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Morningstar | Solid Quarterly Results Once Again Overshadowed by Soft Guidance for Applied Materials

Consistent with expectations, Applied Materials reported strong third-quarter results, led by year-over-year growth across all major segments. Nevertheless, a near-term slowdown in equipment spending led to lower guidance than expected, an issue that also plagued peer Lam Research. Specifically, the push-out in equipment purchases in NAND and foundry segments led to the shortfall. Management had previously forecast a bounceback in semiconductor system sales in the fiscal fourth quarter, but it backtracked on this projection and now foresees a 4% sequential decline. Consequently, shares fell nearly 5% during after-hours trading and are trading at a modest discount to our unchanged fair value estimate of $49. While we think wide-moat Applied Materials remains well positioned going forward, we recommend prospective investors wait for a wider margin of safety before committing capital to this equipment leader.

Fiscal third-quarter sales were $4.47 billion, up 19% year over year but down 2% sequentially. Semiconductor system sales rose 8.5% over the same period last year, with higher DRAM and logic sales offsetting a decline in NAND and foundry spending. DRAM spending has been bolstered by strong demand from cloud vendors. Sequentially, however, memory equipment fell 19%. Following a record fiscal 2017, NAND sales are poised to be lower in the second half of Applied Materials' fiscal 2018 relative to the first half. Services revenue grew 21% year over year to $954 million, as the firm's installed base of more than 40,000 systems drives sales of upgrades, refurbishments, and service contracts. We think this part of the business (21% of total revenue during the quarter) is very sticky and should help mitigate the cyclical tendencies of equipment sales. Display sales rose 81% year over year to a record $741 million, primarily driven by OLED display investments. Gross margins were 45.4%, down 40 basis points sequentially due to modestly lower equipment volume.

Management expects fourth-quarter sales to be at a midpoint of $4.0 billion. This would represent a 10% sequential decline. Investors should be cognizant of likely growth deceleration in wafer fabrication equipment, or WFE, spending beyond 2018, as recent positive trends such as the shift from planar to 3D NAND begin to slowdown. Although we forecast a modest decline in WFE levels in 2019, we think management's prediction of combined 2018 and 2019 WFE spending above $100 billion is still likely. Any near-term weakness in shares of Applied and its peers Lam and KLA-Tencor creates an attractive entry point, in our view.