Applied Tops, Outlook Weakens - Analyst Blog - Applied Materials (NASDAQ:AMAT), ASML Holding (NASDAQ:ASML

Applied Materials' (AMAT) fourth quarter earnings beat the Zacks Consensus by 5 cents, or 16.1%. Revenue came in much higher than expectations, exceeding the Zacks Consensus by 11.3%. All except the Applied Global Services (“AGS”) segment outperformed management guidance. However, the improvement in Energy and Environmental Systems (“EES”) was the most significant.

Revenue

Revenue of $2.89 billion was up 14.6% sequentially and 89.1% year over year. Although a slower rate than in the previous quarter, the year-over-year increase supports Gartner's expectations for triple-digit growth for equipment companies this calendar year.

Revenue by Segment

The Silicon Systems Group (“SSG”) remains the largest segment, with a 51% revenue share. Segment revenue increased 2.5% sequentially and 126.1% year over year. Management had expected the segment to be flat sequentially. Applied Materials has been introducing a number of new products that have helped market share gains and management expects this trend to continue. With memory pricing softening over the last few months, there has been concern regarding the company's ability to grow. However, Applied expects NAND shipments to accelerate in fiscal 2011, as foundries increase spending to meet the growing demand for consumer and mobile computing devices. Applied's etching and CMP products continued to gain share, with a few key wins in the last quarter. Its inspection products are seeing record demand. Additionally, Semitool, through which the company holds a leadership position in the advanced packaging segment, continued to do well.

The second largest segment was AGS, which generated 18% of total revenue. Segment revenue increased 10.3% sequentially and 32.3% year over year, in line with Applied's expectations of a 10% sequential increase. Management stated that Applied was making headway in Asia, which has historically been a tough market for service providers.

The EES segment made a 21% contribution to quarterly revenues, posting sequential and year-over-year increases of 56.6% and 116.4%, respectively. The company is now focused on the crystalline silicon business, which is showing signs of very strong demand, especially in China and Taiwan. Applied Materials 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. Sales for the Baccini and PWS platform were at record levels.

The Display segment also had a solid quarter, growing 30.1% sequentially and 40.5% from last year compared to management expectations of a 20% sequential increase. Display accounted for 10% of Applied's total revenue. Management stated that while LCD panel inventories remain, price cuts were helping to drive inventories in the market. Applied has also created opportunities in areas such as touch panels and OLED products, which are expected to grow through 2011. The company's CVD and PVD tools are expected to drive its performance. With industry-wide utilization rates at over 90%, equipment spending should be robust (projected by management to grow 75%-80% in calendar 2010 over 2009 levels, an indication of fiscal first quarter momentum). Capacity additions by existing customers in Korea, Taiwan and Japan, as well as prospective customers building fabs in China are expected to boost results going forward.

Revenue by Region

Around 79% of quarterly revenue came from the Asia-Pacific region, with the largest contribution from Taiwan, which generated 29% of revenue, while growing 17.3% on a sequential basis. China was second largest, with a 25% share, growing 52.2% sequentially. Korea and SE Asia and Japan followed, with 14%, 6% and 5% contributions, respectively. However, while SE Asia grew 8.0% and Korea 2.3%, Japan declined 22.2%.

Orders

Total orders were up 11.0% sequentially and 105.5% year over year. The EES, SSG and AGS segments saw sequential increases and Display saw a decline. EES saw the greatest increase, at 54.7%.

SE Asia and China were the strongest regions, with a combined increase of 70.6%. Europe was next with a 37.4% increase, followed by North America with and increase of 31.6%. Korea, Japan and Taiwan were down.

The book-to-bill was positive in the SSG and EES segments.

Margins

Applied generated a gross margin (excluding inventory adjustments) of 42.6%, up 764 basis points (bps) from the previous quarter's 35.0%. The gross margin improvement was primarily due to higher volumes. The gross margin was up 455 bps from the year-ago quarter.

Applied's operating expenses of $520.1 million were down 4.1% from the previous quarter's $542.1 million, with the operating margin expanding 1,115 bps sequentially and 1,206 bps year over year. Higher volumes drove down all expenses as a percentage of sales, both with respect to the previous and the year-ago quarters. However, the strongest reason for the operating margin expansion was the stronger gross margin, followed by lower R&D, S&M and G&A in that order.

The operating margin increased sequentially across all segments.

Net Profit

On a pro forma basis, Applied Materials had a net income of $475.8 million, or a 16.5% net income margin compared to $233.6 million or 9.3% in the previous quarter and $154.9 million or 10.1% in the fourth quarter of last year.

The fully diluted pro forma earnings per share (EPS) were 36 cents compared to 17 cents in the previous quarter and 11 cents in the comparable prior-year quarter. Our pro forma estimate excludes restructuring charges and acquisition-related charges on 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 $468.0 million (35 cents per share) compared to $123.1 million (9 cents per share) in the previous quarter and $137.9 million (10 cents per share) in the prior-year quarter.

Balance Sheet

Inventories were down 2.7% sequentially, with inventory turns increasing slightly from 4.1x to 4.3x. Days sales outstanding (DSOs) went from 62 to 58. The cash and short term investments balance was $2.58 billion at quarter-end, having increased $236.4 million during the quarter.

The company generated $525.1 million of cash from operations (nearly double the amount generated in the last quarter), spent $35.0 million on capex, $150.0 million on share repurchases and $93.5 million on dividends. At quarter-end, Applied Materials had $205.5 million of debt on its balance sheet, with a net cash position (excluding short and long term debt) of $2.38 billion. The debt-cap ratio including long term liabilities and short term debt was 6.5%. The debt position has not changed much over the past year.

Guidance

Management provided guidance for the first quarter. With SSG to be flat sequentially, AGS to be up slightly, Display to decline 40% and EES to decline 30%, total revenue is expected to decline 8%-15% sequentially. The non-GAAP EPS is expected to come in at 30-34 cents a share. The Zacks Consensus Estimate for the next quarter is 32 cents, in the middle of the guided range.

Total revenue for 2011 is expected to be similar to 2010 levels (+/- 10%), assuming flat wafer fab equipment purchases. Applied stated that the revenue outlook was based on expectations of continued strength at foundries, as well as a second half pickup in NAND capacity additions.

When Applied announced fourth quarter results, our revenue estimate for the next quarter represented a sequential decline of 8.1% and that for 2011 represented an increase of 6.6% over fiscal 2010. Therefore, our estimate for the next quarter was at the high end of management guidance and that for the year was also toward the high end of guidance.

Conclusion

Applied Materials has a Zacks #3 Rank, signifying a short term Hold recommendation. We think the company's strong market position, new products, design wins and market share gains are largely offset by the softening of some important end markets and uncertainty of demand in others. We also do not see any catalysts that could drive the shares higher in the next 1-3 months.

Given expectations of a slower 2011 for the equipment sector, other semi equipment companies, such as ASML Holding N.V. (ASML), Varian Semiconductor (VSEA), Novellus Systems (NVLS) and KLA Tencor Corp. (KLAC) also share a Zacks #3 Rank. We advise investors to exercise caution when investing in these shares.