Applied Materials (NASDAQ:AMAT) will announce its Q4 2013 earnings on November 14. On account of lower capital spending in the cyclical industries it serves, Applied’s revenue and net income have been pressured over the last two years. The the Semiconductor Equipment and Display Equipment segments over this time frame experienced periods of capacity absorption and in two quarters restructuring charges produced net losses as the company re-positioned its businesses. That said, the company gained growth momentum in the first two quarters of fiscal 2013, as customers resumed equipment purchases to satisfy strong demand for the integrated circuits (ICs) that power high demand Smart Phones and Tablets. This, however, is a more seasonal business and in the last reported quarter (Q3 in a fiscal year that ends with September) the Silicon Systems Group (SSG) once again reported decreasing orders.
Management indicates that this slowdown in investment by its foundry customers is a short-term trend, as these IC manufacturers focus on ramping production on the new capacity installed over the past two quarters to meet higher demand during the holiday season. Though management guided to a flat Q4 2013 outlook, it anticipates investment levels will recover towards the end of this calendar year and into the next. Analysts concur, with consensus revenue estimates incorporating a 14% decline in Applied’s fiscal 2013 followed by a sizable 23% increase in fiscal 2014. The company indeed serves a cyclical industry.
Though declining PC sales might dampen logic investment for the year, the rising demand for mobile devices and larger TVs will drive higher demand for Applied’s semiconductor and display manufacturing equipment incoming quarters. The company has a robust pipeline of new products for pending Technology transitions, which it believes will help it build momentum for profitable growth in 2014 and beyond. Additionally, its merger with Tokyo Electron will help form a stronger entity, combining two of the largest players in the industry with largely complimentary product offerings.
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We will update our price estimate of $14.60 for Applied Materials after the Q4 2013 earnings release provides the required data.
Semiconductor Demand To Improve Next Year Onward
Within the semiconductor segment, though Applied witnessed a seasonal decline in foundry bookings last quarter, it marked stronger growth in orders for memory and logic.
The semiconductor market slowed down in the latter part of 2012 with capacity utilization declining to 81.2% and 79.2% in Q3 2012 and Q4 2012, respectively. Throughout that year, foundries invested heavily to produce 28 nanometer (nm) devices for Qualcomm (smartphone ICs), as well as Altera and Xylinx (FPGAs), among others. Utilization fell as ICs moved onto manufacturers of the smart devices to be sold through the holidays. Displaying a seasonal uptick, industry utilization improved to an estimated 80.5% and 82.5% in Q1 2013 and Q2 2013 respectively.  Now as things settle into the yearend, we expect pending Technology transitions (22nm and 16 nm, FinFET,and 3D NAND) to drive even higher levels of investment in the coming year.
These transitions are reflected in company guidance. Applied predicts wafer fab equipment (WFE) spending for 2013 to be low, between $27-$30 billion, but estimates investment will rise by 10% to 20% in 2014 and reach $37 billion by 2016.  Intel (NASDAQ:INTC), TSMC and Samsung (PINK:SSNLF), who account for roughly half of the total capital spending in the industry, have indicated strong capital investment plans for the current year with the aim of enhancing their technological capabilities. All of the above companies have been the top three customers for Applied for many years, and we do not foresee any reason for the trend to change.
Higher memory spend and the adoption of new technologies such as 3D NAND and FinFET (3D) transistors will help fuel growth in the semiconductor equipment market. Applied derives around 58% of its valuation from the SSG segment alone and an additional 33% is attributable to the Service business, which is largely focused on the semiconductor market, as well.
Growing Strength In The TV Market
With 282% annual and 31% sequential growth, the display business booked its highest orders last quarter, in over two years, as Applied saw rising panel fab investments in China. Growing TV sales and larger average TV sizes are increasing significantly faster than historical trends and are driving demand for display equipment. Technological advances contribute as well as the industry delivers screens with sharper images. Applied estimates an average increase of two inches in TV sizes in 2013, in comparison to the average annual increase of 0.5 inch in a year. For one inch of growth, one new Gen 8.5 factory is needed to fulfill the incremental area of demand. 
Applied has invested in a new panel fab in China and has secured 100% of the CVD and PVD (Physical and Chemical Vapor Deposition) business for the new factory. It already has a strong foothold in the CVD market and expects its market share in display PVD to increase by about 25% this year. In its last earnings call, it mentioned that the rising demand for high-resolution mobile displays expanded the opportunity for its CVD and PVD equipment in the market by more than 30%.
Additionally, the introduction of 4K ultra-high definition and OLED is driving demand for more complex and capital extensive manufacturing processes, as we noted above. The company aims to grow its display business revenue to $1 billion or more in the future.
Merger With Tokyo Electron To Help Form A Stronger Entity
Applied Material announced it merger with Tokyo Electron on September 24. Both companies supply equipment used to manufacture semiconductors, flat-panel displays and solar photovoltaic products. With the aim of forming a global innovator in semiconductor and display manufacturing technology, the two companies will create a combined entity with an estimated value of $29 billion.
The deal has been unanimously approved by the boards of both companies and is subject to customary conditions, including approval by shareholders and review by regulators. It is expected to close in the second half of 2014. After the close, Applied Materials & Tokyo Electron shareholders will own approximately 68% and 32% of the new company, respectively.
With an estimated combined WFE market share of 34%, Applied believes that its merger with Tokyo Electron will help form a stronger entity.Though both companies are among the largest in the industry, they have little overlap in their product offerings. Applied will also benefit from a broader product portfolio, shared R&D costs and lower cost of developing chips. (Read: Applied & Tokyo Electron Plan Merger To Form A Stronger Entity)Notes:
- Intel, TSMC And Samsung Are Driving Semiconductor Capital Spending In 2013, Seeking Alpha, May 20, 2013 [↩]
- Applied Material’s Management Presents at Citi Global Technology Conference – (Transcript), Seeking Alpha, September 4, 2013 [↩]
- Applied Materials’ CEO Discusses F3Q 2013 Results – Earnings Call Transcript, Seeking Alpha, August 15, 2013 [↩]