Applied Materials’ (AMAT) second quarter earnings were in line with the Zacks Consensus Estimate. Revenue came in higher than management expectations and exceeded the Zacks Consensus by 3.2%.
Revenue
Applied reported revenue of $2.86 billion, which was up 6.6% sequentially and 24.7% year over year.
The Applied Global Services (“AGS”) and Energy and Environmental Systems (“EES”) segments outperformed management guidance, while the Silicon Systems Group (“SSG”) and Display segments missed.
Revenue by Segment
SSG remains Applied’s largest segment, with a 51% revenue share. Segment revenue was down 2.9% sequentially and up 3.5% year over year. Management had expected the segment to be flat sequentially, so revenue was below expectations.
The weaker-than-expected revenue was on account of a sluggish PC market that was impacted by rising inflation in emerging markets, lower consumer confidence, uncertainties in energy prices and disruptions in Japan. The tablet segment also took a beating, with Apple Inc. (AAPL) seeing constraints and newer entrants also facing some challenges.
While Applied did not provide specific commentary on the smartphone segment, management did express optimism regarding the trend towards low-power feature-rich devices that were increasing the complexity of semiconductors with positive implications for equipment suppliers, such as Applied.
Applied stated that although DRAM prices appeared to have stabilized, they remained quite soft. Moreover, capacity adds are still not on the horizon and sales in the last quarter were fueled by technology purchases.
However, the logic and foundry segments were on track, with the leading players going ahead with their 28nm and 22 nm programs. The company expects to see further share gains this year.
Applied expects its SSG business to grow 10-15% in 2011, better than Gartner’s 10% growth projection for the semiconductor equipment market. This seems to indicate further share gains in 2011.
The second largest segment was AGS, which generated 21% of total revenue. Segment revenue increased 8.3% sequentially and 34.6% year over year, better than Applied’s expectations of a 3% sequential increase. Management stated that strength in the 200mm tools and the parts & services business drove the performance in the last quarter. Applied expects wafer starts to increase 5-7% in 2011.
The EES segment made a 22% contribution to quarterly revenue, representing a sequential increase of 33.8% (guidance was at least a 10% increase) and a year-over-year increase of 283.7%. Applied is now focused on the crystalline silicon business, which reached record levels in the last quarter with particular strength in China.
Sales of the Baccini and precision wafering system (PWS) platforms were at record levels. Despite falling prices, utilization rates remain high and capacity expansions continue. Applied continues to be a major beneficiary of capacity builds in China, since the company’s market share in the country is significantly higher than in other parts of the world.
Management has projected crystalline silicon capex increase of around 30% in 2011, with 90% of the spending in China and Taiwan, which should be highly beneficial for the company given its position in these markets.
Performance in the Display segment was much better than management expectations of a 67% sequential decline. The segment generated just 6% of revenue in the last quarter, growing 7.5% sequentially and declining 41.5% from last year.
Applied attributed the decline to softer demand for LCD TVs that increased caution at manufacturers. Management stated that this was causing them to push back capacity adds and therefore, orders for new equipment.
However, the small and medium area segment for smartphones and tablets remain robust. There is also a growing demand for touch panel and low-temperature polysilicon for OLED and high-resolution LCDs, from which Applied expects to generate revenues of $300 million this fiscal year. Applied believes the LCD market will shrink 30% this year, partially offset by technology purchases.
Revenue by Geography
Around 73% of Applied’s quarterly revenue came from the Asia/Pacific region, with the largest contribution from Taiwan, which generated 23% and closely followed by China, which generated 21%. However, while China grew 9.9% sequentially, Taiwan was up 2.4%. Korea was up 76.9% and Japan up 25.3%. North America declined 23.4% from a very strong first quarter, while Europe increased 12.2%.
Orders
Total orders were up 7.2% sequentially and 25.7% year over year. All except the Display segment grew sequentially. Display was down 8.4%. All segments grew from last year with the exception of Display, which was flattish (down 0.4%).
Order growth was strongest in Korea (up 63.1%), followed by Japan (up 43.9%). Europe was the only geography to have declined (down 28.9%). Other regions saw orders increase single-digits.
The book-to-bill was negative in the AGS and AGS segments, which recorded 0.98 and 0.96, respectively. SSG and Display recorded BTB of 1.18 and 1.61, respectively.
Margins
Applied generated a gross margin (excluding inventory adjustments) of 41.5%, down 123 basis points (bps) from the previous quarter’s 42.8%. The gross margin decline was almost entirely on account of the higher volumes in the EES segment, made worse by the revenue decline in the highest-margin SSG segment. The gross margin was down 15 bps from the year-ago quarter.
Applied’s operating expenses of $504.0 million were up 2.9% from the previous quarter’s $490.0 million, with the operating margin of 23.9% dropping 60 bps sequentially although increasing 542 bps year over year. All expenses declined as a percentage of sales, but were not enough to offset the impact of the weaker gross margin. In the year-over-year comparison, lower expenses (as a percentage of sales) offset the very slight decline in gross profit.
Net Profit
On a pro forma basis, Applied Materials had a net income of $493.0 million, or a 17.2% net income margin compared to $484.0 million, or 18.0% in the previous quarter and $292.2 million, or 12.7% in the second quarter of fiscal 2010.
The fully diluted pro forma earnings were 37 cents a share compared to earnings of 36 cents in the previous quarter and 22 cents in the comparable prior-year quarter. Our pro forma estimate excludes restructuring gains and acquisition-related chargeson a tax-adjusted basis 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 a net income of $489.0 million ($0.37 per share) compared to $506.0 million ($0.38 per share) in the previous quarter and $264.0 million ($0.20 per share) in the prior-year quarter.
Balance Sheet
Inventories were up 8.9% sequentially, with inventory turns staying flat at 3.7X. Days sales outstanding (DSOs) went from 66 to 61. The cash and short term investments balance was $3.31 billion at quarter-end, having increased $562.0 million during the quarter.
The company generated $704 million of cash from operations, spent $57 million on capex, $118 million on share repurchases and $93 million on dividends. At quarter-end, Applied had $204 million of debt on its balance sheet, with a net cash position (excluding short and long term debt) of $3.10 billion. The debt cap ratio including long term liabilities and short term debt was just 6.0%. The debt position has not changed much over the past year.
Guidance
Management provided guidance for the third quarter. With SSG to be flat to down 7% sequentially, AGS to be flat to down 5% (in-line with the increase in wafer starts), Display to be up more than 25% and EES to decline at least 15-25%, total revenue is expected to be down 3-10% sequentially.
Non-GAAP EPS is expected to come in at 31-37 cents a share. The non-GAAP EPS excludes a cent of acquisition-related expenses and includes a cent of potential charges for financing the acquisition of Varian Semiconductor (VSEA). The Zacks Consensus Estimate for the next quarter is 37 cents, at the high end of the guided range.
Applied did not revise its full-year guidance. Consequently, we assume that it remains unchanged. Accordingly, revenue is expected to come in at $11 billion (up 15% from 2010). The non-GAAP EPS is expected to be $1.50 a share, same as the Zacks Consensus when the company reported.
Conclusion
The Zacks Rank for Applied Materials shares is #3, signifying a short term Hold recommendation. We think the company’s strong position in the semiconductor market and focus of the solar business in China are the biggest positives right now.
We expect the strong portfolio and strategic relationships to drive share gains here. Momentum in the NAND segment and Intel Corp’s (INTC) spending on Fab 4 (logic segment) will be incremental for Applied, offsetting some of the cyclical pressure.
However, despite several long term drivers remaining on track, Applied is seeing some issues in the semiconductor market, which will continue to impact near-term demand. The timing and extent of the LCD market recovery is also something to track, especially given the recent setback to consumer confidence and the softening of demand from emerging countries.
Given the cyclical slowdown in the equipment sector and concerns related to Japan, other semi equipment companies, such as Novellus Systems (NVLS) and KLA Tencor Corp. (KLAC) also carry a Zacks #3 Rank of #3.
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