Despite Challenges, Semiconductor Producers Still Running Hot

David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Although the semiconductor market has been in a trough, companies are valued based on future potential. Several factors have caused market-wide undervaluation. First, investors have overreacted to a slowdown in demand--mistaking the effects of isolated natural disasters as a structural issue. Second, rising emerging market growth and rising interest in smartphone and tablets provide promising returns. However, some companies are better equipped for growth than others. Below, I consider the futures of two cheap semiconductor equipment producers.

Favorable Risk/Reward for Applied Materials (NASDAQ: AMAT)

This semiconductor producer trades fairly compellingly at 12.5x past earnings with a generous 3.5% dividend yield. In light of positive trends in mobility and solar energy adoption, Applied has a strong platform that will enable the company to outperform broader indices. Strong seasonal business is being observed in wafer fab equipment, but management still has a generally conservative outlook. A large pullback is being forecasted across all categories of semiconductor equipment buyers. Although we are seeing signs of weakness (for example, the delayed TV capacity ramp in China), this is indicative more of a seasonal pause than an erosion in fundamentals.

Discussions with customers have suggested that the fourth quarter will feature a seasonal low. Ahead, there are several catalysts to look forward to. The 28-nanometer build-out for capacity next year will be complemented by soaring demand in smartphones and demands. As a large beneficiary of this secular change, the addition of 100,000 - 150,000 wafers should help better meet supply. Management has been reviewing its product strategy and expressed that greater clarity will be presented this month.

Although analysts only rate Applied a 2.6 out of 5 (a "hold"), I believe it generates enough cash flow to make an investment nearly riskless. The free cash flow yield is around 12%, and it has grown EPS by 8.4% annually over the past 5 years. That is more than enough to make the stock not only a growth play but also a value play.

Why Lam Research's (NASDAQ: LRCX) Buyout of Novellus Was A Game Changer

If Credit Suisse's earnings upgrade for Lam Research is of any indication, the semiconductor market looks stronger than expected. I am particularly bullish on Lam because of its decision to purchase Novellus (NASDAQ: NVLS), which better exposes the business to rising mobile chip demand. Impressively, the company has been able to meet customer commitments despite a supposedly depressed macroeconomy. If nothing else, the company is completing large majorities of its $1.6 billion share repurchase program this year to keep EPS elevated and limit downside.

While customers have reduced investments for 2H12, management has appropriately responded by reducing wafer fabrication spending with the NAND segment representing the vast majority of spending reductions. But the tight NAND device supply will likely give way to a resurgence in spending next year. Smartphone and tablet demand will drive not only this resurgence but also strong returns in, of course, mobile DRAM. Customers will likely ramp up capacity in n+1 technology next year, which transitions the market to 20-nanometer. This provides a large market pie for Lam to penetrate.

Better yet, the decision to purchase Novellus for $3.3 billion comes at an ideal time. With economic activity picking up and aggressive industry-wide innovation, investors will carefully see how Lam competes against market leader Applied Materials. This integration enables the company to not only realize $100 million in annual cost savings by 2013's end but also have greater bargaining power with customers.

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