Applied Materials F1Q08 (Qtr End 01/27/08) Earnings Call Transcript

Applied Materials Inc. (AMAT)

F1Q08 (Qtr End 01/27/08) Earnings Call

February 12 2008 4:30 pm ET

Executives

Randy Bane - VP of IR

Mike Splinter - President and CEO

George Davis - CFO

Joe Sweeney - SVP, General Counsel and Corporate Secretary

Analysts

Stephen Chin - UBS

Harlan Sur - Morgan Stanley

Timothy Arcuri - Citi

Jennie - J.P. Morgan

Patrick Ho - Stifel Nicolaus

Gary Hsueh - Oppenheimer & Co.

Satya Kumar - Credit Suisse

Mehdi Hosseini - FBR

Jim Covello - Goldman Sachs

Bin Pang - Harris Company

CJ Muse - Lehman Brothers

Steve O'Rourke - Deutsche Bank

Mahesh Sanganeria - RBC Capital Markets

Jesse Pichel - Piper Jaffray

Edwin Mok - Needham and Company

Presentation

Operator

Welcome to the Applied Materials fiscal 2008 first quarter Earnings 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

Thank you, Marvin. Good afternoon and welcome to Applied Materials fiscal 2008 first quarter earnings call. Joining me on the call today are Mike Splinter, President and CEO; George Davis, Chief Financial Officer; and Joe Sweeney, Senior Vice President, General Counsel, and Corporate Secretary.

Today we will discuss our results for the period ending January 27, 2008. The financial results were released this afternoon at 1:05 p.m. Pacific Time. A copy of the news release is available on Business Wire and on our website, www.appliedmaterials.com.

Before we begin, let me remind you that a slide presentation supporting today's discussion is available on the Investor Relations page of our site.

Today's earnings call contains forward-looking statements, including those related to Applied's performance, display and solar ramps, restructuring costs and savings, cash generation and deployment, growth opportunities, products, strategic position and financial targets, customer's capital spending and the outlook for the semiconductor, display and solar industries.

All forward-looking statements are subject to known and unknown risks and uncertainties that could cause actual results to differ materially from those expressed or implied by such statements. Information concerning these risk factors is contained in today's earnings press release and in the company's filings with the SEC. Forward-looking statements are based on information as of February 12, 2008 and the company assumes no obligation to update such statements.

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

George Davis will lead the call with a discussion of our financial performance for our first quarter. Mike will then follow with comments about company progress to-date and our outlook on the industry environment. George will close our commentary with our targets for the second fiscal quarter of 2008. After these remarks, we will open the call for questions.

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

George Davis

Thank you, Randy. Good afternoon, everyone, and thank you for joining us. Q1 was a dynamic quarter for the company. We met or exceeded our targets in all respects while experiencing very different end market conditions in our business segments. We took steps to address our operating performance and cost structure in our semiconductor equipment and related services businesses, while at the same time investing to meet the growing ramp in our solar and display units.

We also increased our share repurchase activity to return value to stockholders, reflecting our optimism in the long-term potential of Applied. Order momentum was particularly strong in Q1, a turnaround in display resulted in new orders rising by 13% over Q4 significantly exceeding our target of down 5% to 15%. High consumer demand is driving capacity additions across all major LCD customers. Our order book also reflected the first orders related to our SunFab thin film solar lines. These orders increased our order performance by approximately 7 points.

As expected, we experienced lower demand for semiconductor equipment driven primarily by DRAM customers. Backlog for Q1 increased about $400 million to $4.1 billion. Backlog adjustments were minimal and totaled $32 million. We completed the acquisition of Baccini after the close of Q1, so those results and any adjustments related to the acquisition are not yet reflected in our numbers.

Revenue for Q1 decreased 12% to $2.1 billion, slightly better than our target of down 13% to 18%. This decrease from Q4 reflected lower net sales to DRAM and LCD manufacturers, partially offset by higher sales in our Energy and Environmental Solutions segment.

Gross margin for Q1 decreased modestly versus last quarter to 44.8% from 45.5%, primarily due to the effect of lower revenues, partially offset by lower material costs and our cost reduction efforts.

Q1 operating expenses were $562 million and included restructuring charges of $38 million for severance costs related to Applied's cost reduction plan announced on January 15th and the $11 million for implant facility retirements. Our estimate for severance cost has increased since the announcement, primarily due to costs associated with expected international reductions.

Operating income decreased to $373 million or 18% of revenues. Non-GAAP operating income was $493 million or 24% of revenue. Net income was $262 million or $0.19 per share at the high end of our target range of $0.16 to $.20 per share. Excluding the impact of the cost reduction plan related charges, EPS would have improved by $0.02 and exceeded our guidance for the quarter.

Non-GAAP net income of $345 million or $0.25 per share reflected a 26% decrease from Q4. Non-GAAP adjustments are detailed in the press release.

Now I would like to discuss our segment results. As noted in our press release and in our recent Analyst Meeting in New York, we have renamed two of our segments. Adjacent Technologies has been renamed Energy and Environmental Solutions, or EES, reflecting that organization's clear focus on energy.

Fab Solutions has been changed to Applied Global Services, or AGS, to reflect our decision to manage all service-related activities in that unit. This will result in service revenue for display and solar being included in AGS going forward.

We will provide segment level reconciliation on our website to facilitate your segment analysis. There was no material solar service in fiscal year '07, so the adjustments will only affect the display segment. For Q1 '08, display service revenue was $24 million compared to $35 million in Q1 '07.

Let's now look at the Q1 results in the segments. Silicon orders of $1.1 billion were down 20% over Q4, as demand for equipment from DRAM customers declined further while foundry and larger customer demand remained low. Our order composition was DRAM, 34%; Flash Memory, 26%; Foundries, 14%; Logic and other, 26%.

Orders for 70-nanometer and below technology represented 85% of silicon orders. Q1 silicon net sales were down 18% compared to Q4 in-line with expectations, again primarily due to decreased investment by DRAM and Logic customers. In the face of falling revenue, operating income performance in Silicon Systems was strong at $445 million or 36% of sales. Ongoing effective cost controls, as well as disciplined portfolio management and material cost reductions, all contributed to improving performance.

In Applied Global Services, Q1 orders were down 6% from Q4, primarily due to lower orders for spares in-line with industry conditions and declining fab utilization. Net sales decreased 2% from Q4, due to seasonally lower sales for spares, partially offset by increased factory software sales.

Operating income decreased 7%, compared to Q4, in-line with a decrease in revenue and mix. These numbers include display service for the first time. Display orders for Q1 for equipment were up 363% from Q4 and up 1,500% year-over-year, as LCD customers began to invest again in response to rising LCD panel demand. Display sales of a $133 million were down from Q4 as expected, reflecting the low order activity seen in fiscal 2007.

Operating income decreased to $34 million or 26% of net sales due to lower revenue levels and product mix, partially offset by lower cost. Again, these numbers reflect only equipment-related revenue and orders.

Q1 orders in Energy and Environmental Solutions totaled $260 million, up 165% from Q4, and they include recognition of our first applied SunFab thin film line orders and the first full quarter of orders for our precision wafering system products.

Net sales of $122 million, was up 98% from Q4 and they were driven by increased solar-related revenue including the contribution of the PWS revenue and higher sales of our ATON tool.

The Q1 operating loss for Energy and Environmental Solutions of $48 million resulted from increased operating cost associated with a build-out of our global thin film and crystal and silicon solar team, M&A charges related to the HCT acquisition and costs related to the expansion of solar marketing efforts.

Next, I would like to discuss our balance sheet and cash flow. We continue to have strong cash flow performance, generating $390 million in cash from operations, which represent 19% of revenue. We are investing in working capital to support the solar and display ramps while managing SSG inventories in-line with industry conditions.

We maintain our long-term objective for cash from operations at greater than 20% of revenue, but we expect that fiscal year '08 levels will be impacted somewhat during these ramps. Working capital changes in the quarter reflected this pattern with reductions in inventory related to semiconductor equipment, offset by the increase of working capital to support the solar growth. We ended the quarter with cash balances and marketable securities of $3.36 billion.

In Q1, Applied returned $683 million or 175% of operating cash flow to its stockholders. Of this amount, $600 million was for the repurchase of 34 million shares at an average price of $17.84 and $83 million was for cash dividends.

We remain committed to generating strong cash flows and funding our investing needs while returning excess cash to our stockholders. We expect to spend between $300 million and $500 million on share repurchases in Q2 '08. This is in addition to the $334 million in spending related to the close of the Baccini acquisition made at the beginning of the quarter.

Now I will turn the call over to Mike Splinter for his perspective on the quarter and his view of the key industry and market changes affecting our business. Mike?

Mike Splinter

Thank you, George. Q1 performance was at or above our targets and the strong bookings in display and solar gave further evidence of the solid foundation of our growth plans. During the quarter, Applied Materials faced a weak global market for semiconductor equipment and at the same time, experienced a significant upswing in demand for our display products.

2008 is a pivotal year for Applied Materials to focus on execution and growth. We have restructured our industry leading silicon equipment business to improve operational performance and competitiveness across our product portfolio. We have expanded the role of Applied Global Services to be the service provider for all of our businesses to take advantage of our global footprint and we are investing to meet the extraordinary customer demand for our display and solar products.

In a tough year for our core silicon business, we have great optimism about our long-term prospects. In 2008, we expect to extend our leadership in silicon equipment, establish Applied as the key enabler to the solar industry and significantly expand our served market and display. We intend to do this while maintaining a disciplined operating model that generates strong profits and cash flow.

Let me touch on some of the details about the cost reduction actions we took in Q1. In semiconductor equipment-related services, we announced a global cost reduction plan designed to generate about $150 million in annualized savings. We believe these savings are achievable from the efficiencies of moving to a single silicon business unit and the related product portfolio rationalization. This was a difficult, but necessary step that affected approximately 1,000 people in these organizations.

This action is part of a roadmap developed by our Silicon Systems Group to improve its operating model by 4 points over the next three years, while funding the R&D, as necessary, to further improve our product competitiveness.

During this down period, our semiconductor team is working hard with customers to gain acceptance of our new products. New technology solutions including single wafer oxidation steps and E.HARP for next-generation shallow trench isolation are gaining momentum.

Metal and gate tech continue to advance ahead of the competition, and we are collaborating with key memory customers on advancing the state-of-the-art for self-aligned double patterning, which now appears to be the only technology that enables flash memory to move below 30 nanometers.

Applied Global Services has broadened its scope to provide services for display and solar customers. We expect to offer an expanded suite of technically differentiated services in these areas by leveraging the products and technical resources of AGS.

This is how we can provide our solar customers with comprehensive service including process support, parts service, abatement, and manufacturing systems. During the quarter, we signed our first solar service contract for a SunFab line.

In addition, we are expanding our service offerings in our core business from 200-millimeter productivity upgrades to chamber performance services and integrated software. Display has certainly provided the biggest positive in the first quarter. Strong end customer demand for large format flat panel TVs has led to the need for significant capacity additions.

2008 looks to be a record year for new orders and display, and could be a record year for revenue, even though we expect revenue in the first half to be soft in-line with the low order level from last year.

We have significantly increased our served available market in display with the launch of the new AKT-PiVot for array PVD. Our leadership team in display is managing the double challenge of meeting an unprecedented ramp in LCD-related demand while supporting the PECVD component of our rapidly growing SunFab line.

Display has developed a highly outsourced model for manufacturing over the past several years and the supply chain supporting this model is ramping in-line with demand. And ramping fast is exactly what we're doing in solar. Scale is an important factor in lowering the cost per watt of our solar over time.

At our New York Analyst Meeting, we talked about how we see the industry moving to take advantage of the scale that our SunFab and film production lines provide using our industry leading 5.7 square meter glass.

Our thin film solar approach is gaining traction and enthusiastic customer acceptance. We were pleased to be recognized as the Green Energy Innovator of the Year by the prestigious Platt's Global Energy Awards for our pioneering work on the Applied SunFab Thin Film Line.

In addition to our work in thin film solar, we are investing to build our capabilities for crystalline silicon as well. With the close of our acquisition of Baccini, Applied Materials is now offering products in the high value-added areas of the crystalline silicon solar process. Areas where we offer differentiated products to lower manufacturing costs while providing systems that create and process in our wafers, all with the end goal of lowering the cost per watt which will increase the end market.

Looking forward, demand for solar is robust and growing and we are in discussions with many new customers. We are also happy to report that our existing solar customers are talking about repeat orders. Overall, our solar business is accelerating and at the same time, Applied Materials technology is accelerating the adoption of solar around the world.

Unfortunately, the economic environment in the U.S. and the world is not as bright as the outlook for solar. We see the uncertain U.S. economic environment and the potential for slowing global growth to be our near-term challenge.

This is all set for Applied Materials by the positive momentum toward investment in clean energy, as an economic and political priority.

Silicon Systems is facing a soft investment environment. We said in our last call the wafer fab equipment spending is forecast to be down 5% to 15% in 2008 and it's still looking that way. In memory, DRAM is expected to be down greater than 30% and NAND flash is up but not enough to completely offset the difference. Foundry spending is expected to be modestly down and investment for Logic should be roughly flat.

The environment for display this year is much improved with expectations that industry investment will be up above 40% in 2008, driven by an LCD TV market that is projected to grow at annual rates greater than 28% from 2007 to 2011.

The build-out of Gen-8.5 across the industry is coming fast as every manufacturer is speeding to add capacity. Looking forward with Sharp leading the way on Gen-10, we can expect the next wave of flat panel TV factories.

Overall, Applied Materials is moving prudently in some areas and investing broadly in others to optimize our performance through these exciting and challenging economic times. Our cost reduction plan for the silicon sector is well timed for the market conditions we face and our strengthened solar and display is outpacing our expectations.

Our employees are driving our success and are putting their energy behind the projects and initiatives feeling our progress. As a company, Applied is focused on execution in 2008 to deliver on the first leg of the growth commitments we made.

And now I'll turn the call back over to George to provide our targets for the next quarter. George?

George Davis

Thank you, Mike. Our targets for Q2 are that we expect orders to be in the range of down 5% to up 5%. This is coming off very strong order performance in Q1 and reflects expected strength in solar and display.

We expect revenue to be in the range of flat to up 5%. We expect EPS to be in the range of $0.18 to $0.22 per share, in-line with mix effects and higher spend in solar and display.

Thank you, Randy. Let's open the call for questions please.

Randy Bane

That completes our prepared remarks. We will now begin our question-and-answer session. Operator, please begin with the first question.

Question-and-Answer Session

Operator

Our first question comes from the line of Stephen Chin with UBS.

Stephen Chin - UBS

Great. Thank you. Congratulations on the display order execution there. My question is how sustainable do you think this momentum is. For example, can Applied exit the year with trade bookings tracking at over $2.5 billion annual run rate, do you think that's possible?

George Davis

Steve, I think what we are seeing is a substantial push by our customers to pull display orders into the first half of the year. And I think our order outlook, while we are not being able to maintain the record level of orders that we achieved in the first quarter, all evidence is we'll have another strong quarter for display in the second quarter.

But is that run rate sustainable throughout the year? No. We still think overall, that orders for the year for the overall company will be up, as we discussed at the New York meeting.

Stephen Chin - UBS

Can I ask the second question? Can you share any color on Moser Baer's announcement yesterday that they had secured additional solar equipment? Can you give us any color of how Applied Materials began the primary equipment prior to the Moser Baer?

Mike Splinter

Well, Steven, first of all, as you know, Moser Baer was our first solar thin film customer and we have been in discussions with them for sometime. So as we said in New York, we are in discussions with some major customers on gigawatt scale fab lines, but we don't have a specific thing to announce today.

Stephen Chin - UBS

Okay, thanks, and congratulations again.

Mike Splinter

Thank you.

Operator

Our next question comes from the line of Harlan Sur with Morgan Stanley.

Harlan Sur - Morgan Stanley

Hi, good afternoon. Nice execution on the quarter. I think it's fair to assume at this point that the team is probably in negotiations with all of your initial customers for their next round of expansion on the solar side. So, I guess the question is, what kind of ramp rates are we talking about here? Are we going to see second phase expansion maybe doubling the initial capacity, and then a big step up to, let's say, a few 100 megawatts of capacity or even gigawatts of capacity?

Mike Splinter

It really depends on the customer Harlan. We said in New York, we are discussing with up to four people on pretty large scale gigawatt kind of scale factories that almost everyone of our customers today just thinking about a follow-on factory, some significant magnitude bigger than their first one.

Harlan Sur - Morgan Stanley

Okay. And then my second question, as you mentioned in the last call, Mike, that your pipeline supported a growth outlook for at least your silicon business to grow in the second quarter order-wise directionally. Is that still the case here in April?

Mike Splinter

Yes. So we think that silicon orders in revenue will be up modestly in Q2, but I certainly wouldn't call it a momentum at this point.

Harlan Sur - Morgan Stanley

Okay. Thank you very much.

Operator

Our next question comes from the line Timothy Arcuri with Citi.

Timothy Arcuri - Citi

Hi, couple of things. First of all, Mike, if I look at the thin film bookings, it looks like maybe by the end of April, you will have booked maybe 400 to 500 million of that, of whatever the contract value that you currently have is. So, can you give us an idea, based upon contracts you have signed today, how many orders do you have beyond what you have included, which you will have booked in January and April?

Mike Splinter

I am going to let George answer the first part of your first question. Tim, I will catch up with you on the second part.

George Davis

We booked a 160 this quarter. We are not going to forecast the specifics for next quarter, but we do anticipate booking some additional orders off of last year's contracts. So, we expect to book the majority of all those during this year as we've said already. There is no change in that outlook. Whether we get 50% of it in the first half or not, we are not going to guide that right now.

Timothy Arcuri - Citi

Okay. My second question is, George, can you give us some idea then on the backlog? You haven't had this much backlog in terms of months since 2003, late '03, and you posted four straight double-digit sequential revenue growth quarters after that. So can you give us some idea of the age of the backlog? How much of that is shippable within six months, for example?

George Davis

I think what you are seeing is more of a balance issue than any change in the dynamics of our backlog. I mean, you have more of longer lived orders both in display and in services making up that mix. So that's a little bit of the phenomenon you are seeing. Most of the order, the behavior for the orders in terms of when they are going to be recognized for instance on the semiconductor equipment side is basically within sort of the normal pattern quarter-and-a-half out that we normally see.

Randy Bane

Operator?

Operator

Our next question comes from the line of Jay Deahna with J.P. Morgan.

Jennie - J.P. Morgan

Hi, it's [Jennie] here in for Jay Deahna. Can you give us a status update on the initial SunFab installed; are you still targeting working panels by mid year?

Mike Splinter

Yes, [Jennie], we are expecting production output by the middle of the year and things are moving along quite well, for real detail though, I think you have to ask Moser Baer the specific question, it is their factory.

Jennie - J.P. Morgan

Are you still expecting overall company orders to be flat to 10%, revenues to be flat and modestly down in fiscal '08, as you had said at your Analyst Day?

Mike Splinter

Yes, that's right. We are not changing that projection at this point.

George Davis

That's correct.

Jennie - J.P. Morgan

Okay, thank you.

Operator

Our next question comes from the line of Patrick Ho with Stifel Nicolaus.

Patrick Ho - Stifel Nicolaus

Thanks a lot and nice work on the quarter. I know some of your cost reduction efforts have come from the exit of some of your select semi-cap businesses like Ion Implant, ECP. What other measures exactly you are taking to further reduce cost in that segment?

George Davis

The headcount reductions we talked about, that was the January 15th announcement; talking about the headcount reductions both in the Silicon Systems Group, the Services Group that supports the semiconductor equipment side. And then, all the staff groups that are within that were impacted as well. So, the headcount impacts which will primarily be felt as we roll-out through the year were a big part of that cost savings. And that's really what's driving the bulk of the cost savings.

Patrick Ho - Stifel Nicolaus

Okay. So it's nothing like supply chain management and things like that, that's the driver, it's mainly the headcount reductions?

George Davis

Well, over the long run, we've talked about the global supply chain strategy that Tom and his team are putting in place and I think that'll continue to drive. We've obviously had a focus on material cost reductions year-in and year-out. But we believe we need to really significantly expand our global supply chain to get to the next level and that's what Tom and his team are working on. So we expect that over time to have a big impact. But I was really talking more about what we're seeing in Q1.

Patrick Ho - Stifel Nicolaus

Okay, great. And just one clarification on the numbers, the items associated with acquisition, was that in cost of goods?

George Davis

The bulk of it was in cost of goods.

Patrick Ho - Stifel Nicolaus

Great. Thanks a lot.

George Davis

Yeah.

Operator

Our next question comes from the line of Gary Hsueh with Oppenheimer & Co.

Gary Hsueh - Oppenheimer & Co.

Hey, great. Thanks for taking my question. Something I just don't understand about guidance, you're highlighting kind of flattish guidance as solar and kind of display driven sort of quarter. But you're also suggesting that silicon systems businesses will be booking flat to slightly higher. So what's going to drive sort of the minus 5% Q-over-Q kind of scenario in your guidance for orders?

Mike Splinter

The big thing that is on the cautious side is that this is off the peak on displays. Display was an incredible quarter for orders in Q1 as George has alluded to, up 1500% year-over-year. So we are going to be a bit off that peak in Q2.

Gary Hsueh - Oppenheimer & Co.

Okay. Perfect, Mike, and that leads into my next question. If I just look historically, even after you purchased Applied films, the peak and the last peak in flat panel display, CapEx spending for your order number was roughly $355 million in the October quarter of '06 and now you are booking $555 million. Is that a fair comparison or is ATON really sort of driving the difference here between peak to peak?

George Davis

No. The apples-to-apples comparison is really you have to pull -- you had serviced in your $355 million, so it was $310 million for equipment.

Mike Splinter

So, it gave a bit little bigger difference.

George Davis

Yeah. So it's really an extraordinary quarter for display.

Gary Hsueh - Oppenheimer & Co.

Okay. So it's fair to say that display business is heavily front-half loaded and pretty much loaded in the January quarter.

George Davis

Yeah, I wouldn't discount that. I think they are going to have a strong second quarter and probably will exceed the previous record as well, but it's going to be hard to top this quarter.

Gary Hsueh - Oppenheimer & Co.

Okay. Got you. One last kind of question, George you had mentioned that you got 7 percentage points of bookings growth from SunFab that would imply a $175 million in bookings?

George Davis

The exact number was $160 million.

Gary Hsueh - Oppenheimer & Co.

$160 million, okay. So just wondering why the other part, the crystalline silicon side is just kind of running flattish. Why we haven't seen growth this January quarter like a seasonally slow period for crystalline silicon? Or is there some other explanation why we are not seeing bigger growth there outside of SunFab?

George Davis

Now remember also within the EES Group, we also have glass and web, so you've got a number of moving parts. You can't, and again I am not going to breakout every detail of the order book, but you had kind of a run rate level of PWS orders in that. And so I think we didn't see anything that would suggest that you are having a drop off.

Gary Hsueh - Oppenheimer & Co.

Okay, great. Thank you.

George Davis

Okay.

Operator

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

Satya Kumar - Credit Suisse

Yeah. Hi. A quick question on your SunFab. It seems like you have pulled in the order recognition by at least a quarter. Can you talk about what specific milestones you might have achieved particularly with demonstrating performance on tandem solar cells that you now have SunFab orders being recognized?

George Davis

Satya, what we had said, is that our order recognition policy was, when we believed that we were both within 12 months of sign-off with the customer, and we had assurance that the supply chain was available to serve that order and all prior orders, then we would go ahead and book. And so these orders set that criteria.

Satya Kumar - Credit Suisse

So, is it fair to assume that over the last three months you have increased your confidence of demonstrating your specs on the tandem cells at your customers sites or your?

George Davis

I think our confidence across the board on solar continues to grow, and that’s sort of reflective of what we're also seeing from the customer side as well.

Satya Kumar - Credit Suisse

Okay, that's helpful. And when I look at your Silicon Group, I'm trying to reconcile what I'm seeing with you guys with the other companies, the peak, the trough orders are down 45% for you guys in silicon over the last three quarters. Most of your peers are down between 10% and 20%. And if I also look at your comments that CapEx will be down 5% to 15% this year, and your comments of taking share; you lead the book about $1.4 billion a quarter in silicon on average each quarter to get to just down 10%.

What's the disconnect? Are you looking at a pretty steep hockey stick recovering silicon bookings in the back half of the year?

George Davis

Yeah. We said that we saw that second half would have to be significantly stronger than the first half in order for the scenario to play out that not only we were seeing but most people were forecasting for the industry. And we've already gone over some of the timing issues, one customer made a big difference in timing issues in the pervious quarter and again, I don't have your data right in front me. But our view really hasn't changed about what has to happen in '08.

Satya Kumar - Credit Suisse

And real quick, you are guiding to basically down EPS and up revenues, what are the moving parts as to why that should be the case in May?

George Davis

Yeah. What we've done is actually we moved the order guidance up $0.02 and really from where we were last quarter on flat, up 5%. And I think it was a given, we know we're going to continue to increase our investment in solar. We know that there are some revenue mix issues that may play out. So, I think it’s just representative of the volatile environment that we're in and the continuing investment that we've got and we think it's the right range, but we have moved it up $0.02.

Satya Kumar - Credit Suisse

Good order guys. Thanks.

Operator

Our next question comes from the line of Mehdi Hosseini with FBR.

Mehdi Hosseini - FBR

Thanks for taking my question. I want to better understand the thin film bookings. Can you please help me understand of the initial capacities that are out there for qualification; what is the current output? What is the kind of megawatt of production capacity that is out there, so that you could actually attract additional customers?

And the number two question has to do with the specific line-up that you have. Are you planning to acquire, or to have all the different pieces of equipment manufactured in-house because I understand that some of the pieces are actually outsourced and what is your strategy forward in that area?

Mike Splinter

I am not quite sure of your first question. But overall in the industry, there was a little more than a gigawatt of capacity installed in 2007 and we said 6 to 8 by 2010. So there is wide range of capacity to be added over the next few years.

As far as our philosophy on what products we are going to do internally and what we are going to source from other suppliers in the SunFab thin film line, we are going to do the high value added steps internally. That's pretty much always been philosophy as how we do well and how we make a good profit in this business.

So, things like, CVD, PVD, are right in our skill capability. Some of the automation is. But things like an autoclave, we are not going to ever make an autoclave, I don't think. So that's a lower value at piece of equipment. It's an important piece of equipment in a process, but I don't think could create a differentiation there.

Mehdi Hosseini - FBR

Just as a clarification on third part of my question. I was trying to figure out what is the kind of capacity you have as a demo out there. Is there a first line that is up and running that you can use to sell to potentially new customers?

Mike Splinter

We have a demo line in Eisenhower. With that, we can show our technology to our customers, and they can see how the technology performs.

Mehdi Hosseini - FBR

As it stands right now, you don't have a customer that is actually shipping panels?

Mike Splinter

Yeah. Out of the SunFab line, that's correct, we said we will see production panels by mid-year.

Mehdi Hosseini - FBR

Okay. And then going back to the second part of my first question. What about, in terms of improving the yield quality, is there any metrology part of the line that is critical that you would want to do in-house and then how about TCO, some of the processors done to help improve the efficiency rates?

Mike Splinter

Well, Mehdi, you have to remember, this is about moving square meters of glass and it has very fast throughput times; the process just has to run. You might want to know whether sheets of glass are chipped, but other than that I expect our processors to run at high yield and under a good control. We don't think that you need any real metrology, any kind of off-line metrology, if that's what you are thinking of. But something like TCO, yes, we would be considered, that's a step we would consider. It has impact on yield. It's a high value-added, highly technical step.

Mehdi Hosseini - FBR

So that's an area that you could actually would go out and acquire technology or develop internally?

Mike Splinter

We have the technology to be able to do that.

Mehdi Hosseini - FBR

All right. Thank you.

Operator

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

Jim Covello - Goldman Sachs

Good afternoon, guys. Thanks so much for taking the question. George, first just the quick one. I understood your commentary earlier about why the EPS is little bit lower on flat revenues. But what I am trying to understand is, is that above the line or below line? In other words, is that all gross margin pressure or some of that going to come in the OpEx side as well?

George Davis

I think it comes from both sides, Jim, and we had a lot of activities around shutting down factories and doing things in Q1, that won't be doing at the same level in Q2. We've got increasing investment in solar. So a lot of the OpEx will come out of those areas, the manufacturing obviously and the cost of sales but increased investment.

Also it's our biggest quarter for investment in our business transformation process where we're getting to the point where we're going to turn on the first part of that. And so, this is kind of the homestretch on that piece.

Jim Covello - Goldman Sachs

So taking your revenue guidance, I could get to your EPS guidance by modeling a 300 basis point decline in gross margin. But that's obviously not all the debt is going to come out of the gross margin. Do you think it's half or you think it's less than half?

George Davis

I think that's too significant. I think you are really looking at the combination of things, obviously, it also happens to be a quarter where our stock option expense tends to be a little bit higher than the first quarter. So there are multiple items. I think mix and the volatility of the outlook just lead us to say, we're comfortable moving our guidance up $0.02. We're still guiding within that range or above where we achieved, even after you take out the cost of restructuring that we incurred in Q1. So we think it's prudent, given the environment.

Jim Covello - Goldman Sachs

Okay. If I could just ask one follow-up. Obviously, very good things going on long-term in the solar business and in the near-term in the display business relative to silicon business. The last time we had this much excess capacity in the silicon segment, with so much of the business come from DRAM, it really took a couple of years to clean it out, not a couple of quarters. And I'm wondering why you think that would be different this time?

Mike Splinter

Well, Jim, you can pretty much see the cutback in demand or in the capacity additions by the DRAM makers. I think you know those as well as I do. The thing that encourages me about demand is prices continue to stay very low and I think that we'll see devices; laptops, desktop, cell phones, all load up on DRAM bits which are very inexpensive.

So in almost every application that you can think of for DRAM, I think you're going to see bit growth well above the estimates today. So, we're still thinking quarters and I don't think we have a magic ball to see. We're still thinking that by the third quarter, the supply and demand balance is out pretty much.

Jim Covello - Goldman Sachs

Terrific. Thank you very much.

Mike Splinter

You bet.

Operator

Our next question is a follow-up question from Tim Arcuri with Citi.

Tim Arcuri - Citi

Hi. George, now that you have all these moving parts, can you give us some view as to what the kind of a financial model might look like as revenue ramps in July and back half of the year? For example; if you take kind of the current mix, what would gross margin look like say $2.5 billion and $3 billion revenue?

George Davis

Yeah. Tim, I understand where you're going. Let me maybe characterize in a little different way. We expect to see the operating model for the Silicon Systems Group to continue to improve over time. They are taking a lot of steps that I think will have both near-term and longer-term impact. So, their operating model over time will just continue to improve.

On display, which is what I think you are seeing is, we'll see most of the ramp in revenue at the end of the year. So again, it will be how much of it comes in at the end of the year and so how much of that sort of manufacturing processes is absorbed and we see the benefit of that leverage.

Energy and Environmental Systems, as we said, while we'll expect to see both Baccini and PWS revenue in there, we'll still be in the build-out phase for the thin film business and also we'll be incurring the M&A cost associated with both of those acquisitions at that same time.

So I think you're still really going to wait until fiscal year '09 to see the start of the potential for Energy and Environmental. Display, it really depends on the revenue piece, but it should look very good at the end of the year and it looks pretty good quite frankly right now, and then silicon systems very, very strong performance relative to their historical model.

Tim Arcuri - Citi

Okay. So George I guess, as you look out into '09, you should be back in '09, you should be back on the same sort of margin model that you were back say in mid-'07?

George Davis

Yeah, I don't see any reason why we wouldn't be.

Tim Arcuri - Citi

Okay, thanks.

Operator

Our next question comes from the line of Bin Pang with Harris & Company.

Bin Pang - Harris Company

Thanks for taking my question. Just a clarification on the pattern that you expect for Silicon Systems, you commented that you expect to see or the industry I guess expect to see hockey stick scenario in the second half. Is that going to be led by DRAM?

Mike Splinter

We think that it will first be led by foundry and then by memory and we do expect both flash and DRAM to come back a bit in the second half of the year.

Bin Pang - Harris Company

So the memory capacity that you expect would be added in your fourth quarter, or are you talking about your fiscal fourth quarter?

Mike Splinter

Talking really about calendar year on capacity on capacity ads.

Bin Pang - Harris Company

Okay. And one follow-up on the flat panel business. Is it possible to separate exactly how much of the order strength in the quarter that just passed was due to the hire or serve development market?

Mike Splinter

The bulk of what are seeing in this quarter was our historical presence, PECVD tools tend to get ordered earlier in the cycle and so there is imbalance towards that.

Bin Pang - Harris Company

And I guess the follow-up, flat panel orders will be for your newer products?

Mike Splinter

Yes, for array, for our color filter testing and the PiVot array PVD.

Bin Pang - Harris Company

Thank you very much.

Operator

Our next question comes from the line of CJ Muse with Lehman Brothers.

CJ Muse - Lehman Brothers

Yes, thank you for taking my question, hoping to sneak into probably display side, given that you're going to see strong bookings in January and April in that lead times, nine plus months. Does that suggest that your FPD road should be higher in fiscal '09 than fiscal '08?

George Davis

Right now, it looks like if you just model it out, that we would sort of peak in revenue in the first quarter of '09, so in the first part of ’09. But we think we're going to see some of this benefit in '08, it's part of why we think there is disconnect right now between The Street estimates where we're coming out this year and where we see which is, I think The Street has this down 10% and we are somewhere between flat and down 5% based on display having the biggest impact.

CJ Muse - Lehman Brothers

Got you. And then a follow-up, on the margin side, when do you expect to breakeven on the energy environmental division and what kind of initial operating margins are you expecting, as you revenue the initial SunFab business?

George Davis

So, certainly, we expect to breakeven in '09 for sure. And then in terms of the margins coming out of the gate, I think I am not going to forecast that. We will have to see. Because we'll have a lot of mix of businesses in there and quite frankly, the margins on the initial deals will vary depending on how much of the learning curve is taking place at which contract.

CJ Muse – Lehman Brothers

Thank you.

Operator

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

Steve O'Rourke - Deutsche Bank

Thank you. I think in your prepared remarks, you mentioned service contracts booked with SunFab lines. How do the service contracts work with these new lines and how are they connected to a standard warranty for example?

George Davis

Well, the service contracts come after the warranty period. Of course, during the warranty period, we take care of service, spares are purchased and then the service contract essentially is to take care of all aspects for maintenance on the line. And depending on the contract, it might be multiple years of service.

Steve O'Rourke - Deutsche Bank

So you booked service contracts for the lines that you've initially installed these couple of lines.

George Davis

Actually, I said we had only booked in the prepared. I said we booked one.

Steve O'Rourke - Deutsche Bank

Okay. Fair enough.

George Davis

You got that first one. We got to book one before you book a buzz.

Steve O'Rourke - Deutsche Bank

Fair enough. And you talked about follow on factories for SunFab. Will they all be tandem junction do you think and can you give us an update on when you think the first tandem junction line is projected for startup? And when you might think a reasonable timeframe is for product out?

Mike Splinter

So yes, I would think they are all going to be tandem junction from here on out. We may even see some upgrades on some of the single junction lines later on, but basically, around the end of the fiscal year, we will see some output from the first hand of junction line.

Steve O'Rourke - Deutsche Bank

So by October of this year, you will see some output.

Mike Splinter

We think so. Yeah.

Steve O'Rourke - Deutsche Bank

Fair enough. Thank you.

Mike Splinter

We said that we would ship, or we will have shipped the first hand of junction line by the end of March.

Steve O'Rourke - Deutsche Bank

Okay. Thank you very much.

Operator

Our next question comes from the line of Jay Deahna with J.P. Morgan.

Jennie - J.P. Morgan

Hi. It's [Jennie] here in again. Just a clarification. Have you signed one of the gigawatt contracts?

Mike Splinter

We have no announcement on the sign of gigawatt contract at the moment.

Jennie - J.P. Morgan

Do you expect when it will be signed in the next three to six months?

Mike Splinter

Well, you can never tell about contract negotiations, but we are in serious discussions on the topic. So hopefully, we can come to an agreement with at least one of the customers that we are having discussions with at this time.

Jennie - J.P. Morgan

And when you're negotiating these contracts, how do you get comfortable with their financial wherewithal; if they could fund such a large contract?

George Davis

We look at all the normal things we look at for any customer, which is do they have financing, can they secure their commitments with the appropriate instruments. So it's a balance of items that gives us comfort.

Jennie - J.P. Morgan

Do they have to have it secured by the time they sign the contract?

George Davis

It varies depending on the customer.

Jennie - J.P. Morgan

Okay.

George Davis

And that's true, whether it's a gigawatt scale or it's a smaller scale.

Jennie - J.P. Morgan

Okay. Thank you.

Operator

Our next question comes from the line of Mahesh Sanganeria with RBC Capital Markets.

Mahesh Sanganeria - RBC Capital Markets

Yes. Thank you very much. One more question on the revenue recognition for SunFab. This revenue recognition is going to be for the whole line at a time or you will do it by equipment by equipment?

George Davis

Our current plan is for the line to be upon customer sign off.

Mahesh Sanganeria - RBC Capital Markets

Okay. So it's going to be like a big size whenever it happen, it won't be like per tools $20 million to $30 million order.

George Davis

Right, for the initial ones, that's correct.

Mahesh Sanganeria - RBC Capital Markets

Okay. And the second question on the EPS guidance, are you assuming any non-recurring charges in that guidance?

George Davis

No.

Mahesh Sanganeria - RBC Capital Markets

Okay.

George Davis

Again, we have the normal ongoing adjustments of stock-option expensing and M&A. But it doesn't include any anticipated restructuring cost.

Mahesh Sanganeria - RBC Capital Markets

So M&A means amortization of intangibles?

George Davis

Correct. And all again, we have a reconciliation of all that in the schedules with the release.

Mahesh Sanganeria - RBC Capital Markets

All right. Thank you.

George Davis

You're welcome.

Operator

Our next question comes from the line of Jesse Pichel with Piper Jaffray.

Jesse Pichel with Piper Jaffray

Yes, good evening. Of the four gigawatt factories, should we assume that's both crystalline and thin film?

Mike Splinter

No, you should assume that these are thin film factories. In the crystalline silicon area, we're more selling machine by machine in our more traditional way, or our more traditional business model. I guess I would call it in that regard an example was our ATONs. We had our breakthrough in Japan selling our first ATON system, as these crystalline factories scale up I think they'll use more of our large scale systems though.

Jesse Pichel with Piper Jaffray

You use the word utility scale often, did that mean you are in discussions with European utilities and is that a far fetched question? Is the SunFab so easy that a utility could run it and it wouldn't be outside of their core competency, assuming it came with some performance guarantees from AMAT?

Mike Splinter

Well, I don't think we can disclose real customers, but utilities are different than power providers and we have to look at how the industry is set up, but I think what you would certainly say that we're in talks with companies who are interested in being power providers.

George Davis

All right, and many of our customers have looked to put electricity into the grid out of their fabs.

Jesse Pichel with Piper Jaffray

I am under the impression that Oerlikon offers guarantees with respect to throughput and efficiency. Does Applied offer that at current?

Mike Splinter

The Applied contract is setup on watts out. So in the end, I think our customers want to produce watts and that's what's so critically important. One that we often talk about is scale so you mentioned utility scale, but the size of our panels allow the installation and wiring and bracketing to be done much more efficiently. And this is one of the areas why we chose to move to the larger size panel.

Jesse Pichel with Piper Jaffray

My question is, one of the advantages of the big public thin film company we know now for solar is that annually it gets throughput improvements of about 6% plus per year. Do you anticipate that the AMAT lines would also have similar annual improvements? And do you think there is a way for your service business to potentially capture some of the value of a 6% plus annual throughput improvement on a watts basis?

Mike Splinter

Well, Jesse, one of the things why we are so confident about our solar business is our history of 40 years of driving cost down. This has been hallmark of Applied Materials engineering, and I see that continuing. It's a thing we learned in silicon, we showed in display for the last 15 years. We have driven down the cost, helped our customers drive down the cost of displays by 20 times to improve productivity. Now, we are using the same capability in solar, and so I'm very confident we're going to be able drive our roadmap and be very aggressive on moving the cost down.

Jesse Pichel with Piper Jaffray

And can you capture some of that improvement through --

Mike Splinter

We'll see how the service contracts are structured. It will depend on the specific customer, but we like performance-based contracts. We have performance-based contracts today in the silicon area. That means we can apply our technology. It's a win for us, it's a win for our customers and that's the way we like to schedule our contracts.

Jesse Pichel with Piper Jaffray

Great. Thank you so much.

Mike Splinter

You bet.

Randy Bane

Operator, we have time for one more last quick question and then we'll make our closing remarks.

Operator

Our final question comes from the line Edwin Mok with Needham and Company.

Edwin Mok - Needham and Company

Thanks for squeezing me in. Just a quick question on the $116 million for SunFab, you guys have said before you are going to have seven lined up in running by sometime this year, are we expecting due to recognizing level of revenue for those otherwise?

George Davis

Our outlook really hasn't changed. We've said that we expect to book during this year; that we anticipate some revenue at the end of this year but the bulk of the revenue for the contracts that we are signed in '07 will be in early '09.

Edwin Mok - Needham and Company

Maybe a different way to ask this, sorry, just in terms of booking, you guys said you booked $106 million, but just one time?

George Davis

Right.

Edwin Mok - Needham and Company

So you have six more lines in this year, I mean, you don't book six times?

George Davis

Those orders represent more than one order.

Edwin Mok - Needham and Company

I see. Okay. Thanks for that, guys.

Mike Splinter

Okay. Thanks, Edwin and I think just a clarification what we've said, we will ship seven lines by end our Q3. And just a final note, I'd just say, if you look at the orders we reported today and the targets we set, it really reinforces our confidence in the strength of our strategic direction. Applied is focused on execution in 2008. We're going to keep that focus and even in a difficult economic environment we're getting the results and building terrific momentum. Thank you all for attending today and look forward to talking with you in three months.

Randy Bane

We would like to thank you for joining us on our discussion today of our financial results and we would like to remind you that a replay of this call and the supporting slide package will be available on our website starting at 5 pm today and will remain posted until February 27th. Thank you for your interest in Applied Materials. This concludes our call.

Operator

This concludes today's conference call. You may now disconnect.

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