Applied Materials Q4 2022 Earnings Call Transcript

Quartr
Provided by Quartr
November 17, 2022

There are 12 speakers on the call.

Operator

Good afternoon, everyone, and thank you for joining Applied's Q4 of fiscal 2022 earnings call. Joining me are Gary Dickerson, our President and CEO and Bryce Hill, our Chief Financial Officer. Before we begin, I'd like to remind you that today's call contains forward looking statements, which are subject to risks and uncertainties that could cause our actual results to differ. Information concerning the risks and uncertainties is contained in Applied's most recent Form 10 Q and 8 ks filings with the SEC. Today's call also includes non GAAP financial measures.

Operator

Reconciliations to GAAP measures are found in today's earnings press release and in our quarterly earnings materials, which are available on the IR page of our website at appliedmaterials.com. Before we begin, I have a calendar announcement. Applied plans to hold an e beam technology and new product webcast on Wednesday, December 14, at 9 am Pacific Time. Please stay tuned for an invitation to join our presenter, Keith Wells, who is Group Vice President and General Manager of our Imaging and Process Control Group. And with that introduction, I'd like to turn the call over to Gary Dickerson.

Speaker 1

Thank you, Mike. Applied Materials delivered a strong finish to our fiscal year with record quarterly performance. Throughout 2022, the company has demonstrated solid execution while navigating COVID related restrictions, supply chain shortages and a challenging geopolitical and macroeconomic environment. I would like to recognize the hard work and commitment our global team and our suppliers who are doing everything possible to meet our customers' needs. As this is our year end call, I'll begin my prepared remarks with a quick review of our performance and progress over the past 12 months.

Speaker 1

I'll then give our latest outlook for 2023 before describing our longer term growth thesis for the industry and Applied. After that, Bryce will provide more color on our financial performance and key areas of operational focus. Like many others in the technology Doctor, our performance and priorities in 2022 have been shaped by an unprecedented set of challenges. Our top priority has been mitigating supply chain constraints that prevented us from fully meeting customer demand. In Q4, we made incremental progress and we expect to continue closing supply gaps over the next few quarters, as well as finding creative short term solutions, our team has been addressing root causes and building a more resilient, scalable supply chain and stronger strategic relationships with our suppliers.

Speaker 1

In addition, we are strengthening our own manufacturing, logistics and supply chain management. While I'm pleased with the recent improvements in supply chain performance, We are still supply chain limited across a number of key product lines and our backlog grew in Q4. The biggest supply constraints are in our metal deposition business, where customer demand is very strong. This is our largest business unit and where we have highly differentiated solutions for advanced foundry logic and DRAM. The market for these products, which enable next generation wiring is expanding considerably.

Speaker 1

In addition to supply shortages, We're also navigating a difficult geopolitical environment as reflected in the new export control regulations enacted by the U. S. Government on October 7. These new rules are complex and cover a broad range of semiconductor technology that includes wafer fabrication equipment and Related Parts and Services. We have taken all the necessary actions to comply with these new rules, including suspending shipments and support where required.

Speaker 1

We estimate that the unmitigated impact to our fiscal 2023 revenues could be up to $2,500,000,000 We believe the actual impact can be reduced to $1,500,000,000 to $2,000,000,000 This will depend in part on how quickly the government provides licenses and approvals as well as how impacted companies refocus their investments. We are also mindful of the macroeconomic headwinds, including inflation and softening consumer demand. To offset the inflationary cost increases we are facing, we are driving multiple initiatives that include reengineering our products and implementing price adjustments. While it's too early to forecast 2023 with any precision, I can describe what we're currently seeing in the market and hearing from our customers. Starting with memory, spending is expected to be down year on year As weakness in consumer electronics and PCs prompt some customers to defer capacity additions.

Speaker 1

In leading edge foundrylogic, demand looks strong with customers racing for leadership and driving major technology inflections that determine their relative competitive positions. In iCAPS, chips for the IoT, communications, auto, power and sensor markets, Demand is mixed. Consumer driven markets are clearly softer, while the automotive, industrial and power markets remain robust. Those investments are underpinned by large inflections, including the transition to electric vehicles, accelerated adoption of industrial automation and growing demand for renewable energy solutions, especially in Europe. While all of this adds up to an expected pullback in overall wafer fab equipment of the company's business will be more resilient than the underlying market for three key reasons.

Speaker 1

First, we have a significant backlog, the highest in our history measured on both an absolute and percentage of revenue basis. 2nd, demand for some of our most differentiated product lines where we have uniquely enabling technology remains much higher Then our capacity to fulfill that demand. And third, our service business is positioned for steady growth With an increasingly large portion of this business being converted to subscriptions. Over the past 12 months, Our installed base of systems grew 8% and the number of tools under comprehensive long term service contracts grew 16%. The renewal rate for these agreements is well over 90%, which demonstrates the value customers see in our subscription services.

Speaker 1

Looking further ahead, our long term growth thesis for the industry and applied materials has not changed. Semiconductors are the foundation of digital transformation that will touch almost every sector of the economy over the coming years. This puts the semiconductor industry on a path to a $1,000,000,000,000 market by the end of the decade. And while every year will not be an up year, the overall trajectory is clear. We also like where Applied Materials plays within the ecosystem.

Speaker 1

As technology complexity is increasing, we expect equipment intensity to remain at today's levels or rise further. This means wafer fab equipment is likely to grow faster than the overall semiconductor market. Within equipment spending, major technology inflections are enabled by materials engineering shifting more dollars to Applied's available markets over time. We think about the industry's future roadmap in terms of power, performance, area cost and time to market. The PPAC T playbook has 5 pillars, new architectures, new 3 d structures, new materials, new ways to shrink and advanced packaging with each pillar made up of multiple technology inflections.

Speaker 1

For example, new three d structures like gate all around transistors and backside power distribution networks our materials engineering enabled inflections that grow Applied's total available market. As I referenced earlier, wiring is a key bottleneck for chip performance and power at Advanced Nodes. And this is driving significant innovation in new materials. Between the 7 nanometer and 3 nanometer node, contact metallization steps are growing more than 50% and our total available market is expanding almost 80%. For interconnect layers, process steps are being added even faster and we expect our revenue opportunity to approximately triple through these node transitions.

Speaker 1

Advanced Packaging represents a new era for integrated circuit design that opens major new vectors of innovation for chip designers. Advanced Packaging is also enabled by new materials engineering solutions. Although the industry is still in the early stages of adoption, We have already grown our packaging equipment business to nearly $1,000,000,000 Our process diagnostics and controls business also has broad exposure to these inflections and delivered significant growth in 2022. Our progress and opportunities in e beam will be the focus of our December technology briefing. Given our positive long term view of the semiconductor market, The outsized opportunities for Applied Materials within the market and favorable global government incentives, we are making investments in R and D and infrastructure to Industry growth and position the company for future success.

Speaker 1

We will provide more details about our specific plans in the coming months. At the same time, with the current macroeconomic conditions, we are carefully managing discretionary spending and limiting hiring to only strategic positions. Before I hand the call over to Bryce, I'll quickly summarize. Applied Materials ended the year strong with record performance. In the past quarter, we made incremental progress overcoming the supply challenges that have constrained our performance in fiscal 2022.

Speaker 1

However, there is still work to do and our backlog continues to grow. We expect 2023 to be a down year for wafer fab equipment spending, but we believe that Applied's business will be more resilient, thanks to our large backlog, growing service business and strong customer demand for our leadership products that enable key technology inflections. Longer term secular trends create opportunities for Applied to outgrow the semiconductor market by enabling the PPAC T roadmap with our differentiated portfolio of materials engineering solutions. We are making strategic investments for the future, while slowing spending growth in the near term. Now, I'll hand over to Bryce.

Speaker 2

Thank you, Gary. I'd like to start by thanking our team and our supply chain partners for helping to further increase our output for our customers. On today's call, I'll summarize our results for the fiscal year and Q4 as well as provide our guidance for Q1. I'll also discuss the impact of recent U. S.

Speaker 2

Export regulations on our revenue and gross margin. Before going into the results, I'd like to make 3 points. 1st, despite a weaker customer demand outlook, we generated strong orders in Q4 and ended the year with record backlog, particularly in some of our leadership product areas. Combined with the resiliency of our AGS business, The strong backlog puts us in a good position to offset some of the market weakness expected next year. 2nd, We have not changed our view of a $1,000,000,000,000 semiconductor market by 2,030 with a high single digit CAGR for semiconductors and similar or faster growth for equipment due to added process complexity.

Speaker 2

We grew our headcount and R and D spending While we are slowing our spending growth in the current environment, we remain committed to research and development and enabling critical inflections that support our customers' roadmaps. And third, we returned nearly $7,000,000,000 to shareholders this past year, including buybacks equivalent to 6% of shares outstanding at the beginning of the period, with record demand and financial results in 2022, a strong growth opportunity through 2,030 and our broad and unique portfolio of systems and services, we're confident in our financial position and our future. Next, I'll summarize our fiscal year results. Although supply chain constraints impacted our output all year, We delivered record annual revenue and EPS. On a year over year basis, revenue increased nearly 12% to $25,800,000,000 Non GAAP gross margin decreased by around 90 basis points to 46.6%.

Speaker 2

Non GAAP operating profit grew by over 7% to $7,860,000,000 Non GAAP operating margin decreased by 120 basis points to 30.5 percent and non GAAP EPS increased nearly 13% to $7.70 We generated about $5,400,000,000 in operating cash flow this past year and over $4,600,000,000 in free cash flow. We returned 100 and 51 percent of free cash flow to shareholders, including $873,000,000 in dividends and $6,100,000,000 in share repurchases. Our cash returns for the past 3 years were equivalent to over 100% of free cash flow. In the year, Demand for our products and services was very strong with record annual bookings in semi systems and AGS. On a year over year basis, our total ending backlog increased 62% to $19,000,000,000 Our semi systems backlog increased 90% to nearly $12,700,000,000 We expect to reduce our semi systems backlog as supply chain performance improves.

Speaker 2

Our AGS backlog increased 30 percent to over $5,600,000,000 The strong AGS backlog reflects a large increase in long term service agreements, gives us confidence in the continued growth of this business. Moving to our Q4 results, we delivered record quarterly net sales of nearly 6 $750,000,000 and record non GAAP EPS of $2.03 Non GAAP gross margin declined 20 basis points sequentially 46% and non GAAP OpEx grew 3.5% sequentially to nearly $1,100,000,000 with most of the increase in R and D. Turning to the segments, Semi Systems revenue grew more than 6% sequentially to $5,040,000,000 Segment non GAAP operating margin increased 80 basis points sequentially to 36.9%. AGS revenue was flat quarter over quarter at $1,420,000,000 Segment non GAAP operating margin declined to 28.3%. AGS key performance indicators continue to be positive with strong year over year growth in installed base systems, Service Intensity and Subscription Agreements.

Speaker 2

As a result, AGS continues to grow faster than the pace needed to achieve our long term revenue targets. Moving on to display, revenue declined as expected to $251,000,000 Segment non GAAP operating margin also declined to 13.5%. Turning to our cash flows. We generated $857,000,000 in operating cash flow during the quarter, which was 13% of revenue. We returned over $1,720,000,000 to shareholders, including $223,000,000 in dividends and $1,500,000,000 in buybacks.

Speaker 2

We repurchased 17,000,000 shares at an average price of $88.05 Next, I'll discuss the impact of the new U. S. Export regulations to Applied Materials. We currently expect the unmitigated revenue impact of the new rules could be up to $2,500,000,000 in fiscal 2023. We continue to work through the regulatory requirements, including seeking licenses and approvals where appropriate.

Speaker 2

We hope to reduce the revenue impact by between $500,000,000 $1,000,000,000 to a net impact of $1,500,000,000 to $2,000,000,000 We also expect the rules to reduce our non GAAP gross margin by up to 1 percentage point. While this creates a headwind to meeting our gross margin targets for 2024, We remain committed to our goals and believe we can achieve and exceed them over time. In Q4, the new rules reduced our semi systems and AGS revenue by approximately $280,000,000 which is in the range of our expectation on October 12. Inventory charges in Q4 were lower than our preliminary assessment. In Q1, we expect the new rules to reduce Semi Systems and AGS revenue by approximately $490,000,000 combined and reduce our gross margin by around 1 percentage point, both on an unmitigated basis.

Speaker 2

Now I'll share our guidance for Q1. We expect revenue to be $6,700,000,000 plus or minus $400,000,000 And we expect non GAAP EPS of $1.93 plus or minus $0.18 Within this outlook, we expect Semi Systems revenue to be about $5,150,000,000 which is up nearly 13% year over year. We expect AGS revenue to be about $1,330,000,000 which is slightly up year over year. Display revenue should be around $170,000,000 We expect non GAAP gross margin to be approximately 46.1 percent and we expect non GAAP operating expenses to be $1,160,000,000 We are modeling a tax rate of 13%, which is up from 11.8% last year, primarily due to mandatory capitalization of R and D expenses effective in our new fiscal year. Before we begin the Q and A, I'd like to summarize our company's position in the current environment.

Speaker 2

We have record backlog, notably in the highly enabling technologies for next generation nodes. Our supply chain and manufacturing output are incrementally improving. We expect our services business will continue to grow and generate strong recurring revenue and free cash flow. And the longer term growth outlook for the semiconductor industry remains strong. Applied is in a great position to invest in future growth and deliver strong profitability, free cash flow and shareholder returns.

Speaker 2

Now Mike, please begin the Q and A.

Operator

Thanks, Bryce. To help us reach as many people as we can, please ask just one question on today's call. CEO. Operator, let's please begin.

Speaker 3

Thank you. And our first question comes from the line of C. J. Muse with Evercore ISI.

Speaker 4

Yes, good afternoon. Thank you for taking the question. I was hoping to clarify one thing first on China. And really the question is, what changed between October 12 with your press release and then October 30 where it looks like there really wasn't much of an impact at all. And then my, I guess, real question is, as you think about calendar 2023 WFE, It sounds like companies are providing kind of a top down view that things for WFE are look weak and declining.

Speaker 4

However, Every company bottoms up based on deferred revenues and backlogs are much more optimistic on the outlook. So Can you kind of talk through the moving parts there and what kind of range or outcome you see today for Year over year silicon declines in calendar 2023. Thanks so much.

Speaker 2

Sure. Hi, CJ. It's Bryce. I'll start on this one. So relative to the pre announcement that we did, we talked about a $400,000,000 impact plus or minus dollars 150,000,000 for the China trade change.

Speaker 2

And then as we work through it, that impact ended up being less around $280,000,000 and it's just estimating the transactional elements at the end of the quarter. It was an initial estimate, so we did a little bit better from that perspective. The other thing that really happened was execution in the end of the quarter was almost flawless from a logistics perspective. We got more supply chain parts in at the end of the quarter. And so over $200,000,000 of good news from execution and delivery perspective, finishing product and completions in the field.

Speaker 2

So it was really those two things. It was a little bit better than our initial estimate and And then on 23, the WFE question for 2023, We think that it's preliminary. It's too early to give an estimate of 23. So what we're trying to share is what we're seeing in our order patterns and in our business for Q1 and Q2. We talked about in the script how In Q1 or in our bookings for Q4, they were really solid.

Speaker 2

We did see push outs. We did see weakness in the memory business, but our backlog has grown to a record level of backlog. So when we think about our Q1 and Q2, we're still supply constrained. We still have a number of different equipment lines that we have significant backlog. We're trying to catch up to customer orders.

Speaker 2

And so the signals to us really are that we have to work on supply chain, work on improving our output and work on catching up with our customers. So beyond that, we're just not able to make a call yet on WFE for 2023.

Speaker 1

Yes. CJ, this is Gary. As Bryce said, We can certainly give a perspective on our business. We're not going to guide on overall WFE for 2023, But we're in a very strong position. If you look at the kind of profile of the business, it's more weighted towards foundry logic versus memory.

Speaker 1

And we have some very strong products where we have significant backlog and we're still working to close the supply demand gaps in those areas. So from Applied standpoint, as you know, it's all about the race for power and performance And we're really well positioned with leading products in those big inflections. And again, our number one focus is on closing the supply chain gaps.

Speaker 5

Thank you.

Speaker 3

Thank you. And our next question comes from the line of Stacy Rasgon with Bernstein.

Speaker 6

Hi, guys. Thanks for taking my question. I wanted to ask you about the mitigated versus unmitigated impact from China. So you gave the numbers $2,500,000,000 and hoping to bring that down to like $1,500,000,000 But I gathered that a big element of that was getting licenses. Where do you expect those licenses to be gotten?

Speaker 6

Is that only to the multinationals? Do you guys licenses to be given to some of the Chinese folks. I mean, how could that happen? What is the mechanism by which you come in at the unmitigated number versus the come in at the mitigated number versus the unmitigated number.

Speaker 2

Hi, Stacy. It's Bryce. Yes, and it's important probably to say that this unmitigated versus mitigated, it has everything to do with the impact to the China shipments and Chinese customers. In other words, it's not referring to whether we can ship product we are making for those customers to non China customers. So the unmitigated, the way we calculated this is we looked at the orders that we have for the affected customers and that's what you see as the total $2,500,000,000 Does that include multinationals too?

Speaker 2

Say again? I'm sorry,

Speaker 6

does that include multinationals too or is that just the local Chinese guys?

Speaker 2

It does not. So just while we're trying to go. Yes. And so the way we looked at that, there are some customers that we're trying to clarify that we can apply for licenses for or we can get authorizations for once they establish that their technology is within the guidelines. So we have a process to do that.

Speaker 2

And on the other side, we expect some customers may decide to change their plan or So it's really those two elements that we'll be able to clarify that some customers were able to ship with or ship to or some customers changing their plans on the technology side that would allow them to qualify for shipments.

Speaker 6

What would that mean though? Would that suck up like supply that would have ordinarily gotten built by somebody else though? Because otherwise you're just adding like lagging edge Supply into a vacuum essentially, right? How do we think about like the second order effects here?

Speaker 2

Yes, we don't think so. We expect all that equipment to be utilized. And so if that equipment is moved to a different use, then we expect it will be backfilled somewhere else for its original demand purpose, if that makes sense.

Speaker 6

Got it. And I guess just one last one. Right now, I guess you're running at the unmitigated level. When do you think you'll be at the mitigate level or like how likely do you think it'll be that you end up at the mitigate level at some point?

Speaker 2

It's hard to say. It's a process. You can imagine there's a large number of people working on this. In fact, the whole industry is working on this. It's job 2 at this point behind increasing output.

Speaker 2

So I would say it's still a good estimate today and will be working throughout the year on improving the number of customers and plants that we can ship to.

Speaker 6

Got it. Okay. Thank you, guys.

Speaker 2

Yes.

Speaker 3

Thank you. And our next question comes from the line of Vivek Arya with Bank of America.

Speaker 7

Thanks for taking my question. I just wanted to clarify, I thought Bryce you said somewhere that you provided some look for Q2, I don't think I caught that. And then, several of your memory customers have said that their spending could be down over 50% next year, recently Micron said it could be down even more than that. Have you noticed almost a 50% cancellation of orders from them, because I'm just trying to reconcile your commentary that sounds outside of China, of course, more benign and more supportive versus just the very horrific guidance that your memory customers are providing. I understand You're less exposed to memory versus foundry logic, but still it's a reasonable size exposure.

Speaker 7

So I'm curious, has that 50% cut in CapEx translated to any reduction in your backlog or any change in your thinking about memory for next year.

Speaker 2

Okay. Thanks, Vivek. So we're not giving a guide for Q2. We are highlighting the record backlog and the The fact that we're constrained and the fact that in several equipment lines, we're behind on customer orders. So we're going to try to increased output and I'd say that comment is true for both Q1 and Q2.

Speaker 2

So that's as much shaping as we're providing for Q2. On the memory side, just to kind of click back and think about the overall demand environment, we positioned last quarter that we had a significant amount more demand than we have the ability to supply for 2023. What did happen during the course of this quarter as there is a significant amount of push outs and reductions in that demand. Now you can see the end result. We still had solid bookings in Q4.

Speaker 2

We still we created a record backlog, that's now disclosed. So I would say that some of those push outs and some of those reductions were definitely in the memory space. And I wouldn't I'm not going to characterize what percentage it was, but I would say that that's the most affected area in the business in terms of push outs and reductions for 2023.

Speaker 7

So you are seeing a 50% type reduction? I'm just trying to align what we are hearing from those customers versus what you are seeing on the ground in your business?

Speaker 2

Yes, sorry, I can't quantify exactly what it is. I'll just say that that is what it's biased, The reductions were biased in that area.

Speaker 8

Okay. Thank you.

Speaker 7

Yes.

Speaker 3

Thank you. And our next question comes from the line of Krish Sankar with Cowen.

Speaker 6

Yes. Hi. Thanks for taking my question. Bry, so Gary, I just wanted to find out, you mentioned how lagging it is still pretty strong, especially auto analog in China. And I wonder like do you ever think that auto analog But in other words, if memory is going to be down next year, but lagging edge holds up, what is the risk that lagging edge rolls over in 2024

Speaker 2

Okay. I'll start. Maybe Gary wants to say something. We don't have a specific guide for what we call iCAPS, our mature node businesses. What we would say is there was significant growth in 2022.

Speaker 2

And when we think about all the end markets, we think the end markets are mixed. We know some of the consumer markets and even industrial have seen some weakening. But on the positive side, automotive and the power market that feeds EV and Solar and other areas has been really strong. So for us, this is a critical market. We're continuing to invest and continuing to focus in this area and we would just highlight to investors that the growth has been very strong.

Speaker 1

Yes. Krish, the other thing I would add is that we made a change in our organization more than 3 years ago, forming our ICaaS Group. And we have just very, very deep engagements with our customers, both on a technical and a support side of our business and we have the broadest set of innovative products for ICAPS. If I look at where we're at today, those are some of the areas that where we have significant backlog MDP and implant in FY23 are very, very strong for us. Those are areas where we have significant demand from customers.

Speaker 1

And ICAPS is similar in that to the all of the rest of our business. This is always a race for all of these customers relative to power, performance and cost and ICAPS is really materials enabled. We have a really strong team there. We have a great pipeline of products. I will guarantee you every year will not be up, that's for sure.

Speaker 1

And we're not going to guide 24, but we are in a very good position in ICAPS relative to enabling technology

Speaker 3

Thank you. And our next question comes from the line of Mark Lipacis with Jefferies.

Operator

Hi, thanks for taking my question. Gary, maybe for you, it seems like the Consensus for WFE this year is somewhere in the $65,000,000,000 to $75,000,000,000 range. And I'm not asking you to give a guidance or an outlook for next year. But I'm wondering, In the scenario where that is proven to be too cautious of an outlook for next year. Based on the conversations that you have with your customers, would you say That would be because lead times are long and customers just they don't want to cancel orders or There's new secular drivers like bigger chips or advanced packaging or trailing node like some of the things you've talked about or just competition at the Leading Edge is driving people to invest more enabled by subsidies.

Operator

What are your customers suggesting to you or what I mean your backlog grew even as memory came down, like what do you think is the are the biggest drivers into next year, regardless of whatever the end number is and what could surprise on the upside? Thank you.

Speaker 1

Yes, Mark. Thanks for the question. All of our customers in any of these different markets, the technology is moving very, very quickly. So they're all racing against each other for power, performance, cost, their relative competitive position. So certainly as you mentioned in the leading edge Foundry Logic, there's a tremendous amount of focus there, high performance computing and a number of those different markets.

Speaker 1

And again for Applied, what we've talked about is real strength in enabling new structures that are critical to competitive positions for our customers. Gate all around is an incremental $1,000,000,000 for Applied for 100,000 wafer starts more than what we're currently capturing with FinFAT. We're on passed again 5 points of share in the transition from FinFAT to Gate All Around. Wiring is Probably the number one focus and I don't know that everyone really understands how important that inflection is for our customers. That's an area where we have tremendous strength.

Speaker 1

We're enabling 50% reduction in wiring resistance with integrated platforms that combine many technologies together. So that's another one, where Applied is really well positioned. Packaging has grown for Applied to nearly $1,000,000,000 and we have over 50% share in the broad in our served market And we have by far the broadest position in Advanced Packaging and we're still in the early innings of that inflection. But again, that's all part of this technology race for all of our customers. ICAPS, I mentioned that earlier on the call, Those are also markets where I think it's surprising to people, including you've Seeing some of our peers talking about ICAPS growth over a longer period of time, there are technology inflections there and that's As I mentioned earlier, metal deposition, implant, those are areas where we're, very, very in very strong enabling positions, with our customers.

Speaker 1

I think The other thing for Applied beyond all of these different areas, high speed DRAM with logic like structures, all of those big inflections, our PDC business Grew, I think it was 67% in FY 2021. We're up around 35% in FY 2022. That business is also outperforming and we think that will continue to outperform as we go forward. So at least From an Applied standpoint, it's really all around those big inflections and how we're positioned for those major inflections. So I don't know if Bryce, if you want to add anything.

Speaker 2

No, I would just comment that the we highlighted that we still have to catch up to customer demand in several areas. So that adds some momentum into 2023. And then the other piece is just It seems clear that productivity to drive productivity in the world, a lot of these things like in the energy market, data center market, etcetera, still have resilient demand.

Operator

Thank you. Very helpful.

Speaker 3

Thank you. And our next question comes from the line of Atif Malik with Citi.

Speaker 7

Hi, thank you for taking my question. Gary, I have a question on long term impact of China restrictions to both domestic and multinational spender. If I look at China spending over the last 5 years, it has outgrown WFE by 3 to 4 times. What replaces this in terms of spending, capital intensity and above average profitability for you?

Speaker 2

Yes. Hi, Atif. I'll start. This is Bryce. I think on the China side, when we look at that impact, The larger part of the business has been on the trailing nodes for us and we expect that to still be a very strong business for Applied.

Speaker 2

And we see that in both the factory projects that we monitor and also in the different end markets where there's investments. And then On the leading edge, if it's a question of do we expect that demand to be taken away from WFE demand globally and permanently, We don't. It will either be satisfied in some way in China either by multinationals or in some other way or it will move to another in our geography. So we don't believe that, that will be an impact. And just circling back around, I would just focus on over time, we expect the China market to be a strong grower, especially in the iCAPS mature node space.

Speaker 2

Thank you.

Speaker 3

Thank you. Thank you. And our next question comes from the line of Toshiya Hari with Goldman Sachs.

Speaker 4

Hi. Thank you so much for taking the question. I wanted to ask about the AGS business going into next Fiscal year calendar year. Obviously, it's been a very steady grower for you guys and for the overall industry. Many of your leading edge memory customers and logic and foundry customers, I believe, are in the process of cutting wafer starts potentially over the next couple of quarters.

Speaker 4

So I guess the question is when you cite services as one of the reasons why you'll outperform into next year Is the baseline assumption that business continues to grow, given the installed base growth and given how you transform the mix of that business? Or could it be down, but still not? Thank you.

Speaker 2

Okay. Thanks, Toshi. Thank you. Yes, a couple of drivers here. You'll see in our outlook for Q1 that we have a down quarter for AGS, which is unusual.

Speaker 2

And the reason is we've got a full quarter impact, approximately $100,000,000 for the reduction of the China customers that we won't be able to serve for the rest of the year. So that's definitely a headwind in Q1, But you hit the nail on the head with respect to the dynamics thereafter. Every time we ship a tool, it grows our installed base of equipment. We grew the installed base 8% last year. Beyond or after that, our ability to provide services and put those services on subscription agreements.

Speaker 2

We typically outgrow the installed base than we did last year. So that is the driver for the reason the services business is sticky. We have more equipment to serve. Portion of the business is transactional. We do see lower utilization this quarter and next quarter.

Speaker 2

And what we would point to what we have pointed to is even in 2019 where there was lower utilization, we still grew the services business. And besides the headwind of China that I pointed out, we expect that to be the dynamic this year and going forward.

Speaker 1

Toshiya, this is Gary. I'll add a little bit more color. So we do expect services to be up in 2023. As Bryce mentioned, transactional will be down based on capacity utilization, But our profile with a significant amount of our service and spares business being agreements gives us stickiness going forward and that is continuing to increase the comprehensive agreements up 16% Last year, the tenure of our agreements, the length of the agreements were up to 2.6 years, renewal rates at 93%. So we're and it was an interesting thing through the all of the chip shortage period of time.

Speaker 1

We were able to demonstrate value for customers with ramp services to accelerate chip output, managed part services so that people could increased tool availability and output, managed services for yield and optimizing productivity. So all of that helped us position our service business in a higher value for our customers. And again, that's what gives us the ability to continue to grow into 23. And then the longer term model we've communicated is double digit growth and we still have high confidence we'll achieve that.

Speaker 4

Thank you so much.

Speaker 3

Thank you. And our next question comes from the line of Harlan Sur with JPMorgan.

Speaker 8

Hi, good afternoon. Thanks for taking my question. Yes, another follow-up on AGS. So Looking back on fiscal 2022, your semi systems operating margins declined about 200 basis points on strong revenue growth, obviously due to the inflationary cost pressures, but your AGS business sustained near record operating margins at 30%. So I guess how has the team been able to sustain the record or near record AGS operating profitability in this inflationary environment?

Speaker 8

And more importantly, in a down year or potential down year next year. You guys talked last call this call on sustainability of AGS from a revenue perspective. How should we think about the sustainability of operating margins for AGS?

Speaker 2

Yes. Harlan, it's thank you. So one thing I would call out is, we did have lower gross margins and operating margins in Q4 and that's largely due to looking at the specific inventory we had for China customers that will have to either reposition or move somewhere else or scrap. But to your point on operating profit, one of the plans the business has there is to improve the amount of repair that we do for products that we bring back to customers. And so that helps us lower the cost and cost of goods sold with customers, and that's one of the ways that we improve our gross margins and the ultimate profit of that business.

Speaker 2

The other is just increased efficiency as we demonstrate More and more capability with the customers and we provide more services with the same spending profile, then that helps us maintain the profitability. Those sir, the 2 key drivers.

Speaker 8

Thank you.

Speaker 3

Thank you. And our next question comes from the line of Joe Quattrochi with Wells Fargo.

Speaker 4

Yes. Thanks for taking the question. I wanted to ask about the gross margin impact from the China restriction. Can you talk about what's driving that 1 percentage point impact. And then how do we think about what you could potentially recapture in the mitigated scenario that you outlined?

Speaker 2

Yes, thank you. So two things, and it depends on which time period you look at. But If we look forward, the gross margin impact is really that they're generally smaller customers. So the profitability of those customers for Applied is higher. And when we talk about mitigation as we go forward, it's going to be TBD as to who we sell that product to and what the profitability is.

Speaker 2

So at this point, we're expecting the impact that we described. And if you look at the current quarter, we did have specific inventory for customers that's unique. We are working to qualify some of that inventory, and we were successful to a degree, but we did have specific inventory that we had to take a demand reserve on.

Speaker 4

Got it. Thank you.

Speaker 9

Yes.

Speaker 3

Thank you. And our next question comes from the line of Timothy Arcuri with UBS Securities.

Speaker 10

Thanks a lot. Gary, I had a question about WFE intensity. So we're exiting this year at 15.5% And you were saying that through 2,030, you think WFE is going to grow faster than semiconductors. You've certainly been beating that drum now for a while that WFE intensity is going to keep going up. And obviously, there are underlying upward pressures.

Speaker 10

But China has obviously been ordering tools and building capacity well at head of demand now in part due to the fear of these bans. So if China becomes a little more of a lagging tier region, Wouldn't that lower WFE intensity a bit and maybe argue that maybe it has to reset a bit? Thanks, Gary.

Speaker 2

Yes. Tim, I'll jump in for a second here just because I have the picture of the graph in my mind that we use. So We do think intensity is gradually increasing and it's because of the reasons Gary described. A lot of steps in the process are And then when we think about China and iCAPS specifically, In the past, there's been a lot of reuse of existing fabs and existing process tools and that allowed for a low intensity and that's not been what's happening in the past few years and with recent additions. We've talked about the number of factory projects that we see.

Speaker 2

So as capacity gets added, even in the iCAP space, what you see is an intensity level that's more like what we were experiencing on the leading edge just a few years ago, and that's also serving to raise the overall average of intensity. So we're pretty confident that intensity will continue to rise.

Speaker 1

Yes, Tim, on the relative to ICAPS, just reminding people that There was a time period where you had a lot of movement of business to foundries. And during that time period, there were many factories and tools that came on the market. All of that stuff is gone. So that's what Bryce was referring to relative to ICAPS capital intensities. And then if you look at all of the I went through a list of key inflections, technology inflections for customers and I gave some color around wiring and the number of steps that are increasing.

Speaker 1

That's what we're seeing really in all of the different segments of the business. So I think that capital intensity is probably the right zip code, if we look through 2,030.

Speaker 8

Thanks, Gary and Preston.

Speaker 3

Thank you. And our next question comes from the line of Joseph Moore with

Speaker 9

Morgan Stanley.

Speaker 4

Great. Thank you. I wonder if you could talk about the environment in China with the multinationals. Obviously, they need to get a license. They did immediately get a license, but it's a 12 month license.

Speaker 4

So would you say that you generally see the footprint moving away from China with those multinational customers? Do you see any potential for that to become an issue down the road? Can you just talk generally to the fact that the multinationals were included in this?

Speaker 1

Yes. Joe, this is Gary. The multinationals are not impacted today. Relative to their strategies, we'd really rather have them comment on that. So again, just today, they're not impacted.

Speaker 1

How they position their businesses geographically, that's really up to them.

Speaker 8

Thank

Speaker 3

you. Thank you. And our next question comes from the line of Sidney Ho with Deutsche Bank.

Speaker 11

Thanks for taking my question. I want to follow-up on the earlier question on the longer term WFE. As you think about the growth of WFE in the next, call it, 3 to 5 years, how do you think about the mix between the different type of tools, how that could change, meaning deposition and edge versus litho versus process control. As you talk to your customers about their roadmap and technology inflections. And I also want to ask about, I assume your served addressable market will continue to

Speaker 1

Cindy, thanks for the question. So if you look at what our customers are talking about relative to their roadmaps, Really, there are 5 big drivers of the technologies going forward: workload specific architectures, There are new structures, new materials, new ways to shrink, new advanced packaging inflections for our customers. And So what we see, if you look at the advanced foundry logic roadmap, you see a tremendous focus on new structures and new materials. The transistor innovations around gate all around are essential relative to power and performance. Wiring, I talked a lot about wiring.

Speaker 1

Our largest business is metal deposition, and the wires are getting thinner and resistance goes up. So you're seeing more dollars moving in that direction. Advanced Packaging is an area where we see, for sure that's another big one of the big five drivers for the roadmaps for our customers and that's still in the early innings around $1,000,000,000 business for us today, over 50% served market for the areas we participate. And so we see that one, that's an area that will attract a tremendous amount of investment and relative to competition between customers is very, very important. In memory, you certainly see materials scaling in 3 d NAND as customers are moving to more layers or other ways to include logic and memory together through different technology inflections.

Speaker 1

DRAM is moving to high speed and so you have high k metal gate and logic like structures there. So a lot of that investment is moving more towards materials enabled Technologies and that's where Applied has really a tremendous strength. I don't know, Bryce, if you want to add anything there. No. Good.

Speaker 1

Thanks.

Speaker 11

All right. Thank you.

Speaker 3

Thank you. And our next question comes from the line of Quinn Bolton with Needham and Company.

Speaker 9

Thanks for taking my question. Just had a question with the CHIPS Act applications expected to be received or submitted beginning sort of the February timeframe. Wondering as you look at your 2023 WFE outlook, do you expect to see any benefits from ShipSec spending in 2023 or do you think it's really more of a 2024 and beyond before it hits WFE spending? Thanks.

Speaker 2

We do expect, Quinn, a small really small amount in 2023. On the equipment side, it will likely really start in 2024 as a number of those projects are start with construction. There are a few that will start with equipment, but it will really for us be more of the 2024 timeframe.

Speaker 1

Yes. Quinn, one thing I'd add is that those Investments are time bound. And so as Bryce said, not so much in 2023, starting in 2024, but there are There is timing associated with those incentives.

Speaker 9

Got it. Thank you.

Operator

Thanks Quinn. And operator, we have time for 2 more questions today.

Speaker 3

Certainly. And our next

Speaker 5

Gary, I'd like to come back to the comments you made about capital intensity and the specifics of the trailing edge part of your portfolio. And so you described there, I think, like three reasons why I mean, two reasons why capital intensity is very high there, I mean higher than in the past. The first one is That there is more innovation going on, so that drives capital intensity up. And then you mentioned the fact that there used To be like a secondhand market that was feeding the trading edge that is kind of going away. And my question is, there must be also a third element that justifies a very high tax rate intensity today, which is that We've been growing capacity very, very fast this year than last year.

Speaker 5

And there is a significant chance that the capacity growth He's at some point going to slow down or even to pause. And so I'd like to hear your thoughts about that and maybe a sense of How much it could impact in the short term capital intensity?

Speaker 1

Hi, Piyo. This is Gary. Thanks for the question. So I will say that we're 100% certain that all of these markets will not be up every year. But what we do see, if you think about pick a number in terms of edge computing devices by 2,030, These technologies are becoming much, much more pervasive.

Speaker 1

They're really if you think about industrial automation or gas to smart electric vehicles, a number of different inflections. A lot of these iCAPS technologies are going to grow at a fair compound annual growth rate. And I think that's what other people are seeing also. So how that what the shape of that looks like every single year, we're not going to forecast that, but we do think that business is going to see healthy growth. And that's why also we formed the iCAPS organization 3 years ago.

Speaker 1

We saw That market was going to be significant from a growth perspective and pulled together all of our different technologies. So Again, if I look across all of those segments within iCAPS, we think over the longer term, there will be Significant compound annual growth rates. We have very, very strong positions in enabling some of those technology inflections in iCAPS, but We're not going to give specific profile on a year by year basis.

Speaker 5

Thanks, Gary.

Speaker 3

Thank you. And our final question comes from the line of David O'Connor with Exxon BNP.

Speaker 8

Great. Good afternoon. Thanks for taking my question. Follow-up on the backlog to a previous question. Gary or Bryce, how should we think about the timeframe of getting the backlog back to a kind of more normalized level?

Speaker 8

Or When do you expect to get caught up on demand for those products that are running pretty harsh on the PPAC T side? Thank you.

Speaker 2

Yes. Thanks, David. We're expecting it's going to take us more than 2 quarters. So depending on the line of equipment, I would say between 2 4 quarters is our internal estimate. And so that's what we're focused on.

Speaker 2

We are behind with the customers and we're working on increasing output every week. Thanks for the question.

Speaker 8

Thank you.

Operator

Yes. Thanks, David, for your question. And Bryce, would you like to give us your closing thoughts today?

Speaker 2

Absolutely. Clearly, there are questions about the market in the near term, but for our part, We had healthy Q4 orders and we have record backlog that we described and it's mostly in our leadership product areas that drive the big technology inflections. I hope we get to see many of you at the upcoming Credit Suisse and Wells Fargo Conferences. In the meantime, we hope you enjoy a safe and happy Thanksgiving. Thank you.

Speaker 2

Mike, let's close it up.

Operator

Okay. Great, Bryce. So we'd like to thank everybody for joining us today. A replay of the call is going to be available on our website by 5 o'clock Pacific Time, and we would like to thank you for your continued interest in Applied

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Earnings Conference Call
Applied Materials Q4 2022
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