Applied Materials (NASDAQ:AMAT) Beats Expectations in Strong Q3, Provides Optimistic Guidance For Next Quarter

Maker of machinery employed in semiconductor manufacturing, Applied Materials (NASDAQ:AMAT) reported Q3 FY2023 results exceeding Wall Street analysts' expectations, with revenue down 1.46% year on year to $6.43 billion. On top of that, next quarter's revenue guidance ($6.51 billion at the midpoint) was surprisingly good and 10.9% above what analysts were expecting. Applied Materials made a GAAP profit of $1.56 billion, down from its profit of $1.61 billion in the same quarter last year.

Founded in 1967 as the first company that built the tools for other companies to use to make semiconductors, Applied Materials (NASDAQ:AMAT) is the largest provider of semiconductor wafer fabrication equipment.

Applied Materials is the only semiconductor manufacturing (capital) equipment maker who provides tools used in each of the processes used to create semiconductors. Roughly half its systems’ revenues come from deposition technologies, with another 30% from cleaning or removal systems.

Applied Materials counts among its customers the biggest chip makers in the world: TSMC, Intel, Samsung, and Micron, although it tilts more towards foundry and logic chip makers than memory producers.

Semiconductor Manufacturing

The semiconductor capital (manufacturing) equipment group has become highly concentrated over the past decade. Suppliers have consolidated, and the increasing cost of innovation have made it unaffordable to almost everybody, except the largest companies, to produce leading edge chips. The result of the increased industry concentration has been higher operating margins and free cash generation through the cycle. Despite this structural improvement, the businesses can still be quite volatile, as demand fluctuations for the semiconductor equipment are magnified by the already cyclical nature of underlying semiconductor demand. Read More Chip manufacturing is done in "batches" on a single round silicon disk, known as a "wafer". Multiple chips can be fabricated on a single wafer, which itself can cost over $10,000 today for the more advanced nodes. The actual chip fabrication process requires hundreds to thousands of steps that are executed at an atomic scale. From start to finish, including fabrication, testing and packaging, it can take 3 months to make a chip. The process to create a silicon wafer starts with sand, which is melted to extract silicon, then purified and formed into a cylinder, which is then sliced down into discs about 1mm thick that are then polished into wafers. Next, the wafers go to a semiconductor foundry and go through a process where successive layers of insulating, conducting, and semiconducting materials are stacked on top of one another to form many small complex interconnected 3D structures (wires, insulators, etc), with each layer consisting of 15-20 processes such as deposition, lithography, etching, stripping, testing, and cleaning.

Sales Growth

Applied Materials's revenue growth over the last three years has been solid, averaging 18.5% annually. But as you can see below, its revenue declined from $6.52 billion in the same quarter last year to $6.43 billion. Semiconductors are a cyclical industry, and long-term investors should be prepared for periods of high growth followed by periods of revenue contractions (which can sometimes offer opportune times to buy).

Even though Applied Materials surpassed analysts' revenue estimates, this was a slow quarter for the company as its revenue dropped 1.46% year on year.

Applied Materials's revenue inverted from positive to negative growth this quarter, which was unfortunate to see. Looking ahead to the next quarter, the company's management team forecasts a 3.54% year-on-year revenue decline. Analysts seem to agree that the poor performance will continue, as their average revenue growth estimates for the next 12 months are negative 11.1%.

Product Demand & Outstanding Inventory

Days Inventory Outstanding (DIO) is an important metric for chipmakers, as it reflects a business' capital intensity and the cyclical nature of semiconductor supply and demand. In a tight supply environment, inventories tend to be stable, allowing chipmakers to exert pricing power. Steadily increasing DIO can be a warning sign that demand is weak, and if inventories continue to rise, the company may have to downsize production.

This quarter, Applied Materials's DIO came in at 153, which is 9 days above its five-year average, suggesting that the company's inventory levels are higher than what we've seen in the past.

Pricing Power

In the semiconductor industry, a company's gross profit margin is a critical metric to track because it sheds light on its pricing power, complexity of products, and ability to procure raw materials, equipment, and labor. Applied Materials's gross profit margin, which shows how much money the company gets to keep after paying key materials, input, and manufacturing costs, came in at 46.3% in Q3, up 0.2 percentage points year on year.

Applied Materials's gross margins have been trending down over the last 12 months, averaging 46.4%. This weakness isn't great as Applied Materials's margins are already slightly below the industry average and falling margins point to potentially deteriorating pricing power.

Profitability

Applied Materials reported an operating margin of 28.3% in Q3, down 1.7 percentage points year on year. Operating margins are one of the best measures of profitability because they tell us how much money a company takes home after manufacturing its products, marketing and selling them, and, importantly, keeping them relevant through research and development.

Applied Materials's operating margins have been trending down over the last year, averaging 29.2%. The company's profitability is in line with the broader semiconductor industry and it's working to appropriately manage its operating expenses.

Earnings, Cash & Competitive Moat

Wall Street expects earnings per share to decline 19.7% over the next 12 months, although estimates will likely change after earnings.

Although earnings are important, we believe cash is king because you can't use accounting profits to pay the bills. Applied Materials's free cash flow came in at $2.33 billion in Q3, up 84.9% year on year.

As you can see above, Applied Materials produced $6.98 billion in free cash flow over the last 12 months, an eye-popping 26.4% of revenue. This is a great result; Applied Materials's free cash flow conversion places it among the best semiconductor companies and, if sustainable, puts the company in an advantageous position to invest in new products while remaining resilient during industry downturns.

Applied Materials's average return on invested capital (ROIC) of 44.5% over the last five years implies that it has a strong competitive position and was able to invest in profitable growth over time.

Key Takeaways from Applied Materials's Q3 Results

Sporting a market capitalization of $116 billion, more than $6.54 billion in cash on hand, and positive free cash flow over the last 12 months, we believe that Applied Materials is attractively positioned to invest in growth.

We were impressed by how significantly Applied Materials blew past analysts' revenue and EPS expectations this quarter, driven by outperformance in its semiconductor systems and display segments. We were also glad that next quarter's revenue and EPS guidance came in higher than Wall Street's estimates. Overall, we think this was a strong quarter that should satisfy shareholders. The stock is up 3.45% after reporting and currently trades at $142.14 per share.

Is Now The Time?

When considering an investment in Applied Materials, investors should take into account its valuation and business qualities as well as what's happened in the latest quarter. Although Applied Materials is't a bad business, it probably wouldn't be one of our picks. Its revenue growth has been solid, though we don't expect it to maintain historical growth rates. But while its powerful free cash generation enables it to sustainably invest in growth initiatives while maintaining an ample cash cushion, unfortunately its gross margins are weaker than its semiconductor peers we look at.

Applied Materials's price-to-earnings ratio based on the next 12 months is 21.6x. In the end, beauty is in the eye of the beholder. While Applied Materials wouldn't be our first pick, if you like the business, the shares are trading at a pretty interesting price point right now.

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