Applied Materials's (NASDAQ:AMAT) Q1 Sales Top Estimates, Next Quarter Growth Looks Optimistic

Maker of machinery employed in semiconductor manufacturing, Applied Materials (NASDAQ:AMAT) reported Q1 FY2023 results that beat analyst expectations, with revenue up 7.46% year on year to $6.74 billion. Guidance for next quarter's revenue was $6.4 billion at the midpoint, which is 1.13% above the analyst consensus. Applied Materials made a GAAP profit of $1.72 billion, down on its profit of $1.79 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.

Its primary peers and competitors are ASML (NASDAQ:ASML), Lam Research (NASDAQ:LCRX), KLA Corp (NASDAQ: KLAC), and Tokyo Electron (TSE:8035).

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 strong, averaging 21.1% annually. But as you can see below, last year has not been especially strong, with quarterly revenue growing from $6.27 billion to $6.74 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).

While Applied Materials beat analysts' revenue estimates, this was a very slow quarter with just 7.46% revenue growth. This marks 13 straight quarters of revenue growth, which means the current upcycle has had a good run, as a typical upcycle tends to be 8-10 quarters.

Applied Materials' appears to be headed for a downturn. While the company is guiding to growth of 2.48% YoY next quarter, analyst consensus sees 12.7% declines over the next twelve months.

Product Demand & Outstanding Inventory

Days Inventory Outstanding (DIO) are an important metric for chipmakers, as it reflects the capital intensity of the business 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 inventory days came in at 153, 11 days above the five year average, suggesting that that inventory has grown to higher levels than what we used to see in the past.

Pricing Power

Applied Materials's gross profit margin, how much the company gets to keep after paying the costs of manufacturing its products, came in at 46.7% in Q1, down 0.5 percentage points year on year.

Despite declining over the past year, Applied Materials still retains industry average gross margins, averaging 46.4%, pointing to a good competitive offering, decent cost controls, and only modest pricing pressure.

Profitability

Applied Materials reported an operating margin of 0.12% in Q1, down 31.5 percentage points year on year. Operating margins are one of the best measures of profitability, telling us how much the company gets to keep after paying the costs of manufacturing the product, selling and marketing it and most importantly, keeping products relevant through research and development spending.

Operating margins have been trending down over the last year, averaging 22.6%. However, Applied Materials's margins remain one of the strongest in the industry, driven by its solid gross margins and economies of scale generated from its highly efficient operating model.

Earnings, Cash & Competitive Moat

Wall St analysts are expecting earnings per share to decline 23.7% over the next twelve months, although estimates are likely to change post earnings.

Earnings are important, but we believe cash is king as you cannot pay bills with accounting profits. Applied Materials's free cash flow came in at $1.98 billion in Q1, down 21.1% year on year.

Applied Materials has generated $4.08 billion in free cash flow over the last twelve months, translating to 15.5% of revenues. This is a strong result; Applied Materials's free cash flow conversion was higher than most semiconductor companies, in the last year. If it maintains this level of cash generation, it will be able to invest plenty in new products, and ride out any cyclical downturn more easily.

Applied Materials’s average return on invested capital (ROIC) over the last 5 years of 45.4% implies it has a strong competitive position and is able to invest in profitable growth over the long term.

Key Takeaways from Applied Materials's Q1 Results

Sporting a market capitalization of $101 billion, more than $4.05 billion in cash and with positive free cash flow over the last twelve months, we're confident that Applied Materials has the resources it needs to pursue a high growth business strategy.

We liked to see that Applied Materials beat analysts’ earnings expectations pretty strongly this quarter. And we were also glad that the revenue guidance for the next quarter exceeded analysts' expectations. On the other hand, it was less good to see the deterioration in operating margin. Overall, it seems to us that this was still a decent quarter for Applied Materials. The company is up 2.73% on the results and currently trades at $118.5 per share.

Is Now The Time?

Applied Materials may have had a bad quarter, but investors should also consider its valuation and business qualities, when assessing the investment opportunity. Although Applied Materials is not 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.

Applied Materials's price to earnings ratio based on the next twelve months is 19.4x. We don't really see a big opportunity in the stock at the moment, but in the end beauty is in the eye of the beholder. And if you like the company, it seems that Applied Materials doesn't trade at a completely unreasonable price point.

To get the best start with StockStory check out our most recent Stock picks, and then sign up to our earnings alerts by adding companies to your watchlist here. We typically have the quarterly earnings results analyzed within seconds from the data being released, and especially for the companies reporting pre-market, this often gives investors the chance to react to the results before the market has fully absorbed the information.