Applied Materials Inc (AMAT) — Q3 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 third quarter of fiscal 2017 earnings call, which is being recorded. Joining me are Gary Dickerson, our President and CEO; Bob Halliday, our current Chief Financial Officer; and Dan Durn, who will be our next Chief Financial Officer. Before we begin, let me remind you that today's call contains forward-looking statements, including Applied's current view of its industries, product road map, share positions, revenue growth, profitability 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-Q and 8-K filings with the SEC. All forward-looking statements are based on management's estimates, projections and assumptions as of August 17, 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. With revenue and profits at all-time highs, I'm pleased to report that Applied Materials has now delivered earnings records for the past 5 quarters. We have tremendous momentum and a very positive outlook for the future. Our markets are growing with a broader set of demand drivers. Across a wide variety of industries, companies are making huge investments to drive transformative changes that shift economic value towards technology. At the very foundation of these emerging trends is Applied. And we are playing a larger and more valuable role advancing the innovation road maps in semiconductor and display. Our broad portfolio of technologies and businesses, combined with our strategy and investments, means that Applied has never been in a better position. This gives me confidence that we will continue to expand our available opportunity, gain share and outperform our markets. In today's call, I'll outline key industry trends as well as our strategy for sustainable, profitable growth. I'll then provide additional details about our markets and major businesses. Bob will then discuss how we're translating our broad portfolio of capabilities and products into differentiated performance for Applied. And after that, Dan will provide his initial impressions about our future opportunities as well as our outlook for the next quarter. I'll start with the backdrop for today's discussion. These are incredibly exciting times for Applied, and I strongly believe that we have more opportunities today than at any point in our history. There are 3 main reasons for this. First, our markets are strong and getting stronger. Pervasive demand for electronics means that our markets are getting larger and substantially less cyclical. New demand drivers are emerging that layer on top of traditional computing and mobility. The Internet of Things, Big Data and Artificial Intelligence will transform industries over the coming years. In health care, transportation, manufacturing and retail, competition is increasingly dependent on capturing, transmitting, understanding and storing data and images. In these industries and many more, value is shifting towards semiconductors and displays. To realize the potential of IoT, Big Data and AI, major technology inflections are needed to advance the road maps in logic, memory and display. These inflections are enabled by materials innovation, and as the leader in materials engineering, Applied has a fundamental role to play. Second, Applied is better positioned than ever before. We've aligned the company around our innovation leadership strategy, and we've made significant investments to accelerate R&D. We have developed a strong portfolio of differentiated products, with more in the pipeline. It's the company's breadth and depth of products and capabilities that sets us apart from the competition. We have, by far, the largest exposure to industry inflections, and we're combining our skill sets in deposition, removal, materials modification, inspection and metrology to deliver innovative, new solutions. Third, we built a platform that gives us sustainable advantages over the long term. We've done this by strengthening our technical and management teams and putting in place a company-wide operating system, the product management engine, that delivers repeatable success. Across the organization, I see stronger execution. Our product success rate is higher, we are transferring new technology to market faster and we're using our breadth more effectively. I'll now describe the major inflections and investments within our markets. In memory, near-term market fundamentals remain strong, driven by high-performance storage for data centers and increasing smartphone content to support new features, including 3D cameras. We expect healthy investment in memory to continue as the explosion of data storage requirements created by IoT, Big Data, AI and streaming video has only just begun. To keep up with demand, customers are aggressively pursuing their 3D NAND scaling road map, which has 4 major levers: increasing number of pairs, shrinking film and stack heights, multi-tier schemes and lateral scaling. All these approaches are enabled by advanced materials engineering and expand Applied's opportunity. In foundry, market dynamics are equally healthy. In the near term, we see capacity additions at trailing geometries to meet growing demand for sensors and IoT devices as well as strong investment in the leading edge. Looking ahead, advances in Artificial Intelligence are beginning to drive significant architectural changes, and customers are positioning themselves to win the major inflections in high-performance computing. In data centers designed for AI workloads, we see logic content growing at least twice as fast as memory. And as technology complexity increases, capital intensity is also growing about twice the rate of memory. In foundry logic and DRAM, dimensional scaling of devices remains a challenge, with 2 primary areas of focus: resolution and placement accuracy. New innovations in patterning are becoming increasingly important as customers move to advanced nodes. First, self-aligned multi-patterning techniques, SADP and SAQP, are needed in conjunction with EUV lithography to drive the resolution road map. Regardless of the rate of EUV adoption, we expect our opportunity in traditional multi-patterning to grow. Applied has great momentum in this market and has gained 16 points of shares since 2012. Second, new patterning approaches are being developed to address placement errors. As devices scale, the accuracy of vertical alignment between interconnect layers has a significant impact on performance and reliability. Placement errors cannot be addressed by advanced lithography alone and will require materials-enabled solutions. Applied has unique technology in this area, and we expect our opportunities to grow significantly over the next several nodes. Looking at the market as a whole, our outlook is incrementally more positive. We now believe that wafer fab equipment spending for the calendar year will be up 20% or more compared to 2016. We also expect 2018 spending to be higher than our current estimate for 2017. And in these forecasts, we made conservative estimates for spending in China. In addition, within wafer fab equipment, the ongoing shift to materials-enabled solutions in memory and logic opens up new opportunities for Applied. We now address 64% of the total market compared to 53% in 2012. Beyond semiconductor, our outlook for the display market has also strengthened. Display is growing even faster than wafer fab equipment as customers make multi-year investments to address large inflections in both TV and mobile. In TV, a major push to new Gen 10.5 substrates is underway. These huge, 10 square meters substrates are ideally suited for manufacturing larger format screens, 60 inches and bigger. We now expect 30 new Gen 10.5 factories to be built over the next several years. At the same time, mobile OLED investment is getting stronger as customers prepare for broad adoption of OLED in smartphones. OLED enables new form factors that result in a larger display area for smartphones, further expanding the overall market. I'll now provide brief updates for our major business groups. Our semiconductor leadership businesses, where we have strong market share and highly differentiated products, are having an outstanding year, fueled by investment in leading-edge foundry and expanding applications in memory. Demand for our PVD and CMP products is especially strong. We expect the PVD market to grow by around 45% in 2017 as foundry customers adopt new interconnect technology. And the CMP market is on track to grow 40% this year on top of 40% growth in 2016. Our CMP revenues were at an all-time high this quarter and are on track to exceed $1 billion for the fiscal year. In our semiconductor growth businesses, we have great momentum in markets that are growing rapidly. Over the past several years, we have gained significant market share in both etch and CVD. Our combined etch and CVD revenues are at record levels, and we're in a great position to drive further growth. Service is an important part of Applied's portfolio that has grown significantly. This year, we're seeing acceleration of that growth. We delivered record performance this quarter, and for the year, we expect revenues to be up more than 15% over 2016. Demand for our Service Solutions is driven by our rapidly growing installed base, plus our customers' need to shorten ramp times, improve device performance and yield and rapidly optimize their factory output and operating costs. We are investing to expand the services we offer, and we are confident in our ability to sustain our growth in this business. In display, as technologies and manufacturing are becoming more complex, Applied is in a unique position to enable the road map. This year, display revenues are on track to increase more than 50% over 2016, and based on our strong position, we expect to grow display at least another 30% in 2018. Before I hand the call over to Bob, I'll quickly summarize. Applied is executing well, setting new records, growing our available market and gaining market share. I would like to thank our employees for their passion to create value for customers and Applied. I'm confident that together, we will raise the bar further. Applied is in a great position, working at the sweet spot of major trends that will drive tremendous shifts in economic value over the coming years. Finally, our breadth and depth differentiate us from our competitors. We have wider exposure to major industry inflections, and we are bringing together the broadest skill sets and technology portfolio to create new solutions for our customers and accelerate innovation. Now let me hand the call over to Bob.

Thanks, Gary. Today, I'll add my comments about the business environment, describe how our capabilities and products are driving competitive and financial performance and invite Dan to share his perspective, along with our Q4 guidance. As you contemplate the markets, including record levels of demand for semiconductors and displays, I'd like you to note 3 things. First, I feel increasingly confident that our markets are becoming materially and sustainably larger. Gary explained the big picture, and I'll add some data regarding the near-term environment. In semiconductor, 2/3 of NAND demand is driven by smartphones and SSDs. NAND demand for these devices is projected to grow by more than 40% in 2017 and 2018. Smartphones and servers drive the majority of the DRAM market. And demand from these devices should be up by 30% or more in both 2017 and 2018. In foundry, our largest customer recently announced that its 7-nanometer tape-out expectations have nearly doubled. And we continue to see new investment at trailing geometries as well. So the largest drivers of WFE demand are strong. Second, Applied is uniquely well positioned in this improving environment, and we're driving growth and competitive performance across our markets. Applied has incredible breadth. And we're taking advantage of it across our semi and display businesses to help our customers solve their highest-value problems, with solutions based on unique combinations of our technologies. The investments we've made in our new product pipeline are already impacting the market. In 2017, we're delivering strong, double-digit revenue growth in every semiconductor device type. We project our share to be up for the sixth year in a row. And our share is balanced at greater than 22% across memory, logic and foundry. In patterning, we see continued growth and share gains because we're shipping newly designed products that address both line shrinks and edge placement errors. We've also put our services business on a growth trajectory, adding $1 billion in annualized revenues since 2013. And we built a unique and more diverse growth engine in display. In 2012 and 2013, our annual display revenue averaged $657 million. We expect to deliver a similar amount in the current quarter. Our display business is also becoming more profitable, and we're now targeting operating margins in the high 20s. So Applied has the broadest capability, largest served market opportunity and strongest new product pipeline of any company in the industry. Third, and perhaps best of all, Applied's innovation engine and operating discipline are driving higher profitability. The value that our technology brings to the industry is increasing, and that's reflected in our gross margin, which has grown by 5 points over the past 5 years. In Q3, our gross margin was the highest in 9 years. At the same time, we remain focused on expense control. In Q3, our non-GAAP OpEx-to-sales ratio was 17.9%, a record low. As a result, we delivered our first quarter with $1 billion in operating profit, and we had record cash from operations equal to 36% of revenue. Next, I'll comment on our Q3 performance on a year-over-year basis. We grew company revenue by 33% and non-GAAP gross margin by 2.9 points. We grew non-GAAP operating profit by 67% and increased non-GAAP operating margins by 5.9 points to a 16-year high of 28.7%. And we grew non-GAAP EPS by 72% to a record of $0.86 per share. Turning to the balance sheet. We grew cash and investments to $8.3 billion, and 40% was onshore. We repurchased 9 million shares of our stock and returned $482 million to shareholders, including dividends. Turning now to our segment performance on a year-over-year basis. We grew semiconductor systems revenue by 42% to a record $2.5 billion and grew non-GAAP property profit dollars to a record of $920 million. We grew services revenue by 20% to a record $786 million and increased non-GAAP operating profit dollars to a record $215 million. We grew display revenue by 31% and increased non-GAAP operating margin by 2.6 points. In summary, I'm proud of the accomplishments of our teams, and I'm pleased with our top and bottom line growth. Applied's innovation engine is delivering sustainable momentum for our profitable growth. Now I'll hand the call over to Dan.

Thanks, Bob and Gary and the entire team here at Applied Materials. You've given me a warm welcome and a great introduction to the technologies we're preparing to launch into a growing market for our products. I'm incredibly impressed by the depth of our technical talent. Applied has a world-class team, and I believe we can do anything we set our minds to. Gary and Bob talked about new advances in technology that are going to make dramatic change to our industries and to our lives. I saw this unfolding at my previous companies, and I'm excited to be here because these changes are enabled by semiconductors and displays, which begin with what we do at Applied Materials. I'll share more of my impressions about Applied at our Analyst Day in New York. One thing that's already clear to me as a financial person is that Applied has a tremendous portfolio. The leadership semi business, as Gary talked about, has some of the strongest product positions and profitability I've seen anywhere in this industry. The semiconductor growth businesses, as Gary mentioned, are dramatically outpacing their markets. Etch is up 5x over the past 5 years, growing at 2.5x the rate of the market, and that's just one example. Display is growing faster than semi, and we have technologies in the pipeline that will enable us to grow beyond what we can do in OLED smartphones and LCD TVs. And services are a great way to drive growth and diversify the company in areas that are particularly stable and cash-generative. Applied's portfolio is incredibly valuable. I'm excited to be a part of this team, and I'll use all of my energy to help drive Applied's innovation engine and growth. Now I'll provide our fourth quarter guidance. In Q4, we expect our overall revenue to be in the range of $3.85 billion to $4 billion. The midpoint would be up nearly 19% year-over-year. We expect our semiconductor systems revenue to increase by about 14% year-over-year. We expect services revenue to grow about 17% year-over-year, and display revenue should be up by about 48% year-over-year. We expect non-GAAP gross margin of about 46%. Non-GAAP operating expenses should be $685 million, plus or minus $10 million. And we expect non-GAAP EPS to be in the range of $0.86 to $0.94, the midpoint of which would be up by 36% year-over-year. To help you with your models for the calendar year, I'll share some of our early views on Q1 of fiscal 2018. We believe semiconductor systems revenue in Q1 is likely to be higher sequentially and higher year-over-year, and we believe our display revenue in Q1 is likely to be lower sequentially but higher year-over-year. Now I'll summarize by putting the company's guidance and momentum into context. In Q4, we expect the second highest semiconductor equipment revenue in our history, with continued double-digit growth momentum year-over-year. We also expect to set new record levels in services, display and for the company as a whole. We expect record earnings per share. We also look forward to another year of growth in 2018 based on strong customer pull across the portfolio as we supply our enabling technologies to drive the new data economy. I look forward to sharing our longer-term financial targets at the Analyst Day in New York September 27 and especially look forward to meeting many of you there. Now let me turn the call back to Mike to start the Q&A.

Thanks, Dan. Let's please begin.

I guess, the biggest question here is sustainability in memory. And it looks like you're guiding around $43 billion plus or minus this year. And roughly 70% of that looks like it's coming from NAND. And so curious, as you look at that part of the market, can you talk to your visibility to both greenfield and shrink plants as well as your thoughts around demand elasticity and how you're thinking about spend from that business over the next 5-plus years?

Sure, I'll take a shot. Overall, we expect wafer fabrication equipment in 2018 to be up from 2017. By device type, we anticipate that logic and DRAM will increase next year, and we expect both foundry and NAND to be strong as well. I think the 70% of total spending coming from NAND sounds a little high since we estimate NAND will be less than 50% of total spend. However, I will provide a deeper analysis of the memory markets. Let's talk about DRAM and NAND together first. There are three key factors that customers consider regarding Applied in both NAND and DRAM. First, NAND is currently very profitable for our customers, and I will share the specific numbers. Second, demand for both DRAM and NAND remains robust and sustainable. Third, wafer start additions have been modest, which I will detail further. Additionally, it's worth noting that Applied Materials has gained 8 points of wafer fabrication equipment share in both DRAM and NAND over the past four years. Now for more specific details. In terms of customer profitability, DRAM wafer fabrication equipment spending as a percentage of total EBITDA for our customers used to be around 26%. We expect this to decrease to approximately 14% this year and next, demonstrating strong profitability. On the NAND side, this percentage has also decreased from about 26% to around 19%, but we are still seeing higher growth rates in NAND. Next, let's consider bit demand. For smartphones and servers in both 2017 and 2018, we anticipate a 30% bit growth demand. While this may dip slightly when including PCs, the main drivers remain smartphones and servers. In NAND, we project a 40% growth rate for both smartphones and servers. Regarding capacity additions, NAND and DRAM wafer capacity has largely remained flat over the past five years, despite some bit growth due to increased layering. The additional wafer capacity has been modest, increasing from a couple of hundred thousand wafers to 1.6 million. We estimate needing about 2 billion wafer starts in the future. So to summarize the three main points: customers are highly profitable in both DRAM and NAND, bit growth and demand are healthy and expected to continue, and actual wafer additions have been moderate. Therefore, we believe NAND will remain strong for the foreseeable future.

Just quick clarifications. On the Jan quarter, do you think it will be a record level for SSD or not? And secondly, any color on the first half of next calendar year? Your commentary on 2018 seems to be fairly confident. Is it fair to say that the only things that you're seeing in 2018, they are looking pretty strong right now?

Yes, it's strong. And we said in the call that Q1 was going to be a good fiscal quarter for us. So we said semi was going to be incrementally stronger than the comp. And display not quite as strong as the comp in Q4 that we just guided to. So if you look at where we're close to a record SSG this quarter, I think the record was last quarter, Q3. I think there's a pretty good chance that the record in Q1. There's a second question. Did you have a second part?

Yes, I was just wondering if you have any visibility that gives you confidence about the first half of next year overall.

What we said on the call, number one, was that we think next year, WFE is up. We also think our position is really good. And we have a strong degree of confidence in our fiscal Q1, and we don't see that problematic after that. We think it's a pretty good year.

I just want to clarify the 30% year-over-year growth for display, is that for fiscal '18 or calendar '18?

Fiscal revenues. Calendar's good, too. I just don't have that closer on the calendar basis.

Okay. And can you help us out, how much of that is kind of market growth? I think, in the past, you've talked about an $18 billion display spending this year. Is that mostly market growth? Or are you baking in contributions from new products?

Yes. If you look at it in '17 and '18, our total revenues are going to be up in about 30%. If you go look at the market in '17, '18, it's going to be healthy. And our position's going to strengthen. And what I alluded to a little while ago that we're going to have some new product introductions. In fact, we already had 1 about a year or so ago. We're going to have more. So I think we'll get some contributions from the market and our position.

You guys discussed the growing number of programs for large-screen LCD in your pipeline. A few weeks ago under earnings call, LG display discussed spending about KRW 20 trillion of bullet CapEx over the next 4 years. That's about USD 18 billion. And what actually for large-screen OLED? And I think the view is that OLED TV volume's going to grow from 2.5 million, 3 million next year to something like 6 million by 2020. Can you remind us on your position and large-screen OLED, your views on how you see the market evolving? Clearly, I think feel like it's been expected ever after mobile adoption.

Sure. I'll give us some factoids on the overall market, which is touch on, Harlan, and a little bit on the OLED and then Gary might join on that one, too. So in terms of I do for you mentioned them, from our call, which, I think, was 3 months ago, our expectations for the total market of display equipment has gone up for all 5 years in our window, '17, '18, '19, and 20 and '21, all 5 have gone up. And we see strength across the board, basically, in both TV and mobile. A lot of big TV factories and increasing strength in mobile. So it's a very strong market position even more so than 3 months ago. In terms of our product positions, we're going to continue to traditional price. In terms of OLED TVs, kind of my stuff color filter I guess. So it's not the same OLED as you have in mobile, but it is a version of OLED. And our position is pretty good there. But it's not that big technology inflection, which is as much percentage growth in for everybody as you have some back in the mobile phones. We've been increasing our share with nearly all of our customers, and we have a stronger position during this turning point, which is a positive indicator for our long-term prospects. In terms of market trends, we are still in the early stages of OLED for mobile, and as this continues to develop, it will significantly benefit us. The growing adoption of larger screens in TVs, along with the upcoming construction of the 13th Generation 10.5 factories over the next few years, will also contribute positively. Additionally, major technology companies are making substantial investments in areas such as virtual reality, augmented reality, and automotive displays. These emerging display technologies and portable displays could have a more prominent impact when viewed over a 3- to 5-year horizon. We are well-positioned to take advantage of all these evolving opportunities.

I had a question on display. Something has been going on, seeing the display CapEx is going to be down next year, but you guys are guiding to up 30% for revenue. And I understand you're getting some new products introductions. So a 2-part question. How much of the growth next year is driven by new products versus the existing product line? And along the same path, can you split up of your revenue display revenue by LCD versus OLED for this year and next year?

Well, first, I'll do the market then I'll do a little bit on us. So with it of the total spending by display manufacturers is up this year and up again next year. We think it's pretty strong in both TV and mobile. So the big TVs are driving the CapEx spending on TV, and then mobile is mostly the OLED driver. So we see upside. In total, we see upside in TVs next year. And we also see some upside potential in mobile next year. And part of that is you see a proliferation to mobile phone display manufacturers beyond the big one in Korea. So if you think about the factoid we gave you over the last couple of quarters, if you go back to our sales of OLED equipment in fiscal '16, roughly 2/3 was to the biggest manufacturer of OLEDs. We've now proliferated to 10 different people buying some equipment from us. And the big guy, in terms of commitments of orders this year, fiscal '17, is significantly less than 50%. So what you're seeing is next year can grow because TVs are good, and you have a proliferation of more people making the mobile phones.

Gary, I was hoping you could elaborate a little bit on your view on China into 2018. You talked about having relatively conservative assumptions embedded in your WFE forecast for 2018. But what exactly are those assumptions? And what would be the bulk case over the next 12 to 18 months?

Thanks for the question. China is one of our strongest regions in both semiconductor display. Our business is growing a significant amount. If you look at '17 versus '15, we're up 2x in semi, 50% growth in service and 50% in display. In '16 to '17, we anticipate we're going to be up more than 20% overall in China. We track all the projects. We have very close relationships and very high share in China. So we're talking on the projects for all of the customers. And we have leading indicators for the most likely investments. There's a lot of discussion about investment, but we qualify that based on these leading indicators. And based on all of that, 2018, we think, will be up an incremental at least $1 billion, probably in the range of $1 billion to $1.5 billion in 2018. Longer term, we think that this number is going to continue to grow because of the strategic nature of the investment. In China, they're trying to grow the present domestic content, build a secure supply chain and it's a long-term strategy. The investments are not as efficient. Many of the investments next year will be in pilot plants in China, but we believe that this market will continue to grow over time, and our position is very, very strong in both semiconductor and display.

I want to ask about the growth in services. You talked about 15%, which is pretty good. I know you had a strategy operating kind of trying to move that opportunity. Can you talk about how you see is just because of the significant increase in the installed base tools versus some of the other things you might be doing to drive that growth?

If you look at the longer-term historical perspective, we used to maintain around $2 billion a year back in 2013. This year, we expect to reach about $3 billion. The year-on-year growth rate is 15.9%, and the quarterly momentum has even picked up throughout the year. I'm quite confident that next year will be strong for us, potentially even better than this year for a few reasons. First, regarding our service business, it's driven by the market, our position, and our strategy. The market for WFE is quite robust, presenting significant opportunities for us this year and next. In terms of market share, we were at 17.8% of WFE for 300-millimeter tools in 2013, and last year we grew to about 22%, with further growth anticipated this year. Secondly, as we gain market share, our service entitlement is increasing. All these dynamics, including our market position and the products we are offering, are enhancing our service entitlement. Finally, our strategy is continuously improving. Instead of focusing on parts and ad hoc labor, we are now selling long-term service contracts. We're aiming to secure an additional 1,000 service contracts per year, which means we will have more predictability, sustainability, and value for our customers and ourselves. This again elevates our service entitlement. Therefore, I believe the growth rate of our service business will remain strong next year.

It seems like the DRAM industry is at a crossroads here, whereby with the conversion to 1x, bit supply growth is going to decelerate into the teens range. And that's well below what people are thinking in terms of DRAM bit demand, call it, 25%, 30%. So it would seem like next year, we do see capacity increase. And I know you guys are positive in that segment for 2018. And I was hoping you could just share your assumption for capacity additions in DRAM.

I'll start with my remarks, and then Gary can add his insights. If we examine the situation, three out of our four major memory clients are engaged in both DRAM and NAND. Personally, I think there are some variations in strategies for DRAM and NAND. In the case of NAND, demand appears to be quite strong with considerable growth compared to hard disk drives, leading to increased investments and potential profits. On the other hand, DRAM doesn't seem to be experiencing the same level of growth. Although nominally, you can achieve about 28% more bits per wafer, the process involves more partners extracting wafers from the same facility, which results in additional steps and ultimately leads to around 14% growth in output from our factory. This makes it increasingly costly to effectively increase bit production. So, what is the approach? If you have an overarching company strategy, it would likely favor investing in new NAND projects that generate revenue over transformations in DRAM. Based on our forecasts, in 2017, we estimate approximately 75,000 wafer starts shifting to 2.40 to 2.50. However, the net additions might be slightly lower due to a decrease in output linked to a higher layer count. For 2018, we expect similar figures, around 75 additions transitioning to 2.90, but this will lean more toward conversions than new additions because of economic factors.

Looking at the foundry market, clearly, you're benefiting right now from capital intensity trends going to the 10- and 7-nanometer node. But could you just discuss maybe how that node may develop over time? And could you see that node being potentially as large as the 28-nanometer node, which has been very profitable for the chipmakers? Is it possible that this is the next big node that we see, and this could be a multiyear event for the foundry segment?

I believe the answer is yes across the board. If you examine the 28-nanometer node, which peaked at 335,000 wafer starts about nine months ago, our estimate for the 7-nanometer node is expected to peak quickly, moving from around 250,000 to 260,000 and then possibly 280,000. Currently, we're at 300,000 wafer starts, and there may be potential for more growth due to increasing applications for 7-nanometer devices, including typical mobile processing and expanding into cloud and automotive sectors. This trajectory suggests a significant expansion similar to that of the 20-nanometer node. The positive aspect is that this growth is substantial and sustained. As we progress, there will be a transition, prompting us to focus on the roll-out to 5-nanometer while maintaining production at 7 nanometers for a while. Additionally, it's noteworthy that while wafer starts are down from 335,000 to 300,000—about a 10% decrease—capital intensity has seen an increase of over 90% from 28 to 7 nanometers. This means that producing these wafers requires significantly more equipment, and our position in the market is strong due to the volume of equipment sales.

Just quickly on margin, two-part question. One, revenue said just marginally coming down actually the lower.

Edwin, could you repeat the question, please? I just couldn't hear it clearly.

Sure, no problem. So I guess, 2-part question on margin. First is service margin, I noticed it came down this quarter. Wondering what's driving that? And then display, with the revenue increase in this quarter and you guys guiding for higher revenue, is it possible to display get to the city marginal level sometime in the future?

Okay. So first, I'll do service margins. Yes, operating margins. So there's the trendline, and they can pull up service that they get the data here. Q3, Q4. Yes. I think service growth and operating margins are up a little bit in Q3 and up more in Q4, actually. And our trendline is they're going to go up. So I think what you'll see, I'll give you some longer-term perspective on where we're going on that might help. We used to be 23%, 24% operating margins in service. And then in the full year '16, we're probably 26.5 or 7. This year, the guide is like 28%, frankly, and we're going to trend up a little bit more. So our optima did end up gross margin trending up some too. So I think generally, the trends look good. What's driving the trendline and margins? Revenue gross but it on good gross margins are coming up, and you get dropped to us to get the percentage gross margin, and you get the leverage of the revenue growth. So I think operating margins are going to trend up and gross margins trend up as well.

One other thing I would add in terms of service is we've really done a great job in driving lower costs. We're moving a lot more content into lower cost regions. And customers are also facing big challenges in the technology ramps for logic and also for memory. Our opportunity, Bob talked about earlier, in service contracts is also increasing our revenue growth. So we're driving lower costs. We're driving greater value for customers, and that is increasing our overall operating margins and giving us momentum going forward in the service business.

In display, our operating margins and gross margins are improving. For operating margins in display, they have risen from about 9.8% in 2012 to 16.8% in 2013, 24% in 2014, around 25% in 2015, and approximately 20-21% in 2016. We are investing, and this year we expect to reach about 26%. Next year should see further increases with higher volume. Overall, we are optimistic about our display performance. Looking at our long-term model, which we will present at Analyst Day, last year we demonstrated that our operating margins and gross margins in the semiconductor sector are generally higher, but both services and display are on the rise as well. We anticipate reaching high 20s for service and display, and the semiconductor sector should see margins in the higher 30s, leading to an overall average increase.

I just wanted to dig back into the visibility habits are large memory customers. And the reason I ask is just 6 to 9 months ago, your outlook for the year was substantially different. I wonder if that visibility has actually improved or you're really commenting on the trends are you're looking into 2018?

That's a really good question. Let me provide some historical context. We typically make our forecasts based on discussions between the account and marketing teams, analyzing trend data and the factors driving those trends. For our one-year forecast, we rely more on the account teams. Feedback from customers regarding visibility for the second half of the year has been moderate. Sometimes they lack information, and at times they choose not to share it because of competitive concerns. I believe the semiconductor capital equipment industry may have underestimated the outlook for the second half of this year. If we had given it more thorough consideration, we might have predicted a higher figure for the latter half. There is one particular customer whose performance is significantly exceeding expectations. We have invested more time analyzing the underlying factors influencing this, looking beyond just what customers tell us to understand their sales, the types of devices they are producing, and the components involved in phones, PCs, and cloud services. For example, our understanding of the content in devices at the end of 2016 was not just about phone units, but rather the content itself. This trend is continuing into this year. If you ask which types of devices are performing better than our early expectations, it's across the board, particularly in NAND, DRAM, and foundry, with NAND seeing the most significant increase driven by one customer. We are now dedicating a lot more effort to understanding the root causes behind the demand in NAND. Overall, I feel more confident about our outlook than I did a year ago.

I'm going to ask you to take another longer-term view on the end user is as you did with foundry, DRAM. And what I was hoping you could you do is just click out beyond the next few shrinks that we're likely to get to some of the alternative architectures. And the question is really around the equipment intensity that might be seeing with any of the successor architectures that would be there for DRAM. Is it higher? Is it lower? Is it a mix? What's the company seeing longer term for the extension to nonvolatile memory as we know it or volatile memory as we know it?

I'll start with more general stuff, and Gary will do the more technical stuff. I generally am optimistic about the industry and the various device types, but there's going to be granularity to some of that. So I believe that these drivers that this greater and greater valuable applications for silicon at the need to be basically, A, leverage the fiscal assets and universe more efficiently through silicon. And two, I think a lot of the incremental consumption of entertainment meets health care will be leveraged by silicon. So I think the cosmic drivers, whether it's on automobiles, hotels, health care, you name it, silicon's going to play a big role in this. Okay? So that drivers now that said, how to make money in life is 2 ways: scale and differentiation. So if you look at the scale of these things be a big increase in scale up at the cloud with huge volumes. And the differentiations of these solutions, what does that mean? I think you're going to have more different tape outs, some are different types of devices than you have before. I think you'll see the A6 chips. You'll see the graphics processor units at the guilty different types of high-end, low-end, and different types of DRAM. And I think you'll see different types of memory. So I think the proliferation, more devices and more design, which is all good for us, frankly. And NAND, if you go to, but I think about altered memory? I think NAND is going to grow for a while. Hard disk drive. I think DRAM and memory was that segment the market the products because of volume of the differentiator so valuable that you can go to different design times. I don't think it's going to be one shoe fits all feat. And then thirdly, in terms of capital intensity, capital intensity by device type is up across the board from a few years ago, 30% to 90%, right? And I don't see that trend changing for all new devices either.

I agree with Bob that significant investments are being made by leading companies to drive transformative changes that will create economic value in major industries. This presents a significant opportunity for memory in high-performance computing and other areas. Over the last few years, we have seen tremendous innovation in memory architecture, driven by advancements in materials, which is our core strength. We are collaborating with large companies to enhance current memory technologies, especially in scaling 3D NAND, and we are also developing new memory technologies. I believe the pace of innovation will accelerate, with Applied Materials at the forefront of materials innovation. I am optimistic about the overall market opportunity and even more optimistic about our ability to grow as these changes unfold.

Gary, you talked about Gen 10 fabs in the display side. So I was wondering how it will often be OLED. And as a bigger picture, is this large-scale transformation to OLED happening, are you going to see a new baseline to your display revenues?

So the Gen 10.5 factories are really focused on TV and all of the 13 projects that we're tracking right now are not OLED factories. They're, again, large area. We're seeing an increase in terms of the area consumption for large screens. And it's way more efficient to go to these larger factories from a cost perspective. So that's what's driving that. I mean, certainly, we're certainly very optimistic about mobile OLED and the opportunities that we have there. We're still in the early innings. But the driver for Gen 10.5 is larger TV screens. Bob, if you want to add anything else?

Yes, I think that's correct. There are many upper directional errors affecting the market. The new baseline revenue for display is on the rise, which addresses your question, Jagdish. If you observe the trends, there are larger TVs now; not just OLED, but also other innovations like the phones that allow for wraparound features, providing 40% more surface area. I anticipate that we will see foldable devices in a few years, which would effectively double the usable surface area compared to a phone or an iPod. Eventually, we will see a wider adoption of OLED technology, as you mentioned, but that's further down the road. All these factors lead to increased spending. People might have questioned a year or two ago if WFE spending would remain consistent at $32 billion and display spending at $8 billion, thinking it should hold at 25%. However, that's not the case due to different drivers. Display technology has significant applications across the globe in TVs and mobile phones, and the demand for high-quality visual content is rapidly growing. Therefore, I believe the potential is substantial.

I had a question on gross margin heading into next fiscal year. Bob, you talked about display growing 30% year-over-year. I'm guessing, at least at this point, you don't have as high expectations for the semiconductor business. Did you think you can improve gross margins in the next fiscal year?

Our goal is to increase gross margins each year. This year, we’ve performed particularly well and expect to see an increase of about 2.9 points. Overall, we’ve seen significant improvements across our product lines. Every product and sector, including both services and semiconductors, has shown growth in gross margins from 2013 to 2017. The execution has been strong, and the mix this year has been favorable, especially in semiconductors and display services. I believe there's an opportunity for further growth next year, although it may be challenging to match this year's performance. My average goal has been structured around achieving an increase of about a point per year, and if we continue on this path, we are already ahead of my 2019 model. There remains room for further improvement.

Sure Michael, summarizing a few key points from today's call. First, I hope you share my excitement that Applied's markets are significantly larger and more appealing than they have been in the past. We expect another record quarter in Q4 and anticipate continued momentum in Q1 and well beyond. Second, Applied is uniquely equipped to outperform in our core market, further establishing our leadership in semiconductors, expanding our unique opportunities in display, and growing our service businesses. Third, we are more profitable than ever, and we have several strategies to maintain this profitable growth. Lastly, I look forward to seeing all of you at the upcoming Analyst Day on the 27th, and I am eager to demonstrate how we can enhance our performance in the years ahead. Mike, back to you.

Thanks, Dan. We would like to thank everybody for joining us this afternoon. A replay of this call is going to be available on our website beginning at 5:00 p.m. Pacific Time today. And thank you for your continued interest in Applied Materials.