Applied's Outlook Disappoints

Zacks

Applied Materials’ (AMAT) third quarter pro forma earnings beat the Zacks Consensus Estimate by 2 cents or 9.0%. Revenues were partly responsible, beating consensus expectations by 1.0%.

Revenue

Applied reported revenue of $2.34 billion, which was down 7.8% sequentially and 15.9% year over year, better than management’s revised guidance of at least a 10% sequential decline. The outperformance versus expectations was on account of improvement in the Display business and in-line performance of the AGS segment.

As indicated at Semicon West, the SSG segment suffered due to weakness at foundries and NAND memory manufacturers. EES was also weak, although within management’s very broad guidance range.

Revenue by Segment

Despite the weak demand that brought SSG revenue down 13.1% sequentially, revenue remained 10.5% higher than in the year-ago quarter. Of course, the contribution slipped from 70% to 66% of total revenue.

In line with our expectations, foundry investment is turning out to be front-end loaded, with equipment demand dropping off in the second half of the calendar year. Demand from NAND manufacturers are following along the same lines, with SSD adoption also falling well below expectations (not surprising given the extra cost).

Management stated that NAND was likely to remain weak until the end of the calendar year (Applied’s fiscal first quarter), but expects foundries to pick up strongly. The DRAM side of the business was always expected to be weak this year and unless there is a resurgence of demand related to Intel’s (INTC) Ultrabook partners and Microsoft’s (MSFT) Windows 8 adopters, the market will remain very weak.  

On the positive side, there still appears to be room for much more growth related to the transition to smaller geometries. While the timing of this investment remains uncertain as of now, we think this is likely to be a 2013 phenomenon.

The second largest segment was AGS with a 25% revenue share. Segment revenue was up 5.1% sequentially and down 4.0% year over year, exactly in line with Applied’s expectations of a 0-10% sequential increase. Segment performance was the result of strength in spares and services as offset by weakness in 200mm tools.

Despite the current weakness across the industry and Applied’s weak expectations for its fiscal fourth quarter, the company’s expectations for wafer fab equipment (“WFE”) spending remains more positive than Gartner’s expectations of a 22.9% decline. The weakness this year is not surprising, given that 2011 was a very big year for WFE. 

The Display segment did moderately well, with the sequential growth of 6.0% better than management’s very broad guidance range of flat to +/- 20%. While the 36.3% decline from the year-ago quarter indicates continued weakness in the television manufacturing segment, the sequential growth is reflective of growing demand for high-resolution mobile displays for tablets and touch panels for ultrabooks.

Customer transition to new technologies, such as metal oxide transistors and low-temperature polysilicon for OLED and high-resolution LCDs is expected to expand the SAM by 30%, which is a positive.

The EES segment accounted for 3% of total quarterly revenue, down 2.5% sequentially, 86.3% from last year and just slightly weaker than management’s guidance of flat revenues (at the mid-point). The weakness in the last quarter was expected, since there is significant excess capacity.

However, Applied’s market position remains strong due to customers picked up earlier in the year. Some positive trends include the improving module efficiencies and lower manufacturing costs, which would make solar offerings more affordable.

Applied did not update its expectations with respect to the market, so we assume that they remain the same. Accordingly, panel demand is expected to increase 4-30% in 2012 and installations to touch 28-35 gigawatts.

Increasing competition is driving down module prices and government subsidies are becoming more uncertain, which is pushing manufacturers to cost-efficient technologies. These are the secular forces driving demand in all the big solar markets, such as the U.S., Germany, Italy, China and Japan.

Revenue by Geography

Around 73% of Applied’s quarterly revenue came from the Asia/Pacific region, with the largest contribution from Taiwan, which generated 35% and followed by Korea and China, which generated 17% and 11%, respectively. China saw the strongest growth in the last quarter (up 61.8% sequentially), followed by Taiwan, which was up 24.0%.

Taiwan has shown the most consistent growth this fiscal year, increasing at a strong double-digit rate in each of the last three quarters. However, the situation will change going forward given the weakening at foundries that pushed orders down 27.4% in the last quarter. North America and Europe were down 14.9% and 19.7%, respectively to 19% and 8% of revenue, respectively.

Orders

Total orders were down 34.9% sequentially and 24.7% year over year. Orders were down across all segments, although SSG and EES declined the most. Specifically, SSG was down 40.8% sequentially and 5.9% year over year. AGS declined 18.3% sequentially and 13.4% from last year.

Display was down 20.2% and 69.5% from the previous and year-ago quarters, respectively, while EES declined 43.5% and 89.0% from the two periods. As a result, the BTB was negative across all segments, with EES being the weakest, followed by Display, SSG and then AGS.

Orders declined across all geographies except Japan and South East Asia, which were up sequentially by 5.8% and 33.8%, respectively. Korea declined 57.5% while both North America and Europe saw orders declining in the mid-30% range.

Margins

Applied generated a gross margin of 41.6%, down 54 basis points (bps) from the previous quarter’s 42.1%, hurt by the weaker volumes. The gross margin was down 91 bps from the year-ago quarter. 

Applied’s operating expenses of $543 million were down 6.5% from the March 2012 quarter, but not enough to prevent the operating margin sliding 85 bps sequentially (611 bps year over year) to 18.4%. All expenses increased from the year-ago quarter, with only G&A declining on a sequential basis. Specifically, R&D increased 56 bps sequentially and increased 307 bps year over year, while G&A declined 24 bps sequentially while increasing 213 bps year over year.

Net Profit

On a pro forma basis, Applied Materials had a net income of $300 million, or a 12.8% net income margin compared to $348 million, or 13.7% in the previous quarter and $467 million, or 16.8% in the third quarter of fiscal 2011.

The fully diluted pro forma earnings were 24 cents a share compared to earnings of 27 cents in the previous quarter and 35 cents in the comparable prior-year quarter. Our pro forma estimate excludes restructuring, acquisition-related and other charges and tax adjustments in the last quarter. Our pro forma estimate may not match management’s presentation due to the addition/exclusion of some items not considered by management.

On a fully diluted GAAP basis, the company recorded net income of $218 million ($0.17 per share) compared to $289 million ($0.22 per share) in the previous quarter and $476 million ($0.36 per share) in the prior-year quarter.

Balance Sheet

Inventories were down 13.4% sequentially, with inventory turns increasing from 3.7X to 4.0X. Days sales outstanding (DSOs) went from 64 to 60. The cash and short-term investments balance was $2.18 billion at quarter-end, having dropped $6 million during the quarter. Goodwill was 29.6% of total assets in the last quarter.

The company generated $656 million of cash from operations, spent $45 million on capex, $500 million on share repurchases and $115 million on dividends. At quarter-end, Applied had $1.95 billion of debt on its balance sheet, with a net cash position (excluding short and long-term debt) of $218 million. The debt cap ratio, including long-term liabilities and short-term debt, was just 23.6%.

Guidance

Applied expects revenues and orders to bottom in the fiscal fourth quarter unless there is further weakening of the global economy. It currently expects SSG to be down 45-55% sequentially, AGS to be up 5-15% (including more than $75 million from a thin film solar line), Display to be down 25-40% (due to the TV capacity ramp being pushed out another quarter) and EES to be down 10-30%. The net effect will be a 25-40% sequential decline in revenue.

The non-GAAP EPS (excluding 5 cents of acquisition-related charges) is expected to come in at 0-6 cents a share. The Zacks Consensus Estimate for the October quarter was 12 cents when the company provided guidance, much above the high end of the guided range.

The SSG and AGS segments are expected to benefit from the Varian acquisition in fiscal 2012, partially offsetting the uncertainties in the core business. The LCD and touch panel equipment market is expected to remain extremely weak.

Conclusion

Given that the last quarter’s results and forward guidance were much weaker than expected, we think that the positive impact of acquisitions and restructuring activity will be offset. We therefore expect further downward revision to estimates, keeping the Zacks Rank at #5 (Strong Sell in the next 1-3 months).

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