Applied Materials, Inc. (AMAT) Earnings Call Transcript & Summary

Good morning and good afternoon, everyone. This is Krish Sankar from Cowen, the semicap equipment analyst. And the next company joining us is Applied Materials, and we are very fortunate enough to have Dan Durn, the CFO; and also Mike Sullivan, Head of IR. Thanks a lot, Dan. Thanks for your time, really appreciate it. And nice to virtually meet you.

Good seeing you, Krish.

So let me just start, jump into Q&A. And Dan, I know with Applied, there are a lot of interesting things to talk about. So forgive me for this, I'm going to start with something topical, which is the commerce department ruling. And while I understand that a lot of unknowns and political outcomes are difficult to handicap, it looks like investors are concerned about the 2 rules. One is the civil military fusion rule, which impacts China. The other is the direct product rule, which targets Huawei shipments via TSM. So from your vantage point, how do you see this impact aimed at? And how are you preparing for this?

Sure. So I think it's best to segregate the 2, military end user -- military end use and civil military fusion and then the recent guidance published around Huawei. Just taking them in order, I think the best place to start for military end user is to go back to what Gary said on the earnings call. We're a company that spends $2 billion a year on R&D, highly innovative company. IP protection is at the foundation of the semiconductor industry. It's a global interconnected ecosystem. So free and fair trade is something we believe in very deeply. And as we think about the rules that were published by the Department of Commerce, we've gotten guidance and interpretation from government officials, from advisers, former high level senior officials in the government who are advising us, our internal folks. We've got really good people working on this problem for us. And we feel, like, based on everything we understand about what's written and what the intent of those rules are, that we've got a path to be compliant by the time the rules are implemented at the end of June in a way that doesn't create significant disruption to our business. Gary also mentioned that we've got some flexibility as it relates to our operational footprint that give us an ability to be flexible over time to the extent the interpretation that we're driving on the current set of rules isn't necessarily calibrated to the right path forward, but we feel like we've got a good line of sight and a path forward to being fully compliant by the time the rules get implemented Shifting gears to Huawei. We're very early in the process. We're still in the comment period. Final regulations haven't been written, but a similar approach. We're reaching out to government officials, a set of advisers, the rules as they relate to Huawei is a requirement on our customers, not on us. So we're engaging with the broad ecosystem as well. And based on what's written in the conversations we're having, we think there's a line of sight to a path forward where we don't need to adjust the expectation we've set around the business and how we think it unfolds over the course of the year and beyond. And so again, on that front, we do think there's a constructive path forward that doesn't create a significant disruption to the business. So based on that collective body of insight on both fronts, we've got a pretty strong point of view. And certainly, on the civil military fusion and military end user, earnings call was a couple of weeks ago. I would say the confidence level around our perspective has only gotten stronger in those couple of weeks since our earnings call, not the opposite. So we feel good about how we're seeing things on both fronts.

Got it, Dan. That's very helpful. And then one -- final question on this topic, and then I'll move on to the better part of the Q&A. When you look at -- on the civil military fusion side, when you look at the customer base, there are some people who think that memory might be okay because it's a commodity. How do you view this? Do you just assume that you're going to take a more conservative view and look at everyone the same way? Or how are you viewing this memory, foundry logic kind of that segmentation in China?

Yes. So if we take a look at the business we do in China, we do semiconductor business, we do display business. Display is not included in the ECCNs. And so I think that maybe a misperception on the exposure we as a company have. So let's take display and put it off to the side because it doesn't get caught up in the Department of Commerce regulations that were provided. Then as we interpret them, the path forward for us regarding being in compliance, our process with SMIC is going to be the same as YMTC, the same with CXMT and all customers. It's going to be a similar process and path forward. We don't differentiate by device type or by technology node. And again, our path to compliance, we feel good about without significant disruption to the business, but it will be the same. It won't change depending on what device type exposure the customer has.

Got it. Then the one common theme we saw across earnings season was supply constraints because of COVID. So how is the supply constraint looking right now? Has it eased? When do you think these constraints return back to like 100% pre-COVID levels?

Yes. Thanks, Krish. Certainly, the supply chain is getting healthier. And the way I would characterize it is, is if we go back to mid-March, we had a concurrent lockdown shelter-in-place order go out for the Bay Area and Malaysia, and that impacted a material part of our supply chain. In the most recent quarter, those that are on a calendar year cadence saw 2 weeks of impact from that shelter-in-place order. We saw 6 weeks of impact. And so our results were affected to a larger extent than those on a calendar quarter cadence. What we said on the earnings call is that I think the best way to look at the health of the supply chain is break it up into 3 categories. First category and returning to health is are suppliers being designated as part of critical infrastructure, being allowed to open their factories, getting staffing levels back up to pre-COVID levels and output back to pre-COVID levels. We're on the path to return to health, broadly speaking, and I would say exiting our fiscal Q3, a disproportionate share of those issues, I think, were behind us. Then we have to take the second step in the journey, which is recovering from lost volumes that were impacted by the supply chain disruptions. I think that plays out over the next couple of quarters. So call it, fiscal Q4 and our fiscal Q1, which is an effect to the back half of the calendar year. I think those lost volumes get made up over that time. The third of the 3 sets of issues has to do with the logistics channels. A lot of what we ship from point A to point B that's not a full system rides in the belly of commercial aircraft. And as capacity has come out of the system in the commercial airline industry, that certainly impacted the logistics channels. We've pivoted the alternative routes. And there's an economic headwind associated with that. I think that's with us for the foreseeable future. I'm not a commercial airline expert, but I do think behavior patterns of people will say that, that capacity in the commercial airline industry will be impacted for the foreseeable future. So I see that aspect taking a much longer time. We can still get things from point A to point B, which is great, takes a little longer, what used to be 3 days is now 5, what is 5 and 6 is now 8 and 9 days. So there is a time lag associated, but we can still get things from point A to point B. And then there's some significant cost adders that come into play as well. So that's how I would break out the return to health and will play an important role in helping our suppliers navigate the waters, keep their employees safe as we drive forward to serve customers.

That's very good to hear, Dan. Then on the earnings call a couple of weeks ago, I found it very interesting. You gave some color not only into July, but also into the October quarter, right? So just kind of curious like what kind of visibility you have there or is it a function of lead times having stretched that makes you feel good about looking into the October quarter?

Yes. So I would say lead times are a function of health of the supply chain. When the concurrent lockdown orders went in place, you saw the lead times stretch. And since then, as we see the supply chain back to a trajectory of recovery, you've seen them come back in. So I would say it's less a function of that. Given what we've seen in terms of the suppliers getting back to business and returning to health. And if you take a look at where we exited fiscal Q2, we said record backlog for our semi-related businesses and also record orders. And the reason we talked about both aspects is, I don't want people or investors to see the strength of the business being a function of just unmet demand in the current period. There's also an aspect of true underlying demand remaining strong with record orders in our semi-related businesses. So we feel good about both aspects. And then taking a step back from the near-term business environment and just talking philosophically about the seat I sit in and the approach to investor communications. In a normal course business, I think the policy of guiding one quarter out has a lot of merit in a normal environment. In an environment where the macro risk profile is elevated, and there's an opaqueness around what's happening in the ecosystem and the industry that's hard to see through, I think there's a responsibility to share with investors what we're seeing and hearing and have it extend to the horizon of visibility that we have. And it's nothing more than an approach in this elevated risk environment to be as helpful as possible and give a look-through over more than a one quarter period on what we're seeing and hearing to be hopeful to investors at a heightened level of uncertainty. So there's a philosophical aspect. You saw it when the memory market turned on us 6 quarters ago or whatever, 8 quarters ago, whatever it happened to be. You saw our approach to investor communications change a little bit, and we started giving a little bit more of a horizon and look through on the conversations. Then as the industry became healthier, we went back to one quarter at a time. Now that we've got that uncertainty back on the table again, you see the approach going to a longer-term view. So there's a philosophical approach to this aspect of the communication that's also at play here.

Got it. That's very helpful, Dan. And then on that point, one of the -- the headscratcher or what is more industry generic, which is semicap companies have not seen any slowdown in demand, yet we see all the negative news on the macro, et cetera. Now one view is that it's going to happen, maybe it's like a quarter or 2 delayed for semicap. Another view is that, because most of our customers are spending on leading edge, which are critical down the road, they're not going to slow that down. So there's still like a lot of strong demand for leading-edge technologies, which is where you kind of cater to. So I'm kind of curious where do you -- maybe there is no right answer or maybe the answer is somewhere in between. So I'm kind of curious where do you shake out on that.

Yes. So I don't think there's any real direct answer on this, but let me share with you how we think about it to maybe help shed a little bit of color. First of all, our customers aren't putting capacity in place for the next quarter or 2. The investment cycle for our customers is a much longer horizon than that. And they want to be strategically positioned in the market in the right way based on all the factors that they take into account when they make these longer-term investments. So I wouldn't expect there to be a very direct correlation in a very short period of time. Taking a step back from that, though, the mega trends that shape our industry I think are firmly intact. In fact, I would argue that with work from home and school from home and companies examining their operational footprint and the flexibility that they want to drive into their operations in an environment like we're in and then also things like localization of supply chains and injecting more automation and intelligence into those supply chains, I would argue that those mega trends are even stronger today than they were 6 months ago. So long-term opportunity in our industry I think has never been greater and I would argue is even stronger as a result of what we're going through. It's going to be offset in the near term by we said weakness in autos, industrials, the consumer. I think what happens over the, I don't know, call it, 4, 6, 8 quarter period I think is going to be a function of what our customers do, obviously, and the recovery rate of the supply chain, combination of those 2 determine order patterns and capacity deployments. And what our customers do I think is going to be influenced by the debate going on right now. Are we going to see a V-shaped recovery, U-shaped, elongated U, L-shaped. I think there's a fish-hook out there. There's a Nike swoosh. There's a W. Lots of different views. And I don't think there's consensus on that. So I think the customers are watching how government containment actions impact consumers, impact global growth and then take a point of view of that means for the business and how they profile capacity deployments in that 4, 6 quarter time frame. What I would say is the look-through we gave on Q3 and Q4 -- fiscal Q3 and our fiscal Q4, our look-through is that we feel pretty good about. We said the swing factor for memory is going to be the back half of the calendar year and in calendar Q4, we have conversations. I think we have visibility on what our customers want to do, but we called it beyond the horizon of visibility, just recognizing that the error bar on something in calendar Q4 is larger than what we would typically see in the next 2 quarters. And so we feel really good about our position. The company is performing extremely well. Both in Q2 -- fiscal Q1, fiscal Q2 strong year-over-year growth performance. And even in Q2, where we were supply chain limited, our semi-related businesses were up 13% year-over-year. Our first half was up 16% year-over-year. So the company is performing extremely well. We'll continue to drive it a quarter at a time. But I think until there's clarity on the debate of impact to consumer, global GDP and shape of the economic recovery, customers will dial in to respond to the prevailing perspective there.

Got it. Got it. That's pretty good color. And when you look -- you kind of spoke a little bit about the second half, the general assumption is that foundry/logic is holding steady in the second half of this year, calendar second half and then memory start seeing a rebound. Is that kind of like what you're seeing too? And -- so where do you see that within memory, is it NAND or DRAM that you think drives the second half relatively better to the first half?

Sure. So a couple of things. We see foundry/logic strong throughout the year. We see a broadening of the order book, and we've been saying multiple customers, multiple nodes for a while. So that seems to be playing out relative to the expectations we set, playing out in a pretty good fashion. So we feel pretty good about that. The big swing factor on memory is going to be what happens to capacity in the back half of the calendar year. We see strong investments to pursue technology roadmap transitions. We saw it in 2019, we're seeing it again this year. What we saw in '19 though was technology investments without any capacity add-backs. And so you saw wafer starts per month in both NAND and DRAM come out of the system. I think that was probably the first year we've ever seen that wafer starts per month in both of those end markets fall. But the spending level was still over $20 billion. $51.5 billion in WFE, 40% memory [Audio Gap] When we're going through the memory cycle, we saw actions taken in NAND before DRAM. We saw inventories begin to normalize. And we said the pricing in the NAND market stabilized before DRAM. The sequence of NAND leading the recovery was more about inventory getting healthy and pricing getting healthy. I think given where we sit today, I think you see a healthier position in both markets versus where we were when the memory correction started. And if you look at the results in Q2, we went back 3 months, I said you will see an uptick in memory starting in our fiscal Q2. If you look at our results, we showed some pretty decent strength. I think we were up 24% sequentially in memory. Don't quote me, I think that it was up 24% sequentially in memory, and you saw strength in both DRAM and NAND. So we've already seen a bit of that uptick, and it's balanced across those device types. We'll continue to monitor it. Every quarter, and we'll share with customer -- we'll share with investors what we're seeing each and every quarter just to try to be open and provide a look-through on what we're seeing and hearing out in the market. But we've already seen a bit of that strength profile into the most recent quarter and want to keep monitoring it every quarter. So what was initially a NAND-led recovery, I actually see more balance in the spend patterns across those device types as evidenced by what happened in our most recent quarter, and we'll see what happens in the coming quarters as well.

Got it. Helpful, Dan. And FYI, I checked my model, it is 25% sequential growth in memory. On the product front, you clearly have some really good momentum. And I saw that you gained market share in PVD, which I thought is very impressive given that you already have a very high market share there. And then some traction on the PDC side, process control on side too. So do you think with this whole COVID issue, does it disrupt the momentum? Or do you think the underlying product trends are still strong that share gain momentum has still room to run?

Yes. So share still has room to run. As long as our customers are spending, share gain is a proportion of spend, and we really like how we're positioned. Those 2 business spike out because of the great performance, but there's a broad set of underlying performance drivers across the portfolio that we think are really good. And you've heard our view on sequentially up into the current quarter and up again into our fiscal Q4. So we think the underlying demand patterns are strong, and we wouldn't expect to lose momentum from a PVD standpoint, if you think about what's happening. What stays on the chip and defines power performance, the transistor structure, the performance characteristics, this is about our PVD business, our thermal business, our epi business, our implant business, where we've got significant and world-class share positions. This is about the performance of the transistor. And our share position is unparalleled across the industry. I would expect that to continue to perform given what we see on the leading edge, given our market position and the innovation that we're driving to help our customers drive down that power performance road map. I don't see that slowing down. We really like the innovation that we're bringing and the customers do as well, and that's evidenced in how we're performing in the market. On the PDC side, we're showing strength in an inspection -- optical inspection product. The announcement is forthcoming here shortly. And the way we do product announcements, we achieved significant momentum in the market, and it's almost a backward-looking announcement. So we feel really good about how we're positioned there and the uptake from customers. You're also seeing strength from an e-beam perspective and some really differentiated technology on the way. We can see feature sizes and just -- I think it's almost 50x better than what is currently out in the market today, and it's really valuable when customers are driving new road maps and creating new types of transistor structures. Seeing exactly what's happening as those structures are made gives our customers an opportunity to accelerate their road maps. And we all know the value. When you're bringing on a -- in foundry/logic, a $15 billion, $16 billion factory or in memory, a $7 billion, $8 billion, $9 billion factory, time to yield, time to ramp, insertion of those technology road maps is absolutely critical to return on investment, making sure your capital is deployed in a way that it generates return for their shareholders. It's an enormously valuable problem to solve, and we really like how we're positioned on that front. So I wouldn't say we're going to slow down at all as a result of COVID. Customers spend money, you'll see momentum in those product lines.

Got it. That's really good color, Dan. Then a question from an investor pop up asking on the share gain topic, how do you view calendar '20 WFE growth? And with respect to that, how do you see AMAT's share gain growth if you put it adjacent to that?

Yes. So on the most recent call, we were purposely silent on what we expect for WFE this year. What we said is, is that a quarter ago, we set up 10% to 15% probably high end of the range. I think we want to wait and see more data. What we did share was what we have visibility on. In our fiscal Q3 and our fiscal Q4, we see up and up again from a revenue and demand standpoint. We see our systems business being up strong double digits in the fiscal year. And against the backdrop of the market, and I know there's a debate going on. Is it flat? Is it down a little? Is it up a little? I don't know. But what I do know is, is the performance of our business against that backdrop is very, very strong. In 2019, our business was -- our systems business, I think, was down 2.6%. Our closest process tool peers were 13% and 14% down, and the market was down 10%. So strong outperformance on an absolute relative basis in 2019. I would expect something similar again this year based on what we see from an overall market standpoint and the strength and underlying performance of our business. We'll take it a quarter at a time. I want to see how others respond to the current environment before we start taking points of view. Part of it is what we see and what we can do in our business. And then part of it is, is what we've seen from our peers and competitors, how they respond to the challenges out there. A lot of that's going to come together to form a view on WFE. But I think if you look at what we see in our business and you think about the debate flat, down a little, up a little and put our performance in that context, I think you get a point of view on how we think we're going to do this year.

Got it. Got it. And then, Dan, on the cost structure, when you look at it, clearly, with COVID, you have some headwinds related to higher freight costs, et cetera. You probably also have some tailwinds related to lower travel expenses. So how should we think about the cost structure? And how flexible it is if things go south or start getting better from here?

Yes. So you're right. In an environment like this, there are going to be things we need to invest in customers, which are sort of an economic headwind. The social distancing aspects we put in place, the surge labor capacity to make sure our cycle times and factory throughputs are the same today as they were pre-COVID. Those are the right kind of investments to make, making sure that we can get our supplies, our component parts, our modules and our systems from point A to point B. Those are investments we're going to continue to make because we want to service customers and continue to build the trust with them. There will be those set of economic headwinds, and then they'll be offset by efficiencies and things like discretionary spend, travel is one of them. There are others. We'll continue to be disciplined operators on that front, just taking a step back to get a sense of how the model flexes. I think on the COGS front, we're 2/3, 65% variable; 1/3, 35% fixed. That gives you a rough sense of how the COGS, cost structure flexes up and down as revenues ebb and flow. From an OpEx standpoint, I think we'll do what we've always done, which is take the current environment, be disciplined operators recognizing the near-term opportunity to control discretionary spend, pivot as much of that spend to R&D. Today, 70% of OpEx is going to R&D. So it's been a real strong transformation of this aspect of the company since Gary came in. What used to be OpEx 28% of revenue before Gary got here is now in the high teens and 70% of what we spend goes to R&D fuel for growth. If it's a near-term temporary set of circumstances, then we're going to continue to invest through that because we think that the industry is undergoing a once-in-a-generation inflection. Power performance road map driven by 2D shrinks to a much different playbook going forward. 2D shrinks are running out of gas in terms of driving that power and performance road map, new structures, new architectures, new materials, new ways of connecting chips together. We've got an important role and a key enabling role to play in each and every one of them. We'll balance near-term discipline with positioning this company for long-term value accretion and do the right things to create value over the long run for investors. And we feel good about the track record to date on this front and also the way in which you'll approach it going forward. You won't see a change in how we approach it. Gary and I, we're very unemotional. There's no entitlement to spend, and there's no sacred cows. We will be unemotional about this topic. What we see today, underlying demand is strong. We've got a real opportunity and role to play to push the position we have and be that key enablement partner for our customers, and we're going to continue to drive that position forward. If we misread the situation in any way and there's somehow a structural reset in our end markets, it's not our view. Gary and I will be unemotional in balancing those near-term requirements with the long-term opportunity. And at the end of the day, OpEx -- I don't want to be careless about it, but at the end of the day, OpEx, 100% variable over long.

And then final question. Any update on the Kokusai acquisition? And is the pending acquisition constraining your buyback opportunity?

So the way we see Kokusai, we've made really good progress on this front. We announced mid-summer last year, 2019, we said approximately 12 months from when we announced that we would run the regulatory process. We feel good about progress to date. We're still working towards that time line. Customers really like what's happening here, broad support across the customer base, and that's evidenced in 5 of 6 of the geographies already approving the transaction. China is the last of the 6. We're constructively engaged with the regulators there, and we like the way the conversations are going. We'll just continue to monitor the situation, continue to engage constructively, but we feel good about the progress and marching to the original time line. So we feel good on that front. What we said a couple of quarters ago is we were going to dial back share repurchases in the run-up to the close of the Kokusai transaction. In our fiscal Q1 and our fiscal Q2, you saw us active in the market at about $200 million per quarter. We're not going to take a step back in this environment. I see us at a very similar level in the route to the Kokusai transaction. We'll use term loans to finance the transaction. Once we close Kokusai, we'll pivot free cash flow to pay down the term loans, and then we'll get back active in the market from a share repurchase standpoint. We have a strong point of view around where our industry is going and how we, as a company, are positioned against that opportunity. We've been very strong repurchasers of our shares. We've -- I think it's over 15% of the company in the last 3 years and almost 30% -- maybe 30% of the company in the last 5 years. We've got a really strong point of view. We don't think it's recognized broadly in the market. We're going to continue to be active and aggressive purchasers of our shares to the extent that disconnect with intrinsic value persists. You'll see us in the run-up to the Kokusai transaction dial that back, accumulate some cash. We'll pay down the term loans, and then we'll be back to doing what we've always been doing. And then we'll also take a balanced approach to capital allocation. We just raised the dividend almost 5% in the most recent quarter. And there's nothing about the current environment where we would take a step back from Q3 share repurchase. We're going to continue to do what we've been doing over the last couple of quarters.

Right. That was very helpful, Dan. And I got to say congrats on services achieving its first $1 billion-plus revenue a quarter. That is very impressive to see.

No, I appreciate that. Yes. The team has done a great job executing that strategy. It's a business we feel great about. So thank you.

Thank you very much, and I appreciate your time and your insights.

Yes. Thank you. Appreciate the time. Thank you. Bye.