(AMAT) Applied Materials Plunges on Weak Guidance

Applied Materials’ (AMAT) third quarter earnings exceeded the Zacks Consensus Estimate by 2 cents. Revenue came in higher than management expectations and exceeded the Zacks Consensus by 4.0%.

Revenue

Applied reported revenue of $2.79 billion, which was down 2.6% sequentially and up 10.7% year over year.

All segments performed within the guided range, although Display was the only segment that actually grew.

Revenue by Segment

SSG remains Applied’s largest segment, with a 50% revenue share. Segment  revenue was down 3.8% sequentially and 3.4% year over year. Management had expected segment revenue to be flat to down 7% sequentially, so revenue was within expectations. The decline in foundry and NAND spending compounded the existing weakness at DRAM to pull down results.

Applied stated that DRAM prices have weakened considerably due to weakness at PCs. However, mobile DRAM, remains quite strong, driven by the continued demand for smartphones. Applied stated that the likelihood of share gains was receding due to the continued weakness in the market.

Applied expects its SSG business to be down 20-35% in the fourth quarter due to weakness in foundry and NAND spending, although Gartner continues to see the semiconductor equipment market growing 10% this year.

The second largest segment was AGS, which generated 22% of total revenue. Segment revenue dropped 1.8% sequentially, while growing 28.8% year over year, within Applied’s expectations of a 0-5% sequential decline.

Management stated that softening end demand and inventory accumulation were leading to lower utilization rates and a slight reduction in wafer starts. Applied currently does not expect any significant increase in wafer starts in the next quarter (it previously expected wafer starts to increase 5-7% in 2011).

The EES segment made a 20% contribution to quarterly revenue, representing a sequential decline of 11.6% (guidance was at least a 15-25% decline) and a year-over-year increase of 45.5%. Applied is now focused on the crystalline silicon business, which has started to prove beneficial for the company.

Management continues to expect installations to support 19-22 Gigawatts, with 67% falling in the second half. Germany represents the largest share of this demand (Applied estimates 35%), although China is likely to emerge as a very strong player in 2012. China recently introduced feed-in tariffs, which along with the lower cost of manufacturing is likely to make solar a more viable alternative.

Applied 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. Management has projected crystalline silicon capex increase of around 30% in 2011, with 90% of the spending in China and Taiwan, which should be highly beneficial for the company given its position in these markets.

Sales of the Baccini and precision wafering system (PWS) platforms remained strong as the Baccini product line helps transition to advanced systems.

Performance in the Display segment was much better than management expectations of more than a 25% sequential increase. The segment generated just 8% of revenue in the last quarter, growing 41.1% sequentially and 3.2% from last year.

The strength in the last quarter was mostly on account of mobile displays, which were 50% of display revenue and 80% of display orders in the last quarter. The reason for the strength here is the continued demand for mobile devices coupled with supply constraints.

The TV market, however was extremely disappointing, with Applied now projecting it to grow just 11% this year. New capacity builds, including those in lower-cost regions, such as China are getting pushed into 2012.

Revenue by Geography

Around 75% of Applied’s quarterly revenue came from the Asia/Pacific region, with the largest contribution from China, which generated 27% and followed by Korea and Taiwan, Both of which generated 16%. However, while China grew 1.3% sequentially, Korea increased 44.5%, while Taiwan dropped 30.2%. Japan was up 36.5%. North America declined 3.4%, while Europe declined 17.0%.

Orders

Total orders were down 25.0% sequentially and 12.3% year over year. All except the AGS segment declined sequentially. AGS grew 1.7%. All segments grew from last year with the exception of AGS, which was up 3.0%.

The softness was greatest in Taiwan (down 30.2%), followed by Europe (down 17.0%), South East Asia (down 15.7%) and North America (down 3.4%). Korea and Japan were up 44.5% and 36.5%, respectively.

The book-to-bill was negative in all except the AGS segment, which recorded 1.02. The SSG, Display and EES segments recorded BTBs of 0.89, 0.99 and 0.56, respectively.

Margins

Applied generated a gross margin of 42.5%, up 94 basis points (bps) from the previous quarter’s 41.5%. The gross margin improvement in the last quarter was because Applied cut back on its temporary workforce and overtime capacity.

Management expects to selectively shut down factories in the next quarter in order to minimize costs and keep them in line with the sagging demand. The gross margin was up 749 bps from the year-ago quarter.

Applied’s operating expenses of $501.0 million were essentially flat compared to the March quarter, with the operating margin of 24.5% increasing 57 bps sequentially and 542 bps year over year. All expenses increased slightly as a percentage of sales, but were easily offset by the stronger gross margin. SG&A as a percentage of sales was the only head to increase even on a year-over-year basis, although it was offset by declines in cost of sales and  R&D.

Net Profit

On a pro forma basis, Applied Materials had a net income of $467.0 million, or a 16.8% net income margin compared to $493.0 million, or 17.2% in the previous quarter and $233.6 million, or 9.3% in the third quarter of fiscal 2010.

The fully diluted pro forma earnings were 35 cents a share compared to earnings of 37 cents in the previous quarter and 17 cents in the comparable prior-year quarter. Our pro forma estimate excludes restructuring charges, acquisition-related charges, gain on sale of facilities and other items 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 $476.0 million ($0.36 per share) compared to $489.0 million ($0.37 per share) in the previous quarter and $123.1 million ($0.09 per share) in the prior-year quarter.

Balance Sheet

Inventories were up 3.1% sequentially, with inventory turns dropping from 3.7X to 3.5X. Days sales outstanding (DSOs) went from 61 to 59, displaying a positive trend for collections. The cash and short term investments balance was $5.76 billion at quarter-end, having increased $2.45 billion during the quarter due to debt raised. The debt will be used to fund the Varian acquisition.

The company generated $600 million of cash from operations, spent $55 million on capex, $25 million on share repurchases and $105 million on dividends. At quarter-end, Applied had $1.95 billion of debt on its balance sheet, with a net cash position (excluding short and long term debt) of $3.81 billion. The debt cap ratio including long term liabilities and short term debt was just 21.0%.

Guidance

Management provided guidance for the fourth quarter. With SSG to be down 20-35% sequentially, AGS to be down 5-10% (in-line with the sluggishness in wafer starts), Display to be flat and EES to decline more than 30%, total revenue is expected to be down 15-30% sequentially. The non-GAAP EPS is expected to come in at 16-24 cents a share.

The Zacks Consensus Estimate for the next quarter was 32 cents when the company provided guidance, way above the guided range. Management tone appears very cautious and the guidance range very wide.

Applied did not revise its full-year guidance. Accordingly, taking the fourth quarter guidance at its mid-point, we should expect full-year revenue to come in at $10.5 billion and the non-GAAP EPS at $1.28 a share, well below the Zacks Consensus of $1.40 when the company reported.

Conclusion

The Zacks Rank for Applied Materials shares is #5, signifying a short term Strong Sell recommendation. We think the company’s strong position in the semiconductor market and focus of the solar business in China are the biggest positives right now. We expect the strong portfolio and strategic relationships to drive share gains here. However, with DRAM pricing remaining weak and both foundries and NAND producers cutting utilization, the semiconductor side of the business may be expected to nose-dive. The timing and extent of the LCD market recovery is also something to track, especially given the recent setback to consumer confidence and the softening of demand from emerging countries.

Given the cyclical slowdown in the equipment sector, other semi equipment companies, such as ASML Holdings (ASML), Novellus Systems (NVLS) and KLA Tencor Corp. (KLAC) currently carry a Zacks #3 Rank.

APPLD MATLS INC (AMAT): Free Stock Analysis Report

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NOVELLUS SYS (NVLS): Free Stock Analysis Report

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