Applied Materials Inc (AMAT) — Q2 2017 Earnings Call Transcript

Good afternoon, everyone. I'm Mike Sullivan, Head of Investor Relations at Applied Materials. We appreciate you joining us for our second quarter of fiscal 2017 earnings call, which is being recorded. Joining me are Gary Dickerson, our President and CEO; and Bob Halliday, our Chief Financial Officer. Before we begin, let me remind you that today's call contains forward-looking statements, including those about Applied's current view of its industries, performance, product roadmap, share positions, revenue growth, and business outlook. These statements are subject to risks and uncertainties that could cause actual results to differ materially and are not guarantees of future performance. Information concerning these risks and uncertainties is contained in Applied's most recent Form 10-K and 8-K filings with the SEC. All forward-looking statements are based on management's estimates, projections, and assumptions as of May 18, 2017, and Applied assumes no obligation to update them. Today's call also includes non-GAAP adjusted financial measures. Reconciliations to GAAP measures are contained in today's earnings press release and in our reconciliation slides, which are available on the Investor Relations page of our website at appliedmaterials.com. And now I'd like to turn the call over to Gary Dickerson.

Thanks, Mike. I'm very happy to report another record-breaking quarter for Applied Materials with the highest revenue and earnings in our history. We've now set earnings records for four quarters in a row, and as I look across the company, I see tremendous momentum. Our markets are strong and getting stronger, and we're sustainably growing faster than these markets by expanding our served opportunity and gaining share. In today's call, I will provide our perspective on the factors driving the industry and our strategy for sustainable, profitable growth within this environment. I will then describe the key inflections and investments within our markets before concluding with updates on our major businesses. Bob will then provide additional detail about our performance and outlook. Let me start with the big picture. This is an incredibly exciting period for the electronics industry, with a broader set of drivers and a wider spectrum of companies making significant investments to advance semiconductor and display technology. In the past, PCs were the dominant factor in semiconductor demand. PCs drove the technology roadmap, and enterprise refresh cycles drove industry upturns and downturns. More recently, global adoption of smartphones, combined with social media, has created a much more pervasive consumer demand, expanding the market and making it substantially less cyclical. Today, many new demand drivers are emerging that layer on top of traditional computing and mobility. Technologies like the Internet of Things, big data, and artificial intelligence are transforming industries, including transportation, health care, entertainment, and manufacturing. The way these industries create value is increasingly dependent on capturing, transmitting, understanding, and storing data. In turn, this means they are more and more reliant on advanced semiconductors. The impact for Applied is twofold. First, our markets are growing and becoming more stable. Second, this is a period of incredible innovation in logic, memory, and display, and we're in a great position to provide the critical building blocks needed to move the industry forward. At Applied, our strategy is to be the innovation leader in markets that are evolving faster than ever before. To do that, we've fueled innovation by reallocating resources and significantly increasing our investment in new product development. Then, to drive repeatable success and accelerate the pace of learning, we've developed a unique operating system, our product development engine, and trained more than 10,000 employees how to use it. Across the organization, we're focused on delivering highly differentiated products and services that enable customers to build new devices and structures that were never possible before. I believe our innovation leadership is sustainable because of the breadth and depth of our capabilities. Our ability to combine unique competencies, technology, and intellectual property accelerates our innovation process and sets us apart from competitors. Having provided this context, I'll now describe the major inflections and investments taking place within our markets. Sales of memory chips are at record levels, fueled by increasing content in smartphones to support better cameras and VR applications, as well as the need for more and higher performance storage in data centers. Market fundamentals remain strong, and as a result, we're seeing robust investment from our memory customers. We believe we will see double-digit growth in DRAM spending this year, and we expect NAND investment to be even stronger. Our view of 2018 and beyond is also positive for a number of reasons. The explosion of data storage requirements created by IoT, big data, AI, and streaming video has only just begun. Data generation from new categories such as Industry 4.0 and autonomous vehicles can potentially dwarf existing applications within a few years. As 3D NAND bit density increases and cost per bit falls, new segments of the storage market are opening up for solid-state drives. At the same time, the bit density increase from generation to generation is slower for 3D than it was for planar NAND. To compensate, the industry needs more wafer starts and greenfield capacity. In foundry, we're also seeing an acceleration of investment, both at the leading edge and in trailing geometries. In 2017, we expect investment in new leading edge capacity to make up about 60% of total foundry spending. This is driven by demand for more sophisticated smartphone processors as well as customers positioning to win the major inflections in high-performance computing and data centers that are needed to start unlocking the potential of AI. Within foundry, logic, and DRAM, I'm increasingly excited about our opportunities in patterning. As these customers move to smaller chip geometries, all the layers in the device scale. A limited number of layers will move to EUV, but significantly more will move to multi-patterning. This means our patterning opportunity will expand considerably over the coming years. Applied is making significant investments to enable the patterning roadmap. We've already increased our patterning revenues by more than 60% in the past year and still have significant room to grow. Taking all these factors into consideration, we now believe that wafer fab equipment spending for the calendar year could be up about 15% relative to 2016, and our outlook for 2018 and beyond remains positive. Our expectations for the display market also continue to strengthen as a result of large inflections in both TV and mobile screen technology. Average TV sizes are expected to reach 44.5 inches in 2017, up 5 inches in the past three years. One of the key factors driving this growth is demand for large-format TVs, 60 inches and above. As customers optimize factories for these bigger screen sizes, they are investing in new Gen 10.5 capacity. In parallel, we see investment in mobile OLED getting stronger as confidence in the adoption rates of OLED technology increases. Recent forecasts indicate that two-thirds of new smartphones could have OLED displays by 2021, and screen manufacturers are accelerating their investment plans accordingly. My final comments about the market environment relate to China, which is an important long-term growth opportunity for Applied. We believe 2017 spending will be slightly higher than last year. Based on the projects we're tracking, we expect to see a significant and steady investment ramp in both semiconductor and display beginning in 2018. I'll now provide updates on the performance and priorities for our major business groups. Overall, Applied gained two points of wafer fab equipment share in 2016, and based on the strength of our product portfolio, I believe we'll add to those gains over the next several years. In our leadership businesses such as PVD, epi, implant, and thermal processing, where we have strong share and highly differentiated products, we're extending our advantage. The available market for our leadership products is also growing, specifically in PVD and CMP. In PVD, we expect our available market to expand by more than 30% in 2017 as foundry customers adopt new interconnect technology for lower power devices. The CMP market grew 40% in 2016 and is on track to grow another 20% this year, primarily driven by increasing steps in 3D NAND. In our high-growth businesses, we're also outperforming our competitors in markets that are growing rapidly. In 2016, we gained about five points of share in conductor etch and two points in etch overall. This means that since 2012, we've won nearly 20 points of conductor share and 10 points of total etch share. These gains are driven by enabling technologies like Sym3 and selective etch and new process steps. Our CVD business is also outpacing the market, gaining almost six points of market share in 2016. We have great momentum in these businesses and plenty of headroom to grow. Service represents a stable and growing revenue stream for the company. On a year-on-year basis, we've now grown service revenues for 14 consecutive quarters, and our compound rate of growth has been around 10% over the past four years. Our expanding portfolio of service solutions plays an increasingly important role for customers, helping them compress ramp times, improve device performance and yield, and optimize output and operating costs. Because of this, I'm confident that we can continue to grow service at a similar pace. Another exciting growth opportunity for Applied is display. Since 2012, we've grown display revenues around 20% per year, and we have great momentum. This year, we're on track to book more than $2 billion of orders. Display technology and manufacturing is becoming increasingly complex, and Applied is in a unique position to enable the roadmap. By leveraging our semiconductor experience and capabilities, we're delivering the innovative products our customers need to accelerate major technology transitions. Before I hand the call over to Bob, let me quickly summarize. Q2 was another record-breaking quarter, and 2017 is shaping up to be an outstanding year for Applied. Our markets are becoming even more attractive. They are growing sustainably and becoming less volatile, and Applied is playing a larger and more valuable role advancing the innovation roadmap. We have focused our strategy and investments to ensure that Applied is the innovation leader that consistently delivers highly differentiated products and services. As a result, we're raising the ceiling for our performance and potential. We're setting new records, growing our available market and gaining market share. Now let me hand the call over to Bob.

Thanks, Gary. Before going into the details of the quarter, I'll touch on three things that are sustainably better for Applied: one, our markets; two, our improving position in those markets, which is enabling stronger gross margin performance; and three, our profitability and free cash flow. First, our markets are more attractive. We believe wafer fab equipment spending will be higher and less volatile for the foreseeable future. Display equipment spending also looks higher and more attractive for Applied Materials in particular because we're greatly increasing our served addressable market. Many of you have added valuable insights as to why WFE has become larger and less volatile. I believe it boils down to three things: one, the semiconductor market is growing and becoming more diverse; two, equipment intensity is increasing; and three, capital investment is measured and rational. This better industry environment is sustainable. As Gary mentioned, the semiconductor industry we enable has also become larger, more diverse, and more critical to big innovations in the global economy. Today, we're seeing the emergence of new silicon-rich devices needed to enable the Internet of Things, cloud data centers, and artificial intelligence. Data is becoming more valuable, and harnessing that value requires silicon. For Applied, this translates to higher demand for logic and memory capacity at both the leading edge and trailing geometries. I believe the industry has seen a new wave of sustainable growth with economic value creation that justifies the cost of investment. Next, Applied's position in the markets is sustainably stronger. The changes we've made since 2013 in strategy, capital allocation, and business systems like the product development engine have given us our strongest product pipeline in many years. I've been invited to an industrials conference this month to explain how our products are enabling big changes in manufacturing that many people call Industry 4.0. Here is how I plan to summarize our contribution without going into all of the technology. Applied has a very strong overall business that can be separated into just two parts. First, we have our leadership semi equipment and services business, which together generate nearly 60% of our revenue. Our leadership semi businesses drive technologies that are critical to making transistors for data processing and networking. We've maintained steady growth and high share positions averaging about 70% because we bring unique value to our customers. Our services business is similar in that it is highly enabling to our customers and characterized by steady, profitable growth. We're deeply engaged with our logic and foundry customers to enable their advanced roadmaps with this part of our business. When you think about the big new chips used for artificial intelligence, think of Applied Materials. Second, we have our high-growth businesses, which include etch and deposition used in 3D NAND and multi-patterning, along with inspection and display. Our high-growth businesses now represent about 40% of our revenue. We've made outsized investments in new and disruptive products in these areas to capitalize on the inflections we identified in 2013. Our high-growth semi businesses have been growing 40% faster than their markets, and Applied's unique display equipment business is growing even faster. Another way to measure Applied's stronger position in the markets is to consider the changes in our share by semiconductor device type. In 2012, our share in foundry was over 20%, but our share in logic, DRAM, and NAND was under 15%. Today, we believe our share is at least 22% in all four. In fact, we're the number one equipment company by revenue in NAND, DRAM, logic, and foundry. So regardless of the spending mix, Applied is well positioned. A great measure of the strength of our products, the value they bring to our customers, and our execution as a company is gross margin expansion. Since 2013, we have increased our gross margins in our semi, services, and display segments across virtually every business unit. In 2017, I believe we will deliver company non-GAAP gross margin of about 46%, which would be up by about five points versus 2012 and the company's best annual performance in a decade. Now I'll talk about how these changes are flowing through the income statement to enable stronger profitability and shareholder returns. Over the 2013 to 2016 period, we have grown the revenue line by 44%. When we compare 2017 to 2013, we can see revenue growth of 90%. This revenue growth demonstrates the compounding benefits of our share gains and new product penetrations across semi, services, and display. For the year, we expect our top line growth, gross margin performance, and disciplined R&D investment and spending to generate the highest non-GAAP operating margin of the past 17 years and free cash flow of 20% or more. The company has returned 100% of the free cash flow we generated over the past five years and stands committed to returning excess cash to our shareholders. Next, I'll comment on our performance during Q2. As a reminder, we no longer report quarterly orders because we're focused on driving year-over-year growth in revenue and profitability. Quarter-to-quarter demand patterns can vary across our business. However, we have grown our revenue and non-GAAP EPS on a year-over-year basis in 14 of the past 15 quarters. In Q2, we grew company revenue by 45% year-over-year and increased non-GAAP gross margin by 3.6 points. Our non-GAAP operating expenses grew by only 14% over this period, and we continue to invest two-thirds of OpEx in R&D to fuel our product development engine. We set new company records in profitability as we increased non-GAAP operating profit by 110% year-over-year and non-GAAP earnings per share by 132% year-over-year. Now I'll compare our Q2 segment performance to the same period last year. We grew semiconductor systems revenue by 51% to $2.4 billion and non-GAAP operating margin by 9.7 points. We grew services revenue by 14% to a record $724 million and non-GAAP operating margin by 80 basis points. We more than doubled our display revenue to $391 million and increased non-GAAP operating margin by 4.9 points. Turning to the balance sheet, we grew cash from operations by 87% compared to the same period last year. We ended the quarter with $7.7 billion of cash and investments, and nearly half was onshore. This increase includes proceeds from $2.2 billion in debt raised in March to increase onshore liquidity. Soon after the end of the quarter, we used approximately $200 million of the offering to redeem our October 2017 notes. We returned $390 million to shareholders in the quarter, paying $108 million in dividends and using $282 million to repurchase 7 million shares of stock at an average price of $38.15. Now I'll provide our third quarter guidance. We expect overall revenue to be in the range of $3.6 billion to $3.75 billion. The midpoint would be up by 30% year-over-year. On a year-over-year basis, our semiconductor systems revenue should increase by about 41%. Services revenue should increase by about 13%. And display revenue should increase by about 27%. Non-GAAP gross margin should be approximately 46.5%. Non-GAAP operating expenses should be $665 million, plus or minus $10 million. Non-GAAP EPS should be in the range of $0.79 to $0.87, the midpoint of which would be up by 66% year-over-year. Finally, to help you with your models, we project revenue in Corporate and Other to be around $15 million. We expect non-GAAP interest and other expenses of about $42 million and a non-GAAP tax rate of approximately 10.2%. And in the fourth quarter, we expect non-GAAP OpEx to be around $675 million. The projected increase is primarily targeted at R&D for new opportunities we're pursuing in emerging inflections. To summarize, one, our markets are sustainably better than at any other time in the history of the company; two, our competitive position and execution is sustainably better, giving us a strong pipeline of new and disruptive products and gross margin expansion; three, this growth, combined with disciplined investment and spending, is generating higher free cash flow, and we're committed to returning the excess to our shareholders. Now Mike, let's start the Q&A.

Thanks, Bob. Let's begin.

I guess question around sustainability. You're guiding WFE $40-plus billion here for '17. And curious, what gives you the confidence to be so upbeat looking into '18 and beyond? And I guess as part of that, would love to hear your thoughts in terms of the contributions from areas like AI and public cloud investments versus, I guess, more traditional areas like smartphone and PCs in the past.

Sure. Let me provide some context. Instead of just a straightforward answer, I believe it's helpful to look at the situation over time and across different areas. Reflecting on our Analyst Day last September, we initially projected that the 2016 wafer fabrication equipment (WFE) market would be around $33.7 billion, but it actually ended up being just over $35 billion. Last year, we anticipated this year's WFE to reach $34.5 billion, and it has actually started with a four, indicating a very positive trend. Overall, the market is growing, and we initially expected a 5% increase across the board, but now we estimate a 15% overall growth. This growth is evident in areas like DRAM, NAND, and foundries. We are also observing high utilization rates at all fabrication facilities, and there are no signs of reduced ordering patterns or double bookings, which some may have worried about. The strength we're witnessing is consistent across nearly all our customers and types of devices, leading to fundamental questions about demand drivers. I believe we are seeing more underlying demand drivers for devices. In the long run, these drivers will include sectors like automotive and augmented/virtual reality, but right now, we are recognizing more components being integrated into phones. There's a significant increase in NAND and DRAM content in smartphones, and we also see robust activity on the processor side, both in advanced and lagging-edge technologies. This year, lagging-edge technology will account for over 40% of device types, but the cutting-edge segment is also performing well. Overall, there is substantial demand across the board. I believe that, in the near term, there is greater content being added to smartphones and to large data centers, both of which are fueling this growth. Additionally, we see that there are more applications for processor technology, with a growing number of applications driving systemic demand. I think we are still in the early stages of this trend. If you are wondering whether the second half of the year looks good, I would say yes, we are optimistic. If you ask about 2018, I think it will likely start with a four again; I see it looking quite favorable. Long-term, which I focus on a lot, I observe more foundational drivers for growth in both semiconductors and silicon than I have in years, and I believe this growth is sustainable.

And C.J., this is Gary. Looking back, our business was driven by the enterprise and PC upgrade cycles. Then it shifted to mobile and social media, heavily influenced by seasonal product launches for holidays like Christmas and Chinese New Year. Looking ahead, we've discussed the role of AI and the significance of capturing, transmitting, understanding, and storing data, which will disrupt major industries such as transportation, healthcare, entertainment, and manufacturing. AI chip announcements are happening almost weekly, and the logic devices are reaching the physical limits of their size due to the immense value in these industry changes, which benefits us. For manufacturers of these large logic chips, there's a need for improved transistors, enhanced interconnect technology, and increased memory, which aligns with our capabilities at Applied Materials. In the long term, these shifts will create greater sustainability in our markets moving forward.

On the China domestic semiconductor market and the outlook there, especially as we think about looking into 2018, I think conservatively, we're tracking three to four domestic foundry programs and about four to five memory programs. Foundry, obviously, is a bit more mature. Memory, we're kind of early innings, like Phase 1 kind of development. But especially on sort of memory in China, and we get this question a lot from investors which is, is the team starting to get pipeline visibility into some of these programs actually starting to fire, the confidence level that these programs are going to contribute to potentially a growth outlook for 2018? Love to get your views here.

Yes, thanks for the question. China's one of our strongest regions for both semiconductor and display, with very deep customer relationships. And what we're looking at for 2017, if we compare to '15, it's about 2x growth in our semiconductor business, 50% growth in service, 50% in display. The business is really driven by a couple of different strategic factors. One is there’s a big gap between supply and demand, and there's this large drive to try to close that gap, and then also building a secure supply chain. When we look into 2018, what we're seeing right now is that the overall wafer fab equipment spending could be meaningfully up, more than $1 billion, maybe $1.5 billion from '17 to '18, and the domestic part of that increase is also up a meaningful amount in 2018. I don't know, Bob, if you want to add anything else?

Yes, I believe that's quite accurate. Looking at the long term, we observe that the total is generally increasing each year, with the domestic segment in particular also showing growth every year.

Bob, I actually have two questions. Number one, just on the recent debt raise. I know you paid down $200 million of debt with that money. But I'm surprised that there's not kind of a new capital return that was announced with that. So I guess that's my first question. And then I wanted to also ask about SSG in the back half of the year because if I run the numbers on the calendar first half of the year, you're sort of annualizing to like $42 billion WFE roughly. And if we're going to be at $40 billion for the year, then that would sort of say that the back half has to be down like roughly 10%. So I'm wondering if that math's right.

Yes, two complicated questions. The first one, we raised money frankly from an opportunistic point of view and frankly a shareholder perspective. So if you look at it, we raised $2.2 billion. Now we had to repay $200 million, so it's about $2 billion net. It was about 50% of it was 10-year money, about 50% was 30-year money. And the 10% money, maybe like 3.3% and 4.3%, okay? So the average rate is about 3.8%. So basically what we're bringing into our capital structure is long term debt at low rates that's pseudo-equity at low cost of capital. So that's pretty attractive. The second thing we're doing, many people believe that there will be some type of tax policy change this year or next which will ease and facilitate the return of cash from overseas locations. Well, we're kind of hedging our bets. We're not sure about the timing and we want to stay committed to shareholder returns and keep our tax structure in place until there are any substantive changes. So I think this raise, if anything, was to continue to support meaningful returns of capital to investors. And as we said on the call, we've returned over 100% over the last five years. In this past quarter, the total was over $380 million, I think, between dividends and buybacks. So I think we're very committed to shareholder returns. We will hit the model which is shrinking the share count. If we get more line of sight to what's going to happen on the tax policy, then we'll clearly react more effectively and more efficiently to how to maximize those shareholder returns. In terms of how's the year look, we gave in the call a few data points. One, we said that our revenues in '17 fiscal year versus '13 were going to be up 90%. So you can see we're going to have a good year. My take on it is the year is a good year. Our take on it is the year will continue to strengthen throughout the year. Our take on it is that we're going to gain share this year. So it's going to be a really good year for us. And that's just semi. Display, we're going to do well, too. We believe those drivers that drive the market and our share continue for a number of years. So is the number a $40 billion number or north of a $40 billion number? All we want to say now here in early May is it starts with a four. It's up significantly from last year and it strengthened all year.

My question is, you've already talked about it quite a bit. Generally just wondering if you guys have done any sort of analysis if one particular segment would benefit more than the other in terms of logic, NAND, or foundry?

I think relative to AI, as I mentioned earlier, you see announcements almost every week of new logic AI chips going to the physical limits of the reticle field, so the physical limits or the ability of the semiconductor companies to build those chips. A tremendous amount of transistors, vias, interconnect technology, all of that is in the sweet spot for Applied Materials. Our Transistor and Interconnect Group, all of those different products, epi, PVD, CMP, thermal processing, implant, are really unique and very strong positions for Applied Materials. So that growth is really exactly aligned with the products that we have in logic and in foundry and gives us really a great growth opportunity. The other part of it's the materials-enabled memory scaling. More and more you're seeing devices going from 2 dimensions to 3 dimensions. As they're going to 3 dimensions, really, the ability to scale the performance and also the cost is all about new materials, new deposition, epi, new etch technology, selective removal, all of those areas. Personally, I'm increasingly optimistic that we have very innovative, highly differentiated new technologies that will not only enable further scaling in 3D NAND technology but also enable new memory technologies. Our position there is very, very strong. The relationships and the engagements that we have with customers are broader and deeper than we've ever had in the past.

I have a question on the display part. So at the Analyst Day last year, you guys talked about expanding the TAM on the display products from 15% to 30% to 40% over the next two years. Just curious, how are your engagements going with those new display products so far?

We have very broad and deep relationships with all the leading companies in display and also the leading consumer electronics companies that are using those displays. So we're in a really great position to enable these new technologies. As customers are moving forward with new display technology, it increases our total available market and puts us in a good position to continue to grow that business. If you look at display overall, you really have two big drivers. One is the strong organic LED for mobile opportunity, and that is broadening out to a large number of customers, and also the increased adoption of larger TV screens. So both of those are driving our business. As I said earlier, we have very strong and deep relationships with leading customers, and we're focused on the biggest technology challenges. If you look at all of those customers that want to get into the growing mobile OLED market, we're focused on the major technology challenges that enable those customers to build those kinds of devices. We're not ready to announce any specific opportunities at this point in time, but we will later this year.

The question I had was WFE running at 40 billion, 40 plus billion this year and next year, where do you think 3D NAND WFE is within that? And if the prices for NAND roll over, the reality of economics kicks in and 3D NAND makers scale back the CapEx. Or do you think demand is strong enough to continue investing in capacity for the next two to four years?

Sure. The question was whether 3D NAND will continue to expand, and the answer is yes. 3D NAND spending has increased this year, following an increase last year as well. Currently, there are about 1.6 million wafer starts globally in 3D NAND. By the end of this year, they will convert approximately 750,000 wafer starts each month, indicating that there is still a significant amount to convert. Most of it will likely transition over time since 3D performs better than 2D. Additionally, more end customers are switching from hard disk drives to 3D NAND, which is boosting overall demand for memory. The proportion of NAND is expected to trend upward, with 3D becoming the preferred choice over 2D. They are still in the early stages of ramping up, moving from 750,000 to 1.6 million wafer starts. We anticipate that installed capacity will increase over time due to this demand. In terms of new facilities versus upgrading existing ones, we are fairly neutral. The costs associated with building a new 3D NAND factory are manageable, and we believe we are gaining market share across almost every product. The revenue potential from transitioning to a higher level of 3D NAND remains consistent for us.

Just a follow-up question on the higher outlook for wafer fab equipment spending. What customer type is driving that big increase in your WFE? And do you think this $40 billion number is the new normalized level for WFE and not a peak?

Yes, it was seen across the board. We're seeing it at NAND, DRAM, and foundry. Logic's kind of flattish. We're seeing it at almost every customer, I think, too. So it's very broad. And when you get that broad, it's not, hey, they're timing DRAM, they're putting more DRAM in a PC. The root cause is broader than that because it's across a wide range of device types of customers. So then you say, what is the application for driving? We do think it's more and more about more applications for your PC and your data center and stuff like that. So it does start to see these AI stuff, deep learning. Can I point exactly how much does AI I know? But it's across the board we're seeing this, right? So then in terms of the number, those are, I called earlier, I think this year begins with a four. But I'm not saying it's 40, frankly. It's a good number and I think next year's a good number. So I actually think the new normal is 40 plus. I think what I worry about internally at the company, that we don't plan more for the upside than downside. I think there's more opportunity on the upside than the downside.

One thing I'd add to that is that I think everybody is seeing a large increase in the amount of data and also the value of the data. If you look at deep learning, the amount of data that you process is going to go up. Right now, a lot of data's thrown away. So you've got an increase in the amount of data, and then the amount of data that's processed is also going to increase. So both of those factors make me personally pretty bullish about the memory business long term. And certainly, that's also what we're hearing from our customers.

I noticed that display revenues were somewhat lower this quarter and that margins decreased by about 5 points. Can you speak to that, Bob? Is this just temporary noise? Last quarter, you set a target for display growth of 50% for 2017. Do you still have confidence in that projection?

Yes, we do. It's just timing and it's just logistical. Display's going to have a really good year. The underlying market dynamics are very strong for both TVs and mobile. And our position's really good. So I think display is strongly a lot of opportunity. And then we have a product cycle we've discussed coming on board later in the year. So I'm bullish on display, and I think I wouldn't read too much into these quarterly numbers. In terms of the numbers we set last quarter, yes, we'll hit those. Yes.

Bob, I had a question on gross margins. You guys showed nice upside in the quarter. And just wondering what the drivers were here. In the past, I think you pointed to outsized growth and things like etch and display that were headwinds to the business. The recent improvement, is that a function of that headwind abating? Or is that a combination of mix shift and also fundamental and sustainable improvement across the board?

Yes. If you consider a company like Applied, the improvement in gross margin primarily results from two main factors and a smaller one. The first is execution, and the second is mix, with the third, which is less significant, being absorption with volume. When examining execution, it encompasses three aspects: cost reduction, new product development, and field execution. This year, we've seen significant growth, increasing over a few points. The underlying execution has improved, and we've seen an increase of about three points this year. Execution is on an upward trend, and I expect it will continue improving each year. We're experiencing favorable mix shifts, particularly with strong performance from our products in the TIG family, PVD, epi, and similar areas, which has contributed positively. Absorption has also provided some benefit this year. Overall, it's a strong year with over 40, and we’re gaining market share. I believe the company's gross margin performance will continue to improve over time, although this year was supported somewhat by volume and mix. I remain optimistic about margins moving forward. If we need to adjust our model at Analyst Day, I would likely project higher WFE and higher margins.

I wanted to follow up on some of the questions on the upward revision in WFE, particularly with regards to memory. We look at sort of memory cash flows and make some assumptions that there's just an algorithmic percentage of that peak cash flow that gets spent, which is probably more negative than what you guys are describing, that there are sort of people who are looking at the current situation and deciding that they need more supply. I mean, I guess it's more semantics, I guess. But how do you characterize when you see the upward revision that we've seen in just a six-month window? How much of that is just because prices are better, companies have cash flow, and they use it to improve their competitive position versus something that's more sort of structural and dynamic? How do you interpret it as more structural aspect versus just better pricing?

We examined several factors regarding the data trends. We found that data capture has increased significantly, from about 8 zettabytes in 2016 to nearly 25 zettabytes in 2020, and projected to reach 45 zettabytes. This reflects a substantial rise in data collection across homes, vehicles, industries, and companies. We also analyzed the transmission, processing, and sourcing of this data. Closer to the ground, we considered the situations with NAND and DRAM, which we differentiated. While DRAM is performing decently, it hasn't surged dramatically; there's still some budget allocation towards NAND. DRAM prices are stable, and NAND prices are good as well, with supply and demand in balance. DRAM has seen slightly more potential for growth compared to its decline, especially in 2018, as it has improved from earlier projections this year. In contrast, NAND is selling all the 3D NAND it can produce, reflecting positive long-term trends. Regarding our earlier low outlook, we identified two main reasons that affect all of us. First, there seems to be a tendency to be constrained by past perspectives, believing growth can only reach a certain level. This relates to what was mentioned earlier about varying demand drivers. Initially focused on PCs, we recognized the shift to mobile around 2010 and the rising importance of big data content, particularly in phones and data centers. We may have underestimated the true demand drivers. Second, there is a tendency to be overly reliant on near-term customer forecasts which can lead to conservative assumptions for longer timeframes. This conservatism could stem from various reasons, leading to a cautious outlook. Overall, the data suggests the market isn't currently overbought, and there are longer-term factors that indicate sustainability.

Gary or Bob, in terms of the display business for you guys, we do see the longer term trends of OLED. Can you give a little bit of qualitative commentary on the LCD side of things, how you're benefiting this year as TV sizes grow larger? Is this also one of those sustainable trends? Or is this just going to be a one-year or one-and-a-half-year phenomenon as the industry transitions on that front?

Yes, I'll begin, and then Gary can add. Looking at this year, we expect to perform strongly in both TVs and mobile. In TVs, the focus is largely on LCD. For mobile, most of the spending will be on OLED. If we examine the two main drivers, in terms of OLED, it involves the conversion of phones we previously discussed. My estimate is that by early 2018, around 37% to 38% of phones will have the capacity for OLED production, given the existing demand. We believe that number will rise to about 55% by 2020, and 67% by 2021. Therefore, OLED phone displays are somewhat supply constrained, which makes this trend sustainable. I anticipate further increases beyond 67% in 2021 as well. Keep in mind that our backlog typically ships six to nine months later, extending the potential revenue timeline. Regarding TVs, the driving factor is large screen sizes. We mentioned at Analyst Day that through 2020, we were tracking seven Gen 10.5 fabs, and we've now increased that to nine. Those fabs are just beginning to ship, and on average, they have higher spending compared to Gen 8.5 fabs. To date, there has been around $2.2 billion in investment for these projects compared to roughly $1.2 billion for Gen 8.5. Therefore, the large TV segment has strong growth potential for the foreseeable future, and the scalability of these larger fabs positions us well.

You mentioned earlier on the call regarding bit density and 3D NAND from generation to generation being slower than the planar NAND conversion. So just wondering, could you give us an idea on how much more fab capacity might be needed annually to drive, say, 40% bit growth, and what the incremental opportunity can be for AMAT?

Sure. Some of this relates to what I mentioned earlier. We observe that NAND bit growth is likely to be in the high 30s, which is lower compared to last year's much higher figures. For instance, data from an external service provider indicated that content in phones increased by 57%. This suggests we might be underestimating some elements. Additionally, we may not have fully accounted for the shift to hard disk drives. Therefore, I lean towards being more optimistic about that number rather than pessimistic. Looking ahead, as I mentioned, we expect 750,000 wafer starts by the end of this year, and we believe ongoing expenditure in WFE content will remain consistent with this year's levels for several years. Whether they invest in new plants or upgrades doesn't impact our revenue perspective, but we anticipate total spending will be similar to this year for an extended period.

I wanted to follow up on the comments that you had, Bob, that there were some project-related R&D spending in the outlook numbers. The question is to what extent is that more of a near-term micro opportunity that the company is using versus something that may be more longer term and structural, either because you're viewing the market opportunity differently over the next few years and are chasing some additional existing SAM or as you look at different opportunities, chasing some new SAM that's emerged over the last three to six months?

I believe increasing the R&D budget was a smart move. When we presented the initial model back in 2013, our base case was around $30 billion, which then progressed to $33.5 billion, and last year reached $34.5 billion. If I were to create a new base case for the industry, it would likely exceed those figures. Our position has strengthened significantly; we moved from representing 18% of the WFE to approximately 22% last year, and we are still on the rise, aiming for 25.5%. The changes in our model, especially regarding Applied and display, are substantial. Initially, it was an $8 billion spending environment, and now it's nearly double that amount. Our product pipeline is strong, and I believe it's wise to keep investing in these opportunities. We're seeing increased customer interest as we become more innovative. The variety of products we're working on and the innovation in our pipeline are impressive, leading to more customer requests for new products. They're also taking more demonstration tools from us, and we're receiving a growing number of applications. So, I see our spending as justified. It should continue to rise. Although there’s a slight risk that operating expenses might be higher than projected, operating expenses as a percentage of sales have decreased by ten percentage points since 2013. Our operating margins have significantly improved and are likely to exceed expectations. There’s more downside risk than upside concerning revenue gross margins and operating margins in the current model.

Our focus is on innovation centered around significant inflections occurring at 10 and 7 nanometers. When creating AI chips that push physical limits, we encounter numerous technological challenges. This past year, we have seen growth in PVD to support new interconnect technology for lower-power devices and high-performance memory chips. In the memory sector, scaling 3D NAND presents major technical challenges for our clients. The key areas of focus are etch and deposition, where we have introduced very innovative materials. Our market share in the etch segment has increased considerably in recent years, and we are offering some of the most impressive products available. Sym3 has become the fastest-growing product in our company's history, and our Selectra product, which offers 1,000 to 1 selectivity, enables customers to create devices that were previously impossible and in new configurations. We are also addressing challenges for organic LED mobile displays as customers seek to expand their manufacturing capabilities for these new device types. Personally, I believe that Applied Materials' technology, talent, and competencies set us apart from competitors, and we are ideally positioned amid these significant trends. Over the past few years, we have redirected substantial investments within the company. While operating expenses as a percentage of revenue have decreased, we will continue to invest to support these developments and foster sustainable growth. The current opportunities for us are unprecedented.

I would like to revisit the topic of China. You mentioned expecting a significant increase in spending in China in 2018. If we focus on the memory sector, some customers have announced ambitious plans for 3D NAND technology. I’m curious if this anticipated increase in spending for 2018 depends on those customers meeting their targets or launching those devices, and if there are any issues with those devices that could delay the expected spending in 2018.

We have a range of forecasts for China. So as I said earlier, it's one of our strongest regions in both semiconductor and display. We have very, very deep relationships with many of these customers. Right now, what we believe for 2018 is that the business will be up meaningfully from 2017. But frankly, that’s also at the most likely and low-risk end of the forecast. There's a higher range there that would be going up at a much faster pace. We're looking at early indicators for all of those new projects, but I think right now, we're pretty confident that the increase in China in 2018 will happen. Maybe it's $1 billion, $1.5 billion in terms of total wafer fab equipment. So that we have pretty high confidence in terms of the engagements or the information we're getting from all of those customers. There is upside potential, but that's our current view.

Going back to the question about capital returns, your free cash flow as a percentage of revenue has increased significantly over the past five years. It averaged around 15% and is now over 20%. Your dividend yield has also decreased considerably due to the strong performance of your stock. However, considering the long-term debt you recently raised, which you explained earlier in the call, I'm curious if there are any changes to your approach to capital returns. Specifically, why haven't you raised your dividend and perhaps reduced spending on buybacks, especially since the dividend hasn't increased in several years? Or are you conserving cash for potential future mergers and acquisitions?

I believe we will continue to return a substantial amount of cash to investors over time. The way we do this may change as we focus more on dividends. While we haven't made a definitive commitment yet, I believe it will occur. I'm particularly interested in tax policy, as establishing a dividend is a fixed commitment that we need to maintain quarterly. It's essential to consider the long-term impact, as people assess yield rather than small quarterly increases. We need to ensure that any dividend increase over time aligns with our effective yield. As the stock price has risen, our cash commitment has increased as well. I'm open to making this commitment, but I prefer to have clarity on tax policy before formally committing to a growing yield.

Thanks, Sydney, for the question. And Latiff, time check. I just want to see if there's anyone in the queue still.

Okay. Thank you. We'll take that question and then we'll bring it back to me. Thanks.

You guys talked a lot about some of the trends driving logic and foundry, AI, deep learning, VR, and data center. And it's interesting because these drivers have some of the biggest chip sizes in the industry, right? In videos, the latest deep learning chip has 18 billion transistors on a single piece of silicon. Broadcom's latest data center switching chip has like 7 billion transistors. These are huge chips, right? My point is that each of these units is consuming more silicon, but they're also requiring more leading-edge complex manufacturing. So this is great for capital intensity trends. It's great for the equipment business. But frankly, it's a nightmare from a yield perspective. So help us understand the trends you're seeing in your metrology and inspection business and how you guys are helping your customers improve yields. You guys gained share in this segment last year. How do you think this segment grows relative to your overall semi systems business this year?

Thank you for the question, Harlan. Regarding the large logic chips you mentioned, we recently hosted the NVIDIA CEO, who talked about the significant implications for us. He noted that the chips are being built as large as physically possible and highlighted a substantial increase in memory. These developments are certainly advantageous for Applied Materials. In our inspection business, we are experiencing significant growth, having achieved record revenue in 2016 and are on track for even higher revenue in 2017. Our e-beam business, which includes e-beam inspection, e-beam review, and CD-SEM, is expected to grow more than 50% in 2017 compared to 2015. We have a robust technology position with top-notch electron optics and strong customer demand for our e-beam products across logic, foundry, and ongoing orders for PROVision in memory from major clients. Our position is very strong, and we believe we will maintain the growth we've seen in our PDC business over the past couple of years.

Great. Well, thanks, Harlan, for the question. Bob, would you like to add anything else before we close the call?

Sure. Thanks, Mike. One of Gary's favorite expressions around here is innovation's about connecting the dots. Let me see if I connect a few dots that I believe and I hope you heard today. One, we believe the wafer fab equipment market is sustainably higher and less volatile. Also, display is higher and for Applied, it's sustainably a better market because there are more technology inflections and because we're growing our served market. Second, Applied's position in the market is sustainably stronger. And we're executing better and better. And third, we're generating more free cash flow and returning the excess to our shareholders. Speaking of free cash flow, one of your own interesting note comparing Applied Materials to some of the top names in the industrial sector. Relative to the average of the companies, Applied has higher revenue and profit growth along with higher ROIC and free cash flow margins. Compared to these companies, I believe we're being discounted for being more cyclical even as we become demonstrably less cyclical. I believe that over time, we'll be viewed and valued in a new way. So thank you for your time today. We look forward to seeing many of you in person over the next few weeks.

Well, great. Thanks, Bob. And we'd like to thank everybody for joining us this afternoon. A replay of the call is going to be available on the website beginning at 5 p.m. Pacific Time today. And we thank you for your continued interest in Applied Materials.