Transformation In 2013 Sets Stage For Applied's Growth Momentum In 2014

| About: Applied Materials, (AMAT)

Applied Materials (NASDAQ:AMAT), a semiconductor manufacturing equipment provider, announced its Q4 2013 and year end result on November 14. On account of lower capital spending in the cyclical industries it serves, Applied’s revenue and net income have been pressured over the last two years and it reported a 13.9% decline in its fiscal 2013 revenue ($7.5 billion). Nevertheless, Applied believes that 2013 was a transformative year for the company as it reduced its overhead expenses, stepped up investment in product development and built momentum for profitable growth. The company earned a net income of $256 million in fiscal year 2013 as compared to $109 million in 2012.

For Q4 2013, Applied witnessed a marginal increase in revenues and its earnings per share exceeded the high end of its initial estimate by $0.01. At $1.2 billion, SSG revenues were slightly lower as the growth in logic and DRAM was offset by a seasonal decline in foundry investment (which was in line with what the company expected). While display and solar revenues were flat q-o-q, AGS net sales were up 8% due to higher than expected equipment sales.

New orders received by Applied in Q4 2013 increased by 27% y-o-y and 5% q-o-q. For fiscal 2013, the company booked 5% more orders compared to 2012. Applied mentioned in its Q4 earnings call that orders from its leading foundry customer was the highest in its history in 2013 and it anticipates the growth momentum to continue in 2014, backed by stronger investment from its semiconductor and display customers.

Though declining PC sales might dampen logic investment for the year, the rising demand for mobile devices and larger TVs will drive higher demand for Applied’s semiconductor and display manufacturing equipment in subsequent quarters. The company has a robust pipeline of new products for pending technology transitions, which it believes will help it build momentum for profitable growth in 2014 and beyond. Additionally, its merger with Tokyo Electron will help form a stronger entity, combining two of the largest players in the industry with largely complimentary product offerings.

We are in the process of updating our price estimate of $14.60 for Applied Materials.

Mobility Trend Remains The Biggest Growth Driver

With smartphone sales expected to cross 1 billion units this year, the ongoing mobility trend remains the biggest growth driver for the semiconductor industry. With rapid innovation in the market, mobile devices drive demand for leading-edge foundry capacity as the market leaders aggressively accelerate ramps at advanced nodes. The battle of mobility leadership is driving major technology inflections in transistors, interconnect, patterning as well as display.

Applied claims that smartphones and tablets now account for more semiconductor and display revenues than all other categories of consumer electronics combined. It estimates its customers to add manufacturing capacity for more than 500 million incremental smartphone and tablet units in the next two years.

Demand for advanced mobile technology is fueling strong foundry investment in leading-edge processes as they build out 20-nanometer and raise to be first with FinFET technology. The ongoing mobility trend combined with the strong adoption of solid-state drivers is driving demand for NAND flash, with bit growth estimated to be in the 40% to 50% range. Higher memory spend and the adoption of new technologies such as 3D NAND and FinFET (3D) transistors will help fuel growth in the semiconductor equipment market.

Applied anticipates wafer fab equipment (WFE) spending for calendar year 2013 to be low, between $27 – $30 billion, but predicts investment to rise by 10% to 20% in 2014 and reach $37 billion by 2016. Intel (NASDAQ:INTC), TSMC and Samsung (OTC:SSNLF), who account for roughly half of the total capital spending in the industry, have indicated strong capital investment plans for the current year with the aim of enhancing their technological capabilities. All of the above companies have been the top three customers for Applied for many years, and we do not foresee any reason for the trend to change.

Larger TV Sizes, Growing Mobile Demand & New Technology Driving Demand For Display

With 282% annual and 31% sequential growth, the display business booked its highest orders in Q3 2014 , in over two years, as Applied saw rising panel fab investments in China. However, display orders declined by 55.5% sequentially in Q4 2013 as TV unit growth was impacted by the elimination of subsidies in China. However, Applied expects to receive higher display orders in Q1 2014 as the overall TV and mobility investment cycle extends into 2014 and beyond.

Growing global TV sales and larger average TV sizes are increasing significantly faster than historical trends and are driving demand for display equipment. Shipments of 50 inch and bigger screens are up almost 70% year-on-year. Applied estimates an average increase of two inches in TV sizes in calendar 2013, in comparison to the average annual increase of 0.5 inch in a year. For one inch of growth, one new Gen 8.5 factory is needed to fulfill the incremental area of demand.

In mobile, new display technology is being adopted which is a positive trend for Applied as LTPS, OLED and flexible display technologies expands the total available market for its large area, precision materials engineering equipment by more than 30%. Additionally, the introduction of 4K ultra-high definition and OLED is driving demand for more complex and capital extensive manufacturing processes. Applied aims to grow its display business revenue to $1 billion or more in the future.

Better Execution Lowers Overhead Spending

Applied lowered its operating expenses from $2.9 billion in 2012 to $2.6 billion in 2013. During the course of the year, the company reallocated dollars from solar to semiconductors and from overheads to products. It lowered its solar spending by approximately $130 million in 2013 and it shifted the savings plus an additional $40 million in overhead savings to R&D programs within the SSG business.

Applied’s R&D expenses as a percentage of R&D and SG&A expenses increased from 54% in 2012 to 60% in 2013 as a result of a 22% annual decline in the SG&A costs. The company intends to invest additional dollars in R&D to strengthen its technology and product pipeline, especially in disruptive products which expand its addressable market and are key drivers for future profitable growth. In fiscal 2013, Applied moved over two-thirds of the incremental R&D investment into disruptive products.

Applied is also working to lower its material costs and believes that higher volumes in 2014 can help absorb its fixed cost.

Q1 2014 Outlook

- Net sales to be up by 3% to 10%.

- SSG net sales to increase by 15% – 20%, AGS net sales to decline by 5% – 10%.

- Display net sales to be down 15% – 30% and EES net sales to be approximately flat sequentially.

- Non-GAAP operating expenses to be approx. $540 million, +/- $10 million.

- Non-GAAP EPS to be in the range of $0.20 to $0.24.