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Applied Materials’ (AMAT - Analyst Report) fiscal second quarter pro forma earnings of 17 cents beat the Zacks Consensus Estimate by 4 cents, or 30.8%. Revenues were also ahead, beating by 3.5%. Increased demand in the SSG and Display segments and effective cost control helped results.

Revenue

Applied reported revenue of $1.97 billion, which was up 25.4% sequentially and down 22.4% year over year, better than the guided range of a 15-25% increase. The outperformance versus expectations was on account of better-than-expected results in the SSG and Display segments, as offset by the worse-than-expected results in the EES segment.

Revenue by Segment

TheSSG segment contributed 65% of revenue, growing 33.2% sequentially and declining 27.3% from the year-ago quarter. Foundry and DRAM spending helped the revenue increase in the last quarter, with NAND orders finally picking up. Considering order trends, the revenue concentration at a few large foundry customers should continue.

Intel’s (INTC - Analyst Report) Ultrabook partners and Microsoft’s (MSFT - Analyst Report) Windows 8 adopters may be expected to help demand through 2013. Applied generally sees seasonal strength in the second and third quarters of its fiscal year, with weakness in the fourth and first.

The second largest segment was AGS with a 26% revenue share. Segment revenue was up 9.8% sequentially and down 6.2% year over year, at the high end of Applied’s expectations of 0-10% sequential increase. While revenues came in at the high end of guidance, lower-than-expected wafer starts and utilization rates impacted orders.

The 46.0% sequential increase and 5.2% year-over-year decline in the Display segment was much better than the broad guidance range of a sequential increase of 0-25%. Segment contribution remained at 6%. 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. Order growth was attributed to share gains and TV capacity adds in China.

The EES segment accounted for 2% of total quarterly revenue, down 17.4% sequentially, 51.9% from last year and significantly lower than management’s expectations of sequentially consistent revenues. The weakness in solar (due to overcapacity and weaker-than-expected demand) continued in the last quarter, while other parts of the business did better.

Revenue by Geography

Around 74% of Applied’s quarterly revenue came from the Asia/Pacific region, with the largest contribution from Taiwan, which generated 42% and followed by China, which generated 9%. The only softness in the last quarter was in the U.S., which declined 9.7% sequentially. Applied saw double-digit sequential increases across all other geographies, with Japan, Taiwan and China growing the strongest. The revenue distribution by geography was as follows: the U.S. 18%, Europe 7%, Taiwan 42%, Korea 11%, China 9%, Japan 8% and South East Asia 4%.

Orders

Total orders were up 7.2% sequentially and down 18.0% year over year. AGS and EES orders were down 11.6% and 42.6%, respectively. However, SSG and Display more than made up, growing 13.8% and 41.3%, respectively from the Jan 2013 quarter. Display was the only segment that grew from last year (up 132.1%), with all other segments declining double-digits.

The net result was a positive BTB across all except the AGS segment, with Display coming in strongest, followed by SSG and then EES.

Orders were up sequentially across all Asian countries except Taiwan, which was down slightly. The U.S. was also sluggish, growing a mere 1.8%, but Europe was strong, jumping 29.1%.

Margins

Applied generated a gross margin of 43.2%, up 339 basis points (bps) from the previous quarter’s 39.8%, helped by higher volumes and lower inventory charges. The gross margin was up 107 bps from the year-ago quarter.

Applied’s operating expenses of $567 million were up 10.3% from the Dec 2012 quarter. However, all expenses declined as a percentage of sales, which resulted in the 732 bp sequential expansion in the operating margin. The operating margin was still well below the 19.2% posted in the year-ago quarter, with higher R&D being the most significant driver and SG&A also increasing substantially as a percentage of sales.

Net Profit

On a pro forma basis, Applied Materials had a net income of $199 million, or a 10.1% net income margin compared to $69 million, or 4.4% in the previous quarter and $348 million, or 13.7% in the second quarter of fiscal 2012.

The fully diluted pro forma earnings were 17 cents a share compared to earnings of 6 cents in the previous quarter and 27 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 loss of $129 million ($0.11 per share) compared to income of $34 million ($0.03 per share) in the previous quarter and income of $289 million ($0.22 per share) in the year-ago quarter.

Balance Sheet

Inventories increased 3.1% during the quarter, with inventory turns increasing from 3.0X to 3.4X. Days sales outstanding (DSOs) went from 64 to 59. The cash and short term investments balance was $1.77 billion at quarter-end, having increased $17 million during the quarter. Goodwill was 28.2% of total assets in the last quarter.

The company generated $224 million of cash from operations, spent $51 million on capex, $100 million on share repurchases and $108 million on dividends. At quarter-end, Applied had $1.95 billion of debt on its balance sheet, with a net debt position of $176 million. The debt cap ratio including long term liabilities and short term debt was just 27.3%.

Guidance

Applied did not provide expectations for each individual segment as it usually does and instead said that there would be a slight sequential increase in revenue.

The non-GAAP EPS (excluding 4 cents of acquisition-related charges) is expected to come in at 16-20 cents a share. The Zacks Consensus Estimate for the Jul 2013 quarter was 20 cents when the company provided guidance, at the high end of the guided range.

Conclusion

Applied’s results in the last quarter reflect improvements in its core semiconductor and display markets. However, AGS orders indicate that customers remain cautious and management also stated that the strength at foundries (the biggest driver of SSG revenues) remains concentrated in a few hands. Therefore, any recovery is likely to be slow. The EES business is a drag due to multiple issues and over capacity in that market. While management initiatives to cut segment costs are encouraging, the segment will continue to pull down overall results at Applied.

Additionally, since Applied is a company with significant fixed costs, the bottom line has also taken a beating. Therefore, the strength in mobility platforms, increased TV capacity and cost diversion from EES to more profitable areas will have a positive impact on its growth and profitability going forward.

Applied shares currently have a Zacks Rank #3 (Hold), similar to other equipment suppliers, such as KLA Tencor (KLAC - Analyst Report) and Lam Research.

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