Applied Grows but Solar Disappoints - Analyst Blog

Applied Materials’ (AMAT) second quarter 2010 earnings beat the Zacks Consensus by a penny. As a consequence, shares did not move around too much.
 
Estimates for Applied Materials underwent a correction when the company reported first quarter results. At that time, Applied Materials clarified the strong outlook for the year, which reflected expectations of market research companies.
 
Although a couple of analysts have fine-tuned their estimates in 30 days leading to the second quarter earnings announcement, the impact on the Zacks Consensus Estimate was negligible.
 
Revenue
 
Revenue of $2.29 billion was up 24.2% sequentially and 125.0% year over year. The year-over-year increase was reflective of the turnaround in the capital equipment market and particularly, the company’s exposure to the memory segment, which should grow in leaps and bounds this year.
 
Revenue by Segment
 
Silicon Systems (“SSG") remains the largest segment, with a 61% revenue share. Segment revenue increased 44.7% sequentially and 440.0% year over year. The increase from the year-ago quarter is largely attributable to more favorable comps, since the second quarter of 2009 was severely impacted by the recession. However, Applied Materials' advanced technologies enabled it to gain market share exiting the recession. The etch product line was particularly strong, with second quarter sales at higher levels than the four quarters of 2009 combined.

Additionally, the acquisition of Semitool placed the company in a leadership position in the advanced packaging segment, which is currently expected to outgrow the overall equipment market. Most of the current strength is being driven by memory customers, as they transition to more advanced processes and products and also see very strong demand at end customers. The scarcity of products is also resulting in steady DRAM and NAND prices, driving memory manufacturers and foundries to expand capacity, which should bring further growth in this segment.
 
The second largest segment was Applied Global Services ("AGS"), which generated 20% of total revenue. Segment revenue increased 7.0% sequentially and 42.9% year over year. Strength in spares sales, especially with respect to customer delivery goals drove the increase in the last quarter.
 
The Display segment was very strong, growing 104.5% sequentially and 221.4% from the year-ago quarter to 12% of total revenue. The robust growth in the last quarter was due to the ever-growing demand for LCD TVs and notebooks, especially in China. With industry-wide utilization rates at around 95%, equipment spending is very high (projected by management to grow 70% this year over last). Capacity additions by the existing customers in Korea, Taiwan and Japan, as well as prospective customers building fabs in China are expected to boost results going forward.
 
Energy and Environmental Systems (“EES") was the smallest segment with a 7% revenue share, representing sequential and year-over-year declines of 48.3% and 53.5%, respectively. The segment saw mixed results in the last quarter, with solar photovoltaic equipment installations increasing rapidly.

Applied Materials is well-positioned in China, which is experiencing strong demand. Management expects over half of 2010 production to come out of China, so the company’s position in the country is a positive for the next few quarters. However, while crystalline silicon equipment continues to show signs of growth, the outlook for the segment is dampened by softness in the thin film category.

Softer demand, more financing challenges of customers and the bankruptcy of one of the largest customers are impacting this business. There are also concerns regarding overcapacity of the solar segment, currency issues and future incentives in Europe. Segment performance this year will be lower than management’s previous expectations.  
 
Revenue by Geography
 
Around 83% of quarterly revenue came from the Asia-Pacific region, with the largest contribution from Taiwan, which generated 30% of revenue and grew 36.0% sequentially. Korea was up 90.9% and China 62.2%. Both North America and Europe softened in the last quarter, with North America dropping from 13% to 10% of total revenue. Europe fared worse, dropping 46.8% sequentially from 17% to 7% of total quarterly revenue.
 
Orders
 
Total orders were up 28.9% sequentially and 290.3% year over year. The Display segment was the major driver of orders, registering a sequential growth of 103.2%. All except the Applied Global Services segment saw a double-digit sequential increase in orders. All segments except Display (which increased 1,869.2%) witnessed triple-digit increases from the year-ago quarter.
 
Order growth was strong across all geographies except Japan and Taiwan. The strongest growth was in China, which increased 156.3% sequentially, followed by Korea, which increased 45.0%, North America (up 17.2%) and Europe (up 6.8%).
 
Margins
 
Gross margin for the quarter was 41.7%, up 183 basis points (bps) from the previous quarter’s 39.9%. The gross margin improvement was due to higher volumes and a better mix of business, as the higher-margin businesses performed better. The gross margin was up 2,402 bps from the year-ago quarter.
 
The operating expenses of $532.1 million were up 10.6% than the previous quarter’s $481.1 million. However, the operating margin expanded 467 bps sequentially and 4,221 bps year over year. The sequential improvement was due to across-the-board declines in all expenses except S&M (as a percentage of sales). S&M as a percentage of sales was flattish sequentially. All expenses as a percentage of sales declined significantly from the year-ago quarter, driven mainly by higher volumes.
 
On a sequential basis, the SSG operating margin improved 392 bps, AGS 495 bps and Display 1,439 bps. EES declined 7,613 bps and management is taking measures to realign the segment cost structure to the lower level of demand this year.
 
Net Profit
 
On a pro forma basis, Applied Materials had a net income of $292.2 million, or a 12.7% net income margin compared to $179.0 million, or 9.7% in the previous quarter and loss of $174.8 million or 17.1% in the second quarter of last year.
 
Fully diluted pro forma earnings per share (EPS) were 22 cents compared with earnings of 13 cents in the previous quarter and loss of 13 cents in the comparable prior-year quarter. Our pro forma estimate excludes restructuring charges, acquisition-related charges and impairment of investments 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 $264.0 million (20 cents per share) compared with $82.8 million (6 cents per share) in the previous quarter and a net loss of $255.4 million (19 cents per share) in the prior-year quarter.
 
Balance Sheet
 
Inventories were up 1.6% sequentially, with inventory turns increasing from 2.7X to 3.2X. Days sales outstanding (DSOs), and were down from 62 to 57. The cash and short-term investments balance was $2.33 billion at quarter-end, up $180.7 million during the quarter.
 
The company generated $527.0 million of cash from operations, spent $44.7 million on capex and paid $80.6 million in dividends. At quarter-end, Applied Materials had $204.8 million of debt on its balance sheet, with a net cash position (excluding short and long term debt) of $2.10 billion. The debt-cap ratio including long-term liabilities, but not short-term debt was 7.0%. The debt position has not changed much over the past year.
 
Guidance
 
Management provided guidance for the third quarter. With SSG to be flat sequentially, AGS to increase in line with wafer starts, Display down at least 20% and EES up by over 25%, total revenue is expected to come within the range of down 2% to up 5% sequentially. This is expected to result in non-GAAP EPS of 22 to 26 cents per share.
 
Full year expectations were not updated. Consequently, we assume that expectations remain unchanged. Therefore, sales should be up 50%, with SSG growing more than 100%, AGS growing by around 30%, display by around 30% and EES flat to +/-10%. The tax rate for the year is expected to be in the range of 31 to 33%. EES expectations could subsequently be revised lower, given the recent change in outlook.
 
The Zacks Rank for the stock is #3, signifying a short-term Hold recommendation. Other equipment providers such as KLA Tencor Corp. (KLAC), Novellus Systems (NVLS) and Varian Semiconductor (VSEA) have a Zacks Rank of #1, indicating that they currently represent better plays in the semi-equipment market.