, there's a lot of details, but I think in general, yeah, it's just the tools for Intel, Samsung, Taiwan Semi, all those manufacturers, the people that are making the displays. It's the tools that allows them to continue on Moore's law and get chips smaller and smaller and smaller and faster and faster and faster, more efficient. I think a key thing for them is that the process quality makes it so cool. Okay. So an important, like you don't have as many errors on these tiny, tiny chips and they're able to do this with these really complicated chemical processes combined with

these tools that they built out over 50 or something years. And there's so many other details about it, but from investment perspective, that's probably the biggest overview without getting to each of the products. Cause they have, I believe I was looking at their website. They, I didn't count them, but I think they have over a hundred of different products they sell so obviously we're not going to go through all of them today but they have a huge diversification of you know as their name says applied materials all right and as far as history goes applied materials was founded in santa clara california in 1967 by michael mcneely and a few others and they were really one of the pioneers of the microchip industry they kind of i guess

you could say they were one of the leaders behind the name silicon valley um and so they were they were really they're very notable i guess in that area and they were initially funded with some seed money from local investors during the early years of semiconductors though the manufacturers would largely build their own equipment and so applied materials came in and basically changed that where they stepped in as a fabrication system supplier so they kind of just built a a new stakeholder in that value chain. And then it didn't really take long for them to grow. They IPO in 1972. So five years after they were founded, and then by 1975, they were basically a globally, a global business at that point. And they were at that point, semiconductors were very

cyclical. So they'd go through these big sort of industry recessions. And so there were a few times where it was kind of make or break, and they had to fire a lot of employees, but they kind of built back up. And, and today, I guess it's, I think it's been a while since there was sort of one of these down cycles in the industry. 2014 had a major one, but it wasn't as bad as, as in the past. And then today they're basically the global leader in the term nano manufacturing, and they have offices and direct sales teams all over the world. They're a big company as well. Brett will get into that, but before he does, do you want to talk about industry and the landscape? Yeah. So this is, I think in general, it's an industry that people don't know about,

like we have been talking about, but it's called semiconductor equipment. And it's fairly large and it's really based on the capital expenditures and the factory builds out of all the manufacturers. So similar to how TSMC kind of took over the manufacturing from the chip designers back in the day, Applied Materials did the same thing for the chip manufacturers who used to build these things in-house. They started doing that themselves and then selling it to them. That's how this industry started to form. Applied Materials Management is expecting $100 billion in wafer fab equipment spending, which is basically fabrication or wafer fab is just for the spend from TSMC, Samsung, or whoever. They're expecting $100 billion in spending in 2022,

and that will be slightly higher in 2023. Or they didn't give a number. They said they're optimistic about 2023. For applied materials to track demand from them, you really should look at the other companies. So you should look at capital expenditures and capital expenditure planning from TSMC, Samsung, Intel, and the other smaller manufacturers of semiconductors. And then their largest, sorry, they are the largest semi-cap company by revenue. I think, Well, I don't get into it in the earnings with the exact numbers there. And then ASML, which people might know, which is in the lithography space, is the largest market cap.

Competitors include Lam Research, ASML, KLA Corporation, Tokyo Electron. Now, Tokyo Electron is more their direct competitor, but all of these are competitors in kind of the semiconductor equipment market. But there's a big difference between what Applied Materials does. And then there's the lithography, which is what ASML and a few other companies try to get into. That's a whole different thing. So they're kind of competing with ASML, but also kind of not. They're serving their own niches.

And they aren't. And this is kind of the key for maybe doing an analysis of whether they have a competitive advantage. And I'm sure we'll talk about this in the second half. They're not competing too much for bids with these other semiconductor equipment companies with TSMC, Samsung, and Intel. They have a bit of monopoly there as well. Ian, do you want to hit management and ownership? Yep. Gary Dickerson is the CEO and president of Applied Materials. He became president in 2012, CEO in 2013.

Prior to Applied Materials, he was the CEO of a company called Varian Semiconductor Equipment Associates, which was bought by Applied Materials in 2011. So I assume that part of that acquisition was they saw Gary and thought that he might be a good successor. He's also consistently ranked as one of the top CEOs in the world over the last few years. And he's known for prioritizing innovation and product development in his time at Applied Materials. R&D spend has risen significantly as a proportion of expenses over his time at Applied,

which kind of goes to show that the commitment to research and development is something that they're actually investing in. This is a highly paid executive team. Dickerson got about $35 million in total compensation in 2021, with most of that being stock-based compensation, but he's been highly paid over the last couple of years, too. So that's something to keep in mind. Now they've executed and it's, I think the company has more than 10 bags since he became president in 2012. So, you know, it's arguably has been worth it. A couple of the major shareholders are Vanguard and BlackRock with institutions as a whole owning over 80% of the company. insiders own very little of this company, but Dickerson himself owns about a hundred million dollars. He has been selling some. And so you'll see some news about that over the last couple of years, but he still owns over a hundred million dollars of, uh, of applied material stock.

Yeah. And that's with them being public for what? 50 years. I don't have the exact number. Yeah. It'd be tough to have like the founder or something still owning a bunch of stock. It's kind of like one of those really mature companies. I'll hit valuation quickly though. They have a market capitalization of $110 billion, and their ticker is AMAT. Now, their enterprise value is $107.5 billion, and this comes from some tracking out from the market cap, about $7.5 billion in cash and investments, and then adding back about $5.4 billion in long-term debt. Ian will go into more of the details when he goes over the balance sheet. Now, we have enterprise value to operating income, which is just enterprise value divided by trailing operating income, and that is about

13.8. However, since this is fairly capital intensive and there are a lot of working capital things with inventory and stuff like that, that can affect what their cashflow is. I do like to look at operating income and free cashflow. So their enterprise value to free cashflow, which is just enterprise value divided by trailing free cashflow is 18. So slightly higher. Those are probably my two favorite numbers for valuing this company. Although there's a lot you can go into for all the little nitty-gritty details. But one note, it is important for a company like this, as an investor, to look at income and cash generation over multiple years since, like Ryan mentioned, the semiconductor industry has gone into, well, it has been very cyclical in

the past. So if you look at their margins, I believe, and I don't have the numbers in front of me, back in 2014, margins totally went down a lot. And that's because demand fell off a cliff. if that occurs again. Obviously, that can hurt the business, but management knows this and they're hopefully better with decades of experience balancing that out now with all their other partners. But overall, what are you guys' thoughts on valuation? I don't know if we want to talk about this now, but how do you think about valuing this business, Ian? Yeah, I'd say this valuation all comes down to whether the company is cyclical still. And if not cyclical and and they're going to be able to maintain um these are similar levels of revenue

and free cash flow um the valuation looks very attractive here i think if it's if it is kind of follows more of its history and has some ups and downs and um has some some revenue decline over the next couple of years and the valuation um is much more complicated ryan i think ian hit the nail on the head there it's cheap if the previous growth is a sign of what's ahead um or if you just take sort of the trailing numbers at face value but obviously you kind of have to have a gauge on what the end markets look like and whether or not there will be uh another sort of downward cycle um because obviously that can affect their ability to generate cash but i mean it seems Yeah, actually, the valuation kept me pretty interested in studying more because it is not

too crazy like some of the companies we've seen lately. Yeah. And I think one thing to note here is that unlike maybe a subscription business or something else, this is equipment manufacturing. And while it has been a great business in the past, when someone installs, say, TSMC installs something, it's going to be in there for multiple years and maybe 10 years. So it's really reliance on their capital, like their growth capital expenditures, how much expansion they're doing. And semiconductors have expanded over the last few decades. So, I mean, you can maybe expect that to continue. But there is that, you know, if there is a pause in demand or something like that, TSMC, Samsung and Intel might not be interested in as many applied materials machines.

All right. Ryan, do you want to hit their latest earnings? Yeah. And I would also add that they give a big backlog number. So they kind of what has been agreed for them to deliver, but they haven't yet recognized the revenue from it yet. And so there is sort of a you can kind of look through and see demand to some extent just by looking at that number. But that doesn't take into account all potential future revenue. But as for the earnings, they just wrapped up their first quarter, which I hate when companies do this. like every other company was just wrapped up their fourth quarter and applied materials, their fiscal calendar is off. So it's a little frustrating, but in 2021, so I'm going a quarter

ago, applied materials generated $23 billion in revenue for the year of 2021. And that was up 34% versus the year prior. And they also generated just under $5 billion in cash on that revenue based. So it comes out to about a 21% free cashflow margin, which is just for anyone that doesn't know, free cashflow margin is the amount of money they're generating, the amount of cash they're generating from their sales. So basically their end profits and the profits you get as a shareholder. And then they have continued to expand their profitability. So margins have grown over the years as well. Gross margins, basically margins have followed the gross margin expansion. So it's been pretty steady on that basis. There's been a pretty constant theme

throughout recent earnings reports. And it's basically that they are seeing record demand because that pretty much gets asked. I feel like every conference call is sort of like a look through on demand. And they've said it's been really, really strong. However, they're having hard time fulfilling all that demand due to tough supply shortages um of certain silicon components so like every other company right now they're dealing with the supply chain stuff and so the big question is how are they going to be able to meet the demand but going to the first quarter even with the shortages uh applied materials delivered 20 plus top line growth so it looked Well, it looks like they're doing okay managing any, I guess, short-term limitations they might have. But that's something I imagine you're going to hear a lot about if you're reading the conference calls is all the supply stuff, because that seems to be the focus for them right now. But that's pretty much all I have for earnings. So, Ian, you want to hit balance sheet?

Yep. So in my opinion, they have a solid balance sheet. They've got about $5.7 billion in cash, about $5.5 billion in long-term debt. So a net cash position. Most of that debt, all that debt is in low single-digit interest rates. And so fairly low cost debt. And it's only about $240 million in annual interest expense, which to put one number to that, we can look at an EBIT to interest expense ratio, which basically just means how much income are they getting before they pay interest and taxes divided by their interest expense. And they're basically getting 34 times their EBIT to their interest expense. So they could pay their interest 34 times with the cash they're generating. And so plenty of space,

no concern about being able to pay their debt, even if cash flow was to reduce by a significant an amount. Um, and they have access to more borrowing if they want it. They've got about, um, between a revolver, a revolving line of credit and some commercial paper, um, they have access to about three to 4 billion more if they wanted to, um, use it for buybacks or if they wanted to use it for, um, for growth capital, or if they got into a situation where they just needed some more cash, they've got, they have access to it. Yeah. One thing, uh, or go ahead, As I say, I imagine a lot of, when you hear that their EBIT to interest expense ratio is 34 times, part of me thinks, well, maybe they should use more leverage to kind of grow, but they're generating enough cash to do it with purely the cash they generate. And this is, part of me thinks there has to be a level of conservatism in case they do go through another cycle.

They don't want a whole bunch of leverage compared to their cash base. Yeah, they've definitely learned from the past. And that does bring up a good point that I think we should mention is they do repurchase a lot of stock and that's their general how they are generally how they want to return cash to shareholders. They have a small dividend, but it's mainly repurchases. And actually last quarter, I believe they repurchased $1.8 billion worth of their stock. So at this current pace, and it can't continue forever because at the current levels, it's more than the free cash flow. Maybe free cash flow goes, they'll be able to do that, but they can retire about 2% of their shares outstanding. They'll have a bit of a headwind

from share dilution. So when you buy back stock, I should just explain, your share count goes down and that increases the ownership of the existing shareholders. So in general, if the business stays steady and doesn't totally collapse, the value that you own is higher as an existing shareholder if you stay around. One small correction. Last year, they generated $5 billion in free cash flow. This year or this first quarter, they generated 2.6. So they returned about $2 billion to shareholders in the form of repurchases and dividends, but that was less. So they did generate more free cash flow than they returned. So there is potentially some sustainability there. Right. Thank you. Keep that up. Yeah.

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favorite movies. And in the morning, get fresh waffles with their free bright side breakfast. Or squeeze in a workout at their fitness center. Either way, you're ready to conquer the day. Tonight, La Quinta. Tomorrow, you triumph. Book your stay at LQ.com. okay welcome back next up anecdotal evidence um well we're not working with their equipment because we're not material science engineers uh but ian anything here no i don't have anything on this all right yes all your phone i mean my computer's wrong i was gonna say i uh i mean you are probably benefiting from the fruits of the i'm probably benefiting from the fruits of their labor right now because taiwan semi i believe supplies the chips to apple and i have a whole bunch of

apple products and taiwan semi's uh applied materials second largest customer yeah the taiwan semi wouldn't be as good at making chips as efficiently as possible if they didn't have applied materials equipment uh but i don't think any of us are going to be buying a etching tool anytime soon um also it might be a little out of our budget given their pricing power But anything else, guys? Anecdotal evidence? Okay, let's move on to future growth opportunities. Ian, what are your thoughts here? This is more of kind of a secular tailwind, I would say, than a true future growth opportunity. But I think the world is desiring more redundancies in supply chains to protect from supply chain disruptions that we've seen over the last couple of years. And I think that applies to semiconductors, too. And so due to the geopolitical tensions, I think that there's a chance for applied materials business to grow as more companies, more of these semiconductor manufacturers decide to add more machines in different parts of the world so that they can hopefully keep up with demand better.

And I think that may have been some of the boon that they got in 2021. But I expect that that's going to continue into the future as people, as some of these companies, whether it's existing companies or even new companies, decide, you know, we really need more manufacturing capability around the world so we don't get caught in a squeeze if some sort of geopolitical tension or something else arises. Yeah, more conservatism. I think that's management. Applied materials management is probably salivating at that type of stuff.

And especially also the investments in basically coming out of Asia into the United States, all that capital spending of building out the second giant manufacturing base. And in Europe, I guess you include that too, like you were just saying. I mean, it's inefficient for the manufacturers, but that's a good thing for Applied Materials. All right, Ryan, what are your thoughts? What do you got here? I have the Internet of Things. I, so at first I was thinking like, all right, I'm not going to be able to provide any sort of growth avenue or any sort of expertise, uh, to apply materials, but I guess that's not really

the point of it. Basically, what do I think is going to drive growth? It's going to be just a sec, the secular trend of smart devices or internet connected devices. Um, and that really is sort of that, that is what drives their demand to begin with. Um, and so it's not very insightful for me to say that, but if, if you just think about all the things that are becoming internet connected, whether it's smart TVs, phones, watches, potentially glasses, cars, uh, and I'm sure I'm missing tons that really is their growth Avenue. As long as that trend persists, they're going to be fine. Um, the only way that there would be a problem is if there's some sort of reversion uh and i just i don't see that happening but i guess the better the longer lasting that

some of the chips are or like the the longer that the cycles are maybe there's a potential like slip in demand am i thinking about that right no i think you are yeah you are thinking about that right um potentially but there's also i think it also ties into just the economy as a whole so if consumers are not able to spend up on the new iPhone, whatever, new electric vehicle, big smart TV, I don't know, you name it. And they're saying, okay, we're going to keep our old phone or whatever old laptop for longer and longer, because if things were going well right now, we'd buy a new laptop, or we're just going to save it because we don't necessarily need one that can maybe impact their demand in the short run. But I think over the longer term, it's kind

of hard to see as long as unless you think the world is going to shit, which maybe it could, you know that's always a possibility it's hard to see how applied materials won't have increased demand yeah i have a hard time balancing like the increase in smart devices with the longer upgrade cycles like what's going to drive which is going to have a heavier impact so far it seems like the increase in devices but it's weird how everything just comes back down to the american consumer or the western and chinese consumer which is kind of like as long is worth spending, then everything's fine. But all right, I'll move into mine. And that is kind of maybe a niche one, but one of their fastest growing within what Ryan was saying, and that is

the automotive industry. So if you believe EVs are the future and everything it looks like is going to be like that, unless commodity shortage really hurt us in the near term, that is going to raise demand for semiconductor output because an electric vehicle has significantly more semiconductor conductor needs than an ICE vehicle, which is internal combustion engine, a traditional car. So that's going to raise the demand. If these companies, Texas Instruments, I guess, focuses on that, even the leading edge ones, Samsung, Intel, whoever, if they're focusing more on that and they have more demand from that, from all these manufacturers, as all the cars go to electric vehicles in the future, that's going to be hopefully raising demand for applied materials,

products and services again though are you ryan ryan you have something yeah and i'm kind of just adding to your point which is right now increasing even though demand for evs is probably already really good increasing gas prices could uh could potentially be a further propellant of demand yeah that's true and the whole thing is just getting as many like there's just a limit on ev uh part or not ev commodity supplies and stuff like that nickel whatever copper so it's just can they get all those supplies and make that. And then hopefully the entire automobile industry will switch to EVs. Ian, you have something to add there? Nope, nothing to add there. Okay. All right. I kind of see the mute button and then I know whether you might have something

to say. But one thing I want to add though is Intel's recent investments in or announced recent investments in US and Europe. I think it's mainly United States. So I think, and I should probably have looked this up, but I think it's 20 billion in Ohio and 20 billion in Arizona. And there might be another $20 billion in there somewhere. But those are investments that are going to happen over the next maybe five years or something like that. And again, what machines are going to be in those factories, it's going to be applied materials. So I think those announcements are probably a good sign. And TSMC is trying to offshore more to Japan and the United States. Again, those type of geopolitical things that Ian mentioned are already materializing. They're

not just in theory. All right. Highlights and lowlights. Ian, what do you like and dislike about this business? I think the thing I like the most is what you guys just hit on, which is the secular tailwinds. And one of the, just to further emphasize that point, one of the things they called out in the conference call is that today, nine of the 10 most valuable companies in the world either design or build chips. So that just, I think, goes to show how important chips are in today's economy and how probably much more growth there will be as more and more companies, you need chips for every every part of everyday life and so creating the equipment that helps build the semiconductors for those chips i think is is a clear um there's going to be some clear

winners in this space i also like a strong free cash flow generation which i think creates a clear path to returns a low light for me is and this isn't a low light for the company but it's just a low light for myself is i don't know what i don't know there's a lot here that I feel like I'm starting to get a grasp on this business, but there's just a lot that I don't know exactly what's going to happen, or I never know what's going to happen, but don't know if X happens, what does that mean for applied materials? And there's a lot of questions like that, that I'm just not sure exactly. And so that's a low light for me. I think there's a little bit more of a learning curve here than some of the other companies,

but like I said, that's not a knock on the business at all. Yeah, I think those are big three, all three of our biggest lowlights is this business is very, very complicated. Yeah. My low light, I have another one, but basically Ian's low light, I'm going to use that one as well. My highlights though, they are very shareholder friendly company with their returns to shareholders right now. And by returns, I mean cash that they're giving back in the form of repurchase or dividends, not stock returns. Another one is, so far, it seems like demand is really strong as far as the eye can see. If there is a downward cycle coming, it would, I think, surprise pretty much the whole world. Then I imagine there's also incredibly high barriers to entry for not only capital-wise, it's expensive to compete at that scale, but also just technical expertise. Lowlights for me, though, is customer concentration.

And I know this isn't really up to them because Samsung and Taiwan Semiconductor are so big in their own right. And they have demand from the end customer. So it's not really entirely up to them. But 35% of their sales in 2021 came from those two companies. And given some of the tension in China and Taiwan, there could be some adverse effect potentially. There's just risk, I think, involved in having that much of your sales come from a company. I think Taiwan Semi was about 15%. So if there's anything that goes wrong over there or the geopolitical problems, that could be a risk as a shareholder.

Yeah. And they also sell into China, not just Taiwan semi. So that's a big risk as well. We've seen what happens. Everyone's theorizing it right now with the Russia sanctions that potentially could happen to China that could hurt applied materials. But if you want to flip that to optimistically, if things get, and I don't want to say like destroyed or anything like that, but if stuff comes offline in Taiwan, they're going to have to rebuild in other countries. And, you know, applied materials might have some more demand there. So, I think maybe the flip side of that could be a benefit, but definitely, I mean, in the short run, it would be really, really bad for them.

All right. My highlights, I mean, strong competitive position. I think both from, there's like, there's not a, well, there's a switching cost when you have them installed, but there's a switching cost in the form of if you have some little upstart startup coming in and trying to sell kind of the same sort of thing to Taiwan Semi. one you don't have nearly the scale to compete with applied materials i mean if you're gonna you can't manufacture like i mean what are you gonna do get a loan maybe you get a loan from taiwan semi but like i mean it would be very hard to actually fulfill the demand from taiwan semi

intel and samsung unless you're at the scale of applied materials and i also think the r&d advantage is really the key here where they're spending 2.5 billion a year that raises each year rises each year it's also accumulated or uh well why am i saying the word caggard uh uh compounded gosh why i have an investor i can't think of the word compound it's compounded over the last 50 years and there's not really many companies i mean even the manufacturers said we know how to manufacture chips really well we can't do this as well as applied materials we're going to have to outsource this type of stuff to you asml and research tokyo electron whoever seeing that that happened, it's hard to, I mean, who could really disrupt them? It's hard to tell.

Great end market growth, like you guys were talking about. One thing I should mention, though, is machine learning and cloud. Those should also benefit as well. So you have AWS, Azure, Google Cloud, and then some of the other smaller ones like Oracle and IBM to build out the cloud infrastructure that requires a lot of chips. So that's another thing. If you continue, if you believe in the growth of the cloud, that should be demand for semiconductors as well. And then machine learning type stuff that requires a lot of computing, which again, semiconductors, low lights. I have no really good reading into the semiconductor cycle, if and when it's going to end, and then geopolitical risks,

like you guys mentioned. But let's move on to bull case. Ian, what do you think could go well from here? How could it do well? Yeah, my bull case is that it's got a current 5.5% cash flow yield. If it can maintain its free cash flow generation, and then in the worst case scenario, it's going to return significant amounts of cash flow investors through buybacks and small dividends, which it seems very willing to do. And if it can actually grow free cash flow at 5% a year because of some of these growth factors that we've talked about, and it maintains its current multiple, then we're looking at probably low double-digit returns per year for the next five years. So I think there's a little bit of a margin of safety here. That's a little

bit debatable based on the cyclicality of the market, but I think it's got some upside potential too. Yeah. My bull case is almost like, I almost turned my bull case into a bear case here, but I don't think a lot needs to go right for this to be a good investment. They returned 2 billion to shareholders last quarter. There might be some seasonality, but if you annualize that, that's about a 7% shareholder yield between repurchases and dividends. So assuming that after five years from now, revenue hasn't grown at all, this still wouldn't be a bad investment if they kept up that 7% shareholder return. And then I guess in terms of like a rosier assumption, if they see growth like they did in 2020 or 2021, um, or even like the first quarter growth, if they see that over

the coming quarters, this could certainly beat the market, um, or at least provide double digit returns. Yeah. And I think one thing to note is 2020 was a down year. So, you know, whatever the growth was in 2021 likely won't be repeated. Um, but I mean, still 10% growth would be fantastic. I mean, Q1, I think last year's numbers are tough comps. And in Q1, they showed an ability to beat it again. So if that persists, this would be a good investment for sure. True. That's a good point. That's a good point. Yeah. I mean, my bull case, very similar to you guys, is the end market steadily grows. They can retire 5% of shares a year at these prices. And If the stock goes up and they're not really in a position to retire 5% of shares a year,

well, you're going to do well as an investor anyways because of the multiple expansion. If their end market continually grows, some years might be bad. Sometimes there's down years in semiconductors, but over the long term, if the end market steadily grows, they retire a lot of stock, pay out your dividend, free cash flow per share can compound at 12% to 15% over the next decade. I should note that their semiconductor systems segment, which is growing the quickest, and that's where they're serving the foundries, like we mentioned before, or the manufacturers, Intel, Samsung, TSMC, that has higher margins. I believe operating margin is 39% there compared to the display systems one, which is closer. I

think it's below 30%. So if that continues to take more share of the business, margins should expand and hopefully grow at a quicker rate than revenue. But yeah, let's move on to bear case. it's hard because we don't know the industry that well but you know what do you think you go wrong here yeah so i think there's cyclicality risk because i think you guys are going to get into but i'd say the other bare case is that um that there's some technological change and that they don't stay on the cutting edge of the best um manufacturing equipment and so they kind of they get supplanted by one of their competitors um and you know revenue and free cash will start declining, it gets re-rated and they, uh, this becomes a loser in the next couple of years

because they're just not able to continue to be on the cutting edge as they have been for the last 10 years. Yeah. One thing, uh, I'll mention there, ASML has been a really great performer. I think a lot of people know about that stock now, just because of how important it is to the supply chains. And people have talked about that. Um, they're not as old as applied materials and they really came out to dominate the uh what is it euv lithography uh i'm gonna get some of the terms wrong so if you're an expert on this stuff go ahead and laugh but like they that's something applied materials could have gone after they definitely lost or maybe they didn't try to go after them that space but if you see asml's market value they create a lot of shareholder value by

dominating lithography and there could be some next gen thing like you just mentioned if applied materials doesn't capture that, that can be a lot of shareholder value lost. Maybe their existing stuff will still make it a good margin of safety, but there is that threat. All right, Ryan, sorry. What are your thoughts? The bear case is that we're at a cyclical peak for semiconductors. I don't really think that's the case, but obviously, if it were, the cash that the company could return to shareholders would be diminished. I do think a more pressing risk is that the supply chain problems actually get worse. If that happens,

Applied Materials is going to have a hard time meeting demand. I mean, the supply chain seems to be a problem for every company in the world right now, but it would definitely affect Applied Materials. The one thing I like about researching this company is I have a very good understanding now like of the all the stakeholders or all the groups in the value chain and where applied material sits but it's like there's so much of their business that isn't up to them and it's

just like sort of the byproduct of either end consumer demand or supply supply costs and it's just uh i don't know it's kind of fun to research i think the bear case is pretty limited here unless we're at some sort of cyclical peak. But if you look out, if you take a decades long time horizon, I have a hard time seeing this being a bad investment. Yeah, that's me too. The big ones are geopolitical risk. I mean, the really big downside scenario is China and US get very adversarial and say the US bans them from doing business in China or something like that. GSMC, we've talked about that. But yeah, I think for me, the big concern is you get a giant bullwhip effect and the bullwhip effect is just when supply and demand if there's shocks in that

sometimes things can go really far in the other in one direction and it's not actually um going into the direction of what end demand is it's just like what all the stakeholders are thinking so you could have say supply like there's the supply chain or the idea that there's a huge supply chain what am I missing right now? Supply chain is really hammered right now, right? And people think there's a huge demand for semiconductors that we can't fill. But what if people are just double ordering all that good stuff and all these companies are trying to just stockpile as many semiconductors as possible? If we get to the end of that, there can be the bullwhip effect where demand falls off a cliff. That's just sitting in the back of my mind for a company

like this and it really makes it tough. And that is the bear case. I have no idea how likely that is. And if you have a more than a three to four year time horizon, you're probably safe. But again, in the short run, that's just a big bear case. All right. More or less interested in final thoughts here. Yeah. I'm more interested, which kind of surprised me when I first started looking at this company, just because I thought it was going to be too far outside of my circle of competence to even kind of get interested in. But like Ryan, I kind of enjoyed learning about some of the different players in the industry and how kind of how they all fit together and it's one that i want to look more into i think there's two things that make me more interested one is

i think the valuation is at a reasonable spot right now um i think that and i think especially if the cyclicality um isn't as big of a concern as we think as it seems like the market thinks it is um and i think as you guys just noted in your bear cases i think there's a potential here even if we are at the peak of the semiconductor cycle, um, the secular tailwinds seem to be such that the peaks keep getting higher and higher in these cycles. And so even if you buy at the peak today, you're not going to get as good returns as you could if you bought at a trough, but by buying at a peak, um, it doesn't seem like you're, it's a death knell for your investment. It seems like if you're willing to have a long time horizon, um, that you'll see another peak

in the future. It's interesting to me. I want to look more into it, but still a lot of research to do to probably get comfortable with it. Yeah. It is definitely interesting as an investor. I'm still miles away from ever taking a big position in something like this just due to it not being my competency at all. For individual investors, I really recommend doing this occasionally, like just taking a look at a business that's kind of been intimidating to you, something that is outside your circle of competence, just so you can learn, like it's going to make you a better investor and it's going to make you understand how the world works a little bit more. And I kind of got that out of this, but as an investor, yeah, it's going to

take me a long time before I consider taking a position. Yeah. I mean, that's, that's a similar boat more interested it's going on the watch list uh but yeah it's just it's hard to understand the industry and with an industry that either i think i have less of a line of sight i guess into what you know i mean we we don't try to predict what things are going to be like 10 years from now unless it's some really basic trend going on in the world like demographics or something but even like three to five years out like if there's this unpredictability and if the business is hard to understand, I want a heavy discount for that uncertainty. So the valuation needs to be very, very attractive for something that is very uncertain. Now, the valuation could be very

attractive if you look 10 years from now for applied materials. But I'm interested in this company. It's going on the watch list, but it's one of those that's just difficult to understand. but I think that's going to do it. Stock for next week, it's Ryan's turn. Ryan, what do you got for us? Yeah, this one is maybe a little easier to understand. We're going with Zoom video communications. So it's a tool we're using right now. And yeah, it's had probably one of the wildest rides for a stock maybe ever. And so it's not to be confused with the Zoom Z-O-O-M ticker. A lot of people made that mistake

at the beginning of the pandemic. This is Z-M, the video software. And there's Zoom Info, which is also, there's too many Zooms out there and they all have Z ticker, but yeah, that should be fun. Evaluation's gotten

very, people are very pessimistic, so it'll be fun to re-look at that. It's been a few years. Yeah, it's down more than 75% from its highs this year, so Yeah. I was going to say, if it's down 80%, only 50% more, we're down 90%. But that's going to do it for this episode. Thank you all for listening. Remember, give us a review or rating, review on iTunes, rating on Spotify. We're very close to 100

ratings on Spotify. So I think once we get there, we'll stop hammering it on every episode and only do it a few times. But remember, we are not financial advisors and who we say on the show is not formal advice or recommendation. However, Ryan and I are general partners at Arch Capital. Arch Capital clients may hold securities discussed in this podcast. Thank you all for listening. We'll see you next time.