Will AI Save The Chip Industry?

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The pandemic certainly turned the semiconductor industry on its head.

Despite the record production of semiconductors, there were shortages everywhere. That led to months-long waiting lists for many consumer products. So, to meet consumer demand, semiconductor makers ramped up supply.

But then inflation arrived and decided to stay awhile. Central banks responded by raising rates, and economies slowed. The appetite for items like consumer electronics waned, leaving inventories stuffed full of chips.

The entire semiconductor supply chain is still feeling the ramifications.

But there’s a bright light on the horizon every investor should know about…

Chip Demand Slowdown

In fact, seven out of the nine top chipmaking equipment manufacturers globally are likely to log a sales decline in the current quarter as their clients rein in capacity investment in the face of a worsening semiconductor market.

This is a clear sign of global market deterioration from the previous quarter when six of the top nine players reported revenue growth.

Slowing investment by semiconductor manufacturers is the main reason behind the lackluster current outlook. Memory chipmakers, in particular, have been hit hard by the slump in demand for smartphones and servers, as well as plummeting prices.

All nine of the top chip equipment companies project an uptick in demand in the latter half of this year, compared with the first half. But given the risk that capital investments by Taiwan Semiconductor Manufacturing (TSM) and Samsung Electronics will come in below initial plans, the timing of a market recovery is hard to pinpoint.

During a recent earnings call, Applied Materials (AMAT) CEO Gary Dickerson said: “Measured as a percentage of total wafer fab equipment, memory spending is tracking at its lowest level in more than a decade.… In leading-edge foundry logic, we have also seen customers trimming their spending plans for the year.”

Another factor adding to the slowdown is that U.S.-led restrictions on exports to China are reducing sales of equipment for advanced products to China. AMAT’s sales to China, for example, fell 34% year over year to just $1.4 billion, thanks to the U.S. government export restrictions.

However, demand for non-advanced products—such as for automotive and industrial applications—has been holding firmer than expected.

In China, investment in non-advanced products (which have escaped U.S. export restrictions) remains brisk. These include the Internet of Things (IoT), communications, automotive power, and sensor (ICAPS) products.

Applied Materials’ Dickerson also noted that: “While China currently leads in ICAPS spending, we see other countries increasing their investments at a higher rate. In fact, the fastest growing regions for our ICAPS business in 2023 are the U.S., Europe, and Japan.”

An AI Chip Boom and AMAT

But despite the current downbeat environment, the stock prices of chip equipment manufacturers have been steadily on the rise since October 2022. This reflects investor hopes for a bottoming of the chip market, main thanks to generative artificial intelligence. In other words, stock prices for these companies have already begun to factor in future growth, given the arrival of generative AI and large U.S. Subsidies from the Chips Act.

So let’s look at one of the likely beneficiaries, the aforementioned Applied Materials, which is the world’s largest manufacturer of wafer fabrication equipment for the semiconductor industry. It is the chip equipment industry’s standard bearer. The company has the broadest product portfolio and offers customers the closest thing to a one-stop shop.

Currently, Applied Materials is in the same boat as its peers. On May 18, the company announced that sales for the May–July quarter would likely be $5.75 billion to $6.55 billion, forecasting a range between a 12% decline and a slight increase. A decline would be it's first since the August–October quarter of 2019.

In my view, though, results midway through fiscal 2023 validate the belief that the company’s business is more resilient than the wafer fab equipment market overall. Some reasons to think that include its still high—though no longer record-level—backlog, and growth in services.

However, the most compelling reason is Applied Materials’ extensive presence in ICAPS (non-cutting edge) applications. ICAPS products are holding up quite well in the current environment; for example, robust demand for its ion implantation tools is being driven by investments in silicon carbide manufacturing to support the rising production of electric vehicles.

Further, Applied Materials is set to enjoy a surge in demand after announcing a new chipmaking system that lowers the cost of etching transistors into semiconductors. This allows the company to make high-performing transistors at a lower cost than makers of semiconductors, giving it a clear competitive advantage over its rivals.

After another solid quarter of outperformance versus Street expectations, CEO Dickerson emphasized that Applied Materials expects to outperform its markets in 2023, saying the long-term outlook remains highly positive, as semiconductors become a larger and more strategically important market globally. In this environment, Applied Materials should benefit from “outsized” growth opportunities over the long term.

Applied Materials confidently says it is “the leader in materials engineering solutions used to produce virtually every new chip and advanced display in the world.” Of course, with AI exploding and chips needed to both create the technology and allow it to carry out inference activities, many new chips will have to be manufactured over the longer term.

The company itself reported in February that it was benefiting significantly from the proliferation of AI. Indeed, it specifically named AI, along with automotive, high-performance computing, industrial automation, and clean energy, as the sectors that were “more resilient” to macroeconomic pressures. Its installed base of more than 43,000 tools is the largest in the industry, which gives me added confidence in the company’s future.

In mid-March, Applied Materials announced a 23% hike in its quarterly dividend—representing a substantial step up from an average hike of 6.5% in the past four years—and added $10 billion to its share buyback plan.

CEO Gary Dickerson stated that the higher dividend and buyback authorization reflected the company’s positive long-term view of the semiconductor market and the company’s own growth opportunities.

AMAT stock is still down more than 20% from its $155.78 high, even though it is up 25.5% year-to-date, trading at $121 per share. The stock is a buy anywhere under $130 a share.

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