Why Applied Materials Is Destined To Be A Magnificent Dividend Growth Stock

The beauty of long-term investing is how much an investment can pay off decades into the future. So for those in early to middle adulthood, it’s not too early to think about retirement income streams 20, 30 or 40 years from now when choosing stocks today.

One of the best ways to achieve a healthy retirement is to invest in dividend growth stocks. These stocks may not impress in terms of their current dividend yield, but if a stock can grow its payout above the rate of inflation for many years, the capitalization power can really make for a comfortable retirement.

Semiconductor equipment player Applied materials (AMAT 1.23%) it only has a yield of 0.7% today. But for those with a long time horizon, there’s plenty of reason to believe those payouts will be much higher five, 10, and 20 years or more from now.

AI-powered growth and efficiency

Obviously, for a dividend to grow, a company’s earnings per share must grow, and the easiest way to grow earnings and cash flow is for the business to grow efficiently. On this front, things look rosy for applied materials due to multiple technological inflections, including artificial intelligence (AI) and energy tradition.

Applied Materials is the largest supplier of semiconductor equipment by revenue and is among the most diverse. It has a strong position in etching and deposition, where it is one of two to three players for crucial manufacturing steps. It also has businesses in metrology and ion implant machines, among others.

Applied Materials’ leadership in multiple areas, touching on cutting-edge, late-stage and memory chips, has given it the vast knowledge to anticipate market trends and capitalize. While the semiconductor industry is cyclical, it is a long-term growth industry, and Applied Materials has grown its earnings at an average growth rate of 26% over the past five years.

While the take-off of cloud and AI makes this difficult to continue at the company’s larger size, analysts still expect the company to generate revenue at an average growth rate of 15.6% over the next five years. It is well above market growth.

What’s even better is that this growth is efficient, without the need for excessive capital expenditures that many other chip companies have to make. Applied Materials achieves impressive operating margins of close to 30% and achieved a stunning return on equity of 43% over the last 12 months.

Applied Materials’ competitive edge is its unmatched technological expertise in the delicate art of chip manufacturing, and those R&D chops are on full display in the AI ​​era. The semiconductor industry is just beginning to produce gate-all-around transistors and the power delivery behind them. The company believes it has invested ahead of these technology transitions and will gain market share even as these AI-based markets expand in the coming years.

This is a recipe for strong earnings growth.

A low payout ratio and lots of redemptions

Beyond earnings growth, another reason Applied Materials can increase its dividend in the coming years is that it has a very low payout ratio of just 15.3%. That means it only pays out about 15% of its net earnings today as dividends.

Even better, the company is returning even more money to shareholders in the form of share buybacks. Last quarter, the company’s share buybacks of $861 million outpaced dividend payments of $331 million by 2.6 to 1.

So not only does Applied Materials have plenty of room to raise its payout ratio, but its share buybacks are also helping to lower its share count. Over the past year, its buybacks have reduced its share count by about 1.2%. That means it could theoretically increase its dividend per share by 1.2% without increasing the total number of dollars paid out.

Over time, rising earnings combined with a declining share count and a low current payout ratio will pave the way for plenty of dividend growth going forward.

A dividend related to this resilient segment

Finally, a third reason to feel good about Applied Materials’ dividend hike is that management is matching the payout with profits from its services business, which accounted for 23.3% of the company’s revenue last quarter , with operating margins of 29.6%.

On the recent conference call with analysts, CFO Brice Hill noted, “We think of our dividend as driven by earnings from the services business, and that gives us confidence that we will be able to increase the dividend going forward.”

Applied Materials’ main business is selling high-tech equipment, but one of the knocks against the semiconductor business is its cyclical nature. However, the company also attaches service agreements to its cars, which tend to have a much more steady growth path. Hill noted that about 85 percent of Applied Materials’ service revenue is “recurring” in nature.

That’s because even though the company’s car sales ebb and flow, service agreements are typically tied to the size of the installed equipment base. And that existing base tends to grow every year, even if car sales slow or even decline in a year.

Last quarter, Applied Materials posted a 5.3% increase in equipment sales but an 8% increase in services — the 20th straight quarter of growth for that segment. Management noted that the installed base grew 7% year-over-year, but service revenue per room grew even more than that.

In the long term, Applied Materials expects double-digit growth in the segment. There is reason to be optimistic about this; Software is now a big part of service agreements as the company uses AI from its vast installed base of machines to help customers limit defects and increase yields. Management noted on the conference call with analysts that subscription terms last an average of 2.8 years and have a renewal rate of more than 90%.

This gives a lot of stability to the dividend as well as the ability to increase it every year. If Applied Materials is targeting low-double-digit growth for the services segment over the long term, that’s what investors should anticipate for dividend growth as well.