Applied Materials, Inc. (NASDAQ:AMAT) Wells Fargo 6th Annual TMT Summit Conference November 30, 2022 12:20 PM ET
Company Participants
Brice Hill – CFO
Conference Call Participants
Joe Quatrochi – Wells Fargo
Joe Quatrochi
Great. So we’ll go ahead and started. I’m Joe Quatrochi, the semi cap equipment analyst here at Wells Fargo. Excited to have Brice Hill, CFO of Applied Materials with us for this fireside chat. Brice, thanks for joining us.
Brice Hill
Awesome. Thanks for inviting me, and glad to be here.
Question-and-Answer Session
Q – Joe Quatrochi
Great. So maybe to start, since you just recently joined the company. I’m kind of curious, I always like to get kind of your thoughts in terms of what do you think kind of coming to the company recently investors are maybe missing or underappreciating from the Applied Materials’ story? And then as you look out over the next maybe three to five years, what do you think are maybe the biggest opportunities for Applied that maybe people don’t fully appreciate?
Brice Hill
Okay. What I like the best, when I was looking at Applied myself and thinking about joining the company, first of all, financial model. I think, super efficient financial model, which most of the people here probably know. The company is more than doubled over the last six years, efficient from a CapEx perspective, good from a spending perspective, approximately 16% of revenue, good gross margins and doubling the business over that period of time with efficient CapEx. I just thought it’s a great business model, it’s in a secular growth area. Obviously, semiconductors, leading edge semiconductors especially and good management team very effective. I thought those things were super attractive. The second thing is that appealed to me a lot was the broad portfolio and the ability to integrate the equipment and provide solutions that other companies can’t provide in the space. So not everybody may know this or see this. But the company has the ability to put together, in a combined system, different processing elements, which allows it to invent different solutions, work within a vacuum environment, one vacuum environment, several different process steps. And that allows the company to build unique solutions, solve unique problems for customers on the leading edge. So I thought that broad portfolio and ability to integrate is really unique for the company in a strategic advantage that maybe people don’t fully know about.
And then the last thing is the depth of customer relationships. You have to work closely with the customers to understand their roadmap and what the challenges are in building a next generation process technology and then get signed up to do the work to invent something that will solve the problems for a new transistor or a new processing element. So I think it’s those things, Joe. The efficiency of the financial model, the depth of working closely with customers and then just the integrated solution capability for the company. And then what’s most exciting? We are thinking about a trillion dollar semiconductor industry by the end of this decade. And what’s most exciting for this company is just delivering those solutions. We are full of engineers, inventors, manufacturers. We want to build that roadmap and provide those capabilities for human productivity. I mean, the things that we know compute drives. So that’s super exciting for all the people inside the company.
Joe Quatrochi
That’s perfect. And maybe we’ll talk a little bit about — obviously, I think most discussions you have been having recently all about outlook looking into next year. The company recently reported earnings, and maybe just kind of frame the discussion of how you are thinking about wafer fab equipment spending in the next year? It’s clearly, the memory is weak. But how do you think about kind of the holistic demand in the next year and then you also have a pretty significant backlog as well?
Brice Hill
Yes. So we’ve been careful not to give a guide on the full year. And we have seen, just like you suggested, two quarters ago, we went through and just completely scrubbed our entire ’23 backlog, and we were basically asking customers if you don’t need the tool, let us know and we’ll ship it to a different customer because we were constrained. So we feel like we did a good job cleaning up the backlog. Then this quarter, again, we did have a significant number of cancellations and pushouts and a number of them in the memory space. So we do see a weaker environment. Now the issue was that we had demand above our ability to supply when we started those exercises, and that’s the situation we find ourselves in today right now. We are still trying to increase output to catch up to customer orders. And this is very specifically associated with several of our different product lines where we’re two or more quarters behind. And so the reason why we hesitated on guiding the year is just because we have mixed signals. We see some orders pushing, we see some orders canceling. Yet, if you saw our backlog, we have $19 billion backlog, we had strong orders in Q4. We know we’re behind on a few of our different equipment lines, and we’re trying to catch up. So it’s just mixed signals at this point where the year is going to go. And job one for us is just to increase output in Q1 and start catching up on that pent-up demand. And so if it is lower, then I guess we would cross our fingers and hope that by the time we catch up that it — the market begins to improve again. But we’ll have to see. So those are the drivers and the reason.
Joe Quatrochi
And so maybe, you talked about memory being weak. I mean what is the maybe bigger unknown of ’23 in terms of like the end markets? Is it memory being more weak than anticipated today, or is it the foundry logic piece maybe starts to slow somewhat whether it’s leading or trailing?
Brice Hill
I think I’d probably point in a different direction. I’d probably say still — you and I were talking about China before we started this. It’s probably really all the dynamics of the China market. The trade rules — we highlighted we have $2.5 billion impact from the trade rules unmitigated. We will, of course, work on confirming customers that we can ship to and clearing some of the customers with respect to those trade rules. Other customers might change plans. So there’s a lot of uncertainty there. And then the China market itself, that’s been a large market for Applied. It’s been as high as 33% of our revenue, it was 20% in the last quarter. The China market itself is a very important market. It’s been growing in our mature technologies, what we call the ICAP space. It’s been growing significantly. And so I think really, it relates back to how is China going to evolve as the largest economy, evolve with the trade restrictions that have been put in place, and will it keep investing at the same pace on the trailing edge technologies or the more mature technologies. I think those are probably as big a questions at least relative to the other dynamics. Because just one more thing, when we think about ’23 or ’24, what we’re really thinking about is over five years, it grows to a trillion dollar industry. So we agree. It’s hard to call ’23, it’s hard to call ’24 when we’re making our decisions to hire engineers, hire manufacturing people, hire technologists, it’s the roadmap that we’re building for ’25, ’26, ’27, ’28. And so you have to make those decisions with that context in mind.
Joe Quatrochi
That’s helpful. And I guess the thing I didn’t maybe hear you say is leading edge sounds like demand there is still healthy.
Brice Hill
We do think of all the components, because leading edge is typically tied to end customer devices that are being developed, it’s probably the most sticky of all the different segments of the business that you’re highlighting. And we do think there’s strength there.
Joe Quatrochi
That’s helpful. Kind of going back to — you’re talking about the backlog, I think you’ve talked about like two to four quarter’s time to catch up. Maybe help us understand like what that entails. And I guess in that expectation, are you assuming that you said orders were good in the October quarter, you’re assuming that, that resiliency in orders continues, I guess, over that time period as well?
Brice Hill
Well, it’s a good question. First of all, orders are cancelable. So it’s not a guarantee of business for that period of time. Now $19 billion is our largest backlog ever. So what it does, the reason we share that is it tells us that there was a significant amount of bookings in Q4. So we did a lot of business in Q4 with the revenue that we announced, but we even booked more business. And so that tells you that even though there’s weakness in the environment, we still have orders coming in, that’s why we shared that. And what gives us confidence on durability of that, that’s more than — that’s just by math, if you look at our semi business, that’s more than two quarters worth of business. Although it’s not booked that way, it’s booked some in Q1, some in Q2, some in Q3, some in Q4, et cetera, on a declining curve. But one of the reasons we have confidence in the — at least the near term future is because several of our product lines are definitely behind the customers are asking us every day to increase output, and we’re still working on increasing output. And so we may not be getting a clear signal. We’ll see how that evolves once we catch up. But for now, the job is to just increase output.
Joe Quatrochi
In the past, I think one of the kind of metrics that we’ve always looked at is etch and depth tools kind of trail maybe the litho tool into the fab of when you’re kind of populating that line, right? And clearly, ASML is very positive still in ’23. I guess, how do you think about that relationship? Their backlogs obviously, they’re very extended and lead times are well over 12 months for all of their products. How do you look at that as — or do you look at that as kind of this leading indicator of how to plan your business and follow those tools into the fab?
Brice Hill
Yes. I think we don’t look at it directly as a leading indicator. In other words, we don’t do any math with their disclosures and say that implies something specific for me for us. We do think it’s just more indicative of the mixed signals in the market. And it could be like some of our product lines that they have pent-up demand, and they’re trying to catch up. But let’s start at the top for a second. The basic question, if litho tools are shipping, then it should mean that the rest of the industry is shipping equipment also. You’re not — you require a complete tool set, nobody is going to stockpile that equipment because it’s too expensive. So in general, it should be an indicator that there will be corresponding investment across the industry. What I don’t know and maybe what we don’t know in total is, are they still trying to catch up? In other words, are there blank spots and factories waiting for a litho tool, just like there maybe blank spots in factory waiting for some of our tools. So really, it’s a catch up versus an indicator of future investment that’s being made. That’s something for the investment community maybe to study a little bit. But in general, they should go together.
Joe Quatrochi
Helpful. Maybe longer term, taking a step back, and you talked about trillion dollar semiconductor market. I think in the past, you’ve talked about tracking the number of fab projects. I mean how is that grown over the last, say, six months or a year in terms of thinking about those opportunities over the next several years?
Brice Hill
It seems like — so I know last quarter, we said it was 85 factory projects that we are tracking, and it seems like it was in the 60s at the beginning of the year. And we didn’t give a number this last — just in our earnings a few weeks ago, although it did grow again. And part of the reason we didn’t give the number is, some of the newly announced projects are — they were announced as later in the decade. So the prior list we had, we had some confidence that most of those projects will be completed over a three year period of time, which would mean you’d have to buy the equipment. So now the number — so the number grew. It does give us confidence that the investment — the secular investment in semiconductors and semiconductor capacity continues. So we look at it, though, as one indicator. And again, we tried to highlight there’s mixed indicators. There’s more projects, there’s good bookings in the quarter, and there were also some things moving backwards. So it’s a difficult environment to sort out.
Joe Quatrochi
Okay. Maybe shifting gears a little bit. You kind of mentioned the impact of China and the export restrictions and working through that. Maybe just kind of level set in terms of when we think about the mitigation — full mitigation impact that you can kind of lessen the impact of the restrictions, what does that path look like? And like what are the kind of — how do you think about what that looks like from a, I guess, timing perspective and just the process that you have to work through or your customers have to work to get there?
Brice Hill
Let me start at a super macro level and say, we don’t think that trade restrictions over a longer period of time will cause any change in the trajectory of semiconductor equipment. In other words, it will be — we expected the tools that have been sold into China to be completely utilized. We think eventually, they will be completely utilized. There’s some friction there in ’23, while everybody figures that out. So we don’t think that either companies will buy extra tools because those will be idle, and we also don’t think that all of a sudden, there’ll be used equipment on the market that will dampen demand, because you’ll have to replace whatever the original intent was for those tools. So at a macro level, thinking multi years, it’s a friction, but it’s not going to change the equipment forecast, if you will. Now stepping into our year specifically, in October, we picked a day, and we looked at all of the orders we expected from the affected customers and the affected customer properties. And that was the $2.5 billion worth of business in ’23 that we highlighted. And being very specific on how to mitigate that, we said the two ways to mitigate that would be if we can prove that a customer or a customer factory should not be restricted. So maybe somebody thought they were 14-nanometer, and instead they’re 28. And so we can get the clearance to ship to that factory, then that’s a mitigation. The other is we did hear that some customers may actually change their plans. So for example, if they were going to run 14-nanometer, maybe they change it to a 28-nanometer line and then they get the ability to receive equipment and grow from there.
So those were the ways that we specifically meant we would mitigate. And I say that because $2.5 billion, maybe we can get some customer — approval to ship to some of those customers and mitigate it. There’s another way to mitigate the effect overall. If we’re constrained all year long, we’ll just ship that equipment to somebody else. And so we wouldn’t be impacted on the top line, we didn’t count that in that mitigation math. And partly, we don’t know if we’ll be constrained all year long. So anyway, those two instances are what we were communicating. The other thing I’ll say is there’s 100 basis points of gross margin headwind that came with the reduction of these customers. So just for the investors, you saw our gross margins go down in Q4. You see our guidance in Q1 is lower than we were hoping for. And that’s because the restricted Chinese customers and factories were generally smaller customers, and they had better margins for Applied. And so if we can find a similar business, then we’ll be able to mitigate that. But otherwise, it’s a headwind for us on the margin side, which just goes back to show that China has been an important market for Applied. It will continue to be an important market, especially on all of the mature technologies and in the growing ICAPS part of the market, especially sensors and power, automotive, those areas, they’ve been investing heavily, and it’s a really good market.
Joe Quatrochi
Helpful. Maybe just to kind of follow up on China, and we’ll get the gross margin in a second. But if we take a step back and you kind of look at particularly the Chinese memory customers, their capital intensity relative to the industry is probably definitely higher and then trying to kind of get over that R&D curve and catch up on a technology standpoint. So how do you think about that maybe from a just thinking about the growth rate of WFE over the next, say, five years, does that change the way that you think about it? Because at that level of capital intensity for their competitors or the more mature guys is definitely lower, right?
Brice Hill
It’s a good question. I think there’s frictions with start-up, there’s frictions with the learning curve, but we don’t see those as a significant lasting effect. It’s not something that we’re factoring in. When we triangulate our equipment shipment expectations, we triangulate it against the semiconductor market itself. We call that capital intensity and there are different drivers of that capital intensity. That’s not one that we’ve called out as significant sort of that maturity curve. The most — there’s two — just to head in that direction for a second. The reason capital equipment has been growing so fast and growing faster than the semiconductor space is because the complexity on the leading edge is growing, it causes more equipment to be added and new types of solutions. And then the second driver, which is unique is in those mature technologies, after the transition from 200 to 300-millimeter wafers, there was a whole bunch of 200-millimeter factory and equipment that was available in the market that could be reused. So company’s CapEx investments for mature technologies were much lower in the past. Now you see companies are actually having to build a new plant and buy new equipment. And so the intensity in the more mature nodes has gone up to approach the leading edge logic type of intensity. So when you do that across the whole ecosystem, intensity levels are rising.
Joe Quatrochi
That’s interesting. I mean on that kind of used tool market, how do you see that changing over the next year or so? Should we be watching kind of what’s happening in memory is potentially being a source of used tools entering the market? I guess, how do you think about that?
Brice Hill
It could be, but we don’t think it’s a headwind. And the reason is if you took some memory equipment and you said, okay, the customer can’t build the memory any longer, they’re going to shift it — resell it and shift it to a logic use, let’s say. Then our expectation is that memory production capacity has to be backfilled by somebody and maybe somewhere else in the world, but it has to be backfilled because we didn’t expect any of that to be idle or underutilized. And so for us, it’s a friction for ’23. But over time, we expect — we don’t expect any pockets of headwinds or tailwinds as far as that goes from that event.
Joe Quatrochi
Okay, that’s helpful. Maybe shifting gears a little bit on the gross margin side. You’re obviously trying to produce as many tools as you possibly can right now just given that you’re kind of behind on demand. As that shifts at some point, potentially next year, how do you think about the kind of I guess, dynamics for gross margin from that perspective of you’re running your factories at high utilization rates, how do you think about that from a gross margin perspective?
Brice Hill
Yes, it’s interesting. So first of all, just a direct answer. We looked back at 2019, our semiconductor business in 2019 contracted 15%. And when it did, I think the gross margins fell 200 basis points. So we look at that as a proxy, what would happen if that environment materialized. The other thing I would say is we have opportunities to be much more efficient with our own factories when we normalize the supply chain environment. So what’s been happening is we build tools all quarter, and then as we — so we have 90% completed tools waiting on the floor for parts to come in the door. And then once they come in the door, we rush at the end of the quarter to complete as many as we can and ship them to customers. That’s not a highly efficient production model. So we think there’s much efficiencies that can come if we can normalize the supply chain as we catch up.
On the gross margin topic in general, just to highlight to everybody, so we did have this 100 basis point headwind because of the China customers that were removed. We are very focused on improving gross margins. We’re committed to our longer term model of 48.5%. It’s just going to take us longer to get there. We are staffing cost reduction projects. One good thing that happened in this environment was in the past, customers were very reluctant to allow any changes to equipment. The factories are very sensitive environment. You don’t want to change your equipment structures. Now they’re more willing to accept sort of nonfunctional changes. If you change things on a tool that don’t really matter to the processing of the wafer they’re willing to accept those. And what that’s allowing us to do is staff reengineering projects that will get us to more available lower cost components over time, which will help us fight the inflation curve that we’ve run into. And the second thing is pricing. To the extent that we can’t fully address the inflation with cost reductions, then we’re making some changes to pricing that will help us move back to the margin range that we think is the right target range for the company.
Joe Quatrochi
That’s helpful. And then in terms of — I mean, you talked about kind of redesigning. Does that — should we think about that as you adding additional sources of supply and that you maybe have a little bit more nimbleness in terms of those components? And then I think your competitor has kind of done the same thing. So have you seen like a change in maybe the competition to get components because a lot of those components are maybe very similar or almost the same component?
Brice Hill
Yes. So on the first part of that question, I think are we changing components to more available components? Absolutely. When you look at — when you break down a piece of equipment and you look at the bill of materials, the first thing that we’ll look at is where are their supply constraints, are there more commercially available components that we could reengineer that provide the same utility? And that’s absolutely something that’s being attacked. So I think it actually addresses the question — the second part of the challenge, the whole industry has faced constraints and a lot of it is in areas that are not — they’re not functional components. There are things wiring and wiring harnesses and metal structures and these sorts of things, so they’re not IP, if you will. They’re not fundamental to the intellectual property of the company. But those have been where the constraints are in a lot of cases. So if you can reengineer it to make it more commercially available and more cost effective then that’s something that we’re tackling.
Joe Quatrochi
Perfect. Maybe shift gears a little bit. Let’s talk about the services business. That’s a business that I think people are definitely really focused on right now, just given kind of expectations of a slowing in equipment demand and that being a place of stability. I guess, how do you think about the breakdown of that business and think about the stability that can provide? Because obviously, we’ve seen utilization rates declining on the memory side but then also foundry, those have been — the foundries have been running at pretty much 100% utilization. Those are also going to decline as well. Is that — how do you think about that dynamic, maybe even relative to kind of in the past, I think you talked about the last cycle — memory cycle when utilizations declined, that business was still relatively stable. Is this a different situation given that foundries also maybe somewhat declining in terms of utilization rates?
Brice Hill
Great question. So I think, first of all, maybe that’s — this is something I could have pointed out as an area where investors — it’s also an area I had to learn a lot about whether it’s — everybody understands the component. Our services business is a $5.5 billion business. It’s been growing at low double digits for the company. And it does work on a different driver than the rest of the business, to what you’re alluding to. The core business, the semi business, it goes back to equipment demand from the foundries and other IDMs, right, and memory producers. And that has some cyclicality to it. This business, every tool we ship, grows the installed base of tools and gives us an opportunity to sell spares and services, every single tool. So even in a year, if the market — if it was catastrophic and the market fell in half, and was only a $50 billion WFE market, even in that year, we’re adding tools in the field, and we’ll be able to sell services to those tools. So we should see our services business grow. Now when you break down that business, about 15% of our services business is 200-millimeter equipment. So take that off the top, the rest is spares and services and about 60% of that is under contract — under service agreements.
So we expect the services part of that business to continue to grow and the spares, and then we look back at that year in 2019, I don’t actually know what utilization fell to. But in 2019, when the semi business was down 15%, the services business still grew. So there’s a proof point for us, and that’s we expect. Every day, there should be more installed tools in the field, we’ll be able to ship services. The new ones that we’re shipping out are usually more complex in terms of the actual tool itself. And Applied is also selling knowledge to the customers in the form of services. So because we understand thousands of machines in the field, we can collect data on the performance of those machines and help customers match the performance that they need to get yield out of each of those machines. And so that becomes a very valuable performance. Our CEO talks about power, performance, area, cost, those are all design characteristics that circuit designers are looking at. And then time is another element. And what he means by time is when you put new equipment in a factory or even change the spares in the equipment, getting that tool up to a high yield level so that you’re producing good product is a challenge, and that’s one of the things that our services arm helps with. So thanks for pointing that out. It’s a different driver that drives that business, and we think it gives us some resilience to the WFE market.
Joe Quatrochi
That’s helpful. And then I think even to kind of double clicking on a little bit this pure services piece, right, there’s a spare parts part, but the pure services. A lot of people talk about capital intensity in terms of equipment for your customers. But how do you think about like the service intensity? Do you see that growing at a similar rate as capital intensity?
Brice Hill
We do. And it really goes back to this — both the complexity of the machines themselves, which make it more likely that a customer will require service and also more likely that they’ll want the intelligence that we’re offering in terms of tuning that equipment. So both of those things go together. The other thing is that some of the companies that are now putting factories in different locations in the world, they don’t have the same workforce available in those locations, so they’re also more likely to contract with us for our services for those new facilities.
Joe Quatrochi
Yes, that’s perfect. I mean, that was kind of my next question of, the CHIPS Act obviously got a lot of focus and room on WFE perspective, but I think it’s a potential kind of tailwind from the services perspective as well. I guess the other piece of it is, how do you think about the hiring aspect of engineers to be able to go after that opportunity?
Brice Hill
Well, so it’s a strategic focus for the company. One of the issues for semiconductors, the world has so many fab projects being constructed. And we’re talking about continuing to grow the number of fabs and semis produced that hiring and training qualified workers is a strategic advantage if you can do it. And so we have a great training program and that’s one of our focus areas for the company is being able to add people globally and make them effective in the field as quickly as possible.
Joe Quatrochi
Perfect. So I think we’re out of time, so we’ll leave it there. Thank you.
Brice Hill
All right. Thank you very much. Thank you.
Be the first to comment