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Applied Materials Inc (NASDAQ:AMAT)

Applied Materials at Credit Suisse Technology Conference

December 03, 2013 /12:00 p.m. E.T.

Executives

Bob Halliday – CFO

Analyst

John Pitzer – Credit Suisse - Analyst

(CROSSTALKING)

John Pitzer – Credit Suisse

Why don't we go ahead and get started in the interest of time? It is my pleasure this morning to introduce Bob Halliday, the Chief Financial Officer of Applied Materials.

We’ve got about 20, 25 minutes for a fireside chat. We’ll have some time to open it up to questions from the audience as well.

So, Bob, maybe I will kick things off. I'm sure most people in the room are familiar with the Applied story. But both you and Gary are relatively new as CEO, CFO, I think April and September, respectively.

So maybe as a way to set the stage you can talk a little bit about what your core mission is coming into the Company. What's your key strategic initiatives are and what's your – you guys are most focused on as you take over the helm.

Bob Halliday

Sure. So I will talk a little bit about our personalities. Gary and I have worked together since 2004 at Varian Semiconductor. A lot of fun. Gary, at his heart, is a strategic marketing product person. He has deep customer relationships in Asia. They really trust Gary. He has been going there about 30 years now. And I am more the finance and execution person. So I did a lot of the internal stuff at Varian manufacturing supply chain, along with HR, IT facilities and legal and stuff.

So what is the point? First thing, you do when you come into a new company or situation, you do a market assessment. What are the attractive markets?

We came into Applied, we thought that the semi market is pretty attractive the next few years. We thought display was more attractive than people realized. We thought the solar market is just an unattractive market right now because we sell equipment to make solar cells and there is overcapacity there.

So and then, finally, we thought the service industry was way under real valued by the industry in general, including Applied.

So what we did was – the first thing you do in a company is you optimize the portfolio. So we aggressively moved money out of solar into semi and out of overhead into products. That was portfolio optimization and that is going to be ongoing for the next couple of years, frankly. And I think there is opportunity to continue that path.

The second thing is we tried to focus on semi products because if you drive real profitability in our industry. The incremental drop through on equipment sales is over 50% incremental operating margins and about 40% in services. So if you can gain market share, it is a lot of economic leverage. So we are focused heavily on the products.

So I think in the last – so we are focused on semi, focused on market share gains, growing the Company, and dropping through a lot more of profit and cash. So we would have been successfully, I think, on that path.

Opportunistically, Tokyo Electron, which is a very large company in our industry, it Applied part this year – it agreed in September to a merger of the two companies. So if you look at there have been mergers in the last few years in this industry, Varian and Applied, LAN Novellus and ASML and Cymer; and there really were no subsequent mergers for years.

The environment, again you always go to the environment, has been more conducive to that because we have a concentration of very large customers. Whether it is TSMC, Intel, Samsung, Toshiba, Hynix – people like that. They want extraordinarily capable suppliers. An example if you look at somebody like a major foundry, their process windows are so damn tight, their requirements for equipment and uniformity across the equipment is really tight. And their production ramps are much steeper and faster than they used to be. So very capable suppliers generally win.

So increasing your capability whether it is technology, service, or production ramps is a big advantage. And so, when we looked at Tokyo Electron and Applied, those capabilities are measuring very strong share in specific products, very large installed base of service tools for an opportunity for us and three high customer respects. If you look at Tokyo Electron, they have all of those things. Customers really love Tokyo Electron as a technology and quality leader and their share in certain products are very high.

John Pitzer – Credit Suisse

Well, Bob, when you think about the Tokyo Electron transaction the cake is truly the fundamental synergies on the product side. I would argue the icing is some of the financial advantages you will get.

Can you walk a little bit through those advantages and, just in general, your view of cash flow and uses of cash and return of cash to shareholders?

Bob Halliday

Yes, there's a couple of leverage points there. One is generating more income and the second one, which is really fundamental, is generating better cash flow for investors. I think we have a real opportunity for both.

Because the combined companies in the strong wafer fab equipment yield like 37, we said we could do 18 billion. But even in a lesser year, we think we can do significantly better operating margins and that is really my focus for Applied and the combined companies to generate significantly improved operating margins even regardless of the volume. Okay, the wafer fab equipment volume.

So if you can generate 20%, 25% operating margins – and that is very viable even in a low year. Because you look at 50% drop through pretty strong IPs, strong product positions, good service business, we model 25% operating margin. I think that is very doable even in an off year. I don't know why we can't get to 20% or so. So then, what gets to investors? Cash, right?

So if you look at the semi cap industry it is an industry that inherently can generate significant cash returns as long as you don't get too much fixed cost. Because the industry tends to cycle up and down.

So if you look at the history of the industry, you have one boom year, one year you are ascending, its chaos growing, one year you make a lot of money and one year you write off everything. And that is a fundamental issue of putting too much fixed cost into the structures, too much time, it takes too long.

So, if you take these costs and time out you can make 20%, 25% operating margins pretty much year in and year out. And it is cash margins if you do it right. Because we don't have to invest a lot in fixed assets. Its receivables and inventory we cycle up and down and so the cash-operating margin can be 20%, 25%.

And what this merger unleashed for us was almost a unique opportunity structurally to merge the companies. One of the Japanese operating companies was an American operating company and put the parent company structure in Holland and also put a lot of the manufacturing and intellectual property value added through Singapore, which we have already sampled out of that.

So what you get is a much greater flexibility of moving cash around the Company, and returning dividends and higher share buybacks to investors. So, I think it is almost uniquely positioned as a company that can generate high cash returns to investors. And if we are successful in growing the Company, it's a big tech, potentially strong growth. Very high cash-generating business.

John Pitzer – Credit Suisse

Bob, when you look at the Silicon Systems Group, you are starting to see some green shoots of outgrowing the industry this year. Can you spend a little bit of time talking about where you think your greatest market share opportunities are within Silicon Systems?

Bob Halliday

Sure. I think we have market share opportunities in gaining share within segment, in places like etch and inspection. I think we gained share in etch inspection and PVD in 2013. I think some of the momentum continues into 2014. So gaining share within segment is an opportunity.

And then some of our segments may outgrow the overall wafer fab equipment. So if you look at PVD, which enables metal gates, that's a very good market right now.

Epi is very – epitaxal growth equipment is a very good market. So the share gain, some of it would be within segment, some of it would be mix, some of the segments outgrow the overall wafer fab equipment.

So if you look at why would we gain share in markets like that, in inspection the – Gary used to be the president of KLA a number of years ago and he hired a number of KLA guys into Varian and then we've had a few people join us even last year at Applied. So you have got probably about eight to 10 strong senior guys that applied who know the inspection business very well.

So what Gary and the team figured out is the equipment was pretty good, actually – the Applied inspection equipment. But a lot of the applications were qualifying the equipment hadn't been done. So some of the gains we have this year is putting more applications focused qualified equipment. It isn't new equipment we introduced, it is applications where it is marketing work, because you have to qualify it for multiple layers.

And then in etch, we put a new general manager in there about a year and a half ago. He has done a great job. In the end, what we have done is rapid iterations on chambers and things like that, but not a whole new etch tool. It is rapid execution.

So if you look at the share gains and what we have done this year, its portfolio optimization and sort of brute force execution. Picking up the speed, customer responses.

The real wind at our back, which is coming from the products, which you see in the R&D line of our P&L this year that is not going to hit us until like probably the end of next year. So what we are doing now is execution. When the products which will finally now come out we get some real wind at our back and that is pretty exciting.

John Pitzer – Credit Suisse

When you think about the etch market share gain, how important is that NAND transition from 2D to 3D relative to those gains?

Bob Halliday

Yes, it is pretty positive for us. We think we are gaining – we are confident we are gaining share in etch for NAND. We did some rapid prototyping of chambers and we also historically have done somewhat better on memory and, also, if you look at what they are doing particularly in VNAND and also into these somewhat, very deep high aspect ratio etches and we do very well at that to.

John Pitzer – Credit Suisse

Then on the logic side, relative to your SAM growth both in etch and other areas. As EUV gets delayed and there's more multi-patterning, there's clearly sort of an argument to be made that a lot of the stuff that you do needs to be done more at the way for level. Your SAM growth accelerates.

When do you think EUV finally comes into production, and when it does do we have to start to think about the slowing of your SAM growth as EUV alleviates some of the need for double, triple and quadro burning pattern?

Bob Halliday

I am not an EUV expert, so I will just give you my opinion from the back row. If you look at the path, today, the EUV has been a little bit delayed. The power requirements are very high. So you would project that a little – the path is a predict – indicator of the future.

So, my guess is the past will be an indicator of future in that the schedule will be a little bit slipped and the power requirements are daunting. So look at EUV, it is a cool technology. It is mostly commercially enabling as much as technology enabling. Because you can make – you can use lithog – immersion tools and do double patenting, quad patenting and make devices.

EUV, if the power gets up and the performance gets up you don't do as much quad patenting or double patenting. Right? No. First-generation EUV is probably still going to be expensive double patenting.

So when does it commercially work which is a function of power and throughput. My suspicion is the truth is somewhere in the middle and that a couple of things, one, it won't be as commercially viable as soon as people would like. So they will use some of it and not others.

Now, there's several tricks to the trade to make your own devices. One, you can go to more structured layouts which means it is easier to make the devices.

But the other trick that has got real staying power is you change the materials you are using, and that is where we play. So some of you have heard this lecture series, but you can do 2D planar shrinks, which are getting really challenging, particularly the lithography challenges.

Or you can go to a third dimension and you leave some of that or you can change materials. So, 2D shrink is really tough with patenting, EUV, stuff like that because the dimensions are so small. So you free some of that going vertically, like VNAND really releases that. So instead if a 10 nanometer lithography, 50 nanometer lithography. That is a lot easier.

The second way in memory is FinFETs are going vertical. That helps you to con – surface area contacting, things like that. But what they are also doing in FinFETs more and more is more and more materials modification. They are going to thinner layers, modifying their layers, more steps. That plays to our sweet spot.

Now how many generations can you go taller and thinner on a FinFET? I don't know. It gets pretty fragile.

But materials, which is the third trick in the tool bit, big trick that goes on for a long time. Because not only can you al – change materials you are using, you can alter those materials whether you thermally treat them. You put multiple layers. You implant them. So what Applied does has got real staying power and cost-effective for keeping the roadmap going.

2D is getting tough. 3D has got – VNAND is pretty empowering. FinFET is a couple of generations probably. So where we play could really empower the roadmap.

John Pitzer – Credit Suisse

Services. Most people look at services and their eyes glaze over. They fall asleep. I think when this was a – when tech was a growth industry of ForEx global DDP, I think the old saying used to be services is where big companies went to die slowly.

At dinner last night, as you talked about the service opportunity, it struck me that it is a really underpenetrated opportunity for you guys, and maybe a better growth driver than I would have thought. Can you spend a little bit of time just quantifying the opportunity?

Bob Halliday

Sure. So the first thing you do when you do a strategic plan, you are doing an environmental assessment. What is going on in the market. So I already told you, semi market we found more attractive than solar so we aggressively disinvest in one and invest in another. So then, you would say what's changed in the environment. So as you compare and contrast the 1990s or late 1990s to today, customer concentration we all know that, and the usual fear investors have is, geez, is their pricing power with their customers. Well, we provide really disruptive products, we will provide great values to customers.

But the other thing with really big customers which is enabling is – and I will get to the service thing, is you can have high market share because it is copy exact, best tool wins, process windows are tight. Logic chips are tougher than DRAM chips. So big customers can actually be an opportunity to provide high-value in large share numbers.

The second thing that has changed a lot is big install base of tools. So if you look at Applied Materials, we have, I think, 33,000 tools installed and running. Tokyo Electron has got 54,000, but bigger tools sort of 26,000 because they have probers in there too.

So if you look at the average tools, semi cap equipment tool, the footprint for revenues is probably, I don't know, $200,000 a year maybe. Now the one that is the biggest is probably an etch tool because etch tools etch. They eat themselves basically. So they use up parts and services.

So when you look at – so if you look at investment opportunities, you look at how much do you get for selling the equipment, but how much do you get in the aftermarket. So these tools last about 10 years. So if you sell your average etch tool or some of the other tools, too, you might sell for $3.5 million and since you are investing in a product cost, the operating margins are okay, but the etch tool might use $350,000 a year of spare parts and services. And the incremental operating margin is pretty damn good on that.

Now you say, well, let's risk assess it. You know the weighted average cost of capital for private tells is probably 10.5% to 12%. But the equipment is probably a few points higher and the services part is 6.5%. We are selling spare parts for our own stuff. So when I look at the present value of the Company, I look at – I have got this analysis where I have got a stack diagram of every product, service and overhead we have in the Company. And then you assign different discount rates to the stack and opportunity profit to it and you say, well, the sum of all those pieces is the market cap of the Company. If you optimize the stack along growth, profitability and discount rate you start to see, I can move the valuation of the Company by synching its three dimensions – growth, profitability, and discount rate.

So the services is a big opportunity and a risk if you don't fix it because the customers will second source you locally and then those suppliers will go up the food chain. So I think it is a really under realized value. So I think Applied is about 40 – it is hard to get hard numbers. I think we are getting about 41% of our opportunity. I think Tokyo Electron is about 18%, maybe. So it is a big opportunity.

John Pitzer – Credit Suisse

Bob, you guys are on record talking about WFE growth next year in a range of 10% to 20%. One, is that still how you are viewing the world?

And two, 10% to 20% a relatively large range, so what is the pressure point that gets to the high end of that number? What are the pressure points that get you to the low end of that number? What's the risk reward when you look at projects and market segmentation, DRAM logic foundry?

Bob Halliday

So, if you look at it – DRAM this year on those 4 million or 5 million, we think it is up, I think about 10%. I think flash is probably up 30% to 40% next year and I think it is real. Foundry, foundry this year was about 11 billion or 12 billion, or something like that. And it is probably up about 10% this year. I will come back to foundry. Logic is about, I guess, about 9 billion this year. It is probably flattish.

So if you go into those and risk assess them, DRAM I don't know if it is a lot of upside, but I don't know if you want downside. It is not a big number.

Flash, I think it is going to really happen. I think VNANDs are very powerful in terms of commercially, technology and reliability. So I think they are going to be pushed pretty aggressively and I think there will be multiple companies that say, hey, we want to play there. I think you are also getting spending on 2D NAND.

The good thing for that market is it might enable more sales of NAND devices if they are more reliable and cost effective. So I think NAND is real for 30% plus.

Foundry. People push back and foundry said, gee, it is big. How big is 20 nanometers. How big is FinFETs, when do they come? I think a few observations of foundry.

I think if you map the last few years, the big foundry player has tended to spend pretty strongly even in the second half. So they tend to hit what they say in spending. Two, I think you will get some – a little bit more spread out of the spending. If you look at the second tiered foundry guys, it wasn't as big the last couple of years or a year and a half or so. I think they will spend a little more this year.

Now the early part of the year looked strong in foundry. What is the second half of the year? This whole 20 nanometer, how big is it? I don't know. I know that the customer is saying, it is big. But to a certain extent, I am agnostic because we will sell equipment for 20 nanometer or FinFET and a fair amount of the toolsets will stay. So the only risk really is do you have an air bubble in the middle somewhere. I don't think so but who the heck knows.

John Pitzer – Credit Suisse

We probably have time for a question or two from the audience if there is one.

Question-and-Answer Session

Unidentified Speaker

Can you give a little color on the 100,000 3D NAND that you guys talked about at the UBS conference? What gives you confidence that we are actually going to see 100,000 wafer starts for our 3D NANDs?

Bob Halliday

I don't know that we said 100,000 this year. I think if you look at – Michael, what do we say this year about 30,000?

Unidentified Speaker

[INDISCERNIBLE]

Bob Halliday

Yes. So I don't know if it is 100,000. It is probably somewhat less than that. My guess. If you look at the Jian factory, the footprint is 220. I don't – I think they will add a fair amount and they may pick it up a bit later in the year, but I don't know that it is 100,000. We are seeing 2D expansion this year, two places in Japan. A fair amount of that is already in backlog.

So I think there's pretty aggressive spending. I think it is about two thirds 3D, one third 2D. I don't know if it is 100,000 in the year, though.

John Pitzer – Credit Suisse

Any other questions from the audience?

Unidentified Speaker

I guess the reason I was asking is if you look at most people when they talk about 30,000, 40,000 that gets NAND up only maybe 10%, 15% next year. So for NAND to be up 30%, just curious. What are the puts and takes in there?

Bob Halliday

Well, it is a couple of things. One is I think there is going to be some 2D spending, number one. Number two, I think 30, 40 is 3D. So you have got some 2D too. But the third thing is if you look at capital-intensive, first-generation of 3D is higher. Especially for us which is etch and deposition intensive versus litho.

John Pitzer – Credit Suisse

Perfect. With that, we have ended our time in this session, but I want to thank Bob for his time this afternoon or this morning.

Bob Halliday

I appreciate it.

John Pitzer – Credit Suisse

Thanks very much.

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