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Applied Materials, Inc. (NASDAQ:AMAT)

F2Q06 Earnings Conference Call

May 16, 2006 4:30 p.m. EST

Executives

Randy Bane - Managing Director of IR

Nancy Handel - SVP and CFO

Mike Splinter - President and CEO

Analysts

Jay Deahna - JP Morgan

Patrick Ho - Stifel Nicolaus

Brett Hodess - Merrill Lynch

Stephen Chin - UBS

Jim Covello - Goldman Sachs

Mike O'Brien - Bear Stearns

Steve O'Rourke - Deutsche Bank

Satya Kumar - Credit Suisse

Robert Maire - Needham & Co.

Timothy Arcuri - Citigroup

Suresh Balaraman - ThinkEquity Partners

Timm Schulze-Melander - Morgan Stanley

Edward White - Lehman Brothers

Stuart Muter - RBC Capital Markets

Shekhar Pramanick - Moors & Cabot

Gary Hsueh - CIBC World Markets

Steven Pelayo - Soleil Securities

Mark Fitzgerald - Banc of America

Gavin Duffy - A.G. Edwards

Ben Pang - Prudential Financial

Presentation

Operator

Good afternoon and thank you for standing by. Welcome to the Applied Materials second quarter fiscal year 2006 earnings conference call. (Operator Instructions) I would now like to turn the conference over to Mr. Randy Bane, Managing Director of Investor Relations, Applied Materials. Please go ahead, sir.

Randy Bane

Good afternoon and welcome to the Applied Materials second quarter 2006 earnings conference call. With me today are Mike Splinter, President and CEO; Nancy Handel, Senior Vice President and Chief Financial Officer; Joe Sweeney, Senior Vice President, General Counsel and Corporate Secretary.

Financial results for our second fiscal quarter were released on Business Wire shortly after 1:15 Pacific Time. For your convenience, a copy of the news release, as well as a presentation containing the highlights of today's call, are available on the investor section of the website, www.appliedmaterials.com.

Today's earnings call contains forward-looking statements, including those relating to Applied Materials' financial performance; operational efficiency; cash generation and cash deployment; delivery of stockholder value; effective tax rate; growth opportunities in existing, adjacent and new markets; expansion of our served market, strategic position, technology leadership, joint ventures and acquisitions, and financial targets; customers' capacity buildout; fab utilization and investments in advanced technology; and the outlook for electronics, semiconductors and solar industries.

All forward-looking statements are subject to known and unknown risks and uncertainties that could cause actual results to differ materially from those expressed or implied by such statements. Information concerning these risk factors is contained in today's earnings press release and in the Company's filings with the SEC, including the Form 10-K for fiscal 2005 and its most recent Forms 10-Q and 8-K. Forward-looking statements are based on information as of May 16, 2006, and the Company assumes the obligation to update any such statement.

Today's call also contains non-GAAP financial measures. Reconciliations of non-GAAP financial measures to GAAP financial measures are contained in our earnings press release today and in the document entitled Earnings Call Highlights, both of which are available on the investor page of Applied Materials' website, www.appliedmaterials.com.

Today's call will begin with an analysis of the second quarter financial results by Nancy Handel followed by Mike Splinter, who will provide an update on the industry environment and Applied's strategic position. Following Mike's comments, Nancy will provide third quarter 2006 financial targets. We will then open the conference call for questions. With that, I would like to turn the call over to Nancy Handel.

Nancy Handel

Thank you, Randy. Good afternoon, everyone, and thank you for joining us. Today, I will cover the results for the second fiscal quarter of 2006. During the second quarter, strengthening demand for integrated circuits, together with customers' requirements for advanced nano manufacturing solutions, resulted in higher orders. In addition, our continued focus on improving overall efficiency is yielding strong financial performance.

Finally, it is most important to recognize that our employees have made us the leader in our industry due to their commitment to delivering innovative products and services that enhance customers' productivity. I would like to thank them for achieving these excellent results.

Highlights for the second quarter included outstanding order performance and a 21% increase in revenue, flowing through to gross margin at 53%. In addition, we continued to deliver strong cash flow and return value to our stockholders.

For the second fiscal quarter, orders of $2.49 billion surpassed our target and were 22% higher than for the first quarter of 2006. Revenue for the second quarter was $2.25 billion, 21% higher than the last quarter, and exceeded our target. Operating income was $561 million or 25% of revenue, compared to 8% for the first quarter of 2006. Net income was $413 million or $0.26 per share, compared to $143 million or $0.09 per share for the first quarter.

Results for the second quarter included equity-based compensation expenses of $55 million or $0.03 per share and a net benefit of $2 million associated with facilities realignment programs. Of the $55 million in equity-based compensation expenses, $9 million was reflected in gross margin and $46 million in operating expense. Excluding these items, the Company would have reported net income of $453 million or $0.29 per share.

Reported gross margin for the second quarter was 46.5%, compared to 45.1% for the first quarter of 2006. Equity-based compensation programs decreased this quarter's gross margin by 0.4%.

Increased customer demand drove higher than expected order growth. In the quarter, DRAM orders represented 27% of silicon systems orders, flash memory orders were 24% and foundry orders were 17%. Logic and other orders comprised the remaining 32%.

300 millimeter orders represented approximately 73% of total systems orders, and 74% of the system orders were for 100 nm and below process technology. Six orders were in excess of $100 million. Seven orders were between $50 million and $100 million. 14 orders were between $10 million and $50 million.

Customers are continuing to build out 300 millimeter fabs, driving new levels of industry operating efficiency. By the end of calendar 2006, we expect 300 millimeter to make up about 20% of overall semiconductor manufacturing capacity, and we expect capacity buildouts to continue through 2007. With over 55 major fab plants in the works for high utilization and migration to new technologies, this is good reason for optimism.

During the second quarter, orders increased from customers in Korea, Japan and Southeast Asia and China. Orders by major geographic areas were Korea, 22%; Taiwan, 19%; North America, 18%; Japan, 17%; Southeast Asia and China, 14%; and Europe, 10%. Backlog for the second quarter increased to $2.93 billion, compared to $2.73 billion for the first quarter of 2006. Backlog adjustments totaled $46 million, consisting primarily of customer cancellations.

During the second quarter, broad-based customer demand created by rising fab utilization, investments in advanced technology, and our improved product position drove our revenue increase. Operating expenses for the second fiscal quarter were $484 million, relatively flat quarter over quarter. Our continued focus on improving operating efficiency is paying off with increased gross margins and operating profits.

The effective tax rate for the second quarter of 31.3% was slightly lower than forecast. We anticipate the effective tax rate for the third quarter will be approximately 31.5%.

Excluding the non-GAAP adjustments stated in our press release, Applied's return on invested capital would have been 53%. We define return on invested capital as operating profit after tax, excluding one-time tax benefits, calculated on an annualized basis, divided by the average invested capital, less cash, cash equivalents and investments.

We are pleased to report that our free cash flow generation for the quarter was $461 million. We define free cash flow as cash provided by operating activities, less capital expenditures. During the quarter, cash, cash equivalents and investments decreased $30 million to $5.8 billion.

As of April 30, 2006, Applied changed the classification of certain investments from short term to long term. We believe this better reflects Applied's expectation of when such securities will be converted to cash. Prior-period balances have been reclassified to conform to the current period's presentation.

During the second quarter, the Company repurchased 28 million shares of our common stock for $500 million at an average purchase price of $18.16 per share. Since the beginning of fiscal 2005, the Company has repurchased approximately 155 million shares, representing approximately 9% of shares outstanding at October 31, 2004, for a cash outlay of $2.7 billion.

During the third fiscal quarter of 2006, we plan to repurchase shares in the range of $400 million to $600 million. In March 2006, the Company declared a cash dividend in the amount of $0.05 per share payable on June 8 to stockholders of record as of May 18.

Accounts receivable increased over the prior quarter by $194 million and days sales outstanding was 79 days. Inventory increased by $60 million during the quarter. Capital spending for the quarter was $32 million, and depreciation and amortization totaled $66 million. Headcount at the end of the quarter was 12,790 regular employees.

Mike will now provide his perspective on the market environment and the Company's strong strategic position.

Michael Splinter

Thanks, Nancy. In the second quarter, demand for Applied Materials' nanomanufacturing technology was strong and broad-based. Our semiconductor and flat-panels systems business drove growth as product positions continued to strengthen. Our operations, sales and product teams did a fantastic job setting the pace in this ramp, producing excellent financial results.

I would like to discuss several key items today. First, Applied is expanding in our core business and winning new accounts. Our semiconductor systems business has outperformed the competition. We have outgrown each of our major competitors in etch, implant, thin films and inspection for the last two quarters; and we expect to continue strong performance through the year.

For example, our CVD business volume in 2006 is expected to set a new record, growing faster than the market, as our customers turn to new applications like advanced patterning films and strain engineering for device enhancement and to address the continuing increase in the number of metal layers with low-k dielectrics.

Our expertise in advanced technology is attracting customers to our solutions like RadOx, DPN and recessed epi for enhanced transistor performance. Our advanced solutions in CMP, etch and CVD are also high-growth areas now and in the future, as more of these capabilities are adopted by memory manufacturers seeking to improve litho performance and to increase their density of their flash and DRAM products. The effect of this can be seen with orders in these areas up over 80% in the last two quarters.

Second, we are extending our broad product portfolio and entering adjacent markets. We've done it by delivering new technology, like UVision, that opened up the brightfield inspection market for us last year. The formation of Sokudo, our strategic partnership with Dainippon Screen that we announced yesterday, expands our litho-enabling solutions by accelerating our entry in the track. You should expect more new products over the coming months, positioning the Company to continue to outgrown and outperform the industry.

Third, we have developed Applied Global Services into a world-class, diverse product business group that delivers strong growth that is built on our core business. AGS had record revenue and profitability this quarter as spares, refurbished equipment and our Metron products led the way.

AGS is introducing new products and we are making acquisitions like the one in Singapore we announced last week to expand our capabilities globally, particularly in the area of chamber performance services. We expect AGS to continue to grow and deliver new levels of profitability.

Fourth, we are looking long term, beyond semiconductor manufacturing, to access high-growth markets. We have built our AKT flat-panel product business group into a leader in its product area. Today, it is focused on only about 20% of the available market. We are taking steps to grow that total opportunity.

The planned acquisition of Applied Films expands our flat-panel business into the other major product area, color filter, and also opens the fast-growing solar photovoltaic market for us. These new businesses are built on the core thin film nanomanufacturing capabilities of Applied Materials, and in the future, they will generate additional growth.

The new opportunities we have discussed in our core products, service, flat-panel and solar add to our served available market and add to the fundamental core market growth. It really represents what we mean by applying nanomanufacturing technology to areas where our core capabilities can change market dynamics and foster market growth by delivering improvements in cost and productivity of the end products.

I am also pleased with the progress we have made in operational and financial performance. In everything from gross margin to cycle time, balance sheet performance to cash flow, we are delivering on our goal to make Applied Materials fast and flexible so that we can continue to operate our core business with excellence while adding new businesses.

Let me sum up by reflecting on the industry and then make a closing comment. In general, we see a healthy environment where the growth rate in electronics product demand is increasing. According to Dataquest, the $1.3 trillion global electronics market is expected to grow in excess of 7% this year. That is amazing growth on a base that big and represents fast-growing demand for cell phones, digital TVs, gaming PCs, MP3s and a host of other chip-powered products. We believe these products are fundamental in growing economies and will continue to grow ahead of GDP in years to come.

This demand is driving the need for increased semiconductor capacity and incremental equipment investments in order to meet that rising unit demand in the short and the long run. Our customers have spent rationally on capacity and maintain a very high rate of utilization with improved profitability. Because of this, new fab activity is up and producing new opportunities for us. From that perspective, the industry is healthier than it has been in years, and I am confident that 2007 will be a year of continued CapEx expansion.

We are strengthening Applied Materials to make it an even greater partner for our customers. I think it is fair to say that we have a larger set of opportunities in front of us today than we have had at any time in our history. Our employees around the world have done a fantastic job, and their focus, dedication and commitment is driving our ability to grow and grow profitably. Thank you very much. Now I will turn the call back over to Nancy for the Q3 forecast.

Nancy Handel

Thank you, Mike. As we enter our third fiscal quarter, we remain focused on operational efficiency and driving margin improvement throughout the Company. We are also excited about the newly announced opportunities to expand our business. However, please note that the targets that I am about to give do not incorporate the financial implications of these proposed business combinations.

Our fiscal third quarter targets are orders up approximately 5% to 10% from Q2 levels; revenue up approximately 5% to 10% from Q2 levels; and earnings per share, $0.28 to $0.30, which includes an estimated $0.03 per share for equity-based compensation.

Going forward, we see memory remaining strong and foundry expected to be up in the third quarter. We should see growth across our nanomanufacturing technology product areas as we position Applied Materials to outgrow and outperform. With that, I will turn the call back to Randy so we can start the Q&A.

Randy Bane

Thank you, Nancy. Operator, we will now begin our question-and-answer session. We would like to entertain questions from as many callers as possible. As such, please limit your questions to one per firm. Operator, please begin with the first question.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Jay Deahna - JP Morgan.

Jay Deahna - JP Morgan

Actually, Mike, in terms of the outlook, you indicated in your prepared remarks that CapEx should be up in 2007. Can you give us a sense as to what kind of magnitude you are talking about? Are we talking 10%-plus or up undefined? If that is the case, do bookings need to trend higher throughout the rest of this calendar year in order to get into that?

The second part of the question is you laid out some of your strategic objectives. Is that your priority order? Organic, semi equipment, tool development, acquisitions and JVs, then service, then future markets? Or is it basically whatever the best opportunities are within those four that pop up, you hop on them?

Mike Splinter

Okay, Jay, thanks for the question. On CapEx in 2007, we are thinking around 10%, maybe high single-digits, up to 10% growth in 2007. We think that it will be a continued drive of consumer electronics causing the growth in electronics demand well ahead of GDP. Of course, the assumption is that GDP stays on track during that period of time.

As far as the orders in the second half of the year, obviously, we are forecasting 5% to 10% up in the third quarter. We will talk about our fourth quarter later on, but in order to satisfy that CapEx spending in '07, you have to see some level of growth.

On the strategic objectives, I will just lay them out for you. First of all, is to outgrow and outperform in our core business, number one. That is our first and foremost critical objective. Second is to run our Company operationally and financially at a world-class level, and then to grow the Company in new market areas.

So in that core area in the first objective, I include all our current businesses, service, AKT, and in the last objective, new markets that we might go into that we're not in today, some of those represented by the acquisition and joint venture that we announced during the quarter.

Operator

Our next question comes from Patrick Ho - Stifel Nicolaus.

Patrick Ho - Stifel Nicolaus

Thanks a lot. Just getting back to the orders outlook for second, you mentioned that memory was going to be strong and foundry was going to be up. In terms of the guidance, did you see any pull-ins this quarter that created the stronger 2Q '06 results and the outlook for 3Q?

Mike Splinter

Well, I think you can assume that customers are anxious at this point to get capacity online because they need to fulfill customer demand. So, yes, there has been some pull-ins, and we see that environment continuing in Q3. But it is not crazy. I think it is rational.

Patrick Ho - Stifel Nicolaus

A more specific question on the AKT business: do you see the potential order flow picking up in the second half of the year as some of these new next-generation fabs are built?

Mike Splinter

Yes, we do. Actually, our AKT orders were down in this quarter. I think we said that at the beginning of last quarter. So we expect orders to be strong in the second half of the year. So we expect it to be up fairly significantly in the last two quarters.

Operator

Our next question comes from Brett Hodess - Merrill Lynch.

Brett Hodess - Merrill Lynch

On the Applied Services Group, you mentioned that spares were up, but on the services side, how does that growth track relative to the capital spending growth? Is that fairly independent based on installed base? Or is that also getting leverage from the capital spending cycle?

Mike Splinter

Services and spares are much more proportional to the utilization of factories. So service, of course, when you think about it, service does increase off our base business, because of the new equipment that gets out into the market. In any one year, it is a relatively small percentage of the total, but on a continual basis, we are building off the core and it continues to grow in spares and in service. Our refurbished equipment segment was also quite strong this quarter.

Operator

Our next question comes from Stephen Chin, UBS.

Stephen Chin - UBS

A question on the geographies. The orders from the Southeast Asia and China region looks like they more than doubled. Mike, could you provide some more color on what happened there? Was it mostly for 200 millimeter bookings there, and was it one-time in nature? Is this level sustainable going forward, would you think?

Mike Splinter

Well, there was quite a bit of 200 millimeter, particularly from Southeast Asia and a bit in China. But that group overall we see to be continuing strength in Q3. So we think it is going to be maybe even a little stronger than it was in Q2. And Q2, as you point out, was roughly double from our projection in Q1.

Stephen Chin - UBS

If I could just follow up on the other big region in the quarter, it looks like the orders from Korea appear to have hit an all-time high, in my model. Do you think that level is sustainable going forward as well?

Mike Splinter

Well, Korea was quite strong in the quarter. DRAMs and flash continue to be extremely strong. Another factor here is something we've been talking about for some time, is the work we're doing on gaining a bigger share of the memory market. This certainly hurt us in 2005 and our product groups have been doing excellent in 2006 in gaining share. Also AKT, a big part of their sales is in Korea as well. So I think Korea is going to be a big market for us going forward.

Operator

Our next question comes from Jim Covello - Goldman Sachs.

Jim Covello - Goldman Sachs

Good afternoon, guys. Thanks so much. A couple quick questions. First, lead times, could you tell us what they are doing?

Mike Splinter

Not much change on lead time, Jim. There's a few minor spot of tightness in our supply chain. But we think we have been able to work through it and keep our lead times pretty firm.

Jim Covello - Goldman Sachs

Did they kind of go up and now they are coming back down? Or they just never went up that much?

Mike Splinter

They never went up that much.

Jim Covello - Goldman Sachs

And then on the acquisition strategy, it is certainly encouraging to see some product-related acquisitions and joint ventures that we have seen over the last couple of weeks, as opposed to the services acquisitions of the past couple of years. Did the announcements over the last couple of weeks sort of mark a shift in strategy? Or do you think the services acquisition strategy is still going to be part of the big picture?

Mike Splinter

Well, we try to use acquisitions to fulfill the overall strategy. We still think we have lots of opportunity to grow in service. Where there is opportunity to do an acquisition, we will. But obviously, these product-oriented acquisitions are much larger plays than we've done in the service group in the last couple of years.

I think overall, you should take one other message, that we are working on getting better at acquisitions in both how to do them, how to value them, how to integrate them. I think that is part of our overall development here over the last few years.

Operator

Our next question comes from Mike O'Brien - Bear Stearns.

Mike O'Brien - Bear Stearns

Maybe just give me a little more of what is going on with the foundries. I think you said foundries were going to be strong; is that across all of the foundries? Or is it just one or maybe two of them increasing spending more dramatically, while the others still have a foot on the brake?

Mike Splinter

Well, foundry spending was not particularly large in Q2. So their factories are full, or maybe in one case, still filling. We think that they have to start coming back in a bigger way in Q3. There are some signs that that is going to happen more across the board than certainly in Q2.

Mike O'Brien - Bear Stearns

That is through all the foundries? Or is it still a little bit more just one or two of them?

Mike Splinter

No, pretty much all the foundries have to make investments now as capacity is getting tight.

Operator

Our next question comes from Steve O'Rourke - Deutsche Bank.

Steve O'Rourke - Deutsche Bank

A couple of questions. Can you give us a little color on the $46 million in cancellations? I think that was actually backlog adjustments, the majority were cancellations, you had mentioned.

Secondly, just one other region, Japan, orders were pretty strong. It looks like they were pretty volatile over the past several quarters. What do you expect going forward?

Nancy Handel

I'll offer the comment on the backlog cancellation. The majority of that was actually in one customer area, where there was a change in the product mix set that was going to be shipped. So when that happened, we de-booked or canceled the order, and a new order got booked in that case. So that wasn't anything particularly noteworthy there. The rest of it is fairly small miscellaneous single unit kind of activity. There is nothing particularly noteworthy.

Steve O'Rourke - Deutsche Bank

And Japan?

Mike Splinter

Well, maybe I can just make a couple of comments on the direction of what we see and I will include Japan in this. On the next quarter, we are going to see North America down a bit; Japan will be up, Taiwan will be up, and we already talked about Southeast Asia and China.

As far as Japan goes, Japan has been pretty strong for the last, almost two years now. Yes, they have some ups and downs, but I think most of that ups and downs are just part of the lumpy order pattern. If you average out the last two years, they have been about 20% of our order book. I don't see that changing going forward.

Operator

Our next question comes from Satya Kumar - Credit Suisse.

Satya Kumar - Credit Suisse

Thanks for taking my question. You talked about 2007 CapEx up potentially 10%. Can you give us a little bit more color as to what you are thinking in terms of which device segments are driving that CapEx?

Secondly, are the acquisitions and JVs that you are making now going to contribute in terms of revenues in '07? And can you talk a little bit about how much you might potentially outperform the 10% number in '07?

Nancy Handel

I will take that second one first. The targets that we have issued do not reflect any financial input from the two activities that we have announced recently. As we announced during those calls, those are both expected to be mildly dilutive in the near term and expected to be accretive to our earnings beginning in '08.

So our expectation is that we will provide more color on our Q3 call about the impact of these business areas going forward. Mike, do you want to talk about '07?

Mike Splinter

Sure. Well '07, we expect a lot of the current trends to continue to drive from consumer electronics and the continued increase in flash memory utilization for various kinds of data storage. Those two things are going to be the lion's share of what is going to drive CapEx.

So you can take that to be the memory market we think is going to be continuing strong. Then the players and cell phones, MP3 players; it obviously means Japanese will be strong because of the consumer electronics and the other players that really feed that market.

Operator

Our next question comes from Robert Maire, Needham & Co.

Robert Maire - Needham & Co.

In looking at your guidance, I'm trying to get a handle on how much of the 5% to 10% up is conservatism. Do you see a plateau here? Do you see some digestion of stuff that already out there, or is it primarily a mix shift? Can you help us out with the components of what is changing the order pattern here that gives you that kind of guidance?

Nancy Handel

Well, are you talking about orders or revenues? From our revenues, we are really looking for our business to be up across the board, with our service business and our flat-panel business and our core systems business that will be in that outlook.

Similarly, in our orders outlook, service business and flat-panel will be strong again here in the back half of the year, and the systems business should continue at a good pace also.

Robert Maire - Needham & Co.

So with orders being up 5% or 10%, given you are coming off a quarter that is up 22% in orders, is this just lumpy ordering that a lot of orders fell into the just-reported quarter? Or is it that you think there will be a little plateau or digestion period here? I'm just trying to get a handle on the dynamics.

Nancy Handel

Well, the growth area here, the mix will shift a little bit towards the service business. But the silicon business and the panel business will still be coming through strong.

Robert Maire - Needham & Co.

So would that imply that you would expect a reacceleration of order patterns in the second half of the year?

Mike Splinter

Well, Robert, as we said, we think 2007 will be a solid CapEx year. There's always ups and downs in this business. We have lumpy orders. But we think that in the 5% to 10% range on our $2.5 billion basis is still a pretty big number.

Robert Maire - Needham & Co.

Yes, it's a huge number. Is there some sort of a timing issue here where you're talking about 50 fabs or so being worked on. Are the timings similar? In other words, these are not paced or laid out through the year, or most are in a similar mode right now that contributed to a lot of orders falling into the quarter?

Mike Splinter

One other thing you have to remember is there was a strength in 200 millimeter orders because people were filling up some of their older 200 millimeter fabs to fill the demand for the likes of LCD drivers, etc., that use N -1, N -2 capacity. And once those are full, there's no place else to go except the 300 millimeter.

Operator

Our next question comes from Timothy Arcuri, Citigroup.

Timothy Arcuri - Citigroup

Actually, I have two things. First of all, Mike, now that we are about halfway through the year and we can kind of project what it looks like total shipments will be throughout this whole year, if you take your product numbers -- and you have to make some assumptions with flat-panel and service and such -- but if you look at your shipments and you compare it to others in the industry and try to project what this year is going to look like, it looks like shipments are going to be up somewhere in the range of 50% to 60% year-over-year.

That is a lot more CapEx than I think people are thinking. I'm just wondering for your perspectives, because when you divide that by chip revenues, it looks like there's a big jump this year in capital intensity. I'm wondering if those numbers aren't the numbers you get when you do that analysis, or if you think that that is not a valid analysis?

Mike Splinter

We get quite a different number. I think you have heard us say we think WFE is in the 20% to 25% range. We do agree that capital intensity is going up. And I think it is just a slight disagreement on the magnitude.

Timothy Arcuri - Citigroup

So you'd say right now your projection for WFE this year is up more like 20% or 25% and not more like 50% or 60%?

Mike Splinter

Yes.

Operator

Our next question comes from Suresh Balaraman, ThinkEquity Partners.

Suresh Balaraman - ThinkEquity Partners

You guys mentioned that North America would be down. Is that normal lumpiness? Also, have you guys seen any pushouts related to delays in Vista or other product delays?

Mike Splinter

North America is just the normal cycle of who orders and we certainly haven't seen any pushouts in the memory area at this point. I don't think Vista would drive more memory. We haven't seen any pushout due to Vista or in the memory area.

Operator

Our next question comes from Timm Schulze-Melander, Morgan Stanley.

Timm Schulze-Melander - Morgan Stanley

Good afternoon, and congratulations on the strong numbers. A two-part question, if I may. The first, on the reclassification of your cash, that $2.5 billion that has been parked into long-term assets. Is the correct way to think about that that you view that $2.5 billion as really a sort of core strategic buffer and the other $3.5 billion, you're viewing really more tactically?

Secondly, Mike, you made a comment about how Applied is getting better and better in M&A in the valuation and execution of M&A. Is it reasonable just thinking about how you calculate hurdle rates of return, that you are benchmarking them against the return on cash?

Nancy Handel

Yes, I will take the question on the reclassification. I don't think you should read really anything into that activity and accounting change there. This policy really classifies these securities, which are also available for sale, as current or long term based on the maturities of the investment; while the prior classification, the way we had it before was based on the nature of the securities and their availability for use in current operations.

So it really is based on the expectation about the timeframe under which the underlying securities would be utilized in the operations. But as we present our business going forward, we will be adding that in as we present our comments about our liquidity positions.

Mike Splinter

So Timm, on hurdle rates, of course that is one of the things we look at in deciding on an acquisition. But as you can imagine, we are really looking at these things to fit into the strategy of growth. I think these two that we talked about in the last few weeks are good examples of adding on markets to our core business that is already growing. These are new areas that we feel by applying our nanomanufacturing technology, we will be able to accelerate the growth.

So it is a complex equation on how we look at these. But in the end, we want them to help the Company grow and outperform in the long run.

Operator

Our next question comes from Edward White - Lehman Brothers.

Edward White - Lehman Brothers

In the quarter, you had a big jump in the number of large orders, the number of orders over $100 million. It is the highest it's been in some time; and the number in the range of $50 million to $100 million, the highest in some time. Can you talk qualitatively about what is accounting for that, if there is anything to read into that?

Nancy Handel

I don't think there is anything to read into that. It really demonstrates the way the business is coming together and the customers' expectation about what they need to bring in their factory in a reasonable period of time.

Edward White - Lehman Brothers

Secondly, qualitatively, were there any areas where products which were particularly stronger than others, or was it fairly uniform product strength across the board for the quarter?

Mike Splinter

Well, I would say that CVD outgrew all our other product areas. We had strong growth in many areas, but CVD was particularly strong in the quarter, leading all other product groups.

Operator

Our next question comes from Stuart Muter, RBC Capital Markets.

Stuart Muter - RBC Capital Markets

Following up on your comments about CVD and memory, in terms of the flash opportunity now that some processes are going to, SA-CVD, could you help us understand your potential to gain a bigger piece of the flash equipment market with a shift away from high-density plasma CVD?

Mike Splinter

Well, I am not sure I'm going to help you with a lot of numbers here. But yes, the shallow trench isolation is a significant application for us. Customers are moving in our direction to satisfy that need. Also, that is a big step; as big a step in growth in this market with flash is advanced patterning films. Really, the leaders in lithography have now moved from logic to flash memory. They are really working hard every angle to improve the ability to print spaces.

Between those two applications, it is showing significant growth and share gain in the memory area, particularly in flash.

Stuart Muter - RBC Capital Markets

If I could sneak a quick follow-up, just on the foundries, you've mentioned you expect the foundries to be stronger in the second half of your fiscal year. Is that really based upon your belief that they have to spend because their utilization rates are higher, or is that based upon what they are telling you and talking about in terms of the order book that is coming through?

Mike Splinter

Some of both. It depends on the specific customer. Some are already moving their orders up and we're seeing it in the beginning of this quarter. Others we can see the need and activity is starting to increase.

Operator

Our next question comes from Shekhar Pramanick - Moors & Cabot.

Shekhar Pramanick - Moors & Cabot

A two-part question. In your prepared commentary, you talked about increasing the opportunity on the flat-panel side. Should we be reading this more than AFCO, more than CVD, more opportunity in array, where there are a bunch of layers or removal of the layers you could do?

Second, if you could give us a little more update how you are making progress in the UVision or even in the defect sensitive, particularly by memory foundry logic. That would be helpful.

Mike Splinter

On the flat-panel, AFCO obviously allows us to get into the color filter area. As you know, we are also in the e-beam tester area now and growing our share there. But we think we ought to be the Applied Materials of the flat-panel world, over a period time, as we introduce more new products.

On the progress with UVision, we are on track with what we said. This is a great product for memory area where there are really defect sensitive, very small defect sensitivities. So we have been concentrating on the memory manufacturers first, actually. I think as you know, we have more than 13 machines at 13 customers. And that is all progressing on track right now.

On darkfield, I don't think there's any real movement in the market in darkfield at this point. Our ComPlus 3 is doing pretty well. There's been a back and forth, but I don't think there's much movement in the market at this point.

Operator

Our next question comes from Gary Hsueh, CIBC World Markets.

Gary Hsueh - CIBC World Markets

One question, Mike, is on rotation from NAND flash to DRAM orders in the July quarter. You guys have pretty strong exposure to DRAM, as you said, and growing exposure to DRAM. Why is it that we are only seeing plus 5% to 10% order growth if the market is rotating in your favor in July?

Mike Splinter

Well, I am not so sure that the market is rotating in our favor. We think that our numbers are reasonably good with what is going to happen in the next three months, as far as overall orders in the industry.

Gary Hsueh - CIBC World Markets

Well, let me ask a totally separate question to Nancy. Nancy, it looks like you guys have done a real good job here in controlling OpEx in April. But when I plug in my numbers for July, should I be factoring a more meaningful step-up in OpEx, just due to SEMICON West? If I do that, that seems to imply a pretty good drop-through on 5% to 10% revenue growth to the gross margin line. I'm just wondering if there's any kind of mix shift or anything else on the gross margin line that would drive that?

Nancy Handel

I think that when you are looking ahead at our operating expenses, there might be some modest increase. We have a fair number of initiatives underway inside the Company. We've got work going on in our ERP area with our business transformation, as we call it.

We have had initiatives where we have discussed our investments in China. We've obviously got some new product areas. We have done a good job of being more efficient with our operating expense spend. So some modest increase might be anticipated, but not a whole lot more than that.

If you look at the margin, our gross margin has continued to improve. We've been pretty vocal about the kind of programs we have had with global sourcing, with a lot of effort going into operating efficiency in our factory and trying to move down the investment of time and resources and our integrate to order on the manufacturing cycle, our modular final paths, bringing the product back out of the factory. So we are beginning to see some of the benefit from this. We would expect to continue to see that as the factory builds the current outlook.

Operator

Our next question comes from Steven Pelayo, Soleil Securities.

Steven Pelayo - Soleil Securities

Mike, I'm curious if you could just compare your comments today versus 90 days ago. If anything, you guys sound even more optimistic; despite the fact that we've heard some pretty incrementally negative headwinds over the last few weeks. I'm speaking of rising inventories and some pricing pressures and some major product cycle pushouts. Heck, even [Diamento] had some cautionary comments.

So I agree that 2007 is a year of CapEx growth, but I'm quite surprised that you didn't at least acknowledge some of these headwinds in your prepared remarks. Has any of this been incorporated into your outlook or in your guidance? Or do you think this is just normal seasonal softness and all of it's really much ado about nothing?

Mike Splinter

Well, I think you have to look at the breadth of the market. DCs are still growing; the only place where you see inventory that I know clearly is in the PC market. When you look at the entirety of electronics and you look at Dataquest's number for the electronics market, it is growing extremely fast. Cell phones continue to up their number.

I'm not sure where exactly what pricing pressure you're talking about, but flash prices dropped 40% in the first part of the year, have stabilized. There is no inventory of memory that I can recognize. So overall, I think with that kind of demand, it is pretty healthy. We're talking about these things in the first part of year where, at least in electronics, demand is still seasonal to the second half. So most of the consumption will be in the second half of the year.

So as you think about the next four or five months, six months, factories are going to be fuller than they are today. There's going to be a demand for quite a bit more capacity. If we have a positive economic environment heading into '07, it should continue to be good.

Like I said, in our business, there's always ups and downs because of capacity, lumpiness. When you take the longer-term view, you look at where our product line is, how it is making progress in the core business, how the industry is trending, our new opportunities, I think it makes us pretty optimistic about where we are.

Steven Pelayo - Soleil Securities

So if I can just summarize that in a follow-up, you are confident for the October quarter, let's just say orders for Applied Materials 90 days ago versus today -- if anything, you sound more confident that those are going to increase?

Mike Splinter

Yes, I'm more confident today than I was 90 days ago. I have more visibility. But I am certainly not ready to say anything at this point.

Operator

Our next question comes from Mark Fitzgerald, Banc of America.

Mark Fitzgerald - Banc of America

Mike, do you have any sense of how big third-party services at this point for Applied Materials equipment, and specifically for your own services or intellectual property that differentiates you from third party? Therefore, can you grow your business organically, or do you just go out and buy companies like the Singapore operation to grow the service business?

Mike Splinter

The third-party services are actually quite big around the world. So that's one of the reasons why we think that we will be able to gain share. Let me just comment a little bit, Mark, about what we're doing. One of the places where we are really concentrating our efforts is in what we call chamber performance systems or service. This is an area where we are using the technology we have. There are certain kind of coatings that go in that are very hard to repeat. We have patents and IP on many of these different areas.

And we think that by doing that R&D centrally, largely here in Santa Clara, and then expanding globally, it is a great play for us. What we purchased a week or two ago is more capacity in Singapore so that we could implement some of those capabilities in Singapore. We didn't have a location where we could put our chamber performance systems or services in Singapore. So we bought some capacity to be able to proliferate that capability there.

Mark Fitzgerald - Banc of America

So bottom line, there is IP in the service side of the business and organic growth is more the strategy than ever?

Mike Splinter

Absolutely. That is how we are going to win. We can't win with just whether a customer hires a service technician or we hire a service technician. We win by bringing technical capability that nobody else can provide that ends up with productivity for the customers' factories.

Operator

Our next question comes from Gavin Duffy - A.G. Edwards.

Gavin Duffy - A.G. Edwards

Mike, I was just wondering, could you give us a sense of breakout where your customers are going to be as a percentage for next quarter, like DRAM versus foundry, logic?

Mike Splinter

What Nancy said earlier was that foundry was going to be up a bit as a percentage. Everything else was going to be roughly the same, I think. There will be a few points that have to come out of the other areas to feed the percentage growth in foundry. But other than that, we are not seeing any major shift here.

Operator

Our next question comes from Ben Pang - Prudential Financial.

Ben Pang - Prudential Financial

In your comments, you mentioned some of the difficulties you've had in market share in 2005. The reversal that you see in 2006 due to the memory market; is that specifically on flash? Or is it also in DRAM?

The second part of that question is, what is your view right now on how much higher capital spending is for combined memory in 2006 versus 2005?

Mike Splinter

As far as our share, we are working to gain in both flash and DRAM. We are gaining more in flash today than in DRAM. So that is about all I will say on that. As far as the mix of memory spending, your question was on memory versus logic spending?

Ben Pang - Prudential Financial

Right. What I'm trying to get at is '06 is going to obviously be a year for capital spending growth, and right now you are forecasting that you're going to outgrow the market because of market share reversal in memory. I want to get a handle, at least on the memory side, for CapEx; not your market share, but could you just try to put in perspective how high you see memory CapEx in 2006 versus 2005?

Mike Splinter

I don't know if I have the number right off the top of my head. How about if I get the number here, I will answer the question a little bit later.

Operator

Our final question comes from Mike O'Brien - Bear Stearns.

Mike O'Brien - Bear Stearns

If you could just maybe go through a little more detail on just some of the product wins in both etch and in plants? Are these wins that are going to materialize progressively this year, or is it really next generation?

Mike Splinter

Well, there is some of both. But in etch in particular, we have a strong ongoing business, particularly in the memory area. That has been gaining and growing. We are working very hard with customers on next generation with our new conductor etcher and increasing applications on dielectric.

Mike O'Brien - Bear Stearns

Just one final question on the July guidance -- whether it is conservative are not -- but do you expect each segment, semi systems, flat-panel and services, to all grow? Were all three within that guidance, or could one or more of them be down in July?

Nancy Handel

No, the outlook for each of our business areas is for a growth in that third quarter.

Operator

Ladies and gentlemen, we have reached the allotted time for question-and-answer. I will now turn the conference back over to management for closing remarks.

Randy Bane

Thank you, and I appreciate everyone being able to join us for the call this afternoon. If there are any follow-up questions, please call us. The number is posted on the Applied Materials website. I appreciate your time. Thank you very much.

Operator

This concludes today's Applied Materials second quarter fiscal year 2006 earnings conference call. You may now disconnect.

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Source: Applied Materials, Inc. F2Q06 (Qtr ended Apr 30, 2006) Earnings Conference Call Transcript (AMAT)
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