APPLIED MATERIALS INC quarterly report, Q1 FY2014

Applied Materials, Inc. — Q1 FY2014 Form 10-Q

Reporting period: Three months ended January 26, 2014 (13 weeks); comparable period ended January 27, 2013. Applied Materials supplies equipment, services and software to semiconductor, display, solar and related industries. Results are cyclical and depend substantially on customer demand and capital spending.

Financial and operating performance

Metric	Q1 FY2014	Q1 FY2013	Change
Net sales	$2.190 billion	$1.573 billion	Up 39%
Gross margin	$891 million; 40.7%	$582 million; 37.0%	Up 3.7 percentage points
Operating income	$330 million; 15.1%	$39 million; 2.5%	Up $291 million
Net income	$253 million	$34 million	Up $219 million
Diluted EPS	$0.21	$0.03	Up $0.18
Operating cash flow	$372 million	$16 million	Up $356 million

Management-reported non-GAAP adjusted results were gross margin of 42.5%, operating margin of 17.4%, net income of $279 million and diluted EPS of $0.23. These exclude specified acquisition-related, restructuring, merger-related, investment and tax items; they are not GAAP measures.

Cash, liquidity and debt: Cash and cash equivalents were $2.144 billion at January 26, up from $1.711 billion at October 27, 2013. Cash, cash equivalents and investments totaled $3.122 billion, compared with $2.896 billion. Current assets were $6.014 billion and current liabilities $2.477 billion; working capital was $3.5 billion. Long-term debt was $1.946 billion, unchanged from fiscal year-end. No borrowings were outstanding under $1.6 billion of credit facilities, and the company reported compliance with debt covenants. Management said available cash, operating cash generation and borrowing capacity should meet liquidity needs for the next 12 months.

Cash deployment: Investing activities provided $153 million, including net proceeds from investment sales and maturities; capital expenditures were $48 million. Financing activities used $92 million, primarily for $120 million of dividends. The declared quarterly dividend was $0.10 per share. No shares were repurchased during the quarter; $1.6 billion remained under the existing repurchase authorization.

Material changes and business drivers

• Revenue growth was led by Silicon Systems Group (SSG), with sales up 53% year over year to $1.484 billion. Applied Global Services sales rose 8% to $507 million and Display sales rose 83% to $159 million; Energy and Environmental Solutions (EES) sales fell 13% to $40 million.
• New orders increased 8% year over year to $2.285 billion. Backlog ended at $2.435 billion, up from $2.372 billion at the prior quarter-end; about 83% was expected to ship within the next two quarters. Backlog may be rescheduled or canceled.
• SSG operating income was $314 million; Applied Global Services, $125 million; Display, $26 million; and EES had an $11 million operating loss. SSG demand was supported by foundry and memory investment, particularly for advanced mobile chips. Display orders declined 43% year over year, reflecting timing and uneven demand. Solar equipment investment remained weak amid excess capacity, leaving EES loss-making.
• Gross margin improvement reflected higher sales, lower inventory charges and manufacturing costs, and the absence of a regional customs-duty assessment charge recorded in the prior quarter. Consolidated operating results also benefited from a $24 million unrealized gain on foreign-exchange options related to the proposed TEL combination.

Outlook, risks and unusual items

• The filing provides no specific numerical revenue or earnings guidance. Management described strong semiconductor-equipment demand from foundry customers and continuing mobile-related investment, while emphasizing industry cyclicality and uneven customer order patterns. Solar capacity overhang, trade uncertainty and tight customer financing continued to constrain EES demand.
• Applied and Tokyo Electron Limited (TEL) agreed to combine their businesses. The agreement was amended February 14, 2014; completion remained subject to shareholder and regulatory approvals and other customary conditions. A $400 million termination fee may apply in specified circumstances. The agreement anticipated a $3.0 billion stock repurchase program for the combined company after closing, targeted within 12 months.
• Customer concentration is significant: Taiwan Semiconductor Manufacturing Company and Samsung represented 27% and 24% of consolidated sales, respectively. Two customers represented about 64% of SSG orders and 65% of its sales; two customers accounted for 90% of Display sales.
• Other principal risks include semiconductor, display and solar industry cycles; customer order delays or cancellations; concentration in major customers and Asia; supply-chain interruptions; technology transitions and competition; foreign exchange and interest-rate exposure; and completion and integration risks for the TEL transaction. A 100-basis-point increase in interest rates was estimated to reduce fixed-income portfolio fair value by about $14 million.
• Q1 FY2014 included a $3 million impairment charge on privately held investments and $7 million of restructuring charges. The effective tax rate was 19.7%, versus a prior-year tax benefit and an effective rate of negative 88.9%; the comparison was affected by prior-year tax benefits, expiration of the federal R&D tax credit and geographic income mix. Up to $127 million of unrecognized tax benefits could be reduced over the next 12 months, with no material annual effective-tax-rate impact expected.
• Legal matters included pending appeals in a Korean criminal proceeding involving former and current employees; Applied itself was not a party. Management did not believe the described legal matters would materially affect consolidated financial condition or results. Standby guarantees had a maximum potential payment of approximately $43 million; the company did not consider payment probable.

Investor verification points

• Track whether new orders and backlog convert into sales, particularly given possible customer rescheduling or cancellation and the high proportion of revenue concentrated in major customers.
• Assess how much of the reported earnings and margin improvement is sustained operating performance versus non-GAAP exclusions, the $24 million currency-option gain, and period-specific tax effects.
• Monitor SSG demand and customer spending, Display order volatility, and whether persistent solar overcapacity continues to drive EES losses.
• Verify the status, regulatory and shareholder approvals, termination provisions, and expected economics of the TEL transaction; closing was not assured.
• Review inventory growth and deferred systems: inventories increased to $1.533 billion, including $194 million of newly introduced systems at customer locations that did not yet qualify for revenue recognition.
• Confirm cash generation, dividend and repurchase decisions, debt covenant compliance, and exposure to foreign-held cash. About $1.7 billion held by foreign subsidiaries could be subject to U.S. tax if repatriated; Applied intended to permanently reinvest about $1.2 billion overseas.