Applied Materials' (NASDAQ:AMAT) Q2 2014 earnings were at the high end of the company guidance and inline with market consensus. The company reported 19% annual growth in revenue, driven by healthy investments by its semiconductor and display customers. Backed by strong execution of its strategic plans and significant improvements in financial performance, Applied's non-GAAP gross margin was at its highest level in six years. Operating profit exceeded 20% of revenue for the first time in nearly three years and earnings per share increased 75%, significantly outpacing revenue growth. It generated orders of $2.63 billion in the quarter, up 15% from Q1 2014, led by growth in display and silicon systems.
Evolving trends in mobility and connectivity are driving industry growth and accelerating innovation in mobile chips, solid state storage and interactive displays. In semiconductor and display, new materials innovations are enabling key inflections by providing customers with solutions that improve device performance, yield and cost.
Applied claims that fiscal 2013 was a transformative year as it reduced its overhead expenses, stepped up investment in product development and built momentum for profitable growth. It anticipates healthy investment levels by its semiconductor and display customers in the year ahead, and believes that the major technology trends will play to its strength in precision materials engineering.
Our price estimate of $17 for Applied Materials is at a slight discount to the current market price. We are in the process of updating our valuation to incorporate the Q2 2014 earnings.
Wafer Fab Equipment To By Up 10% - 20% In 2014: Mobility Trend Remains The Biggest Growth Driver
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, and thus the market leaders are aggressively accelerating ramps at advanced nodes. Management expressed it best on the conference call for investors:
"The advanced processors, sensors and memory needed to enable high end smartphones have driven significant growth in the silicon content of these devices. Consequently, the foundries continue to make substantial investments as they ramp 20 nanometer capacity and accelerate their pilot lines for 16 nanometer and 14 nanometer FinFET technology."
Applied remains focused on creating a strong pipeline of new, highly differentiated products to enable future inflections in logic, memory, and display. In calendar 2013, it gained 1.4 points of wafer fab equipment market share ending the year at its highest level since 2006. 
Gartner estimates capital equipment spending in the semiconductor industry will increase by 16% and 17% in 2014 and 2015, respectively. Rising mobile shipments, a recovering DRAM market, growing NAND demand and pending technology transitions (22nm and 16 nm, FinFET and 3D NAND) are key factors driving demand for semiconductor equipment.
Mobility and cloud computing are also driving demand for NAND memory and Applied expects bit growth to be about 40% this year. As a result of strong investments in advanced planar NAND, it estimates total NAND spending wil reach $7 billion in 2014. DRAM customers are also investing more as they upgrade capacities at their advanced nodes to meet demand for mobile DRAM. We expect 2014 DRAM spending to be 10% to 15% higher than last year. Despite certain adjustments in customers investment plans recently, Applied continues to believe that the wafer equipment market in 2014 will be up 10% to 20%. 
TV And Mobile Investment To Drive Display Demand
Applied's display revenue increased 15.7% annually but declined 7.5% sequentially, as customers pushed out orders. However, it booked new orders worth $340 million, compared to $79 million in Q1 2014 and $195 million in Q2 2013. Though Applied expects its revenue pattern to be uneven due to shipment timings, its outlook for the display segment remains positive. Growing TV demand and mobile investments are two key factors driving growth in the display segment.
Growing global TV sales and larger average TV sizes are increasing significantly faster than historical trends and are driving demand for display equipment. Applied claims that the average TV size is growing 1.2 to 2 inches annually, which is significantly higher than historic norms. This trend is driving area growth in the 15% range which the company believes is sufficient to support investment in three new Gen 8.5 factories. Three new Gen 8.5 factories are being built in China as its customers compete to meet the growing TV demand.
In mobile devices, the screen resolution is becoming an important differentiator and is leading to significant growth in high definition screens. Applied expects multiple Gen 6 LTPS factories to be built in the next 12 to 18 months to support this demand. High definition screens are driving demand for low temperature polysilicon backplanes The company expects multiple new Gen 6 factories to be built in the next two years to meet the growing market demand.
Merger With Tokyo Electron To Help Form A Stronger Entity
Applied announced it merger with Tokyo Electron in September 2013. Both companies supply equipment used to manufacture semiconductors, flat-panel displays and solar photovoltaic products. With the aim of forming a global innovator in semiconductor and display manufacturing technology, the two companies will create a combined entity with an estimated value of $29 billion.
With an estimated combined WFE market share of 34%, Applied believes that its merger with Tokyo Electron will help form a stronger entity. Though both companies are among the largest in the industry, they have little overlap in their product offerings. Applied will also benefit from a broader product portfolio, shared R&D costs and lower cost of developing chips.
Applied expects to receive regulatory approval for the merger in the second half of 2014. Its shareholder meeting to approve the deal is scheduled for June 23.
Q3 2014 Outlook
- Net sales to be flat to down 5% sequentially. This range translates into year-over-year gowth of 13% to 19%.
- SSG net sales to be down 2% to 6% sequentially. AGS net sales to be flat to up 5%. Display net sales to be down approximately 20% and EES net sales to be up 5% to 10%.
Disclosure: No positions.