This document is being provided publicly in the following form. Please subscribe to FSInsight.com for more. Members Area Signal from Noise Lam Research, Applied Materials Set To Reap IoT Harve Signal from Noise Lam Research, Applied Materials Set To Reap IoT Harvest June 24, 2020 Vito J. Racanelli SENIOR EDITOR & MARKET INTELLIGENCE ANALYST – Internet of Things LT growth bodes well for semi-conductor equipment maker growth – LRCX and AMAT shares near highs but at relatively undemanding valuation multiples – As new IoT demand materializes—autos, healthcare—stocks could rise 25% or more In the previous Signal From Noise (June 17, Continued IoT Growth Good News for Nordic Semiconductor), I focused on the Internet of Things (IoT), which is likely to continue growing, limited only by what uses engineers dream up for semiconductor chips. Just about any area can see increased chips use: autos, healthcare, factory automation, HVAC systems, to name a few. The IOT is rich in possibilities for the world’s consumers and for companies that provide the architecture and backbone. The IoT means most objects can be connected via the internet and local networks, giving and receiving data, from personal medical devices to mobile phones to self- driving cars. If it’s electronic, there’s probably going to be a chip needed to power it or control it. In a normal year, some 80 million cars are sold, each with more and more computing power. Only yesterday, Mercedes Benz and NVIDIA said they plan to cooperate on a new in-vehicle computer system and AI infrastructure, to be introduced in 2024. The rollout of 5G communications is also big for chips, both the systems and the phones. An interesting analogy to the IoT is a gold rush. Who made money consistently? Not the miners, but those who supplied picks and shovels to them. If the IoT is like a gold rush, then chip equipment makers could be in a good place in the semiconductor industry. In that vein, both Lam Research (LRCX) and Applied Materials (AMAT) appear attractive investments for investors looking both for growth, and a bit of cyclicality, albeit long-term. Both are among the world’s few (four or five) companies of substantial size producing the complicated and high-tech equipment—the picks and shovels—needed by chip fabricators, such as Intel (INTC) and Samsung (5930.KS), to make things like memory or flash chips now found in many electronic devices. John DeGulis, a portfolio manager at Sound Shore Management, which owns shares of both LRCX and AMAT for clients, says the world is likely in the middle of a ten-year demand growth spurt for chips and by extension for the equipment that makes them. As the IoT develops, the long-term chip need should continue to be solid and steady. The wafer fabrication equipment market has grown 8% CAGR since 2013, according to LRCX. Source: Lam Research Secondly, and just as importantly, DeGulis points out how the chip cycle has changed— for the better for equipment makers. In the past, it was typified by a more severe boom/bust cycle because they were few end markets for chips. For example, in the 1980s chips went into PCs, the main end user at the time. When PC sales slowed, it was felt all the way up the chain to equipment makers. In the 1990s, mobile phones were added to the end market, widening the customer base and chip demand. Today, chips find uses in many other things, further expanding demand and also dampening the boom/bust cyclicality, he adds. Moreover, cell phones and PCs still need more and better chips. IoT should make end markets even more diverse, as chips are inserted into many products. Cycles, then, could be less severe. There’s a tremendous demand for data use and storage, which requires memory chips, microprocessors, standard chips or complex systems-on-a-chip (SoCs). For fabricators, and companies like LRCX and AMAT, it creates more stable end markets, DeGulis adds. Another point is that as we reach the limits of Moore’s Law, the technology of making chips has become more complicated, favoring the current players. Going from 2D to 3D chips requires a higher expertise and tends to limit the competition among what is eectively an oligopoly, with a handful of global providers of chipmaking equipment, says the fund manager. Additionally, each equipment maker tends to specialize. LAM, for example, has over 50% share in many of the verticals in which it competes, like memory chip equipment. I like the robust balance sheets of both companies, which have relatively little net long-term debt, and returns on equity of over 30% for AMAT and over 40% for LRCX. That’s pretty good for a capital-intensive industrial firm. What about the valuation now that stocks have recovered near to their all- time highs? LRCX trades at 18 times consensus 2021 EPS of $17.72, in line with its Source: Lam Research average PE. LRCX has said it could earn $30-$32 EPS in 2023-2024. If the market applies an undemanding 15 P/E market multiple to that, the price could eventually reach $480, higher than the current $306. Similarly, AMAT trades at less than 15 times consensus $4.27 EPS next year. DeGulis says it’s capable of $5 EPS and a 15 multiple could mean a $75 price, vs current $60. AMAT’s average P/E is 16. I think, given the IoT promise, one could argue they might get a multiple closer to their respective average P/Es. As new IoT demand materializes—autos, healthcare—I believe these stocks could rise 25% or more. According to Rob Sluymer, our head of technical analysis, in contrast to many cyclicals, AMAT and LRCX have already rallied above their June highs, extending up trends that began in March. Relative performance versus the SPX is also noteworthy, breaking out above their 2020 relative highs ahead of the price. Use near term pull backs to accumulate, he says. Where I could be wrong: Chip prices can fluctuate, sometime sharply. Sustained low prices hurt fab companies and, in turn, equipment makers. The spot price of the 8- gigabit DDR4 DRAM memory chip, for example, fell by two thirds in 2018-19. The semiconductor wafer fab equipment market declined 5.9% to $55.5 billion in 2019, as memory spending contracted from 2018 record levels, according to Gartner. Chip prices seem to have stabilized, but there could be a lagged coronavirus eect come fall and that could dent the share prices near term. Even so, short term demand has been surprisingly resistant, and both LRCX and AMAT have been solidly profitable for years. A worsening of US-China trade relations, given many chip fabricators’ investment in China, could hurt equipment makers, too. Longer term, China is likely to become a serious direct challenger both to the chip fabricators—which could hurt their margins— but also to the equipment makers themselves, though that’s probably at least five years o. Another risk is that both have concentrated customer bases. Bottom Line: The IoT should provide a steady and stable increase in future chip demand. That bodes well for LRCX and AMAT. 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Racanelli SENIOR EDITOR & MARKET INTELLIGENCE ANALYST Disclosures (show).