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Applied Materials’ (AMAT - Analyst Report) fiscal fourth quarter pro forma earnings of 19 cents beat the Zacks Consensus Estimate by a penny, or 5.6%. Revenues were particularly strong, beating by 16.2%.

There have been both upward and downward revisions to estimates since the company reported, but the net impact has been slightly negative to expectations for the next quarter.

It appears that Applied continues to benefit from the proliferation of mobile devices, but is also impacted by slowing sales in China.

Revenue

Applied reported revenue of $1.99 billion, flat sequentially and up 20.8% year over year, in line with the guidance.

Revenue by Segment

TheSSG segment contributed 63% of revenue, down 2.3% sequentially and up 42.9% from the year-ago quarter. Segment revenue benefited from growth in logic and DRAM that was partially offset by negative seasonality in the foundry business. Foundries typically lower spending to ramp production for the holiday season.

The second largest segment was AGS with a 27% revenue share. Segment revenue was up 8.2% sequentially and down 13.4% year over year. AGS revenues are correlated to system sales and benefited from stronger equipment sales in the last quarter.

The Display segment saw a 1.2% sequential and 75.3% year-over-year increase in revenue, making it the only segment to have grown from both periods. Segment contribution remained at 8%. Government stimulus-driven spending in China slowed down, but other regions grew, driven by demand for bigger TV screens.

Demand for mobile devices (high-resolution mobile displays for tablets and touch panels for ultrabooks) continues to increase, which is complementing the resurgence in the TV market. Applied’s expanding product line is partly responsible for the increased total available market (TAM), which will spur growth in the following quarters.

The EES segment accounted for 2% of total quarterly revenue, down 2.2% sequentially and 29.0% from last year. The weakness in solar (due to overcapacity) is a prevailing condition in the market and management continues to cut investment in the segment to align the cost structure with sales.

Revenue by Geography

Around 70% of Applied’s quarterly revenue came from the Asia/Pacific region, with the largest contribution from Taiwan, which generated 30% and followed by Japan, which generated 14% and Korea with 12%. China and Japan were the weakest in the last quarter, declining 25.3% and 17.1%, respectively on a sequential basis.

Taiwan was the strongest region (up 65.4% sequentially), which along with Europe (up 7.6%) were the only regions to have seen positive growth. The revenue distribution by geography was as follows: the U.S. 18%, Europe 12%, Taiwan 30%, Japan 14%, Korea 12%, China 10% and South East Asia 4%.

Orders

Total orders were up 4.9% sequentially and up 42.8% year over year. SSG, AGS and EES orders were up 15.5%, 6.0% and 110.5%, respectively. Display orders declined 55.5%, following a However, the 7.5% and 31.3% sequential increases in AGS and Display partially offset these 282% increase in the preceding quarter.

The net result was a BTB of 1.05, with SSG and AGS positive, and Display and EES were negative.

Margins

Applied generated a gross margin of 40.0%, down 82 basis points (bps) from the previous quarter’s 40.8%. A lower mix of EES sales were beneficial for the gross margin in the last quarter and will likely remain so through 2014. However, the gross margin was impacted by a $20 million charge for a customs duty assessment in the AGS segment as well as a $10 million inventory charge in the Display business. The gross margin was up 159 bps from the year-ago quarter.

Applied’s operating expenses of $512 million were down 4.3% from the Jun 2013 quarter. While all expenses declined year over year as a percentage of sales, G&A alone declined sequentially. As a result, the operating margin of 14.2% expanded 51 bps sequentially and 731 bps from last year. 

Management has been diverting costs related to the solar business to R&D expenses for SSG. Therefore, overall R&D has been growing as a percentage of total opex, because of these actions taken by management.

Net Profit

On a pro forma basis, Applied Materials had a net income of $228 million, or a 11.5% net income margin compared to $223 million, or 11.3% in the previous quarter and $70 million, or 4.3% in the fourth quarter of fiscal 2012.

The fully diluted pro forma earnings were 19 cents a share compared to earnings of 18 cents in the previous quarter and 6 cents in the comparable prior-year quarter. Our pro forma estimate excludes restructuring, acquisition-related, impairment and other charges as well as tax adjustments in the last quarter.

On a fully diluted GAAP basis, the company recorded a net profit of $183 million ($0.15 per share) compared to income of $168 million ($0.14 per share) in the previous quarter and loss of $525 million ($0.43 per share) in the year-ago quarter.

Balance Sheet

Inventories increased 4.1% during the quarter, with inventory turns flat at 3.4X. Days sales outstanding (DSOs) went from 54 to 75. The cash and short term investments balance was $1.89 billion at quarter-end, having dropped $84 million during the quarter. Goodwill was 27.4% of total assets in the last quarter.

The company generated $19 million of cash from operations, spent $50 million on capex, $47 million on share repurchases and $120 million on dividends. At quarter-end, Applied had $1.95 billion of debt on its balance sheet, with a net debt position of $55 million. However, the debt cap ratio including long term liabilities and short term debt was just 26.2%.

Guidance

Applied provided guidance for the fiscal first quarter. Revenue for the first quarter is expected to be up 3-10%, with SSG increasing 15-20%, AGS down 5-10%, display down 15-30% and EES roughly flat.

The non-GAAP operating expenses are expected to be $540 million (+/- $10 million) with the EPS (excluding 4 cents of acquisition-related charges) coming in at 20-24 cents a share. The Zacks Consensus Estimate for the Oct 2013 quarter was 23 cents when the company provided guidance, within the guided range.

Conclusion

The last quarter was a moderately good one for Applied. Although SSG remained sluggish, it was not worse than expected. The display side was impacted by slowdown in China, but strength in other areas compensated. Also, diversion of funds locked in EES continued.

The PC market remains a dampener, which has impacted all major players from Intel Corp (INTC - Analyst Report) to Microsoft Corp (MSFT - Analyst Report). However, longer-term drivers for the foundry business remain very strong since mobile devices are dependent on them. Applied has a very strong product line and management has stepped up investments here in preparation for the on-going transitions to larger wafer sizes and smaller process nodes. Management expects significant share gains through 2014, which should generate strong growth.  

There is also scope for share gains on the Display side of the business, as the company’s PVD tools are doing extremely well. The drivers of this business are larger TV screens and better mobile displays that involve more complicated production processes and new tools.

Applied shares currently have a Zacks Rank #3 (Hold), similar to peer KLA Tencor (KLAC - Analyst Report).

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