Here's a Stock Pick for the Next Tech Wave

A trend change has Applied Materials in a prime position.
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Hey. I've got a hot investment tip for you for the five years ahead: Buy technology stocks.

Not a chance, you say? Thought so. And the scorn that many investors heap on technology stocks is one reason you should buy. But only if you understand how what's hot and what's not in the technology sector has changed over the past decade.

Today I'm going to show you exactly how much has changed by looking at one company,

Applied Materials

(AMAT) - Get Report

, a sector star in the 1990s that crashed in 2000 but is on its way back to stardom after reinventing itself.

Too many investors are paralyzed, like deer in the headlights of an oncoming SUV, by the technology stock crash of 2000. They're focused on the same names --

Intel

(INTC) - Get Report

and

Cisco Systems

(CSCO) - Get Report

, for instance. And the same technologies and devices: PCs, microprocessors and routers, to name a few.

Things Have Changed

I've got an important message for any investor frozen in that stance: Today's technology sector bears very little resemblance to the technology sector of the 1990s.

The opportunities are in new technologies and new devices; silicon for microprocessors has been replaced by silicon for solar panels, for example. And the companies positioned to make the most money for their investors over the next five years are, by and large, not the stars of technology in the 1990s.

It's a new world in technology, and if you want to make money in the sector, you'd better get used to it. And fortunately for anyone who wants to make a lot of money in the sector, the transition from old to new technology isn't a story familiar to very many investors. You can still jump on the trend before the bandwagon and stock prices have really built up momentum.

Take a look at Applied Materials. The company is a poster child for exactly how much the technology sector has changed.

Once and Future King

Way back in 2000, Applied Materials was the 600-pound gorilla of the chip-equipment industry, as dominant in that industry as Cisco Systems was. (Even today, its sales are twice those of its next largest competitor, Tokyo Electron.) If you used silicon to make computer chips, you owned equipment made by Applied Materials. Sales climbed to $9.6 billion in the fiscal year that ended in October 2000, a gain of 88% from sales in fiscal 1999. Applied Materials showed net income of $2.1 billion in fiscal 2000.

And then the bottom fell out as chipmakers saw their profits vanish and stopped buying new equipment to make chips. By the time sales stopped their plunge in fiscal 2003, Applied Materials' sales had fallen to $4.5 billion, a decline of 53% from the 2000 peak, and net income had turned into a loss of $149 million. (Full disclosure: I know this history so well because I owned Applied Materials from April 2000 to June 2001, suffering a 45% loss along the way.)

The shares haven't done much of anything for more than two years, traveling between $15 and $20 a share from August 2004 to the present. The shares traded at $17.68 on Oct. 26.

Huge Changes

But that stagnant stock price doesn't reflect the huge changes at Applied Materials over that two-year-plus period. The company still gets the bulk of its revenue from sales to the chip industry, but management isn't looking to the chip-equipment business, the core of Applied Materials, for the bulk of the company's future growth. As Applied Materials put it in its July 2006 quarterly 10(k) filing with the

Securities and Exchange Commission

:

"During the third quarter of fiscal 2006, Applied completed certain transactions in support of the Company's long-term growth strategy. Management believes that these transactions will enhance Applied's ability to extend its nano-manufacturing capabilities into adjacent and new markets, including: color filters for flat-panel displays, solar energy, flexible electronics and energy-efficient glass and track solutions for semiconductor manufacturing. These transactions included the acquisition of Applied Films Corporation and the formation of a joint venture with Dainippon Screen Manufacturing."

Flat-panel displays. Solar panels. Energy-efficient glass. All of these have more growth potential, Applied Materials' business strategy says, than the computer-chip sector. That's quite a statement coming from the world's leading maker of equipment for semiconductor manufacturing.

I think Applied Materials has got the trends right, however. Consider solar panels. The solar industry began consuming more silicon than the semiconductor industry in 2001. Growth has been so fast, in fact, that it has led to a severe shortage of silicon at solar-cell and panel manufacturers.

That slowed growth in the solar-energy industry to 28% in 2005 and could keep growth below 10% this year. New refineries for making the raw material of solar cells and computer chips -- called polysilicon -- won't come on line to end the shortage until 2008 or so.

That problem is actually an opportunity for Applied Materials. Much of the manufacturing equipment in the solar industry has been built in-house by solar companies. That has saved money for companies growing so fast that they're often strapped for cash, but it has also led to very low yields.

Applied Materials figures that its equipment for handling and processing silicon, using technology tested in the semiconductor industry, can increase yields enough to make it an attractive investment in a time of polysilicon shortages. Plus, the new thin-film technologies acquired in the July 2006 purchase of Applied Films added to existing thin-film technologies at the company, fitting in perfectly with the solar industry's drive to reduce the cost of solar power by replacing current technology using crystalline silicon solar cells with thin-film cells.

By 2010, according to Applied Materials projections, crystalline silicon solar cells will sell for $1.25 to $1.50 a watt. Thin-film cells will sell for 90 cents to $1.30 a watt. (In 2006, the cost for crystalline silicon cells was about $2.70 a watt. That's quite an improvement from $21 a watt in 1980.) Cheaper cells, of course, mean faster growth for the solar industry and more equipment sales for Applied Materials.

The company projects $500 million annually in solar-equipment sales by 2010. That's not bad from a standing start in 2005, but it's not enough alone to power future growth at a company projected to do $9.2 billion in sales for fiscal 2006.

Flat-Panel Developments

But fortunately for Applied Materials' growth strategy, the same technologies that can be used to deposit thin films to create solar cells are key to creating flat-panel displays.

On Oct. 17, for example, the company announced a new generation of manufacturing equipment to produce large-size liquid-crystal displays (LCD) for TVs. The fully automated system is designed to handle larger substrates (used as the foundation for the screen) so that six 55-inch screens can be cut from a single panel and then, through improved testing, minimize manufacturing defects, all as a way to reduce manufacturing costs. That's a big deal in the cutthroat flat-panel-display market, where every month brings a reduction in selling price.

In the past 10 years, Applied Materials' display subsidiary, AKT, has become the largest supplier to the flat-panel market of the equipment used to deposit thin films, and that business accounted for approximately 10% of sales at Applied Materials in 2005. But by adding technologies from its Applied Films acquisition to those already in house, Applied Materials is going after a bigger part of what is rapidly becoming a bigger pie.

How big? In 2007, sales of LCD TV sets will pass those for cathode-ray-tube TVs for the first time, according to the market research company iSuppli. Sales are projected to grow to 17.8 million units in 2007, a 63% increase. By 2010, LCD TV sales are projected at 42 million units.

And as with solar cells, Applied Materials has more going for it than just volume growth. With LCD prices falling, only the most efficient manufacturers of flat panels will survive. That makes any equipment -- such as the newest-generation system from Applied Materials -- that can improve efficiency and cut costs a must-have for companies facing this relentless competitive pressure.

These aren't the only growth arrows in Applied Materials' quiver. The company has also decided to go after a bigger chunk of the market for equipment to make flash-memory chips -- the chips that store music in MP3 players and the latest iPods, for example.

Diversity Is the Answer

But by this time, you should get the message: From a highly cyclical company tied to the ebb and flow of the PC industry, Applied Materials has become a much more diversified silicon-equipment maker with exposure to industries such as solar and TV that should smooth out the boom and bust in the company's revenue. That "smoothing" should increase, too -- as will the price-to-earnings ratio the market is willing to pay for less volatile earnings -- as the faster growth from solar, flat panels and flash memory gradually makes revenue from those sources a bigger part of the revenue at Applied Materials.

I'd argue, then, that this is a new Applied Materials that has tapped into the trends that define the new technology sector: growth from nontraditional consumer (rather than PC) sources, less cyclical and better diversified, and ready for a new wave of growth driven by a technology sector that is even more cutthroat than it was in the 1990s.

I don't think the stock market has recognized this transformation at Applied Materials. The stock could well struggle for the rest of 2006, since chip-equipment analysts on Wall Street are projecting a slowdown in equipment sales in the December quarter and into 2007 because of flagging growth at the sector's traditional customers. One competitor,

Novellus Systems

(NVLS)

, has already warned Wall Street that orders in the fourth quarter are likely to be down by 10% from the third quarter.

So while Applied Materials shares are cheap now at about 18 times projected fiscal 2006 earnings estimates, according to Standard & Poor's, you don't have to rush out and buy them. They could get even cheaper in the months ahead.

On the other hand, picking an absolute bottom isn't that important with these shares. You're buying them for the long haul, based on the growth that is due in the second half of 2007 and beyond and on the price appreciation that will come as Wall Street gradually wakes up to the changes at the company.

At the time of publication, Jubak did not own or control any of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column.

Jim Jubak is senior markets editor for MSN Money. He is a former senior financial editor at Worth magazine and editor of Venture magazine. Jubak was a Bagehot Business Journalism Fellow at Columbia University and has written two books: "The Worth Guide to Electronic Investing" and "In the Image of the Brain: Breaking the Barrier Between the Human Mind and Intelligent Machines." As an investor, he says he believes the conventional wisdom is always wrong -- but that he will nonetheless go with the herd if he believes there's a profit to be made. He lives in New York. While Jubak cannot provide personalized investment advice or recommendations, he appreciates your feedback;

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