Applied Materials, Inc. ($AMAT)

Welcome to the Bank of America Global Technology Conference, Vivek Arya from Bank of America, semiconductor and semi cap equipment team and really delighted to kick off the semiconductor part of our Global Tech Conference with the team from Applied Materials. I'm really delighted to have Brice Hill, the Chief Financial Officer. Warm welcome, Brice.

Good morning. Thank you for having us back. Glad to be here.

Yes. Thank you so much for joining us again. And I'll go through my questions, but please feel free to raise your hand if you would like to bring up something on your own. So Brice, I guess, understatement that very exciting times in semiconductors. Every day you wake up, there's like some more news about demand growing. Maybe just walk us through your state of the union, right, at the start of the year, Applied was looking at a growth rate of 20% in your semi systems business, you upped it to 30%. Where have been kind of the incremental growth drivers in the near term and then we'll talk about what you're seeing over the horizon?

Sounds good, Vivek. So state of the union, the union is strong. We increased demand, and we increased our forecast, as you highlighted there to over 30% growth for our semiconductor systems business and that was an increase over prior quarter as you saw new orders coming in from customers. And no surprise, at least relative to the news flow, we were just chatting about incremental investments that are being announced across the ecosystem. I think what's different about what's happening today is people can really connect the dots between the demand function of AI. Our companies are using AI, we're deploying it in multiple ways, people are using it personally. So when they hear the cloud service providers talk about hundreds of billions of dollars of capacity adds to drive the compute behind AI, nobody is surprised. They can connect the dots to the demand. And that's certainly what we're seeing in our business. We talked about how leading edge logic is growing very strongly. We talked about how DRAM is growing very strongly, and we talked about how advanced packaging, which is used to build the connected systems of all these components and drive the AI usage models, that's also growing very strongly in our business. And those things, we received new orders in the last quarter. Customers are being more and more creative about finding clean room space and options to expand their output. That translates into new orders from us and then translate it into a higher growth expectation for this year. I know we'll talk about this, but we're -- the customers are working closely with us to give us a good perspective of what their growth plans are over the coming years. Then in our services business, we had previously set our services business would grow in the low double-digit growth range. I think the easy way to think about this is there's 2 drivers of growth in the services business. One is the installed base of equipment, and the other is the new products that we announced and create each year, which grows the value of each tool in your installed base. Because the systems business is shipping more and more tools, the demand we just talked about, the installed base for the services business grows and so we see that happening. We increased our expectation for growth in the services business to mid-teens. And we said actually this year will be a little bit higher than mid-teens because this year gets a plus also from the increasing utilization across the entire ecosystem. So as the DRAM fabs went from whatever utilization they were at to 100% utilized. And as leading-edge logic goes to 100% utilized and even the ICAPS, the mature nodes, utilizations improve, that helps drive some uplift for the services business. So really a strong signal across all of our businesses as we look at the demand type today.

Got it. If we were to try and dissect this upgrade of the growth rate, does any specific areas stand out, Brice, like whether it was foundry logic or DRAM, NAND or advanced packaging like did something really start to grow much faster than what you had thought before?

Well, I think in the short term, it's hard to separate leading-edge logic and DRAM. I think both of those are a very strong signal. And we didn't call one higher than the other. I guess as we look at factory projects that have been added over the last quarter, this is more longer-term signal. I think there's more DRAM adds than there are logic adds. But at least the way I think about it and everybody can start to dissect the architectures of newly announced server systems and system platforms, but these things are traveling together. You've got a significant amount of leading-edge logic between GPUs, CPUs and accelerators paired with different memory types in a system. And so those things are being driven together.

Yes. Got it. And what are the main areas of constraints that you see? So theoretically, what can make this X percent growth rate more than X right now, why can't it be 35% or 40%? Are you limited just by clean rooms? Are you limited by our ability to produce new tools, the ability for the customers? Like, what are the main areas of constraints right now?

Yes. I think the primary -- we said that demand right now is metered by clean room space. And I think that is the right way to think about it. We've been talking about getting an 8-quarter rolling forecast from our customers, which we consolidate and give to our suppliers. And we've talked about, Vivek, how we added capacity -- our own manufacturing capacity. So I think with the right signal, we can increase our output, and we're not the limiter from that perspective. We certainly have manufacturing capacity available. And if we give our supply chain to lead, we think. So what's really the governor here, the governor here is it takes 3 or 4 years to build a fab. And so you need a pipeline of fab projects, which there is a pipeline of fab projects, but if you want that to go even faster, it takes some time to increase that pipeline. And I think that's what all the customers are working on. So in the short term, it's really clean room, making more clean room available and that's what -- in this year, that's what we saw some of the customers doing is even optimizing the clean room they do have available.

Got it. Yes. Actually, I wanted to pick up on that. When you say optimizing the clean room, are they upgrading to tools sooner than they would have otherwise? Like what does optimization mean to Applied?

Yes. I think we saw a number of different example types of literally just optimizing clean room floor space, so you might change layout, upgrading tools that were underperforming, upgrading process technologies from one node to another node. Those are some of the examples we saw as well as even some utilization of 200-millimeter space for 300-millimeter purposes. We see all of these things going on in the ecosystem.

Got you. And then you mentioned there is a 8-quarter kind of rolling visibility, what is your normal visibility? Like how should we put this 8 quarter in context of what Applied has seen historically?

Yes. It's great because first, I want to say that we have -- we always actually have a little bit longer than that. So we know just like people here know, because you see public announcements, we know all the fabs that are being built by our customers, although it's more precise for the largest customers than it is, for example, of some of the smaller customers in China, right? But you have an indication of what is out there 4 years from now, 5 years from now, 3 years from now, that goes into the fab tractor that we talk about and the like. But when we start talking about 8 quarters, what we get from our customer when you go to 8 quarters is you get the precise process technology, the actual tool recipe that they're going to deploy, which tells us the types of tools, the number of tools and the specs of those tools that will be needed for that particular project as well as when they need to land and we install those tools also, so we have to have install tools -- teams available to do that work. So it's really connecting the dots at a much more precise level. And then when we get that from our customers, we consolidate that forecast, turn it into a forecast that we can provide to our suppliers, our 2,000 suppliers. So adding up all of -- if you think about adding up TSMC and Intel and Samsung, all of our large customers, and they all might need power supplies and you're aggregating that and saying, these are how many power supplies we need for the company, specific types and translating that to your supply chain so that they can put the capacity in place to deliver that product. That's really the purpose of getting that type of visibility. And I think it's working very well for us at this point.

Got it. So historically, the semi cap industry and then CapEx has kind of grown 8% to 10% a year. And now the industry is at a place where you could have multiple years, conceptually [ of 20 ]%, right, 25% plus type of growth rate. What are you doing differently from an operational perspective to make sure that you're able to support customers for that kind of growth?

Yes. I think since COVID, Applied Materials, and I'm sure a lot of companies in the ecosystem, has been strengthening its manufacturing from a regional diversity perspective and also the supply chain from the same perspective. So we have more suppliers, we have more regional diversity. We have more regional diversity in our manufacturing and more raw capacity in our manufacturing. Those are definitely some of the things that we've been doing as well as working more closely with the customers than ever before on what their plans are, and what the scenarios are for the business. So -- but I think, too, that since these are long lead investments when we were evaluating our own capacity additions over the past few years, since the business is profitable, you are sort of looking at what would be the max output required. And you don't want to miss capacity solutions if that max demand signal occurs. So you have to balance that in your planning, which comes to scenarios. Now did anyone forecast what's happening today exactly? No, but from a capacity planning perspective, you want to make those things possible.

Got it. Now specific to the growth rate for this year, how much of that do you think is share gains? How much of that is just kind of broader industry growth. Last year, there was a share shift, right? And just as [indiscernible] kind of moved against Applied. This year, do you think kind of the addressable opportunities move towards you? So how much of this is share gain versus just broader industry?

Yes. This year, the mix -- I think there's 2 things going on. This year, the mix is certainly friendly to Applied, as you said, having leading edges and DRAM and advanced packaging, where we have leading positions as process equipment suppliers, that's going into our wheelhouse, as you might say. But at the same time, even if that mix wasn't there, we expect to grow share in leading-edge logic, and we've talked for several years about how the transition to the gate-all-around transistor and to the newest wiring techniques will add share for Applied Materials since we've got solutions in those spaces. We have been effective at growing share in DRAM over the last decade, and we expect to continue to grow share in DRAM. Some of the construction techniques used in leading-edge logic are being deployed in DRAM, and that's helping us add share there. And then in advanced packaging, we have a leadership position in advanced packaging, a lot of investment in advanced packaging. As we move from 2.5D, which is sort of lateral connection of chips to 3D when you're stacking chips, Applied has been investing in a lot of different packaging technologies that will be used in that road map as well as different substrates that may be used in that road map like panel, like glass, different substrates. We've invested in hybrid bonding. We recently did an acquisition of an X-ray technology that will help us with evaluating the quality of those interconnects. We're in the process of another acquisition that helps us on the advanced packaging with fine line interconnects between devices. So we're really focused on that portfolio as a huge opportunity for the industry and a big opportunity for Applied.

Got it. One last question on kind of the broader market, and then we'll go to the individual areas. Historically, when we just look at the ratio of wafer fab equipment to semiconductor industry sales, that's kind of varied between, say, 12%, 13% to as high as 17%, 18%, right? So the assumption has been that here in the middle, right, 15% is a decent long-term number. But this year, a lot of semi industry growth is coming from ASPs rather than units. So do you think over the next 2, 3, 4 years that this will mix more towards units rather than ASPs is me because units is really what will drive WFE, right? How do you kind of conceptually think about WFE density?

You're right. It's a great question because at least for me, I don't use that equation to think about it. But to your point, I think it was 14-ish percent last year, if you used last year's numbers. And it is subject to movement because of the different ASP trajectories that we see. But I like thinking about as you're sort of suggesting actually that what's happening is more units are being required and more important for Applied Materials, more wafer starts are being required. So if you think about, for example, DRAM, there's 2.3 approximately 1 million wafer starts of DRAM every month. And when we look at the road map, we expect to see 300,000 or 400,000 wafer starts of added capacity every single year in DRAM. So I think you sort of led in this direction, Vivek. The way we think about it is the actual wafer start output, the capacity of wafer starts is growing at the strongest rate it ever has for DRAM, for leading-edge logic. And then the good news also is you have to connect those devices, so that will lead to packaging factories and packaging equipment that supports that. So that indicator may or may not be the easy way of calculating equipment. It might be look at the amount of factories that are being built, look at the amount of wafer start increases that will go out, and that will give you an indication of the equipment business.

Got you. You mentioned DRAM, as many investors are very happy to see, right, the strong performance of DRAM and a lot of memory stocks, but there's also kind of this lingering concern that how much of this is right cyclical and -- so just theoretically, let's say if DRAM prices go down next year, do you think customers will be as motivated to add capacity? Or will they want to protect pricing? What has happened historically?

First, it's hard to picture that, but I'm open to scenario planning, so we can scenario plan. I think that one benefit the equipment side of the business has, is back to our discussion of what is metering the industry and what is currently the gate for the industry. I think it'd be very difficult to argue that we're in a position where we have too much capacity, and we've overbuilt capacity in almost a good way since it is metered, you're sort of behind the demand curve from a capacity perspective. Certainly, if prices go down in the end devices that will -- all the customers will recalculate their ambitions and their interest in how much capacity to add. But right now, the profitability is so significant that I think there -- I think they're really trying to figure out how can they maximize output over the next 5 years.

Right. And I would assume that as many of them are signing long-term agreements with their customers, right? They're also on the hook to make sure that there is some capacity, right, to support all those?

Absolutely.

Right? Agreements. Staying on the topic of memory, how is your content evolve, right, from the various versions of HBM3 and I saw last night, Samsung is now starting to talk about HBM5 as well. So how is your kind of opportunity and content involved in these different HBM generations?

Yes, I think the way to think about it for Applied Materials is as you move forward on these HBM technologies. We talk about -- it increases the overall demand for DRAM. And it also -- there's a trade ratio on the HBM DRAM where it was around 3:1. So it takes 3x the wafer die area to make a DRAM device, if it's going to be stacked. And that trade ratio is moving to 4:1 now with the newer generations of HBM. And so DRAM is already operating at full utilization. We're only adding more requirements on to DRAM. So I think this just ups that demand signal even more strongly than where it was before. And our customers, we expect, will be adding factories like we saw in the last quarter, they'll be adding factories and telling us shortly with our 8-quarter forecast that they'll need more equipment for those factories. And so it's just a -- since it's a great solution for the AI data center servers, and the best memory for those, then it's an added demand signal for us.

All right. So I think Applied has mentioned many times that you gained 10 points of DRAM, WFE share, right, over the last decade or so. What do you think help to drive those share gains? And as you look at the next 3 to 5 years, what can help maintain or expand that market share?

Yes. I think it's -- what we've discussed is some of the same capabilities that we built in leading-edge logic on the transistor side are being deployed in DRAM from an equipment capability perspective. And that's really what's helped the share gain over the years, and I think that road map continues. So we talk about periphery, IO, logic and other elements of the architecture that require those techniques. I think that's what is helping us win positions in the forward DRAM. And we've said that if companies move to 4F squared, that will be a share increase for Applied Materials as we have a stronger position in the 4F squared than even in 6F squared. And when they go to 3D DRAM, same thing, we expect an uplift in our share position in those because of the long lead work we've been doing with the companies on the architecture and the equipment solutions.

Do you have some sense of timing of when they move to 4F squared or 3D DRAM?

For that, we just say we should -- you should talk to customers. So I think our customers, the road maps have been changing. They've been adding more 6F squared process upgrades in the recent. So I think each customer has a different expectation for when they would deploy those.

Got it. Okay. On advanced packaging expected to grow over 50%, right, even faster than the overall. So if you look over the next 2, 3 years, are there certain new emerging areas in advanced packaging, where you think Applied might be better positioned to participate?

Well, definitely. So on the 3D stacking in general, Applied has technologies that we -- that will be deployed by customers and then I mentioned a few of them a little bit before in highlighting that we're building a portfolio of solutions for packaging. So one acquisition that we're underway on right now, for example, is for fine line interconnects. You can think of it, the substrate at the top of the substrate between chips that are being interconnected. The x-ray acquisition that we did is to examine the quality of interconnection of micro bumps between stacked chips and allow you to see things that we couldn't see before the industry couldn't see before, and we've been working for years on hybrid bonding. We've been working for years on panel technology. We have lithography technologies that we're deploying in different packaging solutions. So we really feel like we have a strong portfolio, and we're examining the evolution of larger and larger systems with more and more chips, which create all these different materials and equipment problems like warpage, like thermal management, hotspots, just the ability to get the signals on and off the chips and what technology should be used for that. Applied Materials is investing in a portfolio that we think will be very strong as that road map continues to develop. And we think it's a huge growth area for the industry.

On the foundry logic side, one very large customer, of course, has been driving most of the industry growth. Are you starting to see any sense of diversification, there's an emerging new player in the industry, right? Have you started to see anything new there? Like how do you look at the diversification over the next few years?

Definitely. We said in our earnings call, I think that we're shipping to 4 customers today on leading edge and that is becoming more and more diverse and robust. And of course, that's a great thing for the industry. I think competition in the Foundry business will help drive the road map. And from an equipment and a factory perspective, it drives more solutions. So I think that's a good thing. And we do see interest from new customers.

Got you. Okay. On gross margins, price, there is always this kind of good problem to have where your customers are making so much more money, right, by way of gross margin. So what levers does Applied have to kind of exert your position in the industry, right, and expand gross margins, right, from -- I mean, you're getting towards 50% now. How much more upside is there?

Yes. Investors might notice that we've started reporting our gross margins by reportable operating segments. So you can see our equipment business has 54.8% gross margins, and that's improved quite a bit over the last couple of years. Vivek, I know we've talked about -- we've been working on our pricing process, building a robust, disciplined process where we set targets for every tool. We set -- we base it on our value analysis of what the tool is providing. And so we feel like we've done a very good job of making that a more robust process for the company, and that's helped us with our margin uplift. And I would just say that in general, Applied Materials strategy is to work with customers on the forward technology. So when we think about EPIC and our platform that we're building, the lab that we're building in Sunnyvale, where we've announced 10 customer arrangements at this point where we have some of the top universities and all the top customers partnering with us on that platform to work on collaboratively work on the furthest out technologies together. That's been our strategy. And so what that helps you connect the dots as those portfolios are introduced. Our gross margin, we expect will increase over time because that long lead work that you're doing is on the most difficult technology problems for those customers. And so that's been our strategy, and we're increasing our capability of pursuing that strategy by building the EPIC platform and having the customers join us and working together. And the simple way to think about that is your core, your newest tools and your newest capabilities and your top researchers are all there. And if we can have the customers join us there and bring their architectures in their most difficult problems then we expect to speed up progress in that way.

Got it. You raised the growth on your Applied Global Services, AGS, business towards mid-teens. Do you think there's a point at which you see the growth rates on the product side and the services side converge? Or this is just a long-term kind of secular grower and right and it's not -- it's countercyclical to some.

Well even when it was low double digits, at that point, it was probably ahead of where the equipment is. So we do think it's secular, if you will. We think the underlying drivers are an ever-increasing installed base and those tools tend to have -- be long-lived. So when you put new tools in place, those can be tools that are serviced between 10 and 30 years literally and so it's long life from that perspective. And then we continue to announce new products in the service space. Most recently, a lot of these products have been AI-driven, where we're using AI to help make predictive recommendations on maintenance and upgrades to the tools that help the customers with output. And so as we make new service product announcements that grows the value of each tool in the service base. So we do think that is secular and goes back to the sort of the secular growth in the equipment itself.

Got it. One question on China, Brice. It seems as if that exposure for the industry has kind of settled in this 25%, 30% type of zone. Do you think that, that's sort of the run rate from here? Or you think that it will actually come down over time?

Well, when you say it like that, that makes total sense to me because I think China had an ambition to be self-sufficient from an equipment perspective and a semi cap perspective. And the China share of global semi device demand is around 30%. So if it settles in that ZIP code, that makes sense from a long-term perspective to us. Our most recent quarter, I think, was 24% from a semi systems and services business, so not counting display. So 24% and that's about the level we'll operate in the very short term. And then as the leading-edge grows so quickly, it will probably be a little bit smaller as we get out a few quarters, but that's the right zip code.

Got it. And then on just capital allocation, use of cash. It's interesting over the last decade, we have seen analog companies in semiconductors, right, get very high multiples because of their free cash flow generation and returns. I think for semi cap companies is actually not as well appreciated, right? You have also done a lot of buybacks and retired a lot of cash. So how do you think about capital allocation? Do you think there are opportunities to do M&A accelerate your growth? Or do you think it's still return of cash that will be the primary use of the...

Yes, I definitely would not say return of cash is our primary objective. Our primary objective is to grow the business. When I think of it, Vivek, our business has a greater than 30% return on invested capital. I expect that to be growing and so I think all the finance people here will be thinking, well, if you have that kind of return on investment capital, it probably suggests that you have more projects that you could do at a good return, and that's certainly the way we feel. We're building more lab space. We expect to be able to add more projects that will be profitable for the company. So the first priority is to invest in the business and grow the business. And then to your point, there will be significant cash flow to distribute to shareholders and no change in strategy there. We do that through our dividends, which have grown nicely over the last 4 years and our buybacks.

Are there opportunities to do tuck-ins, right, improve? There's a lot of talk of adding more AI-like capability, right, in kind of different parts of the business? Are you seeing any of those opportunities come up?

Absolutely. I mentioned 2 acquisitions that we've done just recently. So I think we're active in that way. And those will be -- when we do those, that will be to add to the portfolio and add to our portfolio capabilities Applied has a very great interconnected portfolio, and that's what we think helps us work out on the edge of the future technology with our customers, and we'll continue to build on that.

Great. On that positive note, thank you so much, Brice. Really appreciate your time.

All right. Thank you. Thanks very much.