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No. of Recommendations: 2
Not Ready to Call the Bottom

It is still early in the slowdown of the semiconductor industry. Applied’s revenue was 11% lower in Q1 than a year ago. From the first quarter of 2018, gross margin was 170 bps lower and operating margin was 470 bps lower. Non-GAAP GM was 44.6% and operating margin was 24.6%. Non-GAAP margin from a year ago was down 260 bps and operating margin dropped 550 bps. WFE was the source of weakness. AMAT breaks out their business into Semiconductor Systems, Applied Global Services, and Display and Adjacents. YoY, Systems revenue was down 20%, leading to a 990 bps reduction in operating margin for this segment. But Services and Display were both up from a year ago. Margins on services aren’t as good as Systems in an up-cycle, but they are consistent. Display margins are the lowest of the three, but increased 15% from the first quarter a year ago.

The business overall had revenue of $3.7B for the quarter. Costs didn’t drop as fast as revenues, down 7.8% YoY, leading to a reduction of 14.2% in GM. Within overhead, R&D reduced 5% from a year ago while SG&A was flat. Overhead was 20% of total revenue. Applied’s tax rate was 13.2%. Total it all up and they had a net margin of 20.5% in the first quarter. From a year ago, their share count has dropped by 9.9%, or 106M shares.

Their balance sheet is stable with $3.7B in cash and equivs plus another $1.6B in long-term investments. These assets are against $6.6B in short and long-term debt. Book value increased $1.3 per share QoQ. Cash from operations was $834M and $133M went back in for capex (16% of operating cash). Simple FCF was $701M. Management must think the stock is cheap – they bought back $750M worth in the quarter, in addition to the $192M they paid out in dividends. This is not sustainable so seems to have been opportunistic. Their overall cash position was reduced by $300M to fund these share repurchases. They have added 2000 full-time employees from a year ago.


Earnings Call Notes

Unless otherwise specified, financial information is non-GAAP

Gary Dickerson (CEO) prepared remarks

• Over the past two months they have become cautious about near-term macroeconomic trends. They have also seen further pull-backs by customers in investments. Their near-term outlook is “one of caution.”
• View on 2019: smartphone markets are weak, especially high-end. Called out DRAM as seeing continued price declines and building inventory. NAND inventories are coming down, though they are still higher than the long-term trend
• NAND bit demand is forecasted to grow in the mid 30% range, and DRAM bit demand will grow in the high teens.
• WFE sales will be down mid-to-high teens in 2019 compared to 2018. Display equipment revenue will decline by about a third from 2018 levels.
• They expect non-equipment revenue to be 45% of their total this year

Dan Dern (CFO) prepared remarks

• They continue to expect the recovery to be shallow and gradual, but they are not willing to call the bottom
• He made several comments about how strong their financial performance still is, how proactive the customers are being, how they are controlling opex, etc. They are investing more in R&D in the face of the weaker markets so they can continue to innovate for new markets.
• In 2018, the grew the number of fab equipment tools under service contract at three times the rate of new sales. This is less impressive than it sounds given the relative size of their tool fleet in the field compared to the number of systems shipped in a given quarter.
• Financial results were around the midpoint of guidance or a bit above
• They have $3.6B left in their share buyback authorization
• Guidance for Q2: revenue of $3.48B +/-$150M, 43.5% GM, opex of $750M +/- $10M, $0.62 to $0.70 EPS

Question and Answer

• They expect improvement in gross margin in Q3 and continuing up in Q4. This seems contradictory to the prepared comment that they are “not calling the bottom.” Maybe they mean they are going to make up for lower sales with lower costs.
• Overall spending in the past year has shifted to lithography and to other areas of WFE where they don’t compete, so they expect the third-party data on market share will show they declined. This data is expected in about a month.
• CEO took one of the questions as a chance to pull out his soapbox on how the industry needs a new playbook and that AMAT is best-positioned to take advantage of this. I think he’s right about the new playbook. Of course he will say he believes AMAT is best-positioned to take advantage of this new playbook.
• They expect to grow their share in memory overall as scaling happens. For 2018, they think 60% of the total spending was memory, with NAND and DRAM balanced. For 2019, memory will be down “by a good amount,” so they expect the whole market to be down mid-to-high teens. They think the recovery will be slow and gradual. A theme of their answers is to temper recovery expectations.
• In response to a question on how they can flex opex if revenue continues down in the second half of 2019, they said they can
• EUV will replace etch and dep steps, but they are not steps that Applied supplies equipment for
• They expect WFE sales in China to be down in 2019 vs. 2018 with memory weaker than other
• They expect a healthy continuing business in older nodes and in 200mm equipment, driven by IoT, AI, and other new markets. They report 200mm sales as part of their services segment
• AMAT has consciously focused, since five years ago, to increasing their comprehensive service contract business. Half of their supplies and services business comes from these comprehensive contracts, which provides ballast to their financial performance through the cycle.
• They think the right baseline level for total WFE is higher than 2019 is shaping up to come in at
• Question on what it will take for China to build their domestic semiconductor business. It will be “years” for them to develop the talent and technology to be able to compete at the leading edge. Gary cited how difficult scaling in NAND and DRAM are for even the leading companies.
• What signs are you looking for to call the bottom on the semiconductor cycle? They still see inventory at an elevated level, but coming down. If it comes down faster than anticipated, if pricing stabilizes, or if utilizations increase, that is what they are looking for to indicate the market is turning up.

Summary

I look at all the equipment maker’s results as an investor in one of their memory customers. Memory continues to weaken, especially DRAM. They said DRAM prices are still declining and inventories are rising. NAND inventories have started to come down, though they are still above historical norms. The NAND market may have passed an inflection point. Management said several times that they expect the recovery to be gradual. They won’t call the bottom but forecasted their gross margins will start to improve with Q3 results. I suppose this improvement could be from lower costs, but it sounds like they are calling the bottom of the cycle to be Q2. This is consistent with the other WFE sellers as well as Micron. All are saying they expect recovery in the second half of the year. In the Q&A the CEO made some comments on China’s native memory development, saying it would be a long time before they will be able to compete at the leading edge. He stopped short of saying they wouldn’t ever make it there, but the tone was that China is a long way from being a meaningful player in memory.
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