Fitch: Applied Materials' Acquisition of Tokyo Electron Positive for SemiCap Equipment

Wed Sep 25, 2013 12:10pm EDT

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(The following statement was released by the rating agency) NEW YORK, September 25 (Fitch) Fitch believes semiconductor capital (semicap) equipment-maker, Applied Materials Inc.'s (Applied Materials), acquisition of competitor, Tokyo Electron Ltd. (TEL), strengthens the credit profile of the semicap equipment industry and combined company. If approved, the deal better matches supply with demand, given ongoing consolidation of capital spending among semiconductor-makers. Credit Positive for Combined Company The acquisition addresses three credit concerns for the semicap equipment space: lower equipment demand from slowing personal computer (PC) sales, exponentially more costly technology transitions and a consolidating customer base. First, the deal consolidates supply of equipment and services at a time of lower customer demand. Applied Materials and TEL both are one-stop-shop semicap equipment providers, meaning they provide a full suite of products and services for semiconductor manufacturing. Front-end equipment purchases have been hurt by lower PC sales, the volume of which is anticipated to remain pressured by faster growing mobility products. The deal enables the joined companies to reduce costs for higher profitability through the semiconductor cycle, while reducing irrational pricing behavior. The transaction incorporates expectations for $250 million of cost synergies after the first fiscal year and $500 million of annual synergies after the closing's third anniversary. Applied Materials and TEL are targeting 25% operating profit margin over the longer term versus 11.5% and -0.5%, respectively (6.3% for the combined companies) in the latest 12 months. Second, the price tag for the continuation of Moore's Law for the semiconductor supply chain is growing exponentially, requiring heavy research and development (R&D) investments to enable technology transitions. The industry points to exponentially higher costs associated with the transition to 3D NAND memory and to 22 nanometers (nm) for logic. As a result, R&D spending is expected to remain in the 10% to 20% of revenue range for semicap equipment-makers. The company's meaningfully greater scale and larger installed base should enable Applied Materials to meet growing investment requirements without impairing free cash flow. Third, the deal should better balance supply and demand by combining two leading broad based semicap equipment-makers. This relationship has increasingly been pressured by a consolidation of semiconductor capital expenditures among Intel Corp. (Intel), foundries, and memory-makers, a trend that is expected to continue. The exponentially higher cost of technology transitions should drive increased outsourcing by semiconductor companies to foundries, ongoing consolidation of NAND flash memory providers, and market share consolidation for both foundries and NAND makers. Intel's strategic evolution is also expected to drive significant ongoing capital spending to maintain its leading manufacturing capabilities. Credit Positive for Semicap Equipment-Makers Fitch believes the acquisition is a net credit positive for semicap equipment-makers because it better balances supply and demand, given the ongoing consolidation of capital spending among semiconductor companies. On the customer side, the top 10 buyers represent roughly two-thirds of all semicap equipment purchases. However, Intel, Taiwan Semiconductor Manufacturing Company (TSMC), and Samsung Electronics Co. (Samsung) represent nearly half of all equipment purchases, reflecting the consolidation of advanced technology manufacturing and, therefore, the capital spending to support the continuation of Moore's Law. Consolidation among NAND memory providers and strategic shifts in focus by certain foundries to non-leading edge manufacturing have amplified the consolidation of equipment buyers. Capital spending budgets for the #2 through #4 foundries, United Microelectronics Corp., GLOBALFOUNDRIES Inc. and Singapore Manufacturing International Corp., have not kept pace with that of TSMC. Applied Materials' acquisition of TEL marks the ongoing consolidation among semicap equipment suppliers. In May 2013, ASML Holdings NV (ASML), a semiconductor tools supplier, spent $2.6 billion to buy Cymer, Inc. to strengthen its extreme ultraviolet lithography capabilities. This follows wafer etching company Lam Research Corp.'s (Lam Research) purchase of Novellus Systems Inc. (Novellus) for $3.3 billion in 2011. Fitch believes further defensive consolidation among leading semicap equipment providers could be a challenge, despite expectations for a low growth environment. The top five - Applied Materials, ASML, Tokyo Electron, LAM Research, and KLA-Tencor - represent more than half of industry revenues in aggregate, with even greater concentration in key subsectors such as lithography, etching and yield tools. Additionally, the trend is toward increasing consolidation. In 2012, revenues for the top 10 providers approached 70% compared with approximately 60% five years ago. The estimated $37.8 billion semicap equipment market in 2012 is projected to decline by mid-to high-single digits in 2013 and rebound sharply in 2014. Potential Long-Term Risk for Competition Fitch views the transaction as a potential long-term risk to the competition, including KLA-Tencor, which has significant share in yield maximization markets. Both Applied Materials and Tokyo Electron compete with KLA-Tencor in certain yield maximization markets but invest their R&D across a broader set of technology platforms to serve a full line of semicap equipment products and services. KLA-Tencor's sole focus on yield maximization has resulted in technology leadership and significant market share. To the extent a combined Applied Materials and Tokyo Electron use its greater scale to increase investment in yield maximization technologies, KLA-Tencor's share leadership and 30%+ mid-cycle operating profit margin could be eroded. The potential near-term impact on Lam Research is more meaningful, given considerable market share consolidation in etching and film layering as a result of the deal. Nonetheless, Lam Research's more focused investments over time, as well as capabilities acquired in the Novellus deal, have resulted in technology leadership. Bridging this technology gap could require intensified R&D spending by Applied Materials and TEL. Beyond the broader benefits of a consolidating capital equipment industry, Fitch does not view the transaction as having an impact on ASML's industrial position or credit profile - given the latter's unique focus and leadership in photolithography, a process technology that does not directly overlap from a product or service perspective. Recent corporate activity at ASML, including the Cymer acquisition and the customer co-investment program involving Intel, Samsung and TSMC, does, however, highlight the importance of maximizing R&D and consolidating customer relationships. Applied Materials acquisition of Tokyo Electron Applied Materials announced the acquisition of TEL for $9.4 billion in stock, representing a more than 16x multiple of EBITDA but only a 6% premium over TEL's closing stock price. This is substantially lower than previous acquisitions in the semicap equipment space, including Applied Materials' 55% premium paid for Varian Semiconductor Equipment Associates Inc. (Varian) in 2011. The deal is expected to close in mid- to late-2014, pending customary closing conditions, including regulatory approval. Achieving regulatory approval may be a challenge considering the deal is one of the largest ever foreign takeovers of a Japanese firm and the companies have a greater than 30% combined market share. Fitch views the transaction as mainly defensive, given some overlap as broad-line semicap equipment providers, but with some complementary products and disparate profitability profiles. The deal nearly doubles Applied Materials scale with pro forma revenues of more than $12 billion, creating the largest semicap equipment provider by revenues and leader in precision materials engineering and patterning. Contact: Primary Analyst Jason Pompeii Senior Director +1-312-368-3210 Fitch Ratings, Inc. 70 W Madison Street Chicago, IL 60602 Secondary Analyst Jason Paraschac, CFA Senior Director +1-212-908-0764 Tertiary Analyst Stuart Reid Senior Director +44 203 530 1085 Media Relations: Brian Bertsch, New York, Tel: +1 212-908-0549, Email: brian.bertsch@fitchratings.com. Additional information is available at 'www.fitchratings.com'. ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: here. IN ADDITION, RATING DEFINITIONS AND THE TERMS OF USE OF SUCH RATINGS ARE AVAILABLE ON THE AGENCY'S PUBLIC WEBSITE 'WWW.FITCHRATINGS.COM'. PUBLISHED RATINGS, CRITERIA AND METHODOLOGIES ARE AVAILABLE FROM THIS SITE AT ALL TIMES. 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