Applied Materials: Sanding Atoms - [Business Breakdowns, EP.118]

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1:30 Securities discussed in this podcast this podcast is for informational purposes only and should not be relied upon as a basis for investment decisions Zach Foss an investor at ironic capital and today we're breaking down the biggest manufacturer of semiconductor making equipment in the world last week we looked at the other leading equipment maker asml and while that business currently has a higher market cap Applied Materials generated more revenue and earnings last year Its Top Line was 26 billion dollars it

2:02 invested 3 billion dollars in r d and it currently enjoys a portfolio of 17 300 patents to explore the business behind those numbers I'm joined by Dylan Patel chief analyst at semi-analysis Dylan takes us through the industry's Evolution how applies business compares to asml and how geopolitics are a double-edged sword please enjoy this breakdown of Applied Materials Dylan thank you so much for joining us to break down Applied Materials I think

2:34 given the topic we should probably set the stage with just some general information regarding the semiconductor industry so I think to start I would really value kind of your view on how you look at the industry and how it's organized and help introduce us to some of the vernacular and language that people care about when looking at this industry yeah so the semiconductor industry is incredibly Broad and varied and in some regards it's viewed as the

3:00 new most important industry used to be energy and oil and those sorts of things and at least some people are describing the semiconductor industry as the new most important industry it's the backbone of all technology which has been the backbone of all economic growth at least in developed economies for the last few decades so the semiconductor industry is very broad it goes all the way from companies like apple designing their own chips all the way down to

3:24 Niche chemical companies in Japan that no one knows about the way it sort of flows or right if we think about from the top of the funnel down is if you look at the fortune 10 companies I think seven or eight of them designed their own chips but then that flows down to okay who are they working with to help them design these chips right so there's companies called fabulous design companies that actually design chips themselves and more increasingly they're

3:46 working with the mega cap tech companies to help them design chips like the Googles and the microsofts and the Amazons there's also a group of companies that make software for helping design chips right that's going to be companies like Cadence and synopsis Siemens has a big business there as well they purchased a company in the US and there's many Niche players around the world like Global foundries and psmc many many companies that make specific kinds of chips maybe we're talking about

4:12 Automotive chips like an XP in Europe right or on semi in the US and power semiconductors right how do I actually deliver power to chips that's going to be a different kind of company different kind of Fab you have analog chips like Texas Instruments you know they're making their own chips there and then you go down a little bit further and you have the equipment right so there's multiple equipment companies there's about eight or nine companies that sell

4:35 over a billion dollars worth of equipment a year it's a very large space but the largest players sell over 20 billion dollars of equipment a year very very large companies in their own rights these are going to be companies like Applied Materials asml lamb research KLA Downstream from that they have their own supply chain of companies which we probably won't get into too much but also there's the chemical companies many of them are based in Japan as well as

4:59 other places and so there's so many different parts and you can take it so many different ways but hopefully that's a easy to follow sort of waterfall down the industry no I think that's super helpful mental model when it comes to thinking about where these profit pools sit what's interesting to me is if you go back to like the 50s 60s 70s when a lot of these companies were founded it seems like most in the semiconductor

5:21 space were vertically integrated in that the companies themselves were producing the equipment their chips they were participating in all parts of the value chain and it's shifted in a lot of ways it seems like towards more specialization what kind of catalyzed that shift and why is it that we have these different specialized niches within semis today yeah so that's the fantastic one where IBM Intel but IBM especially was this right they made a lot of their own equipment for making

5:48 chips they made their own chips they designed their own chips they put them in machines computers that they would sell people they'd sell the software on them as well everything in one house and then over time you've got the splintering which is hey maybe I don't need to do everything right I can only do one or two parts of the supply chain so one of the first parts to sort of split out was actually the equipment

6:09 side right companies like Applied Materials and so many others start GCA I started making equipment that they would then sell to companies like Intel but these companies still built the Fab they built the chips they designed the chips and many of them right like Motorola and Texas Instruments and IBM still built the computer but Intel you know sort of one of the big first disaggregators of the industry by saying hey we're going to sell chips we're not going to sell

6:33 systems because before that it was some of the massive American companies as well as the massive Japanese companies like Fujitsu and such right these massive companies that did everything the thing is about almost any industry is a small player is always going to be more Nimble more able to innovate more able to focus on their one specific area rather than be a massive conglomerate right I mean that's age-old story against conglomerates over all of history intel was one of the first to do

6:56 this but then we started having more and more splintering right oh hey instead of building the Fab building the chips and designing the chips or all of ourselves tsmc really LED this revolution right tsmc being the world's biggest Foundry in the world saying hey we're not going to design the chips we're only going to build them you give us the specification obviously we work very closely with you and it's very involved process on both sides but they didn't actually design

7:19 any of the chips themselves and this is what allowed companies like Nvidia who started as a completely fabulous company right did not ever have a Fab themselves to be like an asset light sort of business design their own ships for Innovative use cases whether it was Graphics at first or eventually Ai and so many other inflections in between they were able to do this and allowed companies like apple to go hey actually we want to design chips for our own

7:40 products right because we have unique use cases it gives us a competitive advantage in the market so let's design our own chips and let's go out and get tsmc this contract manufacturer to fabricate them in the past there was these design companies or these integrated companies also made their own software for Designing chips they would actually put all of the data related to a chip design either on paper than eventually onto tapes tapes as in like

8:04 the old storage format of data I put them onto tapes there's actually a classical term that still persists it's called tape in which is when you send the tape from the design guys to the Fab guys and so it's called tape in because that was a formal transition but eventually that sort of split as everything got more computerized the whole age of what's called electronic design assistance happen right and now there were third-party companies making software to help you design chips now

8:28 these Eda company these electronic design assistants these companies don't know how to make a chip they don't know how to design one but they know how to make the software for it there's efficiencies in terms of shared r d in terms of hey what helps this person helps this person as well right there's constant Improvement bigger base of people to sell your stuff to right it kind of proliferated and allowed more and more and more companies to innovate

8:50 into this industry right hey we can have this Niche and we don't need to be a massive conglomerate to be able to do everything in the industry all at once because there's these abstraction layers between every single layer seemingly Adam Smith's Wealth of Nations around the vision of Labor and specialization bring extremely true in this market the last couple of decades have been characterized by globalization and collaboration amongst leading players within the industry in tougher geopolitical backdrops you have

9:20 obviously conflict with China you've got the standing of Taiwan it seems like there's kind of a shift with geopolitics and how they're impacting the industry and so before we go deeper into Applied Materials and how that potentially impacts their business what is kind of the geopolitical backdrop that's impacting the semiconductor industry you know writ large so over the last decade or so there have been a handful of Investments to accelerate the semiconductor industry

9:50 right in various respective geographies especially South Korea to some extent but really China right trying to get into the industry and no one really bad at I right China's had strategic National objectives to get into many Industries in the past and they've been somewhat successful depending on the industry but with covid-19 and the lockdowns in 2020 everything kind of changed right because all of a sudden Just in Time Manufacturing didn't work anyone who canceled orders and then

10:15 tried to put them back on and their capacity got reallocated you know there was a lot of supply chain turmoil and this really spoke volumes about the semiconductor industry right because the semiconductor industry is probably one of the most complex Supply chains in the world especially when you talk about numbers of companies involved in it from top to bottom and how technologically difficult it is and how geographically distributed is but furthermore or how little competition there is in so many

10:44 segments of it there's so many segments where it's just two or three players and that's it and for there to be a fourth player is it requires nation state level subsidies which is exactly what's happening right is the nation state level subsidies now and Investments and so you end up with this tremendous like difficulty with trying to increase production you end up with shortages you end up with so many supply chain issues that then makes everyone wake up you

11:07 know culminating you know the automotive industry not being able to get any chips waking up and telling the personal consumer right and the governments like because you know automobiles have always been heavily let's say regulated and heavily watched as far as governments go so it culminated in the automotive industry really waking up the general consumer about oh gosh trips are very important and we need a very stable supply of them and oh by the way all of

11:31 our chips for this one kind come from this place and all the chips this kind come from this other place just as an example as a funny aside in the late 90s there was a Japanese chemical plant that blew up and it shut down production of like 80 percent of the industry now the industry was able to recover pretty quickly but this is how concentrated the industry really is right I said it's in the 90s but I mean there's many aspects

11:53 for this still ranges true today right like every single iPhone relies on Taiwan semiconductor right which is obviously wrapped in geopolitical narrative with Taiwan elections and China and all of this sort of stuff so you're looking at very very geographically distributed concentrated and politically vulnerable Supply chains and so now that you've done a great job bringing us up to speed on current state of play I look at Applied Materials which has gone from five years ago it

12:22 was a 30 billion dollar Enterprise Value company today it's well over a hundred can you just explain to me where Applied Materials fits into this entire semiconductor equation so Applied Materials is the largest equipment company in the world for manufacturing semiconductors and so so they produce this equipment which then gets shipped to your major companies like tsmc like Samsung like Intel and many many more but those are the biggest players and

12:52 then this equipment helps manufacture semiconductors right you produce the Wafers you produce the chips different kinds of equipment for different kinds of chips and then they also service that equipment and they also help intimately with the r d process for Next Generation chips because the equipment needs to be very much intimately involved there helps make sure that the production yields are good they also are involved in a few other small businesses like display they make equipment for making

13:18 displays but really it's about making this equipment to ship to tsmc so they can actually make chips and so over call it 50 years this company has obviously evolved a ton what are kind of the most important parts of their story I think there's a lot in the very early days that's interesting and important to watch but I think to gloss over that there was a long period of m a right where they acquired companies they

13:44 merged with companies and Applied Materials slowly built their portfolio of many different kinds of equipment that they're the leader in right because unlike the second largest equipment company in the world asml the Dutch company who primarily makes one type of equipment you know of course they sell a few other types they make one type of equipment right lithography equipment Applied Materials makes many types of equipment and so this company is really the story of who sort of folds right one

14:12 is they were in this period where they were doing well they were out executing but they were also emerging and acquiring and building up this broad portfolio and then for the last maybe decade they've sort of not been able to acquire companies anymore right it culminated in this acquisition of Tokyo electron which is Japan's biggest equipment company and one of the top four equipment companies in the world they weren't allowed to merge with them and so Applied Materials sort of had a

14:36 different complete shift right which is hey you know maybe we shouldn't look for Acquisitions in m a for for growth but instead we should look for organic growth then of course they were always trying to organically grow but how do we out compete anyone or how do we develop a new line of equipment that is not used in the past but now it is used for future maybe the next process node right the next nanometer chip size right

14:57 that's where they sort of started focusing their efforts all throughout but especially the last couple decades Applied Materials is also in such a well-managed company right and that's the other aspect of this is that's helped them Propel themselves as one they've grown in market share but two they've also just been so well managed on a financial basis with capital allocation and things like that and so I guess a good place to start with better appreciating the business is explaining

15:25 it to a lay person in such a way that they can understand kind of the fundamental difference and what it is that applied material produces versus its peers so maybe just help explain that the most basic level you can given what's a pretty complex process yeah so when you manufacture a semiconductor right let's say we want to make a five nanometer chip that's in the iPhone today and that's in the mac and the new device they announced with the vision

15:49 goggles and nvidia's AI chips all of these chips are five nanometer trips actually interestingly enough but the process for manufacturing them is very very complex right you start with what's effectively a round circle of silicon right it's a crystal silicon structure and that comes from a different set of companies but tsmc will buy this silicon wafer okay now they'll polish it and then they'll do a series of steps and when I say series I mean thousands of

16:15 steps between hundreds of different pieces of equipment to slowly build up this chip right and so it is really a sequential process right first you build this and then you build that and then you build this on top of that and every time in between you need to do so many different steps you need to put stuff down you need to remove it you need to use lithography to Define what you want to do and it's a complex set of

16:37 chemistry it's a complex set of physics to perfectly arrange atoms on a nanometer Precision to make these billions and billions of on off switches right because that's effectively what a transistor is is it's an on off switch and then you're wiring them with miles and miles of wiring on each chip many many layers of metal connecting all these transistors together you've arrange them perfectly and you have to make sure everything works when you talk about Six Sigma Six Sigma and

17:04 Manufacturing where you have certain defect rate that's okay if you talk about thousands of steps Six Sigma on tens of thousands of steps would actually kill you right in semiconductor manufacturing so you have to be way better than Six Sigma in manufacturing and so there's all these various different kinds of steps and that's the thing that's hard to appreciate is what are all of these steps right I mean it's far too deep for us to go into today but

17:26 let's just give one specific example of a specific step right which is it's called CMP chemical mechanical planarization and what it is is you can think of it as you're just literally sanding the wafer right so you get this flat wafer and you're putting stuff on it you're removing stuff from it you're putting stuff on it you're moving stuff from it but many times what you're doing is you're just sending it to the CMP tool which is something Applied

17:48 Materials and you're just polishing it you're polishing it not to nanometer Precision in fact you're polishing it to sub nanometer Precision atoms even atoms thickness and it's basically like you're sanding the wafer so you can get a perfectly flat structure so you can then go on and do your subsequent steps right and this is an area that Applied Materials is effectively a monopoly especially on the most advanced chips and they're the only one making the tools for it but it's also when you look

18:11 at the total cost of equipment into a Fab this is less than three percent it's just one of many franchises that Applied Materials has but there's so many different ones right all of these pieces of equipment do something different and they need to be arranged perfectly in a perfect order and used to the right degrees that's sort of the magic sauce of company like tsmc but they need this equipment which is perfect right like I mentioned six sigmas would kill you on

18:33 thousands of processing steps what you couldn't get functional chips if you had Six Sigma so you have to be way more accurate so these pieces of equipment are so well tuned and perfectly calibrated and so on and so forth that that's sort of the secret sauce of these equipment companies and so how does the equipment business translate into the financial profile of the business how big is it what are the margins look like how is it grown and what are the key

19:00 contributors of that growth just to translate the qualitative into the quantitative sure so the equipment is initially sold per piece of equipment right you sell the equipment and that is done generally by Applied Materials and 45 percentage gross margin range right that's sort of the long term a little bit over here over in recent years that's where most of the revenue comes from but also because this equipment is so complex right you're actually not just selling them the equipment you're

19:27 also selling them a service alongside it right hey we're going to repair this equipment hey we're going to constantly make sure it's calibrated hey we're going to provide you spare parts hey we're going to upgrade it for this not reason right this technical specification needs to change in this way for the next generation of Chip so you actually end up with something like 25 of Applied Materials business actually being servicing equipment that they've already sold and so you've got

19:49 this General pretty solid gross margin of like 45 a little bit above but then you have r d because this is a tremendously expensive in r d right Applied Materials spends two to three billion dollars in r d I think this year it's going to be a little bit over three billion dollars of r d every year and so you're looking at that being like 13 14 of their revenue is r d the rest of the

20:10 expenses besides the cost of goods sold which is roughly half of the equipment cost and Manufacturing and so on and so forth besides that there's a whole lot of profitability here right so you end up with a company where their operating margins are in the 20 range which is amazing when you think about they're making 20 billion plus of Revenue a year some of the more recent years you know are more like 30 percent like 2021 and

20:32 2022 or 30 so huge huge cash flow is generated what is the uses of the cash right is this a capex intensity business no not really I mean there is a sizable amount of capex but it's not a huge chunk of their spending right and so really something like eighty percent of their cash flow that's generated from operating activities is actually just turned around and returned to shareholders because outside of r d and outside of this small sub 15 capex

20:58 you've got nothing to do with this cache right so the profile of the company is very attractive in terms of eps growth in terms of capital allocation in terms of Revenue growth Revenue has grown above 10 percent for more than a decade on an average basis if you look at the last five years it's actually been more like 15 when you zoom down to the bottom end of the income statement right which is hey how's operating income grown and

21:21 more importantly how does EPS Crown right cash flow has grown more than Revenue has grown which is already 10 to 15 right as I mentioned and then you zoom down to EPS you have their EPS growing even faster right you have EPS growing at nearly 20 on a sustainable basis like I mentioned with the capital allocation right they've taken down something like 30 percent of their shares it in the last eight years or so they're constantly growing free cash

21:44 flow faster than they're growing revenue and revenue by the way is growing faster than the general semiconductor industry because the general Trends with how complex it is to manufacture semiconductors and then semiconductors are growing faster than GDP and so I'm reminded of a company like John Deere which sells equipment into an industry which is viewed to be cyclical right Agriculture and they've done a great job moving towards a licensed maintenance model not too dissimilar to some

22:11 software businesses where they have this recurring service aspect of their revenue apply materials seemingly their services component of their business has something similar going on as well but I'm curious from a cyclicality perspective how this business is exposed to an end Market which semiconductors broadly are viewed as cyclical but they've bucked the trend in a lot of ways and I'm curious as to how semiconductors in general are quite cyclical right given they're exposed to Consumers exposed to Cloud capex these

22:42 sorts of things make it an extremely cyclical industry but at the same time there's things that Applied Materials have done to sort of reduce that cyclicality right not to say they've been able to make it go away because Peak to trough of business they still draw down like 35 on Revenue if you look at the 2008 crisis right they drew down 35 percent if you look at some of the smaller Cycles I think it was 2018 they

23:05 drew down 20 right but at the end of the day a third of their business you know in these drawdowns is going to be the services business because if you purchased equipment you still need to service it otherwise you're going to lose the value of the equipment that you purchased the general business is in the high 20s 30 operating margin range the services business is even higher because they're dishing away the cyclicality they're kind of in general services or

23:28 higher operating margin than capex based businesses and then the other side of the story is whenever there's a downturn they just go buck wild on buying back shares they see it as an opportunity because they know the business is cyclical they manage to the cyclical there have been periods of time you know downturns just a year or two but they end up buying back like five six seven percent afloat right in that downturn and then when the market comes back now

23:51 they've permanently improved EPS by a significant amount and you see that with the sort of big drop in the stock in 2022 they bought a lot of stock back back in 1718 time frame they bought a lot of stock back in the 2008's bubble they bought a lot of stock back at those time frames and the other beautiful thing is there hasn't been a time period at least since the com bubble where for a two-year period they didn't grow you

24:14 say Okay year on year was negative this year because of the cycle but if you take a two-year period right they've got this cyclicality sort of managed really well in terms of being able to take advantage of it but also having the foresight to understand that cycle and know that it's going to be better soon enough as soon as the cycle turns but take advantage of it by buying the back stock in preparing for this conversation

24:34 I spent time in the 10K and couldn't help but notice that customer concentration here is more significant than you see in most companies 20 or 30 percent of their revenue is exposed to a handful of companies a can you just explain the relationship they have with those businesses with Samsung and tsnnc and Intel and what that means for how their business is forecasted and how they think about their growth yeah so the relationship and the biggest

25:05 close one right tsmc spent 30 billion dollars plus last year on capex right and of that 80 percent of it was equipment related to manufacturing semiconductors the rest would be actually building the Fab the shell that you put all this equipment in and piping around the gas infrastructure all this sort of stuff an Intel same line of reasoning in Samsung same line of reason so you've got more or less three companies who are spending 30 billion

25:27 dollars a year on Fabs to manufacture chips the difficulty there is there's concentration on both ends right so if I want to buy a specific kind of equipment in general there's one two maybe two and very rarely three companies that can provide that kind of equipment and even if there are one two or three types of companies the process is so complex in broader Strokes you could say hey there's three companies that do this but when you narrow down to exactly the

25:53 chemical reaction you're trying to induce at what nanometer precision and all this sort of stuff you actually end up with there's two maybe one right companies in this field and so when tsmc goes from five nanometer to three and meter they're introducing various technologies that help them do this right they're improving the lithography of course which they're working with asml on but they're also doing with every piece of equipment they need to optimize certain things and so for years

26:18 years ahead of before they start manufacturing a three nanometer chip they're working with the equipment companies on hey well we need to do this to do this to do this and when you go up the chain it's hey we actually need you to make this part of your tool better in this way or hey help us provide suggestions how do you think we can do this and so they work intimately together in what is called their

26:38 research Fabs they'll have these massive Fabs and you hear about Intel a lot in Arizona and in Ohio trying to build these Fabs and tsmc in Arizona right and Samsung and access at least the ameristentric view but in reality all of these companies Intel Samsung and tsmc have one research fab right which is where they conduct all of their research and development and in that research and development Fab Applied Materials and asml and all the other competitors are

27:04 deeply embedded with their equipment their latest versions of the equipment helping throughout and design and figure out how to manufacture the next generation of chips at high yields as we mentioned again the lifeblood of this industry is yields fine I can make one or two chips of that kind right I mean this is the whole story of Intel failing yes they were able to make some chips with 10 nanometer but they were never able to yield it right whereas tsmc did

27:28 10 and then you know 14 10 and 7 in the time frame it took Intel to figure out 10 nanometers and that's because tsmc worked really well on yields they actually worked really closely with the equipment companies in a way Intel Intel got a bunch of hubris and thought they didn't need the equipment company's help as much you ended up with this situation where the equipment companies really helped tsmc figure out how to do things and work closely with them co-develop

27:52 the tools together right co-engineered them so yeah you have customer concentration but that's also where the strength comes from right because there's only a few customers for a big chunk of the equipment and there's only a few suppliers and each of the suppliers is specialized in certain ways so you end up with this sort of business model where the companies like accept that they make decent margins and tsmc makes about a 50 to 60 gross margin and

28:17 Applied Materials makes about a 50 gross margin and asml makes about a 50 gross margin and while there is always hopes of making higher margins there's also a lot of mutual respect where it's like okay this is an acceptable fair price for what you're doing and all the services you're providing no one's really trying to do a race to the bottom because how complex this is right especially when you drill down into this right thousands of process steps each of

28:39 them are going to be different tuned in any individual process step there's only 50 or 100 engineers in the whole world who know such a level maybe 15 of them are Intel 15 at Samsung 15 at tsmc and then the rest of the equipment companies or something like that right so when you drill down very very deeply there is a huge amount of sort of let's not say monopolism but concentration in every regard right of customers and suppliers

29:03 but that's also their strength of the business and so you kind of loosely touched upon it but if I were Intel or Taiwan semi and I wanted to switch away from Applied Materials equipment is that even feasible in certain segments right and this is why I think Applied Materials is maybe less appreciated than a company like asml because asml is a very very clear this is 90 of our business which is lithography it's one kind of equipment we have a few versions

29:31 of it and each version is better than the last and in the last generation stuff there's two competitors but in the New Generation stuff we're the only one but it's a very clean story for people to look at and understand with Applied Materials you've got arguably six or seven franchises right lithography is like 20 of the Fab's spend of the equipment in a Fab but these other pieces that Applied Materials are sort of the Monopoly in or oligopoly in many

29:55 of them are three five percent right here and there so I mentioned CMP earlier it's like three percent of Fab spent but Applied Materials does ninety percent of the business there and so the question is can I replace Applied Materials well no because if I actually look at what's called chemical mechanical planarization you end up with this problem of like hey who's the other company there's a company in Japan or this specific vertical and in that

30:16 vertical where do they compete well actually this company their tools are really selling into this type of Chip right and also this type of manufacturing when I look at a CMP tool for five nanometer actually Applied Materials is the only one really selling into it so then the question is if I wanted to rip and replace Applied Materials for this Japanese company could I maybe but let's think about the economics of that right so this is three

30:39 percent of my fab spend and I'm tsmc I have 40 000 Engineers of which maybe 10 000 are working on the Next Generation process step but what I'm talking about just individual process steps hey I'm the master at this I'm the master at that you're actually looking at hey I only have like 20 or so people that are good at it now the question is so for that 20 or so people here's my area where I can use them right I could

30:59 either spend them on a figuring out how to use the inferior equipment from this other second tier supplier and replace Applied Materials or B I could figure out well instead of that maybe I want to spend them spending their time on improving the yield every chip has billions of transistors right an iPhone smartphone chip has tens of billions of transistors and there's hundreds of chips of those on each wafer that I manufacture do I want to spend the time

31:25 making sure I could replace this equipment or do I want to spend the time making it so Apple's really happy with me because I was able to get five percent more chips per yielding or I was able to improve the performance by five percent because I improved electrical characteristics so I'm going to spend those 20 Engineers who are super focused on CMP and that's all they do and that's all they know I'm going to spend them on

31:45 actually designing the next process note or improving the output or improving the performance I'm not going to spend them on Switching out equipment for second tier supplier who perhaps their equipment can't even work here or any to walk them through all of these years of engineering where at 14 nanometer we use the equipment in this way and for 10 nanometer we modified it and we did this and and at seven nanometer we modified it and we did this and at five we

32:08 upgraded it and did this right so on and so forth do I want to lead them through all of these changes hand hold them because they weren't there they weren't helping me they weren't co-engineering they weren't spending their 20 guys who were experts this working on this problem and funnily enough right when you look at even the areas where the equipment is more competitive not necessarily CMP but some of these other areas around etch and deposition where

32:29 it is a bit more competitive it actually still ends up being well lamb research which is another competitor their etch tool is better at this kind of batch with this kind of chemistry and then Applied Materials is better at this one and so you have different teams working with them on improving that specific one right like we're going to use it for this step this tool from Applied Materials and step B we're going to use the lamp research and then you kind of

32:49 still have this hyper specialization and so if I kind of assess what the future of Applied Materials looks like what are two of the three most important things you think that will contribute to their continued growth from here and where they have a leading position one of them is the sort of Industries verticals where they're the Monopoly right and so this is going to be areas like epitaxial growth CMP ion implant RTP annealing PVD so these are some of the areas where

33:16 Applied Materials is going to remain 70 plus here then there's other areas where Applied Materials is really gearing up to fight their competitors right so one of them is they released a new tool they call it pattern engineering and the whole point is they're trying to fight with lithography in some types of process steps not all of them right but some areas they want to fight with lithography and if that's successful then they can take billions of revenue

33:39 from asml that's a huge huge opportunity there's other areas that are related to hey as we continue shrinking which is hey at three nanometer and at two nanometer and at 1.4 nanometer so on and so forth there's going to be changes to the chip we don't just shrink the transistors and go about our day actually there's meaningful changes on changing the shape of the transistor right it's called Cato all around it's called nanowire that sort of stuff so

34:04 there's a lot of tremendous opportunity and hey there's brand new process steps right can we compete to insert our tool into that brand new process step can we co-engineer with the partners to do this that's a sort of another really key thing to hope for our watch in Applied Materials but then the third is just continuing to execute right because you can try and go super deep into what exactly each of these is and how it's

34:26 going but you can also zoom out and say they've just consistently grown right because the industry consistently grows and semiconductor industry is consistently growing above GDP the equipment industry is consistently growing above semiconductor and then Applied Materials is consistently growing above that the dark side or potential negative is they don't but most likely they do especially with the increasing politization of the industry the industry is so politically important right and so you see this in the form of

34:53 subsidies right yes there's the stick that the governments are waving around but there's also the carrot right which is hey the US has 52 billion dollars in the chip sack plus a tax credit which is estimated to be something like 30 billion dollars and that tax credit is specifically on equipment purchases right Japan is spending something like 30 to 40 billion dollars you're spending something like 40 billion dollars China it's harder to sum up their tax breaks

35:18 because a lot of it's in like subsidized loans estimates I've seen are something like 200 or 250 billion dollars on the semiconductor industry right you're looking at hundreds of billions of dollars that are flowing in to the semiconductor industry and all of this eventually flows to the picks of doubles right which is Applied Materials that's sort of the Viewpoint you could take with a lot of those geopolitical tension is it's actually tremendously positive for Applied Materials and their business

35:44 and while the industry is going through a bit of a downturn and there's going to be some cyclicality these subsidies sort of help make it less cyclical from the perspective of Applied Materials right because now instead of cutting back because orders are weak it's like we're going to cut back because orders are weak but oh hey we have all these subsidy dollars that we're going to spend anyways and so if I kind of look across the semi-cap industry a how many

36:07 billions of dollars are we talking about and then at a high level what a kind of the market share nuances look like or how do you think about market share when you're assessing whether someone is gaining or losing share in the semiconductor fabrication industry the Fabs such as tsmc Intel Samsung Micron skynix the list goes on and on spent about 100 billion dollars a little bit less last year they're going to spend a little bit less than 100 billion dollars

36:33 again this year the projections are they're going to spend less than 100 billion but a little bit less than 100 billion dollars next year right so somewhere in that 90 billion dollar range just because there's some macroeconomic issues but in the past they've been growing from 58 to 70 to 90. so they're going to spend that amount of equipment and then you can sort of divvy it up right you can either say a pay Applied Materials sells 20 and

36:55 asml sells 20 and lamb research sells 15 you can view it like that you could take the other view which is actually asml and Applied Materials do not compete with each other at all there's a few small niches but for the most part 90 Plus of the business does not compete with each other even though they're the two biggest companies in the space why because they don't make equipment that's the same they make completely different equipment and these different pieces of

37:19 equipment are used for different types of processes so in reality you can actually dive down and look at market share in a completely different way this hundred billion dollar pie more or less is split into I'm not sure if you're spending on lithography how much are we spending on deposition how much are we spending on etch of that deposition spent how much are we spending on physical vapor deposition how much are we spending on sputtering how much are

37:42 we spending on chemical vapor deposition how much are we spending on Atomic layer deposition then you could go even deeper like okay well just for Atomic layer deposition is it thermal or is it plasma so you can spend a lot of time going deeper and deeper and deeper breaking out the market to where you're finally okay this is the segment where two companies actually do compete and it's a billion dollar segment right and this company has 800 million and this company

38:05 has 200 million you can go that deep and really splice up the industry which is sort of stuff we do but in general how to assess market shares unless you're going that deep it's easier to just say hey look at the revenue of the company remove out the services business because the service is business while it is 25 30 of the company's Revenue it's not the capex not the wafer fabrication equipment services and then look at

38:27 where that is how is that growing or shrinking across the industry and in reality it ends up being quite stable every once in a while you have a technology inflection like with asml and euv lithography where it goes from 18 to 22 so pretty big shift of total spend and obviously the rest of the industry does lose a little bit but at the end of the day that spend change is still minuscule compared to long-term Applied

38:53 Materials has been 20 they remain about 20 they've grown a little bit as consolidation has happened in the industry but that's sort of a better way to look at Market shared as I was explaining earlier it's so complex these process steps are so different that you don't actually end up with so much competition and so much market share you've done a great job outlining what this business does well and why it's well positioned for the future but if I

39:16 were to speak to an applied material skeptic or a bear what would they be cautious about in regard to the company's future where are the significant risks in this story the biggest risk that faces Applied Materials is definitely the China risk and now the China risk is multiple fold one is just Chinese companies stop buying Applied Materials tools which is something that even the US government is assisting in in some regards but the more concerning thing is that the

39:46 Chinese equipment Market is developing and it's developing rapidly there's still nowhere close to what Applied Materials can do in many areas but there are some tools that the Chinese equipment Market is starting to be able to produce there's numerous Chinese equipment companies Nara and acmr and the list goes on and on of companies attempting to make equipment some are not successful at all yet especially in certain places like litho and dryatch but there's other places where they are

40:14 getting significant market share things like cleans and so these segments it's all about just tackling sub-segment being good being much cheaper and having you know the companies switch over to that tool and you lose out some market share and then a lot of the new Fabs 30 or 25 are being built in China anyways so there's a lot of switching that could happen if these companies get up to Snuff and actually can compete with Applied Materials and land research and

40:42 so on and so forth and so this is the biggest risk for Applied Materials is that there is a switching that true competitors do get built up by all the subsidies that China has pushing and all the domestic nationalization that China is pushing and they haven't seen a new competitor in decades it's been an oligopoly of sorts where everyone's kept pricing power no one's chased margins down but what happens if there's a competitor who sort of is let's say

41:06 irrational by the Western sense of competition completely rational to the Chinese with subsidies chasing the market down and trying to cut costs and be much cheaper to get market share before they even try and make a profit and so we've somehow gotten this deep into the conversation without mentioning artificial intelligence so I commend both of us for that but question being is this shift towards the importance of semiconductors in relation to the compute demands of AI are there

41:37 implications for Applied Materials that are important to consider yeah so I think one interesting thing just to note about the equipment companies is they see things earlier than the rest of the industry in fact if you look back at Old investor days from Applied Materials they were talking about the PC era pretty early because guess what Intel needed to place orders for the PC era they saw that firsthand for the mobile era same way they saw that they were

42:01 saying this sort of stuff and then for the era of AI they were talking about AI obviously everybody was talking about AI but they were saying this is like literally the next era of the semiconductor industry right you cannot build an Nvidia AI chip without Applied Materials equipment they have all this equipment and it's required you can't make a chip and with AI seven nanometer five nanometer three nanometer these transitions are increasingly important for a bit of time there's a bit of a

42:25 bearish view maybe a year or two ago where if you were talking about like hey mobile kind of stopped mobile doesn't grow anymore and apple doesn't have the ability to continue to increase pricing on their end customers and obviously Android just follows the route and PC stopped growing so what do we need three nanometer for what do we need two nanometer for but then it's like oh all of a sudden everybody's like yeah we need three nanometer and two nanometer

42:46 because these models are so complex to run and so hard to run that going and shrinking is going to provide so much benefit and because of that it's like 30 more process steps when you go from five to three nanometers right and that 30 more process steps also involves some modification of the equipment as well so you're looking at generative AI being tremendously positive to companies like Applied Materials because hey we need a lot more semiconductors right we need

43:10 more memory we need more processors we need more all of this and it's all manufactured with Applied Materials as well as their peers equipment and so our concluding question is typically lessons that can be borrowed from the applied material stories and applied to other companies from both an investor perspective and then an operator perspective what are kind of those key lessons for you when you look at this business across everyone else and you're very very wide

43:39 range of coverage across semiconductors yes I think one of the beautiful things about Applied Materials is hey they are in a cyclical industry and one of the most cyclical Industries right we're talking about 35 drawdown in Revenue some of the times historically they didn't let that shake them right they always took the long-term view they always continued to invest in r d sometimes it was 15 of r d in these drawdowns hey it shot up to 20 plus they

44:06 took that long-term view they said hey I need to work closely with my customers because right now it sucks for both of us but let's continue to work very deeply on the r d and when it comes back we'll be entrenched more solidly right they'll need to use us more and more don't understand that we're a long-term partner we are not just a opportunistic company and so that long-term partner is incredibly important right as a company

44:29 in a space that's concentrated even if you weren't concentrated this being a long-term partner helps them with the rest of their business which is hey we're not building the most advanced Fab we're not selling to Samsung we're not selling to Intel selling tsmc actually we're selling to this other company right like Texas Instruments or we're selling to nxp ON Semiconductor and all these other Fabs out there that are not making the most advanced chip well all

44:51 of that fed back in now we can do better and better there as well we can help them in so many ways because we have access to this so that's the other flip side of the coin is if you have concentrated customers constantly investing in r d even when business looks tough knowing that there is a light on the end of the tunnel and maybe that's a bit of a risk but also using that to feedback to the less

45:12 concentrated customers hey being able to use that r d to help them and also the services there's two ways to look at the services business which is they used to sell you equipment and I'm hate that and I want a subscription or two I can look at it as hey I want to actually make it so you're getting the most output out of your equipment which is really what Applied Materials is doing they're saying hey this is our equipment buy it

45:32 but also let's make sure you get every single chip you can out of that let's make sure you can utilize it as much as possible because that's going to make you more profitable and that's just going to make you want to invest more in our equipment that's the other flip side of the coin and especially with the smaller customers who don't have the capability of servicing nearly as much this is incredibly important right tsmc will have some more of their own

45:53 technicians on site that are experts on specific kinds of tools but what about the smaller customers they don't have that capability but because you're offering it to them you're helping them be a better business so I think that's also important is this commitment to your customer your end customer is really important well this is a fascinating business that I know you can speak for hours about I think you did a great job summarizing the basis of a

46:17 business and its comparative advantages going forward thanks for joining us thank you for having me I had a blast to find more episodes of breakdowns ranging from Costco to visa to moderna or to sign up for our weekly summary check out join colossus.com that's j-o-i-n-c-o-l-o-s-s-u-s.com