Applied Materials, Inc.

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1 February 12, 2015 Applied Materials, Inc. Current Recommendation Prior Recommendation NEUTRAL Outperform Date of Last Change 10/22/2013 Current Price (02/11/15) $24.26 Target Price $25.00 SUMMARY (AMAT-NASDAQ) Applied Materials is one of the world s largest suppliers of fabrication equipment to semiconductor, LCD and solar PV cell manufacturers. Applied s first quarter earnings were in-line with the Zacks Consensus Estimate, with most of the segments performing well. The proliferation of mobile devices, strength in mobility platforms, TV capacity builds, better utilization of resources and the recentlyannounced merger with Tokyo Electron are positives. Of course, the high cost structure and customer concentration are things to be cautious about. We therefore have a Neutral recommendation on Applied Materials shares. SUMMARY DATA 52-Week High $ Week Low $17.25 One-Year Return (%) Beta 1.64 Average Daily Volume (sh) 12,896,493 Shares Outstanding (mil) 1,221 Market Capitalization ($mil) $29,633 Short Interest Ratio (days) 6.38 Institutional Ownership (%) 91 Insider Ownership (%) 0 Annual Cash Dividend $0.40 Dividend Yield (%) Yr. Historical Growth Rates Sales (%) 0.1 Earnings Per Share (%) 11.4 Dividend (%) 11.9 P/E using TTM EPS 22.7 P/E using 2015 Estimate 18.7 P/E using 2016 Estimate 16.3 Zacks Rank *: Short Term 1 3 months outlook * Definition / Disclosure on last page 3 - Hold Risk Level * Type of Stock Below Avg., Large-Growth Industry Seqpt-Wafer Fab Zacks Industry Rank * 53 out of 267 ZACKS CONSENSUS ESTIMATES Revenue Estimates (In millions of $) Q1 Q2 Q3 Q4 Year (Jan) (Apr) (Jul) (Oct) (Oct) ,573 A 1,973 A 1,975 A 1,988 A 7,509 A ,190 A 2,353 A 2,265 A 2,264 A 9,072 A ,359 A 2,501 E 2,566 E 2,516 E 9,942 E ,598 E 10,543 E Earnings Per Share Estimates (EPS is operating earnings before non-recurring items, but including employee stock options expenses) Q1 Q2 Q3 Q4 Year (Jan) (Apr) (Jul) (Oct) (Oct) 2013 $0.06 A $0.16 A $0.18 A $0.19 A $0.59 A 2014 $0.23 A $0.28 A $0.28 A $0.27 A $1.07 A 2015 $0.27 A $0.33 E $0.35 E $0.35 E $1.30 E 2016 $0.36 E $1.49 E Projected EPS Growth - Next 5 Years % Zacks Investment Research, All Rights reserved S. Riverside Plaza, Chicago IL 60606

2 RECENT NEWS Applied Materials Inc. s fiscal first-quarter 2015 pro forma earnings per share of $0.27 were in line with the Zacks Consensus Estimate. Revenues Applied Materials reported revenues of $2.36 billion, up 4.2% sequentially and 7.7% year over year, and within the guidance range provided by the company. Revenues beat the Zacks Consensus Estimate of 2.33 billion. Revenues by Segment The Silicon Systems Group (SSG) contributed 61% of revenues, up 0.8% sequentially but down 2.6% from the year-ago quarter. Foundry demand was strong because of the drive toward new-age mobile devices that are also more power efficient. Technology transitions facilitating this change are a big positive for a leading equipment manufacturer like Applied Materials. Technology transitions are also driving equipment purchases at memory makers. Moreover, management is optimistic that Applied s leading-edge products (particularly deposition and etch) will continue to help the company gain market share. The second-largest contributor was Applied Global Services (AGS) with a 25% revenue share. Segment revenues were down 1.5% sequentially but up 15% year over year. AGS revenues are correlated to the SSG segment. Therefore increased wafer starts and higher utilization rates across the industry were positives for the segment. The Display segment was up 44.7% sequentially and 73.0% from the year-ago level with segment contribution jumping from 8% to 12%. Display had a good drive, with new Gen 6 PVD products for advanced mobile displays and new CVD encapsulation systems for OLEDs. Applied is reaping the benefits of its growth initiatives within FSG, Display and AGS that will allow it to grow revenues and profitability as customers ramp new nodes into higher volumes. The Energy and Environmental Solutions (EES) segment accounted for 2% of total quarterly revenues, increasing 14.6% sequentially and 37.5% from the year-ago quarter. Revenues by Geography Around 72% of Applied s quarterly revenues came from the Asia/Pacific region. Taiwan contributed 22% of revenues, followed by Korea with 20% share, China with 16% and Japan with 10% share. While Taiwan was the weakest link in the last quarter, declining 16% on a sequential basis, Korea was the strongest, growing 148.1% sequentially. All other regions declined. Southeast Asian countries performed dismally (down 37.5% sequentially), followed by Europe (down 19.7%). The U.S saw a sequential decline of 16.4%. Equity Research AMAT Page 2

3 Orders Total orders were up 0.8% sequentially but down 0.5% year over year. On a sequential basis, Display and AGS orders were down 17.7% and 7.63% respectively. EES and SSG orders improved 13.6% and 6.9% respectively. However, all segments except SSG increased on a year over year basis. Backlog for the quarter declined 5% sequentially, nearly half of which was attributable to SSG, followed by AGS, Display and EES. Margins Applied Materials generated gross margin of 42.3%, down 187 basis points (bps) from the previous quarter s 44.2%. Gross margin also shrank 12 bps from the year-ago quarter. Applied s operating expenses of $552 million declined 1.3% from the last quarter. The decline in general and administrative expense was the most significant, but was offset by an increase in selling and marketing expense. As a result, operating margin of 18.9% shrank 57 bps sequentially but was up 210 bps from the year-ago quarter. Net Profit On a pro-forma basis, Applied Materials reported net income of $338 million, or $0.27 which was flat sequentially. In the year-ago quarter, Applied reported a net income of $268 million, or $0.22. Our pro-forma calculation excludes restructuring, acquisition-related, impairment and other charges as well as tax adjustments in the reported quarter. On a fully diluted GAAP basis, the company recorded a net profit of $348 million ($0.28 per share) compared with $290 million ($0.23 per share) in the previous quarter and $253 million ($0.21 per share) in the year-ago quarter. Balance Sheet Inventories increased 4.8% during the quarter while Accounts receivables declined 5.4% sequentially to $1.5 billion. Cash and short-term investments balance was $3.09 billion at quarter end, compared with $3.16 billion in the prior quarter. Goodwill was 25.3% of total assets in this quarter. Applied Materials generated $60 million of cash from operations, which reflects higher revenue from Display tools that were previously secured with cash in advance. The company spent $49 million on capex and $122 million on dividends. At quarter end, the company had $1.95 billion of debt on its balance sheet. Guidance Applied also provided guidance for the second quarter of fiscal Revenues are expected to be flat to up a couple of percentage points sequentially. Non-GAAP EPS is expected to come in a range of $0.26 to $0.30. Conclusion The first quarter was a moderately good one for Applied Materials. Equity Research AMAT Page 3

4 Applied Materials has a solid product line and management has stepped up investments to prepare for the ongoing transitions to larger wafer sizes and smaller process nodes. The ramp up in FinFET, 3D NAND and new display technology will likely be the catalysts going forward. There is also scope for share gains on the Display side of the business backed by PVD tools. The drivers of this business are larger TV screens and better mobile displays that involve more complicated production processes and new tools. Also, management expects demand for DRAM chips, to improve in the upcoming quarter. Developing trends in mobility, connectivity, video and wearable devices are fueling the growth of the industry. This in turn is increasing advancement in mobile processors, solid-state storage and interactive displays. Customers are focused on increasing shares in these inflections and this is in turn is resulting in a period of continued investment by semiconductor customers. Due to major transitions in semiconductor and Display technology, big opportunities lie ahead of Applied. Its upcoming merger with Tokyo Electron will further take it toward its long-term strategic goals. Applied has strengthened its R&D and at the same time increased investment in product development. Also, the investment by its customers provides a solid foundation for the upcoming year. Though there are challenges inherent in its spending mix and issues about timings, the company remains well poised to tap the opportunity. To fully capitalize on these transitions, Applied has focused its structure and talent around key areas of value creation. It plans to align its product portfolio in a way that it generates the best returns for its clients. Equity Research AMAT Page 4

5 VALUATION Applied Materials shares are trading at 22.3X trailing 12 months earnings. Historically, the shares have traded in the range of 7.8X to 82.5X trailing 12 months P/E (a very wide range). The very wide range makes it less reliable for future predictions. On the other hand, since the earnings growth rate is lower than that of the peer group, we think that downward potential exists. We therefore have a Neutral recommendation on Applied shares, supported by a price target of $25.00 (23.4X 2014 EPS). Key Indicators P/E F1 P/E F2 Est. 5-Yr EPS Gr% P/CF P/E P/E 5-Yr High Applied Materials, Inc (AMAT) P/E 5-Yr Low Industry Average S&P Sunedison Semi (SEMI) NA NA NA NA NA ASML Holding NV (ASML) Lam Research (LRCX) TTM is trailing 12 months; F1 is 2015 and F2 is 2016, CF is operating cash flow Applied Materials, Inc (AMAT) P/B Last Qtr. P/B 5-Yr High P/B 5-Yr Low ROE D/E Last Qtr. Div Yield Last Qtr. EV/EBITDA Industry Average S&P NA 2.1 NA Equity Research AMAT Page 5

6 Earnings Surprise and Estimate Revision History NOTE THIS IS A NEWS-ONLY UPDATE; THE REST OF THIS REPORT HAS NOT BEEN UPDATED YET. Equity Research AMAT Page 6

7 OVERVIEW Applied Materials, Inc. (AMAT) is one of the world s largest suppliers of equipment for the fabrication of semiconductor, flat panel liquid crystal displays (LCDs), and solar photovoltaic (PV) cells and modules. The company also offers deployment and support services related to the equipment supplied. ` In fiscal year 2013, Applied reported results in four segments Silicon, Applied Global Services, Display, and Energy and Environmental Solutions. Revenue by Segment in % 7% 2% 64% Silicon Applied Global Services Display Energy and Env Solns Applied Materials Silicon segment offers equipment for front-end operations in the semiconductor manufacturing process. Front-end processes involve the deposition or implantation of multiple thin layers of electronically conductive, semiconductive and insulating materials onto and within a silicon wafer with the help of photomasks (reticles) to give multiple copies of integrated circuit devices. Specific processes enabled by Applied s equipment include atomic layer deposition (ALD), chemical vapor deposition (CVD), physical vapor deposition (PVD), etching (cleaning off the extra photoresist as exposed by the mask), rapid thermal processing (RTP), chemical mechanical planarization (CMP), wafer metrology and inspection. The company also makes equipment for the etching, measurement and inspection of photomasks. With over 33,000 systems installed, the Applied Global Services segment goes a long way to ensure customer satisfaction and support. There are primarily three kinds of services offered. The first, fab and equipment services, is with respect to facilitation of processes at fabs using Applied s equipment. Offerings under this category include spares, the ExpertConnect remote diagnostics tool for maintaining and optimizing customers manufacturing operations; Applied FabVantage Consulting Services delivered through teams providing technology to identify and solve manufacturing challenges; and TechEdge advanced service services to address manufacturing issues like excursion control and predictive maintenance. Legacy systems essentially extend the life of 200mm equipment through system enhancements and certification of refurbished equipment and also include fab transition services. Automation systems are proprietary software for factory-level or tool-level control and automation. Applied has developed technologies for significantly larger-sized wafers made of materials other than silicon. This has helped it expand its portfolio into equipment for thin film transistor (TFT) LCDs (made Equity Research AMAT Page 7

8 from glass) and OLED, which are used in smartphones, TVs and other consumer electronic devices. The company operates this business under the Display segment. The Energy and Environmental Solutions segment primarily consists of the solar product line. The company ventured into this business in 2006 and currently offers equipment for manufacturing both wafer-based crystalline silicon (c-si) and glass-based thin film used in the solar PV cell fabrication process. To this, Applied added the SunFab Thin Film product line for manufacturing very large glass substrates that could be used by solar farms, utilities and building-integrated solar PV installations. In the third quarter of 2010, market conditions prompted the company to discontinue sales of its fully-integrated Sunfab product to new customers. Revenue by Geography in % 4% 9% 35% 11% 12% 20% Taiwan U.S. Korea China Japan Europe Southeast Asia Applied uses a direct sales force for the distribution of its products. The company s significant presence in Asia is attributable to the fact that a large chunk of semiconductor manufacturing has shifted to the region. Being a leading producer of specialized equipment, most of the competition comes from other large equipment makers, such as KLA-Tencor Corporation and Lam Research Corporation. REASONS TO BUY Applied Materials has further strengthened its leadership position in the semiconductor capital equipment market following its merger with Tokyo Electron Limited. The combined entity will see significant cost synergies ($250 million within the first full year of operation and $500 million within the third full year of operation). Tokyo Electron will generate profits within the first full year of operation. But synergies are not the major focus: the two equipment companies recognize the changing needs of the market, i.e. consumer preference increasingly moving from PCs to mobile devices such as tablets and smartphones; TVs getting increasingly connected and rising energy needs driving the adoption of alternative energy sources, such as solar. Developing new manufacturing technologies is a very expensive process and equipment makers often need to get together for the purpose. However, because of the merger, Applied will be able to keep ownership of these new technologies in-house, which will enhance its competitive position. The company s silicon business did not do very well last year, but Applied still continued to score important design wins for the CVD, PVD and CMP tools that should help it generate additional revenue and maybe pick up some market share this year. Applied is also well positioned in etch. Foundries are Equity Research AMAT Page 8

9 currently seeing very strong demand for mobile products, which in turn is driving demand for DRAM products. NAND too is gaining, though mobile is not the only driver here. NAND demand is also being driven by its application in cloud computing. Additionally, the process technology leader is driving ahead with its die shrinks, which is an added pressure on foundries to make cheaper devices in larger volumes. The resultant node transitions from 28nm to 22nm to 20nm, 16nm and 14nm FinFET is leading to increased demand for the tools that Applied supplies. The long-term growth prospects in the LCD TV market remain positive for Applied s display business. LCD TVs account for the bulk of display segment revenues, with mobile devices like smartphones and tablets making up a much smaller share. Display Search estimates that LCD TV shipments declined 6% in 2012 (first decline) and was followed by a 3% decline in 2013 with 2014 expected to see a return to growth of around 5%. OLED shipments on the other hand are expected to grow gradually, but will be limited to less than 1% of revenue through Applied s expanding product line is partly responsible for the increased total available market (TAM), which will spur growth in the following quarters. Continued price declines should also help sales. Since emerging markets are expected to account for most of the growth, we may expect continued demand for the company s equipment, which could improve the efficiency of the manufacturing process. A few years back, management decided to diversify away from the semiconductor business into a less cyclical and more upcoming category. They therefore started investing in a solar equipment product line. The solar business was initially driven by a number of European countries, particularly Germany, which started exploring solar power as a source of energy. Applied s early decision enabled it to gain share in this market. The company is now focused on growing the crystalline business while cutting costs to bring the structure in line with demand. The thin film category is currently on the back burner, due to a number of issues faced by panel makers 1. In this context, Applied s decision to discontinue its equipment line for the category makes perfect sense. However, management intends to go on investing in the thin film business, which could ultimately help it stay ahead of other equipment makers. We think that over the next few years, the company is likely to see positive cash flow from the crystalline business, which will be used to fund these R&D investments. Market dynamics appear to be improving. Being an equipment company offering products for front-end applications, Applied is dependent on wafer starts at new and existing semiconductor facilities. Therefore, in an up cycle, the company would be able to sell its superior quality products and maybe pick up some market share. Through the rest of the cycle however, market share gains if any are slow. Considering this backdrop and the fab build rate, the company may see a gradual improvement in its results this year. Applied has a very strong balance sheet, with a cash and short term investments balance of $2.87 billion at the end of first quarter. The debt cap ratio including long term liabilities and short term debt was just 23.9%. Additionally, management returns value to customers through regular share repurchases and dividends. The company s dividend stream has been consistent and rising. The dividend yield of the company is currently 2.1%. REASONS TO SELL 1 The main problem was with respect to the high manufacturing costs of thin film panels and very slow adoption of solar technology. This was hurting thin film panel makers on two fronts. First, though thin film solar panels have a higher conversion rate, meaning that they generate more solar power than photovoltaic panels, the cost of manufacturing them is also higher. Therefore, panel makers need huge capital outlay. Because of the early adoption stage of the technology, banks and financial institutions are not forthcoming. So panel makers are up against financing challenges. Second, since they have to charge high prices to cover these costs, only very large operations, such as utilities and solar farms are in a position to purchase. Therefore, demand is not significant. After struggling for several months, many panel makers decided to discontinue thin film production until costs could be lowered or demand increased sufficiently. Equity Research AMAT Page 9

10 Although restructuring actions have lowered the cost structure, the company has also taken restructuring charges that have impacted GAAP profits. In fiscal 2008, the company took $40 million in charges, which went up to $158 million in fiscal 2009 and $246 million in fiscal While 2011 was a dry year, in 2012, the company started incurring restructuring charges yet again. Restructuring charges may be expected to continue in the foreseeable future. We do not feel comfortable about excluding restructuring charges from pro forma calculations when they continue for significantly long periods of time. We believe that in such cases, management could be tempted to include regular quarterly expenses in the number, thus portraying a more favorable picture. Capital equipment sales are typically high-value and AMAT is dependent on a relatively fewer highvalue product sales to a limited customer base. Therefore, winning each individual order is very important. Moreover, the company has also got to take an extremely customer-centric approach, maintaining very good relations with each individual customer. Losing a sale or a customer would have a significant impact on results. In difficult times, the company might also have to write off receivables to accommodate customers, as it has done in the past. The company has a high fixed cost structure, so margins suffer a lot when sales fall. On the other hand, the structure is required to generate sales to support increases in customer demand. Additionally, Applied Materials has to spend a considerable amount of money on R&D to maintain its edge in innovation and recover margins that are high enough to continue this spend. DISCLOSURES & DEFINITIONS The analysts contributing to this report do not hold any shares of AMAT. The EPS and revenue forecasts are the Zacks Consensus estimates. Additionally, the analysts contributing to this report certify that the views expressed herein accurately reflect the analysts personal views as to the subject securities and issuers. Zacks certifies that no part of the analysts compensation was, is, or will be, directly or indirectly, related to the specific recommendation or views expressed by the analyst in the report. Additional information on the securities mentioned in this report is available upon request. This report is based on data obtained from sources we believe to be reliable, but is not guaranteed as to accuracy and does not purport to be complete. Because of individual objectives, the report should not be construed as advice designed to meet the particular investment needs of any investor. Any opinions expressed herein are subject to change. This report is not to be construed as an offer or the solicitation of an offer to buy or sell the securities herein mentioned. Zacks or its officers, employees or customers may have a position long or short in the securities mentioned and buy or sell the securities from time to time. Zacks uses the following rating system for the securities it covers. Outperform- Zacks expects that the subject company will outperform the broader U.S. equity market over the next six to twelve months. Neutral- Zacks expects that the company will perform in line with the broader U.S. equity market over the next six to twelve months. Underperform- Zacks expects the company will under perform the broader U.S. Equity market over the next six to twelve months. The current distribution of Zacks Ratings is as follows on the 1121 companies covered: Outperform %, Neutral %, Underperform 7.2%. Data is as of midnight on the business day immediately prior to this publication. Our recommendation for each stock is closely linked to the Zacks Rank, which results from a proprietary quantitative model using trends in earnings estimate revisions. This model is proven most effective for judging the timeliness of a stock over the next 1 to 3 months. The model assigns each stock a rank from 1 through 5. Zacks Rank 1 = Strong Buy. Zacks Rank 2 = Buy. Zacks Rank 3 = Hold. Zacks Rank 4 = Sell. Zacks Rank 5 = Strong Sell. We also provide a Zacks Industry Rank for each company which provides an idea of the near-term attractiveness of a company s industry group. We have 264 industry groups in total. Thus, the Zacks Industry Rank is a number between 1 and 264. In terms of investment attractiveness, the higher the rank the better. Historically, the top half of the industries has outperformed the general market. In determining Risk Level, we rely on a proprietary quantitative model that divides the entire universe of stocks into five groups, based on each stock s historical price volatility. The first group has stocks with the lowest values and are deemed Low Risk, while the 5 th group has the highest values and are designated High Risk. Designations of Below-Average Risk, Average Risk, and Above-Average Risk correspond to the second, third, and fourth groups of stocks, respectively. Equity Research AMAT Page 10