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Applied Materials, Inc. (NASDAQ:AMAT)

Q3 2006 Earnings Conference Call

August 15, 2006, 4:30 pm ET

Executives

Randy Bane - Vice President of Investor Relations

Michael R. Splinter - President and Chief Executive Officer

Nancy Handel - Senior Vice President and Chief Financial Officer

Analysts

Steven Chin - UBS

Jay Deahna - JP Morgan

Timothy Arcuri - Citigroup

Satya Kumar - Credit Suisse

Brett Hodess - Merrill Lynch

Jim Covello - Goldman Sachs

Michael O'Brien - Bear Stearns

Robert Maire - Needham & Co.

Steve O'Rourke - Deutsche Bank

Edward White - Lehman Brothers

Gary Hsueh - CIBC World Markets

Stuart Muter - RBC Capital Markets

Operator

Good afternoon and thank you for standing by. Welcome to the Applied Materials Q3 fiscal year 2006 Earnings Conference Call. [Operator Instructions]. I would now like to turn the conference over to Mr. Randy Bane, Vice President of Investor Relations, Applied Materials. Please go ahead, sir.

Randy Bane - Vice President of Investor Relations

Thank you Ian, good afternoon and welcome to Applied Materials’ Fiscal Q3 Conference Call. Joining me today is Mike Splinter, President and CEO; Nancy Handel, Senior Vice President and Chief Financial Officer; Joe Sweeney, Senior Vice President, General Counsel and Corporate Secretary.

Today we will discuss our results for the period ending July 30th, 2006. We released these results this afternoon at 1:05 pm Pacific Time. A copy of the news release is available on Business Wire and posted to our website, www.appliedmaterials.com.

Today's Earnings Call contains forward-looking statements, including those relating to Applied Materials' financial performance; operational efficiency; tax rate, cash generation and deployment; acquisitions and joint ventures, growth and opportunities and financial target, end use demand for semiconductors and flat panel displays, and our customers’ capacity plan.

Our 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 containing these risk factors is contained in today's earnings press release and in the Company's filings with the SEC. Forward-looking statements are based on information as of August 15, 2006, and the Company assumes no obligation to update such statements.

Today's call also contains non-GAAP financial measures. Reconciliation of these measures to GAAP measures are contained in our earnings press release issued today and in our Earnings Call Highlights documents, both of which are available on the investor page of our website.

Nancy will lead off with a discussion on select financial results for Q3 and provide insight into the company’s initiative. After Nancy’s remarks, Mike will discuss current industry and company development followed by our fourth fiscal quarter target. He will then turn it back to Nancy and then we will go ahead and open the call to questions.

With that, I would like to turn the call over to Nancy, Nancy?

Nancy Handel - Senior Vice President and Chief Financial Officer

Thank you, Randy. Good afternoon everyone, and thank you for joining us. Today, I will discuss the results for the third fiscal quarter of 2006 and provide you with an overview of the strategic initiatives that enable us to continue delivering world-class operational and financial performance.

During Q3, orders reached a near record level driven by continued strength in end user demand for integrated circuits and by increased customer requirements for advanced silicon and display solutions. Orders totaled $2.67 billion for the quarter, up 7% from the prior quarter with significant competitive gains as demonstrated by year-over-year growth in etch and process diagnostics and controls that was faster than the market. We also had stronger than expected order growth in our display products.

Increased customer demand in memory and foundries drove slightly higher than expected order growth. Of our systems bookings this quarter, flash memory increased to 29%, DRAM was 24%, with logic and other at 27%, and foundries at 20%. Approximately 87% of systems orders were for our 300-millimeter, virtually all for 100nm and below process technology. Six orders were in excess of $100 million. Six orders were between $50 million and $100 million and 16 orders were between $10 million and $15 million. During Q3, 82% of our orders were from outside and North America. Demand from Japan, Southeast Asia and China, and Taiwan strengthened. Orders by major geographic areas were; Taiwan, 21%; Japan, 20%; North America, 18%; Korea, 15%; Southeast Asia and China, 16%; Europe 9%. Revenue for Q3 was $2.54 billion, 13% higher than last quarter exceeding our target.

Revenue upside was driven by higher customer utilization rates and improved competitiveness in our silicon products and our display products. Backlog for Q3 increased to $3.32 billion compared to $2.93 billion for Q2 of 2006. Backlog adjustments totaled $264 million consisting primarily of the addition of $285 million of Applied Films backlog, offset partially by 20 million of customer cancellations. The majority of the cancellations were associated with 200-millimeter systems for flash memory. Reported gross margin for Q3 improved 160 basis points to 48.1% compared to 46.5% for Q2 of 2006. Improvements were driven by increased factory loading and continued progress on cycle time and material cost reduction.

Equity based compensation charges reduced this quarter gross margin by 40 basis point. Operating expenses for fiscal Q3 were $540 million, 12% higher than last quarter. Operating expenses included increased spending for incentive, compensation program, and early investment in the company’s business transformation initiative, which we mentioned on last quarter’s call. Our continued focus on improving operating efficiencies possibly impacted both our gross margin and our operating profit. Operating income was $681 million or 26.8% of revenue, 180 basis points higher than the 25% reported for Q2 of 2006, with flow through 41%. Non-GAAP operating income was in line with our financial model, demonstrating increased operation and efficiency that enables us to funding our strategic initiative within the model.

We exceeded our net income target for this quarter. Net income was $512 million or $0.33 per share compared to $413 million or $0.26 per share for Q2. These results included a benefit of $34 million or personally $0.02 per share from the resolution of audit of prior year’s tax filing, partially offset by an in process R&D charge of $14 million or approximately $0.01 per share associated with the acquisition Applied Films. Our financial model based upon non-GAAP matrix was developed to enhance understanding of ongoing operational performance. The model excludes items deemed by management to be unusual or nonrecurring. The reconciliation of our reported earnings per share of $0.33 to a non-GAAP earnings per share of $0.35 was included with our press release. The effective tax rate of 29.1% for Q3 was lower than the forecast rate of 31.5% primarily due to the resolution of audits to prior year’s tax filings. We anticipate the effective tax rate for Q4 to be approximately 32.2%.

Now I would like to discuss some highlights of our balance sheet and cash growth. During the quarter cash, cash equivalents and investments decreased $672 million to $5.2 billion. The company used cash for its purchase of Applied Films, our investment in the Sokudo joint venture and for share repurchases and cash dividend. This was partially offset by cash generated from operation. Accounts receivable increased $345 million and day sales are standing increase slightly to 82 days.

Inventory increased by $259 million basically due to $151 million of Applied Film. Capital spending for the quarter was $40 million and depreciation and amortization totaled $62 million. Free cash flow generation for the quarter was $332 million down from $471 million in the prior quarter. This decline reflects a $180 million estimated tax payment and other increases and working capital items associated with increased business volumes. We define free cash flow at cash provided by operating activities less capital expenditures. The strong free cash flow and financial position enables us to continue our history of returning cash to shareholders by simultaneously reinvesting in our business.

During Q3 the company repurchase 31 million shares of our common stock for $500 million at an average price of $15 to $30 per share since the beginning of fiscal 2005 the company has repurchase approximately 186 million shares representing approximately 11% of the shares outstanding at October 31st 2004 for cash outlay of $3.2 billion. During the fourth fiscal quarter of 2006 we plan to repurchase shares in the range of $400 million to $600 million. In June 2006, the company declares the cash dividend in the amount of $0.05 per share payable on September 7th to stockholders a record as of August 17th. Headcount at the end of the quarter was 13,884 regular employees; the increase of 1,094 employees was primarily related to Applied Films’ acquisition.

As part of our growth strategy we completed the acquisition of Applied Films for approximately $484 million or $328 million net of Applied Films cash. Applied Films is a leading supplier of thin film deposition equipment used in manufacturing flat panel displays, solar cells, flexible electronics and energy efficient glass. This acquisition compliments our thin film nano-manufacturing capabilities and provides an opportunity to expand into new high growth markets. At July 30th 2006, Applied Films had assets of $549 million including net accounts receivable of $15 million, inventories of $151 million, plant and equipment of $16 million, goodwill of $201 million, intangible assets of $140 million and other assets of $26 million.

Also in this quarter we invested $147 million into our joint venture with Dainippon Screen called Sokudo. Sokudo brings together the complimentary resources and capabilities of screen and applied materials to deliver advanced technically differentiated track solution for customers’ critical semiconductor manufacturing requirement.

Now I would like to conclude with our long-term strategic initiative that will enable us to continue delivering world-class operational and financial performance. These initiatives are designed to leverage commonality to achieve R&D productivity gains, improve engineering, manufacturing and sourcing capabilities and enhanced world-class management and organization capability. For example, we are driving material cost reduction and have instituted programs such as our recently expanded international procurement office based in Shanghai China to enable global material sourcing. In addition we are consolidating the direct material supply base to improve the company’s buying power, which has resulted in a 34% reduction in the number of suppliers from the beginning of the year.

In manufacturing we continue to reduce cycle time through our integrate-to-order, module final test, and merchant transit program. Integrate to order is a combined business process and product design approach to reduce the order to ship cycle time for configured systems. Modular final test is a process that fully tests products in their modular form before they are crated and shipped eliminating the requirement for a system to be fully assembled, tested and then dismantled before transport. Merchant transit is a process of accumulating modules at an alternate site outside of the Applied Materials factory prior to shipment. In Q3 more than 80% of systems shipped were manufactured using the integrate-to-order process. And finally, we have launched our business transformation initiative, a multi-year global initiative to improve our business processes, replace multiple software assistance with a single enterprise system and streamline the sharing of real time operating data across the company.

As you can see from this list of initiatives we are firmly committed to improving profitability. Our success is dependant on the outstanding contributions of our employees. I would like to thank our employees, for it is through their efforts that we will continue to deliver excellent results and extend our leadership in the industry.

Now I’ll turn the call over to Mike, who will provide an update on our growth strategy as well his perspective on the market environment and the company’s strong strategic position. Mike will also provide the guidance for the Q4, Mike?

Michael R. Splinter - President and Chief Executive Officer

Thank you Nancy. I would like to also add my welcome to all of you and thank you for joining us on the call this afternoon. My remarks are going to start with a review of our overall strategy, then move to discuss our Q3 performance and our current view of the industry, and finally our Q4 financial targets. Our activities in the Q3 demonstrate that we are making real progress on Applied Materials strategy.

First, central to our strategy is growing in our core semiconductor business, both systems and services. While we have great opportunity to expand in multiple directions our technology leading products and new offerings are aimed at market share games particularly on the memory space, where we believe we have made excellent progress this year. Second, on top of this strong base we are entering adjacent and new markets that leverage our core competencies and provide opportunities to further grow the company over the long term. We will do this by aggressively pursuing organic expansions and through M&A activities. Finally, we will enhance our business processes and synergies working across the company to achieve operational and financial efficiencies that increase margins and deliver higher levels of profitability and returns for our shareholders.

The near term goal of our growth strategy is to expand our opportunities and move Applied Materials from serving an addressable market of 17 billion back in 2004 to approximately 37 billion by 2008. We’ll do this by significantly expanding our core semiconductor business, enhancing our flat-panel display offerings, and initiating new solutions in solar and clean energy.

Now let’s review our progress. In the quarter we saw significant sales increases throughout our business from core markets as well as adjacent markets. Revenue grew 54% over the same period one year ago demonstrating our ability to drive share through product innovation and bringing new technologies into the marketplace. We saw market share gains in etch, inspection, global services and across our thin film product line, and we continue to drive better returns across all of our products.

Let’s look at the core product areas more closely. Leading up to Semicon we introduced Technology Solutions that will enable our customers to advance to the 45-nanometer generation. We’ve enhanced our advanced patterning films, one of the industry’s most successful emerging CBD applications. This revolutionary application allows customers the ability to cost effectively pattern nano scale features with increasing complexity while reducing their reliance on next generation lithography solutions. We also announced Sokudo, our joint venture with Dainippon Screen. We intend to make a significant difference in patterning by helping customers maximize lithography process window and improve overall litho cell economics, especially in high density chips like flash and DRAM.

For critical device contact structures we introduced the Endura Integrated Liner-Barrier II system, which reduces resistance by up to 40%, the key element in increasing chip speed and improving power performance. We’ve also improved interconnect technology introducing active preclean on our Endura Cu Barrier/Seed system. This new process helps customers confidently transition to next generation low l films such as our innovative Black Diamond II. Our Endura Cu Barrier/Seed system is the tool of record for critical 45-nanometer development at all leading chip makers.

In etch, we had a strong quarter growing revenue on pace with the rest of the company. In addition we are making progress on our strategic plan to expand our customer base and applications served. During the quarter we had strategic wins in key memory and foundry customers, with our industry leading advantage silicon and metal prowess. Another area where our products are showing strength is in the high growth non-flash market, specifically we made progress with RadOx, CMP and advanced patterning films. Here memory makers benefit from significant performance gains at a price that keeps memory affordable for the customers propelling that market.

We are going to continue our efforts in this space to make memory specific applications and gain share in this critical market. Applied global services set a new revenue record. We made significant breakthroughs in our service agreements at major Asian manufacturers. We introduced our Metron Aquareus system for copper abatement adding to our leading range of innovative point-of-use abatement technologies and energy saving solutions that enable chip makers worldwide to meet their most stringent environmental goals. Uvision, our Brightfield inspection system with DUV laser 3D technology continues to gain momentum in line with our expectations. UVision is now installed at virtually every major customer. It has been winning repeat orders at customers in realizing the potential of rapidly finding nanometer-scale defects never seen before.

In terms of expanding into new markets we concluded the acquisition of Applied Films in the quarter. This acquisition integrates new capabilities into our flat-panel display group and positions us for further growth inline with our corporate objectives. Through this acquisition we now have an entrance into the PVD color filter area, which currently is more than $200 million market opportunity. It also provides key products and capabilities with the seller market as well as other applications. We are committed to achieving the promise of this acquisition and using our cross organizational capabilities in large areas of thin film processing to drive product differentiation and business efficiencies. Mark Pinto our CTO will be overseeing the integration efforts where Applied Films capabilities will be incorporated into our new business and new products group. The key to success here will be to quickly integrate the product lines and raise the gross margins to the Applied Materials expected range, making the acquisition accretive sometime late next year or in our early 2008.

Now let’s turn to the industry outlook. In Q3 semiconductor environment with continued strong growth and overall unit demand particularly from memory products. Semiconductor industry continues to grow overall revenue in the 8% to 10% range year-over-year, but units are growing at a much faster clip greater than 20% this year. The flash memory units growing over 60% year-on-year, this is a very positive trend both for Applied Materials and the entire equipment industry. Further we are entering what looks to be a challenging period for equipment bookings as inventories are rising at our customers’ income segment and both foundries and flat-panel display companies reassess their investments. After an excellent record setting revenue quarter in our display division we expect to pull back in revenue of roughly 20% as major firms manage their capacity expansion plan.

Meanwhile orders will stay relatively flat as a couple of the major players continue to pursue their 8.5 factories. Overall we expect this recess to be short lived as both the laptop and TV-end markets continue to expand at a very rapid pace. What we’ve heard from our semiconductor customers in recent weeks indicates that there is inventory building in the PC market affecting some customers’ outlook for wafer capacity expansion. PC story will be told over the next few months as we enter the back-to-school and holiday sales period. In the short-term, we see inventory growing in this segment, but we are also seeing manufacturers reacting quickly to ensure this inventory doesn’t continue to expand further.

Foundries have maintained their cautious investment policies throughout the year. If we look at what foundries are expected to spend this year in equipment, it’s about $6 billion down about 30% from their 2004 peak levels. Foundries are demonstrating prudence and model flexibility and adjusting utilization rates to bring supply and demand back into balance. On the other hand, memory manufacturers have remained optimistic and even aggressive about their capacity expansion plans. Profitably in DRAM market segment improve for many manufacturers during the quarter, while business trends and outlook held strong. This has given these manufacturers continued confidence for investment. This confidence appears sound as new high content memory applications are due to ramp into the market place over the next year or so.

Our customers’ investments in memory are aimed at capturing share for this fast growing market with growth likely driven by the advent of the instant on and platforms with Microsoft’s new operating system, Vista, for consumers next year. The memory manufacturers continue to drive investments in capacity with an eye on supply/demand outlook over the long term. In the current environment memory will continue to be over 50% of our revenue and bookings. Over the long term we remain optimistic. New Fab built plans expanded and we are now tracking 55 projects over the next two years. This level of plant capacity expansion is rational given the demand picture and if these projects stay on track next year it be a positive year for capital expanding in 2007.

Our targets for Q4 reflect the current market dynamics and some cautiousness about the near term. We expect orders to be flat with a range of plus/minus 2% driven primarily by strength in memory orders. We expect revenue to be also flat within a range of plus/minus 2%. We expect EPS to be $0.29 to $0.30, which include an estimated $0.03 for equity-based compensation and approximately 1 penny for the dilution of AFCO and Sokudo.

Looking past short-term issues, we are confident that many market opportunities are developing longer term. As such we are firmly committed to our investments and long-term initiatives that build on our core technologies and help us expand in adjacent markets. Building upon our current strength, these areas are expected to provide significant growth potential for Applied Materials. Going forward, we are confident about the driving forces of our business. We are gaining market share with new and better applications to meet our customers’ critical requirements. We are also growing our served available market and now have more opportunity for growth than at any time in our company’s history, and we expect our business process and efficiency initiatives will build on our performance and deliver new levels of gross margin and profitability over time.

This was a strong quarter for Applied Materials, and our employees deserve thanks for their efforts in delivering the results you can see in our margin improvements and continued ability to deliver differentiated and innovative products to the industry. The events of this quarter demonstrate our ability to grow organically by utilizing our financial strength to expand the company for generating strong cash flow returns for our shareholders. Thank you very much.

Now I would like to turn the call back over to Nancy for a moment, Nancy?

Nancy Handel

Yeah, thank you Mike. What I’d like to discuss is that on a personal note I’d like to announce to you today what I’ve been discussing with Mike and with the board and that is the fact that I will be retiring from Applied Materials that end of this calendar year after more than 21 years with the company. I have to say that; you know I have really thoroughly enjoyed my opportunity to grow my career at Applied. Particularly, this opportunity over the past two years to serve as chief financial officer and to lead a fantastic group of people around the world that make up our global finance team.

I believe that I have done my best to position the company and the finance organization for continued success in our important strategic initiative and it’s now a good time to transition and really to focus and expand my longstanding interests in the non-profit community and to make a little bit of extra time for some fun. It’s been a great ride but we still have more work to do, we’ve got another quarter to close here and then some, so I appreciate your continued support and trust.

So, now I would like to turn the call back to Randy.

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]. And your first question comes from the line of Jay Deahna with JP Morgan.

Jay Deahna - JP Morgan

Thanks, thanks very much and good afternoon. Mike, on the outlook for capital spending for next year, how much of it is dependant upon some fairly decent shipped inventory depletion between now and the end of the year, how do you feel about the prospects for that and if you look at the different segments, foundry flash processors and DRAM, how do you feel relatively on each one of those in terms of the outlook for next year. I think this still should be good for DRAM and may be some of the push outs and foundries might shift that into next year as they start 65 nm expansion, but I would love to get your thoughts on that, thanks.

Michael Splinter

Sure Jay, actually in point, so when we look at the CapEx for next year really what we feel that this is hinging on is how well the inventory gets drained during the -- this next six months because that will determine really what the first half of next year looks like. What we are seeing -- where we think the big issue is primarily in the PC space and not necessarily in DRAM related DC space but overall in the PC space so we want to watch a couple of critical areas, in particular the foundries are very important to us. One of the things that you can kind of assess from the call is that our orders from foundries for the upcoming quarter are projected to be pretty low, maybe in the 10% to 15% range. So how fast they are able to cut back on their starts and diminish that inventory is really the key for us. I think in flash memory, the players are going to continue to spend and put in the capacity that the longer term volume and applications are going to present themselves. I think the DRAMs are seeing an opportunity especially in Taiwan, are seeing an opportunity right now to make investments and grow their position in the market, so I am pretty confident that DRAM flash memory in general is going to be positive in 2007 and where they hinge back is in the foundries and some of the PC related IDMs, and that’s the thing to watch over the next few months on how those inventory trend as we see the sell through numbers in back to school and then in Christmas and Chinese New Year.

Jay Deahna - JP Morgan

Pulling it together, are you still expecting some level off of CapEx last year?

Michael Splinter

Well, I'm certainly less optimistic when it was three months ago Jay, but it really depends on what happens in the next three months and what happens in the foundries.

Jay Deahna - JP Morgan

Great thanks.

Operator

Your next question comes from the line of Jim Covello with Goldman Sachs.

Jim Covello - Goldman Sachs

Good afternoon guys, thanks a lot. Couple of quick questions, Mike, could you talk a little bit about the kinds of pricing discussions you’re having at the end of the quarter with your customers particularly some of the customers in the memory space, who are seeing a little bit of squeeze in their margins and I will follow up after that, thanks.

Michael Splinter

Jim, really we have the -- pricing has been -- you can see a lot of the big deals that we made in the quarter; we really get to discuss through the quarter. I don’t think we really had any big gigantic exposure at the end of the quarter. So I think our pricing has been pretty steady for the whole year really and when you look at how stressed our factory was to make deliveries in this quarter, I think that this consistent to with that. So I wouldn’t say much about pricing and you see as reflected in our gross margin numbers. You know, you take that gross margin number apart a little bit and I think it indicates some pretty strong equipment gross margin.

Jim Covello - Goldman Sachs

Now to that and that was kind of my follow up question on the margins. If the revenue guidance is flat and EPS guidance is down a little bit, can you talk about the components that’s causing the EPS to be down a little bit?

Nancy Handel

The overall earnings outlook for the next quarter has obviously some unique items in it, one is the focus on the integration of Applied Films so, it will be the first time they show up and we have given an indication that the kind of impact that they might have on our reported earnings in the Q4. We also in light of the outlook for a revenue guidance and targets that Mike has discussed, you see that the factory loading should be sort of on par with what we had this quarter and so the efficiency gain that we have had in previous quarters now we are kind of leveled out a little bit in terms of the factory leading. We expect though to continue to gain some of the benefits that we have from our initiatives in our global sourcing and material cost reduction and some of the ones I described are modular final test and IPO. So we are putting an acceleration on bringing those benefits in, at the same time we get a little bit of the other opposite pressure from the integration and from the little bit of change in the pace of ramp for the business.

Jim Covello - Goldman Sachs

I am sorry, just on that point, the factory loadings would be flattish though?

Nancy Handel

The factory loading should be flattish.

Jim Covello - Goldman Sachs

So but if the factory loadings are flattish, I understand you’re not going to get a benefit from the factory loadings in out quarter, but that shouldn’t be a drag, I wouldn’t think and so the only delta between this quarter and next quarter would be the acquisition plus what else?

Nancy Handel

Well, there is a little bit of mix in there. In terms of our business between the panel business, the display business, as well as our AJS operation and our systems business. That’s not a huge factor in the coming quarter. In addition, we had good throughput through the factory in Q3 and now we have got a fair amount of product that’s going to ship in the first month of this quarter. So the factory loading was a little bit stronger in the Q3.

Jim Covello - Goldman Sachs

Okay, then just final question on that. If -- the flat panel typically has lower margin associated with it, so with sales being down in flat panel I would have thought that mix would have been positive a little bit?

Nancy Handel

Well, I think that the discussion around contribution is at the bottom line level with the panel business. I mean the display business area really contributes strongly at the bottom line so it wouldn’t have been a big impact on the earnings per share.

Jim Covello - Goldman Sachs

Okay, thanks very much.

Operator

Your next question comes from the line of Edward White with the Lehman Brothers.

Edward White - Lehman Brothers

Hi, I was wondering if you could talk a little bit about the outlook from sort of the non-foundry IDM logic you know both the PC side and the non-PC side in this environment. And you talk a little bit about the memory been strong foundry been weak, but if you look at the, you know, the logic IDM, how are they looking?

Michael Splinter

Thanks for your question; it again kind of divides along the products segment lines. We still see that those companies that are making DSPs for instance or communication products are still doing quite well and will continue their expanding on track. The race in the processor space is still the -- you know the two major companies that have been going along, both I think are tightening up a bit, but they are going ahead with their expansion as far as we can tell and then kind of the other spot is in Japan, where we still have a fair number of IDMs, various types and from our results you can see Japan is still quite strong and we expect them to continue to make investments across the next couple of quarters.

Edward White - Lehman Brothers

Okay, and then one quick follow up. Nancy, you gave the percentage of revenues for integrate to order, but can you give some sense as to where it might be for modular final test and merchant transit. So can you give some idea as to how pervasive that is in your revenue mix?

Nancy Handel

We are making great progress, but those two initiatives are a little bit earlier in their life cycle than the integrate to order and actually the integrate to order, success is almost the precursor to the ability to do the modular final test and their emerging transit. So they should begin to continue to increase their contribution to our profitability, but they are a little bit further in the pipeline than the IPO is.

Edward White - Lehman Brothers

Okay, great thank you.

Michael Splinter

Thanks, operator?

Operator

And your next question comes from the line of Steve O'Rourke with Deutsche Bank.

Steve O'Rourke - Deutsche Bank

Thank you, good afternoon. A couple of questions, first, you mentioned the lower cycle plans, what are they now? What have they come down from and where can they go and can you comment also on the utilization of your Austin manufacturing facility?

Nancy Handel

The cycle time -- let me see if I’ve got a fact here. The cycle time have reduce significantly, overall cycle time is down to 100 days we keep trying to pull that down a few days at that time in terms of our build, you know basically order to customer fulfillment cycle time. In terms of our Austin factory you know we’ve really been able to get the utilization at a higher level they are -- although certainly we still have capacity in our Austin manufacturing side that is available for use. One of the things that I think is important is that you can look at how we’ve been able to be productive in our Austin site that we’ve put revenue through there that was incomparable to the kind of revenue that we saw in the year 2000 on a quarterly basis, some of our quarters in there and we basically get it with a third as many people. So we’ve got a high degree of productivity in our Austin site and it has got some additional capacity available to it, but it’s really running at a higher level of efficiency.

Steve O'Rourke - Deutsche Bank

Okay, and one follow up. How should we be looking at operating expenses over the next quarter?

Nancy Handel

The operating expenses in the next quarter are going to be -- they are going to up, the addition of Applied Films certainly just kind of drops right into that line item although it drops into many elements of the profit statement but it’s going to be a contributor to our increase there. We also have some initial investment that continuing in our business transformation initiative, we’ve talked about that, that ultimately is a investment that would be capitalized but some of these early dollars during the design phase are part of the expenses so, we are driving everyone to look at the budget in terms of efficiency and manage that project tightly but there is a few dollars that would come into the operating expense line.

Steve O'Rourke - Deutsche Bank

Thank you.

Operator

And your next question comes from the line of Satya Kumar with Credit Suisse.

Satya Kumar - Credit Suisse

Thank you so, when I look at your July revenues, are there AFCO revenues in there?

Nancy Handel

No, there were not. The transaction closed at the end of that period and they will appear in our Q4 for the first time. The balance sheet came on at the end of July but the P&L statement will come in during Q4. The result -- impact and that was in process R&D right off that was noted in the supplemental schedule with the press release.

Satya Kumar - Credit Suisse

Okay, could you help quantify those a little bit for October for AFCO?

Nancy Handel

Well, its going to come in -- very significant changes that are occurring with the way that we will recognize the revenue and the profitability for Applied Films, they previously had a revenue process that was percentage completion and our revenue process is really either revenue at shipment for standard products or revenue at sign off and so they will be making changes to our revenue process which is going to basically in the near term reduce the revenue at the same time near expenses are still coming in as an incurred basis so there going to be a little bit of a dampening effect and that’s why we call them out on the targets that we gave for the quarter.

Satya Kumar - Credit Suisse

And, Nancy a quick follow up. If I look at your average memory orders year to date, it looks like they are up almost 100% from last year’s levels. Seems like that’s a lot more than CapEx, which is up about 30% or so. Is it -- what's really driving the faster growth rate in orders versus CapEx that you’re seeing from customers front-loading their orders and are you seeing backlog growth as a result of that? And more specifically if you’re looking beyond the October quarter, should we expect these orders to pull back more sharply because of these factors?

Michael Splinter

Satya, I’ll take the question. One of the things that we’ve been trying to emphasis really since the big spending shift of 2005 towards memories is our applications and share in the memory space, so we’ve been reasonably successful this year at gaining footholds and manufacturing tool of record at most of the memory manufacturers both for specific new products that we are offering as well as some of the existing products that we’ve already introduced for logic that now as the memory guys shrink dimensions are really important. So, most of the run ahead of the growth in CapEx and memories by the memory makers is share gained. Now, I itemize some of those applications I don’t want to go over and again here but what we should expect after October, I still think the memory guys are going to continue to invest. They see their opportunity and see the growth for the applications they are making, you can see how strong the DRAM pricing has been over this year. I think we’re probably all surprised at how strong that’s been this year and it’s given incentive to those memory makers to continue to grow their capital and grow their capacity. Operator?

Operator

And your next question comes from the line of Steven Chin with UBS.

Steven Chin - UBS

Thank you. I want to just go back to the guidance, I think I heard you said that the flat panel orders would be flat orders, if that was the case is it fair to assume that the systems bookings are going to be up more on your --perhaps 5% to 10% quarter-over-quarter? And you know, the other remaining category services typically seasonally down in Q4, is that a fair assessment?

Michael Splinter

Well I think it’s certainly a fair assessment. We gave you the information about flat panel revenue being down, orders will be flat. You know, our services both the revenue -- we expect services revenue and orders to kind of move up modestly in our Q4. Of course in Q1 services moves up -- orders move up quite a bit more but I think you can draw the conclusion between our semiconductor segment and our flat panel segment. I think you know, beyond that I don’t think there is that much differentiation.

Steven Chin - UBS

Okay, thank you.

Michael Splinter

Next question.

Operator

Your next question comes from the line of Brett Hodess with Merrill Lynch.

Brett Hodess - Merrill Lynch

Good afternoon. Mike, given the number of new areas that you’ve moved in the service side of the business, do you think that the service side of the business if we get into a little slower period here will have the effective -- finally having some offsetting impact on your revenue line relative to the equipment or it still you know, small when the piece of the business is slower and up growing piece of the business is that equipment is going to dominate the revenue pattern.

Michael Splinter

Well, Brett, I think you have studied pretty closely what's happening in our service business and percent of revenue now is up close 25% of our overall revenue and certainly that’s quite different than it was three of four years ago when it was in the low teens, so that as a percentage of our overall revenue, it’s double. Equipment both in flat panels and in semiconductor is still the major part of our business though and while we are better buffered against that sever downturn I don’t think there is anything that we can do or hope to do in the short term, that saves us from having to take appropriate action if there is a severe equipment downturn that Applied Materials has been through this kind of ups and downs before we have a pretty good formula for cutting back on spending, we have a variable workforce, we’ve been moving a lot elements to Asia to ensure we are best -- are best possible efficiency. So I think the summary, yes our service business is growing, it’s a better buffer but it’s certainly not a gigantic buffer.

Brett Hodess - Merrill Lynch

Great, thank you.

Michael Splinter

Good day.

Operator

And your next question comes from the line of Timothy Arcuri with Citigroup.

Timothy Arcuri - Citigroup

Hi Mike, two things. I guess first of all, if you kind of look at the industry on two broad matrix, if you look at you know, chip capacity utilization and you look at that relative through true orders and you also look at something like, you know equipment orders per chip being produced, if you just look at two really broad matrix like that. We have a situation that we had in 2000 or 1996 and both of those ended pretty badly. So I am wondering do those two you know matrix kind of from a really top level perspective worry you, in terms kind of how long a down turn be it in January or be it in April could be and what actions are you potentially taking that could mitigate that? Thanks.

Michael Splinter

So, of course there was indicators concern as the, and we watch them. I think one of the things that different in this go around you know, if you think that you are familiar with the ‘96 situation, as another memory situation but the situation today is quite different than that in that the number of applications is expanding so much for the various types of memories whether it’s in cell phones, growth in density and cameras etc, etc. So I think the foundation, the ability to grow and have that capacity go into real applications where there is real need, is much different the ‘96 and certainly different than 2000, where you know the underlying demand was quite false and I don’t feel like underlying demand in this particular situation is way off that. So I think that’s the big difference. As far as actions inside the -- if you’re saying actions inside the company where very much looking -- its kind of one foot on the gas, one foot on the brake. We want to make sure we are capturing every opportunity we can. But we also want to make sure we are controlling our spending especially our spending growth. We’ve controlled our headcount and we watch our temporary workforce. These kind of things that really allow us to scale back our spending quickly. What we would not be willing to do is compromise our growth initiatives and efficiency initiatives for the future because those are the future growth of the company.

Timothy Arcuri - Citigroup

Mike thanks. I guess just on that point, is there some change which actually to be you know, operating model. I think before you said that, you know $2 billion operating margin should be about 26% and you know net margin would be about 19%. So with the investments in solar with AFCO, has there been there any change in that model?

Nancy Handel

I would like to just -- you know comment that. We really are working on looking at refreshing the model. This model has been out here since the summer of ‘03 and you know we are looking through at our initiatives in the solar and the new business areas. We are looking at the time frame for bringing AFCO into our kind of profitability model. We’re looking at the contributions from our display business and also just some of the realities now of the tax rate changes that have occurred, our old model had a lower tax rate than we are dealing with now. So the team here is actually working on refining the models during this Q4 as well as working on the disclosure of material that we’re looking at in terms of how we are going to describe our business going forward, so we are trying to make sure that we have integrated those to ways of looking at the business and at the end of the quarter we come out with a new view we can share with Wall Street.

Timothy Arcuri - Citigroup

Okay thanks.

Operator

And your next question comes from the line of Stuart Muter with RBC Capital Markets.

Stuart Muter - RBC Capital Markets

Yeah thanks for taking my question and good afternoon. Following up on some early questions about service, I’m hearing you are making good progress on spares and consumables. Could you talk a little bit about the profitability trend in service, how that’s played out this year and how you see it going forward?

Michael Splinter

Actually this is a good point. In our service area we’ve seen growth and profitability at every quarter this year it’s -- I’m sure it’s an all-time Applied Material size, but it’s certainly the recent time highs they have gain about a point, a quarter on the gross margin line in our service area.

Stuart Muter - RBC Capital Markets

Excellent thank you.

Michael Splinter

Thanks Stuart.

Operator

And your next question comes from the line of Robert Maire with Needham.

Robert Maire - Needham & Co.

Yeah just a clarification the order number reported did not include AFCO but the order guide is going forward includes AFCO?

Nancy Handel

Yeah that’s true. The orders number for this quarter there wasn’t any AFCO in the orders or revenue for this quarter.

Robert Maire - Needham & Co.

Okay, so if I back out the AFCO in the orders, would that suggest that orders minus AFCO or core Applied Business is down 5% in orders --?

Nancy Handel

No, that would be an incorrect assumption. AFCO really is -- with their, you know timing at their business practices, I think we’ve reflected them put it in our plus and minus 2% that we’ve given in terms of how that orders come in.

Robert Maire - Needham & Co.

Okay, so they are not accounting for more than 2% of your business because you know it’s kind of like we are comparing apples and oranges and not understanding that.

Nancy Handel

It’s relatively small contribution in terms of orders and revenue in Q4.

Robert Maire - Needham & Co.

Okay.

Nancy Handel

The guidance is really you know considered around the core Applied Material’s business that we have been reporting throughout.

Robert Maire - Needham & Co.

Okay, but it doesn’t -- but the forward guidance for orders doesn’t include AFCO in part of that number?

Nancy Handel

Yes.

Robert Maire - Needham & Co.

Okay and would that be a more significant percentage going forward you are indicating that there is some timing thing here with AFCO or --?

Nancy Handel

Yeah we would expect this business to continue to increase we also expect its possibility to continue to improve as we are able to go in and get some of those synergies that we are part of the desirability of computing acquisition. So as we say that when we did the acquisition that we expect you know, by the beginning of a way we should be seeing some contribution from AFCO going forward, but we’ve got a little bit of work to do in the near term.

Robert Maire - Needham & Co.

Any earnings guidance has no -- AFCO have no significant impact on that I would imagine.

Nancy Handel

Well that’s a comment we made about the $0.01 per share that were part of my comment that Applied Films coming in now in Q4 with the change in revenue package that would be relaying revenue into the future and the fact that their operating expenses are here today that’s why we know that they could have almost a penny or so kind of impact on our Q4.

Robert Maire - Needham & Co.

Okay and one last clarification. Given that the significant piece of their business is flat-panel related you just said that you expect their orders to increase, but flat-panel is sort of weakening here. Is there something different about their business in the near term versus Applied flat-panel business?

Michael Splinter

Well, one thing Robert -- one thing I think you may have noticed watching AFCO or Applied Films during this last quarter is that they got a significant order and solar market order I think was published at $30 million or so. We expect the penetration there to continue to grow over the upcoming quarters.

Robert Maire - Needham & Co.

Okay, so we are all set flat panel weakness, perhaps -- okay, thank you.

Michael Splinter

You bet, thank you.

Operator

And your next question comes from the line of Gary Hsueh with CIBC World Markets.

Gary Hsueh - CIBC World Markets

Hi, Nancy, congratulations of returning, I’ve got a quick question. I realized that the model is under scrutiny here but looking at the ones and dilution from AFCO and Sokudo next quarter, I mean if you look at revenues flexing down from the January quarter and if you kind of try to assess with the downside risk near-term is in terms of dilution from these two businesses assuming the timing is pretty tight and you can’t really do anything about the current cost structure, what's the ultimate sort of downside risk in terms of EPS solution from Sokudo and AFCO, let’s say prior trough levels in these two businesses.

Nancy Handel

Well I think that -- you mean just specifically related to them?

Gary Hsueh - CIBC World Markets

Yeah, like if it cherry pick like the two recent troughs for both respective businesses whatever they might be, what does it mean in terms of EPS solution to the model for near-term?

Nancy Handel

Well I’ll look at the horizon that we got projections for the business and their impact on our business is really it will improve overtime but a kind of impact they are having on us today I think really represent sort of the downside for them. This is kind of the stage where their revenue is you know, maybe at its point where it’s been adjusted for our revenue cycle and their expenses having then you know, brought in line with our financial model, yes, so I think the kind of impact that we are talking about now should represent the downside for them.

Gary Hsueh - CIBC World Markets

I mean so you are saying, Nancy, that really shouldn’t be modeling much more dilution than a penny a quarter over the next two or three quarters let’s say if revenue start to go down?

Nancy Handel

I don’t think so, I guess they will have to see what the impact of the action was but we really think we’ve got the business targeted to be a creative beginning in a way. So we should be able to move in that direction during ‘07.

Gary Hsueh - CIBC World Markets

Okay, so no matter what happen the worse case scenario for the two businesses in terms of EPS solution for the full year of ‘07 is like $0.04 to $0.05?

Nancy Handel

I think that’s a good place to start.

Gary Hsueh - CIBC World Markets

Okay, all right, great thanks, Nancy.

Michael Splinter

Operator, we have time for one more question.

Operator

Okay, sir, and your final question comes the line of Michael O'Brien with Bear Stearns.

Michael O'Brien - Bear Stearns

Yeah, thanks. I’m just curious like on the memory side of things you know, you’re saying it continue to be strong you know, is every one right now you say is spending at the same time, more staggered, I’m just trying to get an idea of how likely we are going to see you know, peak in memory even if memory demand -- if they all take a break in the quarter. And then with respect to your severe downturn you know, which you talked about and you are a little less confident in 2007, I mean when do we start seeing that flow through? I mean it sounds like if this isn’t as bad as it get, plus or minus 2% that’s not so bad.

Michael Splinter

If all -- you are right, Michael, and all I get is plus or minus 2% that’s not so bad but you know, our industry generally has bigger swings than that. You know, the memory spending, when you just go talk to these guys they are almost to a person or to a company, very bullish right now about their opportunity -- either about their new term opportunity in the DRAM area or about their longer term opportunity in the flash area and they are willing to push through the clear pricing pressure there is today in the flash memory space, so pretty much everyone of those memory guys has a new Fab on the books and is in one stage of ramping it or another. So, I think this thing kind of keeps cycling on pace unless somebody loses their courage. On the severe down turn scenario, again the timing from -- if you question may be I don’t quite understand the question but if your question is what's the timing kind of from seeing an orders down turn to seeing a revenue impact, today in our industry is very fast because throughput times are fast, our backlog is -- it doesn’t extend very long like it used to when the cycle times were much-much longer. So, the timing from orders to impact is very short, three, four, five months kind of impact.

Michael O'Brien - Bear Stearns

That was kind of my question, but if I kind of look at the you know, you are saying the memory guys almost to a company are still quite still bullish so -- and the foundries are already -- in a pretty negative scenario for October, Intel and others were pretty low levels. I am just trying to see here in the near term, what's going to take that for that step -- step function down in orders?

Michael Splinter

The thing I believe that -- in order to see a big step function down, the foundries have to continue their kind of negative bias on capacity and the memory guys have to have some kind of an advance that doesn’t -- that takes away their courage for investment and I think that when you look at the various players if it was going to happen, it would happen in the DRAM space before it happens from the flash guys.

Michael O'Brien - Bear Stearns

Okay thanks good luck.

Michael Splinter

Thanks. I think that was the last question and I just wanted to finish off by saying thank you to Nancy and acknowledge her 21 years at Applied Materials in making a huge impact on our company through the good times and the bad and she has done all different kinds of jobs in management and demonstrated leadership across the company. So Nancy, thank you and thank you for your contributions. You’ll be thoroughly missed. Thank you.

Nancy Handel

Thank you.

Randy Bane - Vice President of Investor Relations

Thank you Mike and thank you Nancy, now we would like to thank you everyone for listening to our Q3 2006 earnings announcement. The replay of this call will be available on our website at 5:00 pm today and will remain posted there until August 30. Thank you for your interest in Applied Materials. This concludes our call.

Operator

And that concludes today's call; you may now disconnect your line.

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Source: Applied Materials Q3 2006 Earnings Conference Call Transcript (AMAT)

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