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Notes from 4Q’18 and FY’18 Earnings Release and Conference Call

Top of the Cycle

I’m late posting this as earnings were almost two months ago, but judging by the activity on this board, nobody has missed it. For the year 2018, Applied had revenue of $17.25B, an increase of 19% over the previous year. Gross margin was 46.3% and net margin was 29.0%. They saw equipment demand slow in the second half of 2018 and are forecasting a weaker first half of 2019 as well.

Looking down their income summary, their gross margin is stable from year to year. Their GM only increased 40 bps in 2018 over 2017, despite the 1900 bps increase in revenue. They have little operating leverage it seems, which will be good on the way back down the cycle. Their net margin of 27.8% compares to 26.6% the year before. Their market cap is $33.3B right now and their PE multiple is a little over 10. This seems inexpensive to me given the strength of their market position and the stability of their earnings. I am not a buyer here, but if you were I don’t think you’ll get hurt when you look back in five years. I think the down-cycle has not reached the bottom yet.

Their regional sales breakdown has foundry down a lot in 2018 over 2017 and DRAM almost doubled. NAND is flat as the market had been slowing from the early part of the year so manufacturers slowed down their expansions. Logic and other increased almost 50% year-over-year.

I’ll talk about share repurchases and the balance sheet at the same time. In 2018 they paid out $5.283B for share repurchases and lowered the share count by 58M. I’m netting out the share growth from stock issuances to employees here in the share count change, and ignoring the benefit of those issuances, because it is small. A simple calculation here is the effective price they paid for these repurchases was $91 per share. Note I said effective purchase price – they didn’t actually pay this much for shares as it never traded that high. But, the effect on equity owners was as if they paid $91 per share for those 58M shares. Dismal is the first word that comes to mind for this timing. One analyst asked about this on the call and the CFO’s answer was that their share repurchases had been going on for more than ten years and overall their record is good. This is true, though they still picked a bad year to over pay in their buy-backs. This is where the balance sheet comes in. Their balance sheet is fine, but not as good as it should be. They had $3.165B in simple free cash flow (cash from operations minus capex) but paid out almost $5.9B to shareholders this year, so almost twice their FCF went back to shareholders in the peak year of the cycle. Poor timing. They now have $5.6B in cash, equivalents and long-term investments. I assume they will do better next year and I am not worried about their financial strength, but their capital allocation this year was a head-scratcher.


Earnings Call Notes

Gary Dickerson (CEO) prepared remarks

• Challenging market environment in the second half of the year, which they expect to continue into 2019, but they are not seeing the magnitude of variations that have characterized semiconductors in the past
• Near term issues lowering demand include slowing memory maker demand. Memory customers expect pricing to stabilize in the second half of 2019. AMAT believes supply and demand are relatively well-balanced and investments are rational.
• EUV adoption is hurting their share of WFE revenue in 2019
• They believe 2018 and 2019 combined spending on WFE will be $100B, with 2018 being a little higher. They see strong fundamental growth drivers for semiconductors overall. Diversified end markets are a big part of this.
• In 2019, they will have similar financial performance to the performance of 2017, despite a less favorable environment. They believe this is the case because of how they have improved the company.
• Moore’s Law is running out of gas, so a new “playbook” is needed to continue to advance computing performance. Applied believes this new playbook will create new opportunities for them.

Dan (CFO) prepared remarks

• Guidance is lower than the first half of 2018, but without the recent export restrictions, their guidance would have been higher (!!). They are not ready to call the bottom, but they believe the semiconductor market is less volatile.
• They see annualized WFE in the mid-$40B range, $10B higher than in all years prior to the current cycle. They have a positive industry thesis based on three points:
o Large market for PCs and mobile devices along with an emerging market for AI and ML
o After a long period of downtrend, capital equipment intensity has stabilized
o Customers are more profitable, and are more proactive in keeping supply and demand in balance
• Revenue was at the midpoint and they were a little better on cost than projected. WFE sales were slightly below expectations. Services were strong with 18% YoY growth. Revenues in display was a little stronger than expected.
• $4.3B remains in their share repurchase authorization
• $3.56-$3.86B in revenue for Q1. Silicon systems revenue to be down 21% YoY. Services up 7% YoY, compared to a strong quarter a year ago. Non-GAAP GM of 44.6% and non-GAAP earnings of $0.75 to $0.83 per share for Q1.
• They announced this morning a research center in New York, investing $600M in the first seven years of the center. NY will invest $200M in this center.

Question and Answer

• They expect to lose share in 2019, an important reason for this being the first use of EUV lithography in production in 2019. When 3D NAND spending recovers, that will be much more favorable for Applied.
• The “new playbook” Applied sees is needed by the semiconductor industry to replace Moore’s law involves five ; new chip architectures, new packaging structures, new materials, new structures within the devices, and new ways to shrink. All five of these require advancement in materials engineering and are opportunities for Applied.
• In 2019, they see their display business declining around 20%, following rapid growth the last five years. In the long term they are still positive on display.
• For 2019, the order of market strength from highest to lowest is: foundry, logic, DRAM, NAND.
• They aren’t ready to call the bottom of the semi business. They see a gradual u-shaped recovery in 2019.
• In China, Applied has a large display business. About half of China for them is semiconductor systems, roughly balanced between the different areas of foundry, memory, and logic.
• Over the past ten years, their share repurchase program has brought down the share count from 1.7B to under 1B. They have returned 90% of free cash flow to shareholders through share repurchases and dividends.
• In DRAM, they see high-teens increase in 2019 over 2018 spending. Customers are being disciplined in adding capacity. A “decent outlook” for 2019.

Summary

I think Applied is a good buy here, but I’m not buying because I think it is too early in the cycle. The multiple of 10 is on the low side given their strong market position (only a handful of equipment suppliers left) and the secular trend to higher spending on semiconductors. They overdid it this year in shareholder returns by at least a factor of two. Leadership is not ready to call the bottom of the cycle for the equipment makers yet but the tone of the call was that they believe the bottom is close. I think this is optimistic since the semiconductor makers are still on the downslope of this cycle. Still, given the variability of semis it is impressive that AMAT is able to keep their financial performance as stable as they do, varying margins only a couple hundred basis points.

- S. Hughes (no AMAT position)
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