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

Good morning, everyone, and I guess good afternoon, everyone in the East Coast. I'm Sidney Ho. I cover semiconductor, semi-cap equipment and IT hardware here at Deutsche Bank. The next company we have is Applied Materials. Applied is a leading global provider of semiconductor capital equipment with strong exposure in both memory and foundry/logic. Applied has also has presence in display market, which is a little bit less than 10% of revenue today. But today, we're joined by Applied's CFO, Dan Durn. Welcome, Dan. Great to have you here.

Thanks.

So before we start, for those investors who are listening to the webcast through our portal, if you want to ask a question, there is a box on your screen where you can find -- you can type in your question. And I will try to ask those questions as we go through the discussion.

So with that out of the way, maybe I'll start off with some near-term industry-related questions. So maybe the top of mind for a lot of folks these days is on the DRAM side. Dan, there have been some concerns in the investor community over the past month about some DRAM inventory building, whether it's at PC OEM or in the cloud. And pricing is -- spot pricing has come down a little bit. Can you give us an update on what you are seeing in your DRAM business and if you are seeing any changes in demand?

Yes. Thanks, Sidney. I appreciate the opportunity to participate today. So I'll comment specifically on what we're seeing in the DRAM business and probably take a step back and provide a bit more context on the overall market, just to provide the right context around the DRAM specific comments. So we see the back half of 2021, calendar year 2021, being strong for DRAM. We don't see any erosion of the strength in the business and the expectations we have. Based on the things we see in the market, based on the conversations we have with customers, we expect the back part of the year to profile, as we've been expecting for in the last couple of quarters. So strong position from a DRAM standpoint on a relative basis. We're well positioned against the road map opportunities. And the customers' plans from a capacity standpoint are very much in line with how we've been thinking about the opportunity. As we take a step back and think about the overall WFE, we talked about this year being over $80 billion. That's off of a baseline last year of just over $61 billion. And so you're kind of a mid-30% grower for overall WFE, mid-30s plus minus. Our business continues to perform well. First 3 quarters of the calendar year, our systems business overall is up over 50% year-over-year. So we think this is going to be another strong year of outperformance. And within DRAM specifically, we think it grows a little bit faster than the overall industry. But again, our position against that opportunity, we're performing really, really well. So we like how we're positioned. We like the strength of the market, and we like to follow through based on the conversations we're having with customers towards the back part of the year. It feels like it's playing out exactly how we expect.

Wonderful. If I move on to the main side of things. You continue to suggest a little bit of uncertainty in the NAND market in the second half of calendar '21, while expecting foundry and logic, as you said, DRAM to grow half over half. Can you talk about what you're seeing in the mid-market that is giving you a little more pause on the short-term outlook for the market?

Yes. I wouldn't necessarily call it pause. I do think we see that market profiling differently than foundry/logic and DRAM. And the setup this year, if we go back to 2020 as a baseline, we had an industry that grew, call it, high teens, mid- to high teens. The NAND market in 2020 probably outgrew the overall industry 2:1, so call it a 40-ish percent grower last year. This year, the profile of the market is going to be shaped differently. We talked about the overall market growing mid-30s plus/minus. Foundry/logic will grow the fastest and significantly greater than the overall market. We see DRAM is growing faster than the overall market. And we think this year, NAND undergrows -- still going to grow, but it undergrows the overall market. Now the question is, is what is the shape of that market throughout the year. And our foundry/logic and DRAM to us very clearly have an upward slope second half over first half. I think embedded within those market expectations for NAND is a flattish to slightly down profile. And I just think it's too early to be able to definitively say is it going to be flattish throughout the year, is it going to be slightly down throughout the year. It's still too close to the call, and we want to watch more of the market develop. So I think we've got a good point of view on the market. I think that perspective has been pretty consistent for several quarters now. So I don't think there's a mystery from our standpoint on the market. The question is, is what's the shape throughout the year. And it will profile differently than DRAM and foundry/logic.

That's helpful. Speaking of Foundry and Logic, obviously, that seems like, every month, we have some good news out of that market. Your comments have been very strong in the case that, that probably should continue into next year. Can you talk about the key trends you're seeing in the leading-edge nodes right now?

Yes. So the leading edge continues to be strong for us. We've got a great position in the business. And as we think about the road map going forward, increasingly less driven by feature size shrinks and simultaneous benefit of power performance area cost to what Gary has been calling for quite some time the new playbook. And you see this messaging being echoed by, universally, all of the customers. They talk about a new playbook to drive the power performance road map. It's about new types of materials, new types of architectures, going vertical on the chip, new ways to combine chips together and heterogeneous integration, new ways to shrink feature sizes. And so the road map is diversifying and being driven by a much broader set of drivers than we've ever seen historically. And while today, primary investment is around a FinFET technology, and you see some of the things that sit around that FinFET technology like wiring resistance. It's a great opportunity for us to bring unique capabilities to the market where we can integrate 6, 7 different types of technologies under vacuum and deliver an integrated solution to our customers to reduce that wiring resistance by 50%. That's a great opportunity for us to continue to penetrate at an outsized rate what's going on in the market today. Heterogenous integration, 3D packaging, advanced packaging, this is just beginning to take hold right now. We've got a great position in the market where we compete. We've got probably over 60% share of the opportunities that we compete for. So a clear market leader on this inflection that's playing out in the market. And we would expect that growth going forward to increase. And then when you think about FinFET transitioning to, say, gate all around, again, this is going to be a new type of transistor structure that's going to play to our traditional sources of strength, what we call our leadership positions product positions where transistor formation is at the core of that product suite and that traditional source of strength. It's going to be a great inflection for us. Again, we see it as another opportunity to continue to penetrate as these inflections unfold. And it's one of the reasons why we see, node over node, our opportunities increasing as that road map plays out. So we feel really good about the strength of our business, and we feel really good about our customers' road maps not only increasingly being driven by Integrated Materials Solutions but the different types of transistors that play to a source of strength for us over time. So we think we're well positioned as that market continues to grow.

That's super helpful. Now one of the areas that I feel like -- at least I was platform surprised is by the trailing edge, which I know you guys now call it the ICAP business. And you guys had a master class just I think it was 2 days ago that give us through a little more detail on that. It's making about half the foundry/logic revenue in fiscal Q3 clearly much higher than the historical mix. How do you think about the long-term growth potential of that business and the financial profile compared to some of your leading edge nodes, maybe just a recap of what you guys said 2 days ago.

Yes. So just to give some perspectives on that market. If we go back in time, the ICAPS markets have been growing, and the foundry/logic market has been diversifying for the better part of a decade. Today, those market's leading edge and the ICAPS nodes are fairly balanced, but that's not a 1-year phenomenon or a 2-year phenomenon. If we were to go back a decade, leading edge was probably 90%, 80% of the overall spend. And slowly over time, over the last decade, that's been diversifying. 90-10 became 800 became 60-40. And now you see balance between those end markets. And as we go forward at our Analyst Day, what we talked about was expectations around the market in 2024. And we see the leading edge and the ICAPS markets continuing to be fairly balanced between now and 2024. And at the core of the strength we see in those ICAPS markets is intelligence being pushed to the edge. This is not a new dynamic. And as you push intelligence to the edge, you're seeing more machine-to-machine generated data. 2018 machines for the first time, generated more data than human beings. And by 2025, we think 99% of the data being generated will be machine to machine. And so it's no surprise to us that at the core of that data trend and dynamic is this intelligence that's getting pushed to the edge. And what's feeding that intelligence getting pushed to the edge is a larger and more diversified foundry/logic market where you're seeing now innovation across all the node profiles not just at the leading edge. From an economic standpoint, this is really attractive business for us. And whether we talk about the ICAPS nodes, whether we talk about our packaging business, you've got an operating margin profile that is in line with our semi systems business. And we're agnostic. We're almost agnostic to how the relative growth rates between those businesses play out over time. We're really well positioned. We've got highly enabling technology. We've got great relationships with customers, and we've got an excellent margin profile around these businesses. And I'm just really encouraged by the diversification that we're seeing in foundry/logic between the leading edge and these ICAP nodes. And we think that serves the business really, really well going forward.

Excellent. If you step back -- in your opening remarks, you talked about WFE being over $80 billion. I know you haven't updated your commentary about the combined '21, '22 WFE. Hopefully, it's over $660 billion. Can you talk about what your -- how you think about the biggest market drivers next year? And if you look at specifically your own business, I assume visibility has improved because lead times have stretched up. But to the extent you can talk about maybe first half -- at least for the first half of next year, that will be helpful.

Yes. So I think what we'll say, Sidney at this point in time is we're not going to be point specific around WFE next year. We think it's premature because I want to see what actually gets done this year. What we have said is for several quarters now we saw true underlying demand next year being up over 2021. So we saw that upward trajectory. And as we go throughout this year, I think what's becoming increasingly obvious to us or increasingly apparent to us is there's going to be demand this year that gets unmet due to supply chain constraints, and that demand is going to slide into next year. So as I think about probability distribution around next year being up over this year, I would say the probability of that, the confidence interval around that, has gone up in the last 3 months based on this dynamic that I'm talking about of unmet demand sliding into next year. Now when you disaggregate the overall WFE and the upward slope, yes, we're still over $160 billion. We feel quite confident in that perspective. I think it's premature to break down that overall WFE into the 3 different device types and make predictions from a growth standpoint. We've got a point of view. I just want to see more data throughout the year before we shape those expectations for investors. What I will say, though, is the strength we see in foundry/logic, DRAM and NAND, all of those 3 markets are growing this year, some faster than others, but they're all growing. I would expect the strength of those 3 markets to continue -- from an overall spend standpoint, I would expect the strength of those 3 markets to continue into next year.

Okay. That's fair. Now speaking of some of the unmet demand pushing into calendar '22, clearly, we have the top of the supply chain here. When thinking about supply constraints and the higher logistical costs that you are facing, do you think these issues will mostly resolve themselves as we move past the pandemic? Or are there some other issues being driven by maybe the demand growing much stronger than the supply chain could catch up to? Are these -- a lot of issues won't be resolved just because the pandemic is over?

Yes. So I think we have to segment the different dynamics. I think there's pandemic-related dynamics. There's things that are tangential to the pandemic, and then I think there's things that are unrelated. And so when I think about the headwinds in the current environment, not to be overly precise, but I think you're probably in the 50 basis point range around gross margin. I think that gives you a sense of how the underlying business is performing in this environment and the potential headwind that we're faced with directly related to the pandemic, availability of logistics channels. Commercial aircraft and commercial flights have an influence on those logistics channels and the availability of them for us and the things that we do. And clearly, until the pandemic and the implications of it die down and people get back to travel and need more availability of commercial aircraft, you're going to see headwinds from that dynamic. So I put that in the pandemic-related dynamic. Then there's things that are tangentially related, maybe not directly, but tangentially. So the world went through a period of economic disruption as the pandemic unfolded. Now they're in the process of getting back to doing business around the globe, and that's created pockets of nonlinearity from a supply chain standpoint. I think those are going to be with us for the better part of 2022, things like availability of semiconductor chips, those types of things, other associated components in the supply chain. Those are going to work themselves out over the course of the next year, call it, 4, 5, 6 quarters. And I think once we get into 2023, best we can tell right now those tangentially related issues are going to increasingly be behind us. And then you think about things that are unrelated, which are the significant content increases in end market devices. It's a strong driver of semiconductor demand. Auto is just a perfect example of the content-rich devices that are being sold to consumers today. When you layer those content gains on top of the first 2 dynamics, it's exacerbated some of those issues facing us and lots of different industries. I think those content gains are probably underappreciated, broadly speaking, but they're certainly exacerbated by the first 2 buckets. That's kind of how we think about it. And I think these issues begin to alleviate -- collectively begin to alleviate, say, over the course of the next 4, 5, 6 quarters. But I think they're going to be here. Some of those issues will be here with us well into 2023.

Got it. That makes sense. Maybe taking a step back and ask a few longer-term questions on the industry. So clearly, we broke out of this WFE range that's in the mid-30s and whatnot for a while now. But as you think about longer term, WFE as a percentage of semiconductor revenues or capital intensity, has increased recently and looks like it will be close to 15% this year. Is this a trend that you think is sustainable? Or do you think it can continue to increase over time? But more importantly, who is paying for the added cost to the process?

Yes. So if I were to take a snapshot of today and the capital intensity we see in this environment, I do think we have a strong point of view that, that continues to rise going forward. And there's going to be a number of drivers of that. Then the question is, is the affordability of that. And capital intensity has been rising since 2013. So the better part of the decade, we've seen a slow, steady climb in capital intensity. But over that same time period, while our customers are investing a lot in WFE, the percentage of their profitability, WFE to their EBITDA has actually come down pretty significantly. So they're already showing signs of monetizing the capital intensity given some of the end market demand drivers we see. The memory players are down 40% WFE EBITDA. The foundry/logic players are down 33%, 1/3 WFE to EBITDA. And so they're already showing signs of monetizing this more effectively. And as we think about the incremental drivers of semiconductors going forward, Increasingly, it's going to be driven by the largest companies exposed to the largest industries as those industries transform digitally. And the basis of competition of these corporations is going to change and change dramatically, which creates a setup around incremental investments being nondiscretionary and I think even existential. Companies are going to invest and serve their customers in a differentiated way, drive more efficiency into their supply chain, change the basis of competition in their industry. They invest, they're going to survive and thrive. And if they don't, I think they cease to exist. And so when you think about the incremental utility from these investments, companies are going to be able to monetize those investments greater than those investments are monetized today because the primary driver today is a consumer-oriented device. So I do think economic pools globally in the global economy, economic pools are going to shift. Profit pools are going to shift, and more of it is going to sit in the electronics industry. So I do think there's going to be more oxygen collectively for the companies exposed to the semiconductor industry. And I think the participants in the market are going to benefit. We're already beginning to see early signs of that when you've seen some of the reports recently from pricing standpoint, as pricing increases around these capabilities. I think we're in the early stages that you'll see more, but I do think more of the profit pool comes to this industry.

Great. Great. With the WFE standing at over $80 billion today, the investor stuff -- at least the conversations I have with investors is all about who -- how the semi cycle is going to look like. So they had some suggestions that cycles look going forward may be not as drastic as end market demand has diversified. Companies can remain profitable during down cycles. How do you think about cycles going forward?

Yes. So I do think there's going to continue to be cycles in the industry. I do think there will be cycles. But I think the shape and the characteristics of those cycles will evolve. And they're going to evolve in a way that reflects how the industry is growing and maturing. I think the trend line in the industry to us is very clear. It's an upward sloping trend line. I think this industry is a secular grower. And we've seen that play out over the last decade. If you look at the 2-year rolling averages in this industry, each successive rolling 2-year average of WFE is up over the prior. So it's been pretty consistent growth for a while. And over the long run, we see that growth continuing. Now the question is, is you put a cyclical overlay on that trend line and what does it look like. I do think that you're going to get higher highs and higher lows over time as the industry plays out but also reflecting the fact that end market drivers are diversifying, like all industries that diversify. Not only consumers of semiconductor demand, but also within our market, WFE, we spent some time talking around diversification of the foundry/logic market between leading edge and the ICAPS nodes. There's diversification happening on multiple fronts as the industry goes structurally larger. I think that lowers the amplitude on a percentage basis versus what we've seen historically. And I think that serves this industry really well. I guess the last thing I'd say that's going to help shape a lower amplitude from a cyclical standpoint is the fact that the customer base has consolidated. And what you see now are a handful of customers that have a pretty good read-through on true end market demand and are behaving in a capacity addition standpoint in a very disciplined way. And so I think that consolidation trend that we've seen play out over the last decade is serving the industry well today. So I think there's a number of arguments that come to play around what the shape of that cyclicality looks like. I think that's -- the cyclical dynamic will always be there. But I do think the shape is going to evolve that reflects a much more mature and diversified set of end market drivers. And I think our business, as it goes structurally larger and less amplitude, cyclical peak truck amplitude is going to serve this industry really, really well.

That's great. Great insight. So maybe let's take the discussion closer to the home a little bit to your business. So as I look at your growth in the past 2 years, it's been higher than the WFE growth. Are there particular areas you would emphasize that allow you to continue to outgrow the WFE market going forward?

Yes. So I think the company is performing really, really well on an absolute basis, but also on a relative basis. The company outperformed in '19 and again in '20, and the setup here in 2021 looks really, really good to us. Last year, the overall market was probably up a little more than mid-teens, and our semi systems segment was up over 26%. This year, it looks like a mid-30s overall market grower. And in the first 3 quarters of the calendar year, our semi systems segment is up over 50%. So the company is performing really, really well in this environment. What I really like about the strength we see, it's very broad-based. As I look customer by customer, and I look at our momentum node over node at each of our customers as their road maps progress forward, we see our opportunity increasing. When I look at the product portfolio and the strength and breadth of that product portfolio top to bottom, it's broad-based. It's not single-threaded through 1 or 2 sets of products. And then when I break it down by end markets, foundry/logic, DRAM, NAND, clearly, strong performance in foundry/logic, DRAM, strong business in NAND. That strength is broad-based. Then you ask yourself what's driving it. And as we talk about the inflection of the power performance road map in the industry to what we call a new playbook but the elements of the new playbook are really mirrored by virtually every customer and market participant. We're really well positioned given the breadth of our portfolio. We're really well positioned to play a key enabling role in each vector of that new playbook. And then when I think about things like Integrated Materials Solutions and bringing the strength of that portfolio together under vacuum to solve problems the industry historically hasn't been able to solve, and you look at the power performance benefits of that technology, just to take one, we've got a tool that combines 6, 7 different types of technologies under vacuum to lower wiring resistance by, in the next 4, 5 years, that's a -- that one tool is going to produce multibillions of dollars of revenue for the company. And then when you think about how well we're positioned around heterogeneous integration, advanced packaging, this is something that Gary and the team have been on for quite some time, made early investments into these capabilities and the market position we have right as that market is beginning to inflect, all of these capabilities and breadth of great technology, integrated technology, key market inflections and being well positioned to capitalize on it, it's really broad-based strength. And I take a lot of comfort in the breadth of that strength instead of being very narrowly focused.

That's wonderful. Now one of the areas that I think is interesting that you guys highlighted is the process and diagnostics control business within semi systems. And you set that process -- that business is on track to grow more than 60% in calendar '21, which is very good. What is driving this growth for Applied?

Yes. So there's 2 parts of that portfolio for us. We've got e-beam technologies, and we've got optical technologies. Against that 60-plus percent growth, e-beam is going to grow above that segment average. Optical will grow below. And what is the key to the strength of our e-beam business is our electron optics are the best in the industry. We've got sub 1-nanometer resolution with this technology. And as we think about the inflections in the market and the ability to speed up what happens in our customers' R&D labs by understanding with precision, seeing with precision what's happening on the wafer, that e-beam metrology, I think, is an underappreciated capability and underappreciated segment of the market and probably underappreciated for its importance to our customers and their road maps going forward. Seeing what's happening on that wafer with sub-nanometer precision is really important. And when you think about integrating that with a whole host of sensors and technologies that we have embedded in the chambers and embedded on our platforms, this e-beam technology is critical to our actionable insight accelerator. Again, these are capabilities that we bring together. Synthesize that data and that perspective of what's happening on the wafer, make that available to our customers so they can accelerate their road maps in R&D, it's a critical component of that. It's also -- these capabilities that I'm referencing are also one of the reasons why our DRAM market share is growing as fast as it is. It's foundational to that increased penetration in the market. So in that segment, strong driver of growth of our e-beam technologies. I also think we're well positioned from an optical standpoint. We've got a great product-driven strategy. We're seeing traction on leading-edge capabilities, and we're on the cusp of penetrating and broadening that foundry/logic penetration into other segments of the market. So good progress in performance there. But clearly, the strong driver of that segment this year is our e-beam technology and primarily our e-beam metrology.

Excellent. If I switch over to the service business, AGS continues to grow very nicely. You have indicated that about 90% of that business is recurring in nature. How should we think about the growth of your service business going forward? On the flip side, are there any concerns that the recent growth that you've seen is driven by customers maybe stocking up some inventory?

Yes. So let me take them in reverse order. We really don't see that dynamic from a stocking standpoint. If I look at the most recent guide and the performance in the current environment. There's virtually none of that embedded in those numbers. And so this is strong underlying fundamental performance. As we think about growth of that business going forward, I think there's a construct that we put in place. When we talk about growth of the installed base, the great thing for us is, is we're leveraging the industry's largest installed base. In an environment like this, that installed base is growing very rapidly. And I think that sets us up well for growth going forward. So I think it all starts with the installed base, over 40,000 systems, over 160,000 chambers in the market. And that sets us up well. And then when you think about overlaying on top of that a strategy that says recurring revenue, long-term service agreements, this is where we provide a better level of service and performance to our customers. They don't spend more money. They just spend more of it with us as opposed to things that other people do or in their own organizations. So driving long-term service agreements, what was a little while ago 40% of the overall revenue. Then we drove it to 50%. We're now at 60% of the overall service revenue coming from long-term service agreements. And we talk about continuing to drive this. We're targeting 70% of the revenue stream being long-term service agreements; subscription-like revenue, 70% of it, by 2024. So we think that's an important element of the growth. The last element I'd point to is revenue per tool. What we talked about between 2020 and 2024 is increasing revenue per tool in the entire fleet by 20%. We're already halfway there. So as I think about that construct around growth of this business, we talked about it being a high single-digit grower at our Analyst Day. I think we're really well set up to outperform that target given the strength and execution of the business. I do think there's an opportunity to do even better than where we set the expectation, and the team and the company are performing really, really well in this regard.

Great. Maybe a couple of financial questions. Looking at the financial model that you guys put out for fiscal '24, you seem to be well positioned to surpass that base case, which is based on $85 billion. I know we're not $85 billion WFE yet. But let's say, it creeps up to $85 billion, are there certain elements in your offering model that you won't hit because there is a time element to it, whether that's gross margin or operating expenses?

Yes. So if I were to break it down, I would say that we're performing really, really well on a relative basis. We've outperformed in '19, '20, '21, but we're not at the 22.3% market share yet. That's going to take a little more time to play out. And I don't see any reason why the rate of gains that we've seen in the recent environment would slow down, and we will go well past that target if we continue the gains we've seen in 2020 and 2021. Second thing I'd say is we just did a 48% gross margin quarter. We talked about maybe 50 basis points of headwind in the current environment, and we talk about the long-term model of 48.5%. So I think we're well down the path of executing to that model and potentially exceeding those targets, particularly when the headwinds we see in the current environment fall away. When I think about our services business, we talked about a business that's over $6 billion. We've got a lot of momentum in the business, but that's going to take a little time to play out in good, strong, steady growth year in and year out. I feel good about our ability to do better than where that target was. Our display business in the current environment is about a $1.6 billion business, $400 million a quarter plus or minus. Embedded in those targets was a business that was sized for about $2.2 billion, so a midpoint of the cycle. So clearly, there's some more room to run in that regard. We talked about operating margins of 32.4%. You can see where we are in the current environment. I think we're well down the path of executing and putting ourselves in a position to do even better than we would expect as part of those expectations for the model. I guess the last piece I'd point to that plays out over time, the great thing is, is the company is producing a lot of cash. We're going to have a strong capital allocation program. You've seen what we've done in the last couple of quarters. I would expect to continue to do that. And so you'll see a strong capital return program over time, which will compress the share count and allow us to grow EPS even faster than the underlying business is growing. So I feel good on multiple fronts that we're well positioned to do better than where those expectations were set.

Excellent. I think we're just running out of time. So thank you very much for spending time with us, Dan and, hopefully, enjoy the rest of the day.

Always good seeing you, Sidney. Take care.

Take care.