Growth stocks can be rewarding investment instruments due to their ability to captivate investors with market-beating growth. On the flipside, the downside risk presented by such stocks can be huge once the growth narrative ends. One such stock that fits this profile is Applied Materials, Inc. (NASDAQ:AMAT), the world’s largest manufacturer of semiconductor equipment.
Applied Materials operates in the highly cyclical semiconductor business where it sells chip manufacturing equipment to some of the world’s largest chip foundries, including Samsung (OTCMKTS:SSNLF) and Taiwan Semiconductor Mfg. Co. Ltd. (ADR) (NYSE:TSM).
Sweet Spot for AMAT Stock
Applied Materials is currently in a sweet spot where it’s enjoying a cyclical upturn in fab equipment spending. A cyclical upturn frequently lasts for three or so years before growth peters out and the trend is eventually reversed.
The yo-yo nature of the semiconductor space is clearly reflected in AMAT stock. After receiving a shellacking in 2015 due to tepid growth, Applied Materials turned the heat on in 2016 and managed to finish as the second biggest gainer in the Nasdaq behind only Nvidia Corporation (NASDAQ:NVDA). AMAT stock has strong top- and bottom-line growth to thank for the superb gains after finishing the year with revenue growth of 12% and earnings-per-share growth of 37%.
Applied Materials has kicked off the new year in high gear, managing to outpace the technology sector and the market. Although the technology sector as a whole is expected to perform well in 2017, AMAT stock has already outpaced the Technology SPDR (ETF) (NYSEARCA:XLK) with gains of 5.6% vs 3.3% year-to-date, respectively. The iShares PHLX Semiconductor ETF (NASDAQ:SOXX), of which AMAT is the biggest weighting, has managed a modest 3.1% gain.
This suggests that the market is counting on AMAT to continue growing in 2017.
Increased Equipment Spending
Numerical navel-gazers, Gartner and SEMI World Fab Forecast, have predicted that fab equipment spending will return to decent growth in 2017 and 2018. Gartner has predicted that worldwide semiconductor and equipment spending will grow by 9.9% and 11.4% in 2017 and 2018, respectively. Meanwhile, SEMI has forecast 10.6% growth in 2017.
There are three reasons why the semiconductor sector experiences revenue cycles:
- Capital spending ups and downs
- Demand slowdowns
- Process migration
Capital spending is the big variable here in this predictable sequence. When semiconductor companies are seeing strong demand and profits are flowing, they tend to invest heavily in new manufacturing capacity. This added capacity usually fully ramps up in about two years, and almost inevitably results in oversupply of chips in the market.
This oversupply crimps prices and forces manufacturers to cut capex and equipment spending. This in turn leads to lower supply of chips in the market, which culminates in higher chip prices and sets off another cycle of heavy equipment purchases.
In Applied Material’s case, capital spending increases and process migration are currently acting as the company’s main growth drivers. A sharp ramp up in 3D NAND production by companies such as Micron Technology, Inc. (NASDAQ:MU) as well as heavy DRAM and Flash investments by Samsung and other companies are driving aggressive increases in manufacturing capacity.
Meanwhile, transition to newer processes such as 10nm and 7nm nodes by Intel Corporation (NASDAQ:INTC) and GlobalFoundries has been driving demand for leading-edge machines that can manufacture these chips.
AMAT said in its full-year report that it expects revenue to grow 45% and EPS to expand 154% during the first quarter of 2017. That’s a great way to set the pace for the rest of the year.
Bottom Line on AMAT Stock
Investors can be forgiven for feeling jittery about a stock that rallied 73% in 2016. But the silver lining is that Applied Materials is sitting on a strong cyclical upturn in equipment spending. This is likely to drive robust earnings growth and support another strong rally in 2017 and perhaps beyond that. This might be the right time to load up on AMAT stock.
As of this writing, Brian Wu did not hold a position in any of the aforementioned securities.