Gearing up with Applied Materials

November 21, 2013, 12:34 PM UTC
Anatomy of a trade
Fortune

James Hamel, 46, and Jason White, 40, part of the team that runs the $754 million Artisan Global Opportunities Fund, seek companies with competitive advantages, reasonable valuations, and profit cycles that are accelerating or about to do so. The approach has generated 19.9% annualized returns since the fund’s launch in 2008, besting its benchmark by five percentage points per year. One pick the managers can’t get enough of lately: Applied Materials.

1. It dominates key markets

The company’s profits have been lackluster recently. But the Artisan duo say the industry is in flux, and Applied Materials, the leading supplier of fabrication tools and services to chipmakers, is positioned to cash in on the changes. The company has a broad product portfolio and maintains a dominant share in four processing segments: ion implantation, rapid thermal processing, physical vapor deposition, and chemical-mechanical planarization. It has streamlined its operations to reduce costs and has a “big library” of patents to shield its assets.

2. Small chips mean new demand

Chip sizes keep getting smaller and smaller, and that’s driving up spending on semiconductor manufacturing. Also, as tablets and smartphones grow in popularity, key customers such as Intel are ramping up to manufacture chips for those markets. Intel has also entered the foundry business, which is good news for chip equipment suppliers generally. “Intel is increasing the competitive intensity within the industry,” explains White, creating an “arms race” that is spurring industrywide spending.

3. Good deals will pay off

In September, Applied Materials announced plans to merge with Tokyo Electron. If approved by regulators, the deal will create a company worth about $29 billion. Joining forces with what has till now been one of its top competitors will further diversify Applied Materials’ product portfolio and nearly double its market share. “It’s a watershed event,” says White. He and Hamel say another deal, the acquisition of Varian Semiconductor in 2011, brought in a crop of outstanding executives, including Applied Materials’ current CEO, Gary Dickerson.

4. The price is still right

Hamel and White added Applied Materials to the fund’s portfolio in March. After more purchases, it’s now a top 10 holding. Trading at a recent $18, the stock has jumped 61% in the past year. Still, says White, “there’s runway left to drive nice share price appreciation.” Hamel predicts earnings per share will improve from this year’s 60¢ to as high as $2.20 by 2016. “If they execute on the $2.20,” he says, “we’d expect the stock to trade in the mid-20s.” And those estimates don’t even take the Tokyo Electron merger into account.

This story is from the December 09, 2013 issue of Fortune.