Novellus Systems (NVLS) reported second quarter earnings that beat the Zacks Consensus Estimate by 3 cents, or 3.9%.
Revenue came within the guidance range, but was less than encouraging.
Still, analysts were already discounting Novellus’ expectations from the last conference call. Therefore, despite the weak revenue, flattish gross margins, declining operating margins and a higher tax rate, earnings outperformed.
Investors were disappointed at management’s cautious tone for the rest of the year, driving share prices lower.
Revenue
Novellus reported revenue of $350.2 million, down 15.2% sequentially and up 9.0% year over year, within management’s guidance range of $330-372 million.
Novellus warned that near-term demand trends appear to be weakening, particularly for key end applications, such as PCs, tablets and smartphones. Foundry customers have turned cautious and both DRAM and NAND pricing are trending down. Economic uncertainties continue to weigh on consumer purchasing power, so there could be a protracted period of weakness.
Capacity buildouts for the 2011 holiday season appear to be complete, so further capex spending may be pushed into 2012. DRAM was always expected to be soft this year, with NAND accounting for most of the growth. However, Novellus stated that although NAND remains its strongest business, market conditions appeared to be worsening and further capacity adds are uncertain. Additionally, some foundry orders were again pushed out in the last quarter and the possibility of further pushouts remains, according to management.
Novellus appeared generally more positive about its business in China, which has historically been hard to track and project, despite the fact that the market has been growing phenomenally. However, here too, we noticed a cautious tone.
While technology upgrades to 300mm manufacturing and 3x nm are sources of underlying strength at foundries, they too are unlikely to gain momentum in the current environment.
Revenue by Geography
Asia remained the largest contributor to Novellus’ revenues in the last quarter, with a 63% revenue share. However, revenues from Asia were down 6.3% sequentially and up just 1.0% from a year ago. The sequential decline was mainly on account of the Greater China region, which went from 42% to 40% of total revenue. Japan of course was also very soft, declining from 8% to just 4% of revenue. Korea partially offset this, growing 60.1% sequentially to 17% of total revenue.
Korea was the weakest region in the first quarter. This lumpiness is not unusual for Novellus, since it sells high-value low-volume equipment that can skew results from quarter to quarter. Korea remained soft when compared with the year-ago quarter, although all other regions were up, as foundry spending continued to disappoint.
Approximately 26% of revenue came from the U.S., which was down 35.2% sequentially and up 18.1% year over year, a reflection of the drop-off in spending and focus on yield improvements at the leading edge. Novellus is very strongly positioned here and should see improvement as spending trends up again.
Europe accounted for the remaining 11% of revenue, which was up 3.6% sequentially and 49.8% year over year.
Orders
Orders declined both sequentially and year over year to $317 million in the last quarter. This was the first time in seven quarters that orders declined, although growth rates had been dropping off in the two preceding quarters. Backlog was down 13.6%. Novellus did not mention the lead time, so we assume that it remained at 12-16 weeks, slightly higher than the normal 12-week range.
Margins
The pro forma gross margin for the quarter was 50.3%, down 7 basis points (bps) from the previous quarter’s 50.4% and at the lower end of the guided range of 50% (+/- 1%). Lower utilization impacted the gross margin in the last quarter, almost totally offset by a better mix. Gross margins have been expanding nicely in recent quarters and are currently just slightly short of Novellus’ long-term target of 52-54%. However, given that the semi capex market is likely to remain depressed, there may not be much improvement until the back half of 2012.
Operating expenses of $94.8 million were flattish sequentially and up 13.1% year over year. The operating margin was 23.3%, down 412 bps from 27.4% recorded in the previous quarter and up 53 bps from 22.8% reported in the year-ago quarter. Although R&D dollars were up just slightly and SG&A dollars actually declined, expenses were much higher as a percentage of sales, due to the sluggish top line.
Net Income
Novellus raised some debt in the last quarter, which resulted in higher interest expenses. The tax rate was also much higher at 17.6% compared to 14.5% in the March quarter and 15.7% in the June quarter of 2010.
Since there were no one-time items, the GAAP net income was the same as the non GAAP net income of $64.7 million (18.5% of sales) compared to $97.5 million (23.6%) in the previous quarter and $63.5 million (19.8%) in the year-ago quarter. Earnings on a GAAP basis were 79 cents in the last quarter compared to $1.04 and 66 cents in the preceding and year-ago quarters, respectively.
Balance Sheet
Inventories increased 1.1%, with inventory turns going from 3.7X to 3.1X. Days sales outstanding (DSOs) were flat at around 62. DSOs have been going up for a while now and flat in the last quarter may not be so great given the substantial revenue decline. Novellus ended with cash and short term investments of $812.4 million ($9.10 per share), up $173.8 million during the quarter. In the last quarter, Novellus generated $95.2 million in cash from operations, spending $4.8 million on capex and $626.2 million on share repurchases. Novellus has $415 million left under authorization.
Guidance
Novellus expects semiconductor capex to be up 10-15% this year (down from 15-20% previously), more in line with what market research firms were projecting.
For the second quarter, Novellus expects orders to be down 0-20%, with shipments dropping 11.3-16.5% sequentially. Revenues are expected to see another decline of 3-14% to $300-340 million. As a result, gross margins will go down to 49% (+/- 1%), even as opex dollars are contained at current levels. GAAP earnings are expected to come in at 60 to 75 cents a share based on a 15% (+/-2%) tax rate and share count of 74 million. This is significantly lower than the Zacks Consensus Estimate of 83 cents.
Our Take
End market softness (both supply and demand-related) has increased concerns that the cycle may be pausing. As a result, Novellus has seen declining orders, revenue and margins, which in turn resulted in plunging share prices.
As may be expected, prices for both NAND and DRAM have softened, indicating that memory manufacturers will be reluctant to spend on capex. On the other hand, uncertain demand has made foundries more cautious. This makes for an unfavorable operating climate for an equipment provider that is dependent on capacity builds or technology upgrades by customers.
However, the company remains one of the largest players in the space, with broad exposure to both Asian foundries and U.S.-based Intel Corp (INTC) and Advanced Micro Devices (AMD) through the Globalfoundries facility. We think this positioning will play a key role in 2012 and beyond when end demand may be expected to improve again.
Given the mixed outlook, we are incrementally cautious on Novellus shares, rating them Neutral on a long-term basis (3-6 months). We also have a short-term Hold rating on the shares, which translates to a Zacks #3 Rank.
