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APPLIED MATERIALS INC /DE - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) All statements in this Quarterly Report on Form 10-Q and those made by the management of Applied, other than statements of historical fact, are forward-looking statements. Examples of forward-looking statements include statements regarding Applied's future financial or operating results, cash flows and cash deployment strategies, declaration of dividends, share repurchases, business strategies, projected costs, products, competitive positions, management's plans and objectives for future operations, research and development, acquisitions and joint ventures, growth opportunities, customers, working capital, liquidity, financing plans, investment portfolio and policies, and legal proceedings and claims, as well as industry trends and outlooks. These forward-looking statements are based on management's estimates, projections and assumptions as of the date hereof and include the assumptions that underlie such statements. Forward-looking statements may contain words such as "may," "will," "should," "could," "would," "expect," "plan," "anticipate," "believe," "estimate," "potential" and "continue," the negative of these terms, or other comparable terminology. Any expectations based on these forward-looking statements are subject to risks and uncertainties and other important factors, including those discussed in Part II, Item 1A, "Risk Factors," below and elsewhere in this report. Other risks and uncertainties may be disclosed in Applied's prior Securities and Exchange Commission (SEC) filings. These and many other factors could affect Applied's future financial condition and operating results and could cause actual results to differ materially from expectations based on forward-looking statements made in this document or elsewhere by Applied or on its behalf. Applied undertakes no obligation to revise or update any forward-looking statements. Overview Applied provides manufacturing equipment, services and software to the global semiconductor, flat panel display, solar photovoltaic (PV) and related industries. Applied's customers include manufacturers of semiconductor wafers and chips, flat panel liquid crystal displays (LCDs), solar PV cells and modules, and other electronic devices. These customers may use what they manufacture in their own end products or sell the items to other companies for use in advanced electronic components. Applied operates in four reportable segments: Silicon Systems Group, Applied Global Services, Display, and Energy and Environmental Solutions. A summary of financial information for each reportable segment is found in Note 16 of Notes to Consolidated Condensed Financial Statements. A discussion of factors that could affect Applied's operations is set forth under "Risk Factors" in Item 1A, which is incorporated herein by reference. Product development and manufacturing activities occur primarily in North America, Europe, Israel and Asia. Applied's broad range of equipment and service products are highly technical and are sold primarily through a direct sales force. Applied's results historically have been driven primarily by worldwide demand for semiconductors, which in turn depends on end-user demand for electronic products. Each of Applied's businesses is subject to highly cyclical industry conditions, as demand for manufacturing equipment and services can change depending on supply and demand for chips, LCDs, solar PVs and other electronic devices, as well as other factors, such as global economic and market conditions, and technological advances in fabrication processes. The following table presents certain significant measurements for the three and nine months ended July 31, 2011 and August 1, 2010: Three Months Ended Nine Months Ended July 31, August 1, Change July 31, August 1, Change 2011 2010 2011 over 2010 2011 2010 2011 over 2010 (In millions, except percentages) New orders $ 2,390 $ 2,725 $ (335 ) $ 8,547 $ 7,723 $ 824 Net sales $ 2,787 $ 2,518 $ 269 $ 8,336 $ 6,662 $ 1,674 Gross margin $ 1,184 $ 860 $ 324 $ 3,509 $ 2,498 $ 1,011 Gross margin percentage 42 % 34 % 8 points 42 % 37 % 5 points Operating income $ 687 $ 183 $ 504 $ 2,037 $ 685 $ 1,352 Operating margin percentage 25 % 7 % 18 points 24 % 10 % 14 points Net income $ 476 $ 123 $ 353 $ 1,471 $ 470 $ 1,001 Earnings per share $ 0.36 $ 0.09 $ 0.27 $ 1.10 $ 0.35 $ 0.75 36 -------------------------------------------------------------------------------- Table of Contents Fiscal year 2011 is a 52-week year with 39 weeks in the first nine months, while fiscal year 2010 was a 53-week year with 40 weeks in the first nine months. Financial results for the third quarter of fiscal 2011 reflected a decrease in total new orders year-over-year while net sales and net income increased year-over-year. New orders were down in the third quarter of fiscal 2011 for semiconductor equipment, crystalline silicon (c-Si) solar PV equipment, and LCD equipment. The decline of total new orders for the third quarter of fiscal 2011 compared to the third quarter fiscal of 2010 reflected a softening in the macroeconomic environment and industry conditions. Net sales increased for the third quarter of fiscal 2011 compared to the third quarter of fiscal 2010, primarily due to increased industry investment in c-Si equipment. Operating income for the third quarter of fiscal 2011 included a net gain on sale of facilities of $28 million offset by asset impairment charges of $3 million. Operating income for the third quarter of fiscal 2010 included inventory-related charges of $250 million, asset impairment charges of $110 million and restructuring charges of $45 million associated with the Energy and Environmental Solutions restructuring plan announced in July 2010, offset by a $20 million favorable adjustment to the restructuring plan announced in November 2009. Net income increased for the third quarter of fiscal 2011 compared to the third quarter of fiscal 2010 primarily due to the absence of charges associated with the Energy and Environmental Solutions restructuring plan. Financial results for the first nine months of fiscal 2011 reflected increased demand across all segments except for Display due to more favorable global economic and industry conditions in the first nine months of fiscal 2011 compared to the first nine months of fiscal 2010. Total new orders, net sales and net income for the first nine months of fiscal 2011 increased year-over-year, due to increased demand for semiconductor equipment and services and c-Si equipment. Operating income for the first nine months of fiscal 2011 included favorable adjustments to restructuring reserves of $60 million, offset by asset impairment charges of $30 million, and a net gain on sale of facilities of $27 million. Net income for the first nine months of 2010 included restructuring charges of $129 million and asset impairment charges of $119 million. The current macroeconomic environment and industry conditions are causing certain customers to delay capital spending. Results of Operations New Orders New orders by geographic region, determined by the product shipment destination specified by the customer, for the three and nine months ended July 31, 2011 and August 1, 2010 were as follows: Three Months Ended Nine Months Ended July 31, Change August 1, July 31, Change August 1, 2011 2011 over 2010 2010 2011 2011 over 2010 2010 ($) (%) (%) ($) (%) ($) (%) (%) ($) (%) (In millions, except percentages) China 534 22 29 415 15 1,855 22 57 1,181 16 Taiwan 425 18 (42 ) 733 27 1,952 23 (5 ) 2,047 28 Japan 372 15 60 233 8 828 10 46 568 8 Korea 362 15 (30 ) 519 19 956 11 (35 ) 1,467 20 Southeast Asia 87 4 (64 ) 245 9 365 4 (30 ) 522 7 Asia Pacific 1,780 74 (17 ) 2,145 78 5,956 70 3 5,785 79 North America(*) 356 15 4 342 13 1,745 20 94 898 13 Europe 254 11 7 238 9 846 10 57 540 8 Total 2,390 100 (12 ) 2,725 100 8,547 100 18 7,223 100 * Primarily the United States. New orders of $2.4 billion for the third quarter of fiscal 2011 were down 12 percent from the third quarter of fiscal 2010. The decrease was primarily attributable to reduced demand for semiconductor equipment from memory and foundry customers, c-Si equipment, and LCD equipment. New orders of $8.5 billion for the first nine months of 37 -------------------------------------------------------------------------------- Table of Contents fiscal 2011 were up 18 percent from the first nine months of fiscal 2010. The increase was primarily attributable to an increase in demand during the first half of the fiscal year for semiconductor equipment and services from logic and foundry customers, as well as increased demand for c-Si equipment from solar manufacturers. Customers in China and Taiwan together represented 40 percent of total new orders for the three months ended July 31, 2011 and 45 percent of total new orders for the nine months ended July 31, 2011. New orders by reportable segment for the three and nine months ended July 31, 2011 and August 1, 2010 were as follows: Three Months Ended Nine Months Ended July 31, Change August 1, July 31, Change August 1, 2011 2011 over 2010 2010 2011 2011 over 2010 2010 ($) (%) (%) ($) (%) ($) (%) (%) ($) (%) (In millions, except percentages) Silicon Systems Group 1,239 52 (19 ) 1,535 56 4,563 53 12 4,086 57 Applied Global Services 613 26 3 595 22 1,769 21 14 1,552 21 Display 220 9 (9 ) 242 9 617 7 (1 ) 624 9 Energy and Environmental Solutions 318 13 (10 ) 353 13 1,598 19 66 961 13 Total 2,390 100 (12 ) 2,725 100 8,547 100 18 7,223 100 The Silicon Systems Group's relative share of total new orders decreased in the three months ended July 31, 2011 compared to the three months ended August 1, 2010, while the relative share of new orders in the Applied Global Services segment increased. For the nine months ended July 31, 2011, the relative share of total new orders for the Silicon Systems Group and Display decreased compared to the nine months ended August 1, 2010, while the relative share of new orders in Energy and Environmental Solutions increased. The increase in Energy and Environmental Solutions' relative share of total new orders was due to increased demand for c-Si equipment. Applied's backlog for the most recent three fiscal quarters was as follows: $3.2 billion at July 31, 2011, $3.9 billion at May 1, 2011, and $3.5 billion at January 30, 2011. Backlog adjustments were negative for the quarter ended July 31, 2011 and included $248 million, consisting primarily of financial debookings. Backlog decreased in the third quarter of fiscal 2011 from the second quarter of fiscal 2011 primarily due to decreases in new orders for the Silicon Systems Group and Energy and Environmental Solutions reflecting decreased demand for semiconductor equipment and c-Si equipment, respectively. Backlog consists of: (1) orders for which written authorizations have been accepted and assigned shipment dates are within the next 12 months, or shipment has occurred but revenue has not been recognized; (2) contractual service revenue and maintenance fees to be earned within the next 12 months; and (3) orders for SunFab lines that are anticipated to be recognized as revenue within the next 12 months. Applied's backlog at any particular time is not necessarily indicative of actual sales for any future periods, due to the potential for customer changes in delivery schedules or cancellation of orders. In the third quarter of fiscal 2011, approximately 49 percent of net sales in the Silicon Systems Group, Applied's largest business segment, were for orders received and shipped within the quarter. 38-------------------------------------------------------------------------------- Table of Contents Net Sales Net sales by geographic region, determined by the location of customers' facilities to which products were shipped, for the three and nine months ended July 31, 2011 and August 1, 2010 were as follows: Three Months Ended Nine Months Ended July 31, Change August 1, July 31, Change August 1, 2011 2011 over 2010 2010 2011 2011 over 2010 2010 ($) (%) (%) ($) (%) ($) (%) (%) ($) (%) (In millions, except percentages) China 751 27 60 469 19 2,166 26 157 843 13 Taiwan 454 16 (36 ) 707 28 1,740 21 (9 ) 1,921 29 Korea 432 16 9 398 16 900 11 (34 ) 1,361 20 Japan 284 10 40 203 8 658 8 8 610 9 Southeast Asia 156 6 (4 ) 162 6 495 6 23 403 6 Asia Pacific 2,077 75 7 1,939 77 5,959 72 16 5,138 77 North America(*) 451 16 53 294 12 1,528 18 100 765 12 Europe 259 9 (9 ) 285 11 849 10 12 759 11 Total 2,787 100 11 2,518 100 8,336 100 25 6,662 100 * Primarily the United States. Net sales of $2.8 billion for the third quarter of fiscal 2011 were up 11 percent from the third quarter of fiscal 2010. For the three months ended July 31, 2011, customers in China, Taiwan, Korea and North America combined represented 75 percent of total net sales. For the nine months ended July 31, 2011, customers in China, Taiwan, and North America combined represented 65 percent of total net sales. Net sales of $8.3 billion for the first nine months of fiscal 2011 were up 25 percent from the first nine months of fiscal 2010. For the three and nine months ended July 31, 2011, the majority of net sales in China reflected purchases of c-Si equipment by solar PV manufacturers. Net sales by reportable segment for the three and nine months ended July 31, 2011 and August 1, 2010 were as follows: Three Months Ended Nine Months Ended July 31, Change August 1, July 31, Change August 1, 2011 2011 over 2010 2010 2011 2011 over 2010 2010 ($) (%) (%) ($) (%) ($) (%) (%) ($) (%) (In millions, except percentages) Silicon Systems Group 1,398 50 (3 ) 1,447 57 4,348 52 14 3,821 58 Applied Global Services 603 22 29 468 19 1,784 22 32 1,349 20 Display 223 8 3 216 9 528 6 (15 ) 618 9 Energy and Environmental Solutions 563 20 45 387 15 1,676 20 92 874 13 Total 2,787 100 11 2,518 100 8,336 100 25 6,662 100 The Silicon Systems Group's relative share of total net sales decreased for the three and nine months ended July 31, 2011 compared to the three and nine months ended August 1, 2010, while net sales in the Energy and Environmental Solutions segment increased significantly. The increase in Energy and Environmental Solutions' relative share of total net sales during the three and nine months ended July 31, 2011 was due to increased demand for c-Si equipment. 39-------------------------------------------------------------------------------- Table of Contents Gross Margin Gross margins for the three and nine months ended July 31, 2011 and August 1, 2010 were as follows: Three Months Ended Nine Months Ended July 31, August 1, Change July 31, August 1, Change 2011 2010 2011 over 2010 2011 2010 2011 over 2010 (In millions, except percentages) Gross margin $ 1,184 $ 860 $ 324 $ 3,509 $ 2,498 $ 1,011 Gross margin (% of net sales) 42 % 34 % 8 points 42 % 37 % 5 points Inventory-related charges of $247 million related to SunFab thin film solar equipment taken during the third quarter of fiscal 2010 in connection with the restructuring of the Energy and Environmental Solutions segment lowered gross margin for the third quarter of fiscal 2010 by approximately 10 percentage points. Inventory-related charges of $330 million associated with SunFab thin film solar equipment lowered gross margin for the first nine months of fiscal 2010 by approximately 5 percentage points. Gross margin during the third quarters of fiscal 2011 and 2010 included $13 million and $10 million of share-based compensation expense, respectively. Gross margin during the first nine months of fiscal 2011 and 2010 included $36 million and $23 million of share-based compensation expense, respectively. Research, Development and Engineering Research, Development and Engineering (RD&E) expenses for the three and nine months ended July 31, 2011 and August 1, 2010 were as follows: Three Months Ended Nine Months Ended July 31, August 1, Change July 31, August 1, Change 2011 2010 2011 over 2010 2011 2010 2011 over 2010 (In millions) Research, development and engineering $ 282 $ 290 $ (8 ) $ 850 $ 865 $ (15 ) Applied's future operating results depend to a considerable extent on its ability to maintain a competitive advantage in the equipment and service products it provides. Applied believes that it is critical to continue to make substantial investments in RD&E to assure the availability of innovative technology that meets the current and projected requirements of its customers' most advanced designs. Applied historically has maintained its commitment to investing in RD&E in order to continue to offer new products and technologies. The reduction in RD&E expense for the three and nine months ended July 31, 2011 compared to the comparable 2010 periods was principally due to a reduction of thin film solar development activities. RD&E expense during the third quarters of fiscal 2011 and 2010 included $12 million and $11 million of share-based compensation expense, respectively. RD&E expense during the first nine months of fiscal 2011 and 2010 included $35 million and $33 million of share-based compensation expense, respectively. Development cycles range from 12 to 36 months depending on whether the product is an enhancement of an existing product, which typically has a shorter development cycle, or a new product, which typically has a longer development cycle. Most of Applied's existing products resulted from internal development activities and innovations involving new technologies, materials and processes. From time to time, Applied also acquires technologies, either in existing or new product areas, to complement its existing technology capabilities and to reduce time to market. 40-------------------------------------------------------------------------------- Table of Contents Selling, General and Administrative Selling, general and administrative (SG&A) expenses for the three and nine months ended July 31, 2011 and August 1, 2010 were as follows: Three Months Ended Nine Months Ended July 31, August 1, Change July 31, August 1, Change 2011 2010 2011 over 2010 2011 2010 2011 over 2010 (In millions) Selling, general and administrative $ 240 $ 252 $ (12 ) $ 679 $ 700 $ (21 ) The decrease in SG&A expenses for both the three and nine months ended July 31, 2011 compared to the same periods in 2010 reflected lower expenses as a result of the restructuring of the Energy and Environmental Solutions segment that occurred in the third quarter of fiscal 2010. SG&A expenses for the three and nine months ended July 31, 2011 included $9 million in deal costs associated with the proposed merger with Varian Semiconductor Equipment Associates, Inc. (Varian). SG&A expenses for the nine months ended August 1, 2010 included $10 million in deal costs associated with the acquisition of Semitool, Inc. SG&A expenses during the third quarters of fiscal 2011 and 2010 included $13 million and $12 million of share-based compensation expense, respectively. SG&A expenses during the first nine months of fiscal 2011 and 2010 each included $39 million of share-based compensation expense. Foreign currency fluctuation, generally resulting from balance sheet remeasurement related activity and foreign exchange hedging activity, was a gain of $8 million in the third quarter of fiscal 2011 compared to a loss of $9 million in the third quarter of fiscal 2010. Foreign currency fluctuation gain in the nine months ended July 31, 2011 amounted to $21 million compared to a loss of $12 million in the nine months ended August 1, 2010. Restructuring and Asset Impairments Restructuring and asset impairment expenses for the three and nine months ended July 31, 2011 and August 1, 2010 were as follows: Three Months Ended Nine Months Ended July 31, August 1, Change July 31, August 1, Change 2011 2010 2011 over 2010 2011 2010 2011 over 2010 (In millions) Restructuring and asset impairments $ 3 $ 135 $ (132 ) $ (30 ) $ 248 $ (278 ) On July 21, 2010, Applied announced a plan to restructure its Energy and Environmental Solutions segment, which was expected to impact between 400 to 500 positions globally. During the third quarter of fiscal 2010, Applied incurred employee severance charges of $45 million associated with this program. During the first quarter of fiscal 2011, as a result of changes in Applied's operating environment and business requirements, Applied revised its workforce reduction under this program to approximately 200 positions and recorded a favorable adjustment of $28 million. The improved economic environment continued in the second quarter of fiscal 2011, and as a result Applied recorded an additional favorable adjustment of $8 million. As of July 31, 2011, the remaining severance accrual associated with restructuring reserves under this program was $1 million. On November 11, 2009, Applied announced a restructuring program to reduce its global workforce as of October 25, 2009 by approximately 1,300 to 1,500 positions, or 10 to 12 percent, over a period of 18 months. During the first quarter of fiscal 2010, Applied recorded restructuring charges of $104 million associated with this program. During the third quarter of fiscal 2010, as a result of changes in business requirements, Applied revised its global workforce reduction under this program to approximately 1,000 positions and recorded a favorable adjustment of $20 million. The improved economic environment continued in the second quarter of fiscal 2011, and as a result Applied recorded an additional favorable adjustment of $19 million. As of July 31, 2011, the remaining severance accrual associated with restructuring reserves under this program was $10 million. During the first and second quarters of fiscal 2011, Applied favorably adjusted the severance accrual associated with a global restructuring program announced in the first quarter of fiscal 2009 by $4 million and $1 million, respectively. As of July 31, 2011, no severance accrual remained under this program. 41-------------------------------------------------------------------------------- Table of Contents As of July 31, 2011, Applied had $5 million in restructuring reserves associated with facilities. In the second quarter of fiscal 2011, Applied incurred impairment charges of $24 million associated with certain intangible assets and purchased technology. See Note 8 of the Notes to Consolidated Condensed Financial Statement. In the third quarter of fiscal 2011, Applied incurred asset impairment charges of $3 million related to certain fixed assets. In the second quarter of fiscal 2010, Applied recorded an asset impairment charge of $9 million to write down a facility to its estimated fair value based on prices for comparable local properties. The facility was reclassified as an asset held for sale. In the first quarter of fiscal 2011, Applied recorded additional impairment charges of $3 million related to this facility. For further details, see Note 11 of Notes to Consolidated Condensed Financial Statements. Interest and Other Expense Interest and other expense for the three and nine months ended July 31, 2011 and August 1, 2010 were as follows: Three Months Ended Nine Months Ended July 31, August 1, Change July 31, August 1, Change 2011 2010 2011 over 2010 2011 2010 2011 over 2010 (In millions) Interest and other expense $ 25 $ 5 $ 20 $ 35 $ 15 $ 20 The increases in interest and other expense for three and nine months ended July 31, 2011 were primarily due to interest accrued of $11 million related to senior unsecured notes issued in the third quarter of fiscal 2011 and to fees of $8 million associated with a bridge loan facility that was entered into and terminated during the third quarter of fiscal 2011. Income Taxes Income tax expenses for the three and nine months ended July 31, 2011 and August 1, 2010 were as follows: Three Months Ended Nine Months Ended July 31, August 1, Change July 31, August 1, Change 2011 2010 2011 over 2010 2011 2010 2011 over 2010 (Inmillions, except percentages) Provision for income taxes $ 193 $ 55 $ 138 $ 564 $ 214 $ 350 Effective income tax rate 29 % 31 % (2) points 28 % 31 % (3) points The rates for the three and nine months ended July 31, 2011 were both lower than the rates for the comparable periods in the prior year primarily due to an increase in income in jurisdictions outside the U.S. with lower tax rates. The tax rates for the three and nine months ended July 31, 2011 further benefited from tax incentives offered in several jurisdictions. The tax rates for the nine months ended July 31, 2011 and the three and nine months ended August 1, 2010 included the impact of restructuring charges. Applied's future effective income tax rate depends on various factors, such as tax legislation, the geographic composition of Applied's pre-tax income, and the tax rate on equity compensation. Management carefully monitors these factors and timely adjusts the interim income tax rate accordingly. Segment Information Applied reports financial results in four segments: Silicon Systems Group, Applied Global Services, Display, and Energy and Environmental Solutions. A description of the products and services, as well as financial data, for each reportable segment can be found in Note 16 of Notes to Consolidated Condensed Financial Statements. Applied does not allocate to its reportable segments certain operating expenses that it manages separately at the corporate level. These unallocated costs include costs for share-based compensation; certain management, finance, legal, human resources, and RD&E functions provided at the corporate level; and unabsorbed information technology and occupancy. In addition, Applied does not allocate to its reportable segments restructuring and 42 -------------------------------------------------------------------------------- Table of Contents asset impairment charges and any associated adjustments related to restructuring actions, unless these charges or adjustments pertain to a specific reportable segment. The results for each reportable segment are discussed below. Silicon Systems Group Segment The Silicon Systems Group segment includes semiconductor capital equipment for deposition, etch, rapid thermal processing, chemical mechanical planarization, metrology and inspection, and wafer packaging. Development efforts are focused on solving customers' key technical challenges, including transistor performance and nanoscale patterning, and improving chip manufacturing productivity to reduce costs. Certain significant measures for the three and nine months ended July 31, 2011 and August 1, 2010 were as follows: Three Months Ended Nine Months Ended July 31, August 1, Change July 31, August 1, Change 2011 2010 2011 over 2010 2011 2010 2011 over 2010 (In millions, except percentages) New orders $ 1,239 $ 1,535 $ (296 ) (19) % $ 4,563 $ 4,086 $ 477 12 % Net sales 1,398 1,447 (49 ) (3) % 4,348 3,821 527 14 % Operating income 452 525 (73 ) (14) % 1,486 1,328 158 12 % Operating margin 32 % 36 % (4) points 34 % 35 % (1) point New orders decreased by $296 million to $1.2 billion for the third quarter of fiscal 2011 compared to the third quarter of fiscal 2010. The decrease in new orders for the three months ended July 31, 2011 was primarily attributable to memory and foundry customers. New orders increased by $477 million to $4.6 billion for the first nine months of fiscal 2011 compared to the first nine months of fiscal 2010. The increase in new orders for the nine months ended July 31, 2011 was primarily from logic and foundry customers, while orders from memory customers declined. New orders for the Silicon Systems Group by end use application for the three and nine months ended July 31, 2011 and August 1, 2010 were as follows: Three Months Ended Nine Months Ended July 31, August 1, July 31, August 1, 2011 2010 2011 2010 Foundry 37 % 37 % 47 % 39 % Memory 38 % 45 % 29 % 48 % Logic and other 25 % 18 % 24 % 13 % 100 % 100 % 100 % 100 % Net sales decreased by $49 million to $1.4 billion for the third quarter of fiscal 2011 compared to the third quarter of fiscal 2010. The decrease in net sales for the three months ended July 31, 2011 was attributable to memory and foundry customers. Net sales increased by $527 million to $4.3 billion for the first nine months of fiscal 2011 compared to the first nine months of fiscal 2010. The increase in net sales for the nine months ended July 31, 2011 was from logic and foundry customers, while investment from memory customers declined. Three customers accounted for 52 percent of net sales in this segment in the first nine months of fiscal 2011. Approximately 49 percent of net sales in the third quarter of fiscal 2011 were for orders received and shipped within the quarter. 43 -------------------------------------------------------------------------------- Table of Contents The following region accounted for at least 30 percent of total net sales for the Silicon Systems Group segment for either the three or nine months ended July 31, 2011 and August 1, 2010: Three Months Ended Nine Months Ended July 31, Change August 1, July 31, Change August 1, 2011 2011 over 2010 2010 2011 2011 over 2010 2010 ($) (%) (%) ($) (%) ($) (%) (%) (%) (%) (In millions, except percentages) Taiwan 262 19 (51 ) 535 37 1,128 26 (19 ) 1,395 36 In the third quarter of fiscal 2011, customers in Taiwan accounted for 19 percent of total net sales for the Silicon Systems Group segment compared to 37 percent in the third quarter of fiscal 2010. For the first nine months of fiscal 2011, customers in Taiwan accounted for 26 percent of total net sales for the Silicon Systems Group segment compared to 36 percent for the first nine months of fiscal 2010. The book to bill ratio (new orders divided by net sales) decreased to 0.9 for the third quarter of fiscal 2011 compared to 1.1 for the third quarter of fiscal 2010 reflecting lower year-over-year demand. The book to bill ratio decreased to 1.0 for the first nine months of fiscal 2011 compared to 1.1 for the first nine months of fiscal 2010 reflecting a higher year-over-year increase in net sales relative to new orders. Operating income decreased by $73 million to $452 million for the third quarter of fiscal 2011 compared to the third quarter of fiscal 2010. The decrease in operating income for the three months ended July 31, 2011 was primarily due to lower sales and an increase in RD&E expenses. Operating income increased by $158 million to $1.5 billion for the first nine months of fiscal 2011 compared to the first nine months of fiscal 2010. Operating income for the nine months ended July 31, 2011 increased due to higher revenue from semiconductor equipment sales and reflected the recovery in the semiconductor equipment industry during the first nine months of fiscal 2011 and lower costs from continued transition of the manufacturing of certain products to Applied's Singapore Operations Center. Operating results of the Silicon Systems Group may be affected by an agreement between Applied and Samsung Electronics Co., Ltd (Samsung) that is generally effective for a three-year period from November 1, 2010, which provides in part for volume-based rebates and other incentives to Samsung. The financial impact of the rebates and incentives on the segment is highly variable and depends on the volume of semiconductor equipment purchases by Samsung. Applied Global Services Segment The Applied Global Services segment encompasses technically differentiated products, including spares, services, certain earlier generation equipment products, and remanufactured equipment, to improve operating efficiency, reduce operating costs, and lessen the environmental impact of semiconductor, display and solar customers' factories. Customer demand for products and services is fulfilled through a global distribution system with trained service engineers located in close proximity to customer sites. In fiscal 2010, as part of the restructuring of the Energy and Environmental Solutions segment, Applied discontinued sales to new customers of its fully-intergrated SunFab production lines but continued to offer individual tools for thin film solar manufacturing. Applied is supporting existing SunFab customers with services, upgrades and capacity increases through its Applied Global Services segment as these products are considered to have reached a particular stage in the product lifecycle. Effective in the first quarter of fiscal 2011, Applied accounts for SunFab thin film products under its Applied Global Services segment. 44 -------------------------------------------------------------------------------- Table of Contents Certain significant measures for the three and nine months ended July 31, 2011 and August 1, 2010 were as follows: Three Months Ended Nine Months Ended July 31, August 1, Change July 31, August 1, Change 2011 2010 2011 over 2010 2011 2010 2011 over 2010 (In millions, except percentages) New orders $ 613 $ 595 $ 18 3 % $ 1,769 $ 1,552 $ 217 14 % Net sales 603 468 135 29 % 1,784 1,349 435 32 % Operating income 146 84 62 74 % 322 237 85 36 % Operating margin 24 % 18 % 6 points 18 % 18 % - New orders increased by $18 million to $613 million for the third quarter of fiscal 2011 compared to the third quarter of fiscal 2010, and also increased by $217 million to $1.8 billion for the first nine months of fiscal 2011 compared to the first nine months of fiscal 2010. The increases in new orders for the three and nine months ended July 31, 2011 were primarily due to higher demand for spare parts and refurbished equipment, reflecting customers' higher factory utilization rates. Net sales increased by $135 million to $603 million for the third quarter of fiscal 2011 compared to the third quarter of fiscal 2010, and also increased by $435 million to $1.8 billion for the first nine months of fiscal 2011 compared to the first nine months of fiscal 2010. The increases in net sales for the three and nine months ended July 31, 2011 were due primarily to higher sales of refurbished equipment. The book to bill ratio decreased to 1.0 for the third quarter of fiscal 2011 compared to 1.3 for the third quarter of fiscal 2010 decreased to 1.0 for the first nine months of fiscal 2011 compared to 1.2 for the first nine months of fiscal 2010 reflecting a higher year-over-year increase in net sales relative to demand. Operating income increased by $62 million to $146 million for the third quarter of fiscal 2011 compared to the third quarter of fiscal 2010. Operating income increased by $85 million to $322 million for the first nine months of fiscal 2011 compared to the first nine months of fiscal 2010. The increases in operating income for the three and nine months ended July 31, 2011 primarily reflected increased sales and improved gross margins of refurbished equipment. Operating results for the nine months ended July 31, 2011 included impairment charges of $24 million. The decreases in operating margin for the three and nine months ended July 31, 2011 were due to changes in product mix and impairment charges incurred. Display Segment The Display segment encompasses products for manufacturing LCDs for TVs, personal computers, video-enabled devices and touch panel applications. The segment is focused on expanding market share by differentiation with larger-scale substrates, entry into new markets, and development of products to enable cost reductions through productivity and uniformity. Certain significant measures for the three and nine months ended July 31, 2011 and August 1, 2010 were as follows: Three Months Ended Nine Months Ended July 31, August 1, Change July 31, August 1, Change 2011 2010 2011 over 2010 2011 2010 2011 over 2010 (In millions, except percentages) New orders $ 220 $ 242 $ (22 ) (9) % $ 617 $ 624 $ (7 ) (1) % Net sales 223 216 7 3 % 528 618 (90 ) (15) % Operating income 58 64 (6 ) (9) % 116 179 (63 ) (35) % Operating margin 26 % 30 % (4) points 22 % 29 % (7) points New orders decreased by $22 million to $220 million for the third quarter of fiscal 2011 compared to the third quarter of fiscal 2010, and decreased by $7 million to $617 million for the first nine months of fiscal 2011 compared to the first nine months of fiscal 2010. The decrease in new orders for the three months ended July 31, 2011 was due to booking timing and investment delay offset by increased demand for touch panel tools and Low-Temperature 45-------------------------------------------------------------------------------- Table of Contents Polycrystalline Silicon (LTPS) systems. The decrease in new orders for the nine months ended July 31, 2011 reflected investment delay partially offset by orders for touch panel tools. Net sales increased by $7 million to $223 million for the third quarter of fiscal 2011 compared to the third quarter of fiscal 2010. The increase in net sales for the three months ended July 31, 2011 was driven by production capacity expansion for new mobile devices such as smart phones and tablets, while investment in LCD products declined. Net sales decreased by $90 million to $528 million for the first nine months of fiscal 2011 compared to the first nine months of fiscal 2010. The decrease in net sales for the nine months ended July 31, 2011 reflected decreased demand for LCD products. The Display segment experienced a cyclical downturn in LCD products, which was partially offset by demand for LTPS systems and touch panel systems. Three customers accounted for 57 percent of net sales in the Display segment in the first nine months of fiscal 2011. The following regions accounted for at least 30 percent of total net sales for the Display Group segment for either the three or nine months ended July 31, 2011 and August 1, 2010: Three Months Ended Nine Months Ended July 31, Change August 1, July 31, Change August 1, 2011 2011 over 2010 2010 2011 2011 over 2010 2010 ($) (%) (%) ($) (%) ($) (%) (%) ($) (%) (In millions, except percentages) China 111 50 41 79 37 255 48 73 147 24 Taiwan 58 26 (17 ) 70 33 156 30 (23 ) 203 33 Customers in China accounted for 50 percent of net sales in this segment for the third quarter of fiscal 2011. In the third quarter of fiscal 2010, customers in China and Taiwan accounted for 70 percent of total net sales for the Display segment. For the first nine months of fiscal 2011, customers in China and Taiwan accounted for 78 percent of total net sales in this segment compared to 57% for the first nine months of fiscal 2010. The book to bill ratio decreased to 1.0 for the third quarter of fiscal 2011 compared to 1.1 for the third quarter of fiscal 2010. The decrease for the three months ended July 31, 2011 reflected higher year-over-year net sales relative to year-over-year new orders. The book to bill ratio increased to 1.2 for the first nine months of fiscal 2011 compared to 1.0 for the first nine months of fiscal 2010. The increase for the nine months ended July 31, 2011 reflected lower year-over-year net sales relative to year-over-year new orders. Operating income decreased by $6 million to $58 million for the third quarter of fiscal 2011 compared to the third quarter of fiscal 2010. The decrease in operating income for the three months ended July 31, 2011 primarily reflected a decrease in net sales. Operating income decreased by $63 million to $116 million for the first nine months of fiscal 2011 compared to the first nine months of fiscal 2010. The decrease in operating income for the nine months ended July 31, 2011 reflected an unfavorable currency exchange rate and an unfavorable product mix. The decreases in operating margin for the three and nine months ended July 31, 2011 were due to changes in product mix. Energy and Environmental Solutions Segment The Energy and Environmental Solutions segment includes products for fabricating c - Si solar PVs, high throughput roll-to-roll coating systems for flexible electronics and web products. This business is focused on delivering solutions to generate and conserve energy, with an emphasis on lowering the cost to produce solar power by providing equipment to enhance manufacturing scale and efficiency. Until the first quarter of fiscal 2011, the Energy and Environmental Solutions segment included the fully-integrated SunFab production line for manufacturing thin film solar panels. During the third quarter of fiscal 2010, Applied announced a plan to restructure its Energy and Environmental Solutions segment in response to adverse market conditions for thin film solar and as a result, Applied discontinued marketing of its fully-integrated SunFab lines, but is offering individual tools for thin film solar manufacturing. Applied is supporting existing SunFab line customers with services, upgrades and capacity increases through its Applied Global Services segment, and effective in the first quarter of fiscal 2011, Applied accounts for thin film products under its Applied Global Services segment rather than its Energy and Environmental Solutions segment. 46 -------------------------------------------------------------------------------- Table of Contents Certain significant measures for the three and nine months ended July 31, 2011 and August 1, 2010 were as follows: Three Months Ended Nine Months Ended July 31, August 1, Change July 31, August 1, Change 2011 2010 2011 over 2010 2011 2010 2011 over 2010 (In millions, except percentages) New orders $ 318 $ 353 $ (35 ) (10 )% $ 1,598 $ 961 $ 637 66 % Net sales 563 387 176 45 % 1,676 874 802 92 % Operating income (loss) 123 (371 ) 494 133 % 436 (552 ) 988 179 % Operating margin 22 % (96 )% 118 points 26 % (63 )% 89 points New orders decreased by $35 million to $318 million for the third quarter of fiscal 2011 compared to the third quarter of fiscal 2010. The decrease in new orders for the three months ended July 31, 2011 reflected a tightening of access to capital and excess manufacturing capacity for customers in China. New orders increased by $637 million to $1.6 billion for the first nine months of fiscal 2011 compared to the first nine months of fiscal 2010. The increase in new orders for the nine months ended July 31, 2011 reflected significantly increased demand for c-Si equipment, particularly wafering and metallization products. The increased demand was partially driven by government subsidies for solar panel manufacturers in China. Net sales increased by $176 million to $563 million for the third quarter of fiscal 2011 compared to the third quarter of fiscal 2010, and also increased by $802 million to $1.7 billion for the first nine months of fiscal 2011 compared to the first nine months of fiscal 2010. The increases in net sales for the three and nine months ended July 31, 2011 primarily reflected higher sales to c-Si customers. Net sales of SunFab thin film lines for the three and nine months ended August 1, 2010 were $79 million and $309 million, respectively. The following regions accounted for at least 30 percent of total net sales for the Energy and Environmental Solutions segment for either the three or nine months ended July 31, 2011 and August 1, 2010: Three Months Ended Nine Months Ended July 31, Change August 1, July 31, Change August 1, 2011 2011 over 2010 2010 2011 2011 over 2010 2010 ($) (%) (%) ($) (%) ($) (%) (%) ($) (%) (In millions, except percentages) China 485 86 106 236 61 1,360 81 237 403 46 Europe 7 1 (94 ) 122 31 49 3 (87 ) 372 43 For the third quarter of fiscal 2011, customers in China accounted for 76 percent of new orders and 86 percent of net sales in the Energy and Environmental Solutions segment. For the first nine months of fiscal 2011, customers in China accounted for 78 percent of new orders and 81 percent of net sales in this segment. In the third quarter of fiscal 2010, customers in China and Europe accounted for 92 percent of total net sales for the Energy and Environmental Solutions segment. For the first nine months of fiscal 2010, customers in China and Europe accounted for 89 percent of total net sales in this segment. The book to bill ratio decreased to 0.6 for the third quarter of fiscal 2011 compared to 0.9 for the third quarter of fiscal 2010. The book to bill ratio decreased to 1.0 for the first nine months of fiscal 2011 compared to 1.1 for the first nine months of fiscal 2010. The decrease for both the three and nine months ended July 31, 2011 reflected a higher increase in net sales year-over-year relative to demand. The Energy and Environmental Solutions segment reported operating income of $123 million for the third quarter of fiscal 2011 compared to an operating loss of $371 million for the third quarter of fiscal 2010. Operating loss for the three months ended August 1, 2010 included charges totaling $405 million associated with the Energy and Environmental Solutions restructuring plan announced in July 2010. The increase in operating income in the third quarter of fiscal 2011 was also attributable to higher net sales of c-Si equipment. The Energy and Environmental Solutions segment reported operating income of $436 million for the first nine months of fiscal 2011 compared to an operating loss of $552 million for the first nine months of fiscal 2010. Operating loss for the nine months ended August 1, 2010 included charges totaling $405 million associated with the Energy and Environmental Solutions restructuring plan announced in July 2010. The increase in operating income for the first 47-------------------------------------------------------------------------------- Table of Contents nine months of fiscal 2011 was also attributable to significantly higher net sales of c-Si equipment and included favorable adjustments of $36 million related to the restructuring program announced in the third quarter of fiscal 2010. The increases in operating margin for the three and nine months ended July 31, 2011 were due to higher manufacturing volume for c-Si equipment. Financial Condition, Liquidity and Capital Resources Applied's cash, cash equivalents and investments increased to $6.8 billion at July 31, 2011 from $3.9 billion at October 31, 2010, due primarily to the receipt of proceeds from the issuance of $1.75 billion of senior unsecured notes discussed below and cash provided by operating activities of $1.73 billion. Cash, cash equivalents and investments consist of the following: July 31, October 31, 2011 2010 (In millions) Cash and cash equivalents $ 5,018 $ 1,858 Short-term investments 739 727 Long-term investments 1,052 1,307 Total cash, cash-equivalents and investments $ 6,809 $ 3,892 A summary of cash provided by (used in) operating, investing, and financing activities is as follows: July 31, August 1, 2011 2010 (In millions) Cash provided by operating activities $ 1,728 $ 1,198 Cash provided by (used in) investing activities $ 218 $ (847 ) Cash provided by (used in) financing activities $ 1,210 $ (362 ) Applied generated $1.7 billion of cash from operating activities for the nine months ended July 31, 2011. The primary sources of cash from operating activities for the nine months ended July 31, 2011 were net income, as adjusted to exclude the effect of non-cash charges including depreciation, amortization, share-based compensation, restructuring and asset impairments, and changes in components of working capital. Applied's working capital was $7.0 billion at July 31, 2011 and $3.9 billion at October 31, 2010. Applied utilized programs to discount letters of credit issued by customers of $211 million and $134 million for the nine months ended July 31, 2011 and August 1, 2010, respectively. Discounting of letters of credit depends on many factors, including the willingness of financial institutions to discount the letters of credit and the cost of such arrangements. For the nine months ended July 31, 2011 and August 1, 2010, Applied factored accounts receivable and discounted promissory notes totaling $80 million and $106 million, respectively. Days sales outstanding for the third quarter of fiscal 2011 decreased to 59 days, compared to 61 days in the second quarter of fiscal 2011, primarily due to strong collections performance offset in part by higher extended terms in ending accounts receivable from the second quarter of fiscal 2011. Days sales outstanding varies due to the timing of shipments and the payment terms. During the first nine months of fiscal 2010, Applied received a U.S. federal income tax refund of approximately $130 million for the carryback of Applied's net operating loss from fiscal 2009 to fiscal 2005. Applied generated $218 million of cash from investing activities during the nine months ended July 31, 2011. Capital expenditures of $136 million for the nine months ended July 31, 2011, which included construction in progress additions and purchases of equipment in North America, was offset by $99 million in proceeds received from the sale of properties located in North America and $27 million in proceeds received from completed divestiture of certain assets held for sale, net of cash sold. Proceeds from sales and maturities of investments, net of purchases of investments, totaled $227 million for the nine months ended July 31, 2011. Investing activities also include investments in technology and acquisitions of companies to allow Applied to access new market opportunities or emerging technologies. During the nine months ended August 1, 2010, Applied acquired Semitool Inc., a public company based in the state of Montana, for $323 million, net of cash acquired. 48-------------------------------------------------------------------------------- Table of Contents Applied generated $1.2 billion of cash from financing activities during the nine months ended July 31, 2011, consisting primarily of net proceeds received from the issuance of senior unsecured notes of $1.75 billion, as discussed further below, $64 million in proceeds from common stock issuances related to equity compensation awards, offset in part by $293 million in common stock repurchases and $291 million in cash dividends. The following table summarizes the dividends declared by Applied's Board of Directors during fiscal 2011: Date Declared Record Date Payable Date Amount Per Share December 7, 2010 March 2, 2011 March 23, 2011 $ 0.07 March 8, 2011 June 1, 2011 June 22, 2011 $ 0.08 June 6, 2011 August 31, 2011 September 21, 2011 $ 0.08 Applied currently anticipates that cash dividends will continue to be paid on a quarterly basis, although the declaration of any future cash dividend is at the discretion of the Board of Directors and will depend on Applied's financial condition, results of operations, capital requirements, business conditions and other factors, as well as a determination by the Board of Directors that cash dividends are in the best interests of Applied's stockholders. Applied has credit facilities for unsecured borrowings in various currencies of up to $1.6 billion, of which $1.5 billion is comprised of a four-year revolving credit agreement with a group of banks that is scheduled to expire in May 2015. This agreement provides for borrowings in United States dollars at interest rates keyed to one of the two rates selected by Applied for each advance and includes financial and other covenants with which Applied was in compliance at July 31, 2011. Remaining credit facilities in the amount of approximately $103 million are with Japanese banks. Applied's ability to borrow under these facilities is subject to bank approval at the time of the borrowing request, and any advances will be at rates indexed to the banks' prime reference rate denominated in Japanese yen. No amounts were outstanding under any of these facilities at both July 31, 2011 and October 31, 2010. In the third quarter of fiscal 2011, Applied established a short-term debt financing program of up to $1.5 billion through the issuance of commercial paper notes. As of July 31, 2011, Applied did not have any commercial paper outstanding. On May 4, 2011, Applied and Varian announced the signing of a definitive merger agreement (the Merger Agreement) under which Applied agreed to acquire Varian for $63 per share in cash. The total consideration amount is approximately $4.9 billion, which includes certain post-closing equity based compensation. Upon completion of the merger, the purchase price allocation will result in an increase in Applied's goodwill and purchased intangible assets. Varian designs, manufactures, markets and services semiconductor processing equipment and is the leading supplier of ion implantation equipment used by chip makers around the world. Varian stockholders approved the Merger Agreement at a special meeting held on August 11, 2011. Consummation of the proposed merger remains subject to various other customary closing conditions, including receipt of certain domestic and foreign antitrust approvals (including under the U.S. Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended (the HSR Act). Upon completion of the merger, Varian will operate within Applied's Silicon Systems Group and will continue to be based in Gloucester, Massachusetts. The Merger Agreement contains certain termination rights and provides that (i) upon the termination of the Merger Agreement under specified circumstances, including, among others, by Varian to accept a superior offer or by Applied upon a change in the recommendation of Varian's board of directors, Varian will owe Applied a cash termination fee of $147 million; and (ii) upon termination of the Merger Agreement due to the failure to obtain certain antitrust approvals, Applied will owe Varian a cash termination fee of $200 million. On June 13, 2011, Applied received a request for additional information from the Antitrust Division of the U.S. Department of Justice (DOJ) in connection with the merger as part of the regulatory process under the HSR Act. Applied is responding to the request and will continue to work cooperatively with the DOJ as the DOJ conducts its review. The effect of the DOJ's request is to extend the waiting period imposed by the HSR Act until 30 days after Applied has substantially complied with the request and Varian has substantially complied with the request that it received. 49-------------------------------------------------------------------------------- Table of Contents Applied expects to fund the transaction with a combination of existing cash balances and debt. In May 2011, Applied put in place a $2.0 billion bridge loan facility, which was subsequently terminated upon issuance of senior unsecured notes, as discussed below. In June 2011, Applied issued senior unsecured notes (collectively, the Notes) in the aggregate principal amount of $1.75 billion as follows: Effective Principal Stated Interest Interest Interest Due Date Amount Interest Rate Rate Pay Date Pay Date (In millions) June 15, 2016 $ 400 2.650 % 2.666 % June 15 December 15 June 15, 2021 750 4.300 % 4.326 % June 15 December 15 June 15, 2041 600 5.850 % 5.879 % June 15 December 15 $ 1,750 Applied intends to use the net proceeds of the Notes to fund a portion of the consideration and certain costs associated with the proposed merger with Varian. In the event that the Merger Agreement is terminated or Applied does not consummate the merger on or before May 31, 2012, Applied will be required to redeem the Notes at a redemption price of 101% of the aggregate principal amount of the Notes plus any accrued and unpaid interest. The indenture governing the Notes include certain covenants with which Applied was in compliance at July 31, 2011. See Note 10 of Notes to Consolidated Condensed Financial Statements for additional discussion of long-term debt. In the ordinary course of business, Applied provides standby letters of credit or other guarantee instruments to third parties as required for certain transactions initiated by either Applied or its subsidiaries. As of July 31, 2011, the maximum potential amount of future payments that Applied could be required to make under these guarantee agreements was approximately $52 million. Applied has not recorded any liability in connection with these guarantee agreements beyond that required to appropriately account for the underlying transaction being guaranteed. Applied does not believe, based on historical experience and information currently available, that it is probable that any amounts will be required to be paid under these guarantee agreements. Applied also has agreements with various banks to facilitate subsidiary banking operations worldwide, including overdraft arrangements, issuance of bank guarantees, and letters of credit. As of July 31, 2011, Applied Materials Inc. has provided parent guarantees to banks for approximately $200 million to cover these services. Applied's investment portfolio consists principally of investment grade money market mutual funds, U.S. Treasury and agency securities, municipal bonds, corporate bonds and mortgage-backed and asset-backed securities, as well as equity securities. Applied regularly monitors the credit risk in its investment portfolio and takes appropriate measures, which may include the sale of certain securities, to manage such risks prudently in accordance with its investment policies. Although cash requirements will fluctuate based on the timing and extent of factors such as those discussed above, Applied's management believes that cash generated from operations, together with the liquidity provided by existing cash balances and borrowing capability, will be sufficient to satisfy Applied's liquidity requirements for the next 12 months. For further details regarding Applied's operating, investing and financing activities, see the Consolidated Condensed Statements of Cash Flows in this report. Long-term Contractual Obligations Information concerning Applied's long-term contractual obligations is contained on page 47 in the Company's Form 10-K for the fiscal year ended October 31, 2010, and is incorporated by herein by reference, with the exception of its long-term contractual obligations related to the $1.75 billion principal amount of Notes issued in June 2011 and the associated maturity dates. See Note 10 to the Consolidated Condensed Financial Statements for detailed information about the Notes. 50 -------------------------------------------------------------------------------- Table of Contents Critical Accounting Policies and Estimates The preparation of consolidated financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make judgments, assumptions and estimates that affect the amounts reported. Note 1 of Notes to Consolidated Condensed Financial Statements describes the significant accounting policies used in the preparation of the consolidated condensed financial statements. Certain of these significant accounting policies are considered to be critical accounting policies. A critical accounting policy is defined as one that is both material to the presentation of Applied's consolidated financial statements and that requires management to make difficult, subjective or complex judgments that could have a material effect on Applied's financial condition or results of operations. Specifically, these policies have the following attributes: (1) Applied is required to make assumptions about matters that are highly uncertain at the time of the estimate; and (2) different estimates Applied could reasonably have used, or changes in the estimate that are reasonably likely to occur, would have a material effect on Applied's financial condition or results of operations. Estimates and assumptions about future events and their effects cannot be determined with certainty. Applied bases its estimates on historical experience and on various other assumptions believed to be applicable and reasonable under the circumstances. These estimates may change as new events occur, as additional information is obtained and as Applied's operating environment changes. These changes have historically been minor and have been included in the consolidated financial statements as soon as they became known. In addition, management is periodically faced with uncertainties, the outcomes of which are not within its control and will not be known for prolonged periods of time. These uncertainties include those discussed in Part II, Item 1A, "Risk Factors." Based on a critical assessment of its accounting policies and the underlying judgments and uncertainties affecting the application of those policies, management believes that Applied's consolidated financial statements are fairly stated in accordance with accounting principles generally accepted in the United States of America, and provide a meaningful presentation of Applied's financial condition and results of operations. Management believes that the following are critical accounting policies: Revenue Recognition Applied recognizes revenue when all four revenue recognition criteria have been met: persuasive evidence of an arrangement exists; delivery has occurred or services have been rendered; seller's price to buyer is fixed or determinable; and collectability is probable. Each sale arrangement may contain commercial terms that differ from other arrangements. In addition, Applied frequently enters into contracts that contain multiple deliverables. Judgment is required to properly identify the accounting units of the multiple deliverable transactions and to determine the manner in which revenue should be allocated among the accounting units. Moreover, judgment is used in interpreting the commercial terms and determining when all criteria of revenue recognition have been met in order for revenue recognition to occur in the appropriate accounting period. While changes in the allocation of the estimated sales price between the units of accounting will not affect the amount of total revenue recognized for a particular sales arrangement, any material changes in these allocations could impact the timing of revenue recognition, which could have a material effect on Applied's financial condition and results of operations. In 2009, the Financial Accounting Standards Board issued amended revenue recognition guidance for arrangements with multiple deliverables and certain software sold with tangible products. This new guidance eliminates the residual method of revenue recognition and allows the use of management's best estimate of selling price for individual elements of an arrangement when vendor specific evidence or third party evidence is unavailable. Applied implemented this guidance prospectively beginning in the first quarter of fiscal 2010 for transactions that were initiated or materially modified during fiscal 2010. The implementation of the new guidance had an insignificant impact on reported net sales compared to net sales under previous guidance, as the new guidance did not change the units of accounting within sales arrangements and the elimination of the residual method for the allocation of arrangement consideration had an inconsequential impact on the amount and timing of reported net sales. 51-------------------------------------------------------------------------------- Table of Contents Warranty Costs Applied provides for the estimated cost of warranty when revenue is recognized. Estimated warranty costs are determined by analyzing specific product, current and historical configuration statistics and regional warranty support costs. Applied's warranty obligation is affected by product and component failure rates, material usage and labor costs incurred in correcting product failures during the warranty period. As Applied's customer engineers and process support engineers are highly trained and deployed globally, labor availability is a significant factor in determining labor costs. The quantity and availability of critical replacement parts is another significant factor in estimating warranty costs. Unforeseen component failures or exceptional component performance can also result in changes to warranty costs. If actual warranty costs differ substantially from Applied's estimates, revisions to the estimated warranty liability would be required, which could have a material adverse effect on Applied's business, financial condition and results of operations. Allowance for Doubtful Accounts Applied maintains an allowance for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments. This allowance is based on historical experience, credit evaluations, specific customer collection history and any customer-specific issues Applied has identified. Changes in circumstances, such as an unexpected material adverse change in a major customer's ability to meet its financial obligation to Applied or its payment trends, may require Applied to further adjust its estimates of the recoverability of amounts due to Applied, which could have a material adverse effect on Applied's business, financial condition and results of operations. Inventory Valuation Inventories are generally stated at the lower of cost or market, with cost determined on a first-in, first-out basis. The carrying value of inventory is reduced for estimated obsolescence by the difference between its cost and the estimated market value based upon assumptions about future demand. Applied evaluates the inventory carrying value for potential excess and obsolete inventory exposures by analyzing historical and anticipated demand. In addition, inventories are evaluated for potential obsolescence due to the effect of known and anticipated engineering change orders and new products. If actual demand were to be substantially lower than estimated, additional adjustments for excess or obsolete inventory may be required, which could have a material adverse effect on Applied's business, financial condition and results of operations. Goodwill and Intangible Assets Applied reviews goodwill and intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable, and also annually reviews goodwill and intangibles with indefinite lives for impairment. Intangible assets, such as purchased technology, are generally recorded in connection with a business acquisition. The value assigned to intangible assets is usually based on estimates and judgments regarding expectations for the success and life cycle of products and technology acquired. If actual product acceptance differs significantly from the estimates, Applied may be required to record an impairment charge to reduce the carrying value of the reporting unit to its realizable value. The fair value of a reporting unit is estimated using both the income approach and the market approach taking into account such factors as future anticipated operating results and estimated cost of capital. Management uses significant judgment when assessing goodwill for potential impairment, especially in emerging markets. A severe decline in market value could result in an unexpected impairment charge for impaired goodwill, which could have a material adverse effect on Applied's business, financial condition and results of operations. Income Taxes The effective tax rate is highly dependent upon the geographic composition of worldwide earnings, tax regulations governing each region, non-tax deductible expenses incurred in connection with acquisitions and availability of tax credits. Management carefully monitors the changes in many factors and adjusts the effective income tax rate as required. If actual results differ from these estimates, Applied could be required to record a 52-------------------------------------------------------------------------------- Table of Contents valuation allowance on deferred tax assets or adjust its effective income tax rate, which could have a material adverse effect on Applied's business, financial condition and results of operations. Applied accounts for income taxes by recognizing deferred tax assets and liabilities using statutory tax rates for the effect of temporary differences between the book and tax bases of recorded assets and liabilities, net operating losses and tax credit carryforwards. Deferred tax assets are also reduced by a valuation allowance if it is more likely than not that a portion of the deferred tax asset will not be realized. Management has determined that it is more likely than not that Applied's future taxable income will be sufficient to realize its deferred tax assets. The calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties in the application of complex tax laws. Resolution of these uncertainties in a manner inconsistent with Applied's expectations could have a material impact on Applied's results of operations and financial condition. Non-GAAP Results Management uses non-GAAP results to evaluate the Company's operating and financial performance in light of business objectives and for planning purposes. Applied Materials believes these measures enhance investors' ability to review the Company's business from the same perspective as the Company's management and facilitate comparisons of this period's results with prior periods. The non-GAAP results presented below exclude the impact of the following, where applicable: restructuring and asset impairment charges and any associated adjustment related to restructuring actions, certain discrete tax items, certain acquisition-related costs, investment impairments, and gain or loss on sale of facilities. These non-GAAP measures are not in accordance with GAAP and may differ from non-GAAP methods of accounting and reporting used by other companies. The presentation of this additional information should not be considered a substitute for results prepared in accordance with GAAP. Non-GAAP operating income for the three and nine months ended July 31, 2011 was $683 million and $2.0 billion, respectively, compared to non-GAAP operating income of $339 million and $1.0 billion for the three and nine months ended August 1, 2010, respectively. Non-GAAP net income for the third quarter of fiscal 2011 was $467 million, or $0.35 per share, compared to a non-GAAP net income of $234 million or $0.17 per share for the third quarter of fiscal 2010. Non-GAAP net income for the nine months ended July 31, 2011 was $1.5 billion, or $1.09 per share, compared to a non-GAAP net income of $705 million or $0.52 per share for the nine months ended August 1, 2010. 53 -------------------------------------------------------------------------------- Table of Contents The following table presents a reconciliation of the GAAP and non-GAAP results for the three and nine months ended July 31, 2011 and August 1, 2010: APPLIED MATERIALS, INC. RECONCILIATION OF GAAP TO NON-GAAP RESULTS Three Months Ended Nine Months Ended July 31, August 1, July 31, August 1, 2011 2010 2011 2010 (Inmillions, except per share amounts) Non-GAAP Operating Income Reported operating income (GAAP basis) $ 687 $ 183 $ 2,037 $ 685 Certain items associated with acquisitions1 12 21 37 77 Varian and Semitool deal cost 9 - 9 10 Restructuring charges and asset impairments2,3,4,5 3 135 (30 ) 248 Gain on sale of facilities, net (28 ) - (27 ) - Non-GAAP operating income $ 683 $ 339 $ 2,026 $ 1,020 Non-GAAP Net Income Reported net income (GAAP basis) $ 476 $ 123 $ 1,471 $ 470 Certain items associated with acquisitions1 12 21 37 77 Varian and Semitool deal cost 9 - 9 10 Restructuring charges and asset impairments2,3,4,5 3 135 (30 ) 248 Impairment of strategic investments - 8 - 13 Gain on sale of facilities, net (28 ) - (27 ) - Reinstatement of federal R&D tax credit - - (13 ) - Income tax effect of non-GAAP adjustments (5 ) (53 ) 5 (113 ) Non-GAAP net income $ 467 $ 234 $ 1,452 $ 705 Non-GAAP Earnings Per Diluted Share Reported earnings per diluted share (GAAP basis) $ 0.36 $ 0.09 $ 1.10 $ 0.35 Certain items associated with acquisitions 0.01 0.01 0.02 0.04 Varian and Semitool deal cost - - 0.01 0.01 Restructuring charges and asset impairments - 0.07 (0.01 ) 0.12 Impairment of strategic investments - - - - Gain on sale of facilities, net (0.02 ) - (0.02 ) - Reinstatement of federal R&D tax credit - - (0.01 ) - Non-GAAP earnings per diluted share $ 0.35 $ 0.17 $ 1.09 $ 0.52 Weighted average number of diluted shares 1,330 1,349 1,333 1,351 1 These items are incremental charges attributable to acquisitions consisting of inventory fair value adjustments on products sold and amortization of purchased intangible assets. 2 Results for the three months ended July 31, 2011 included asset impairment charges of $3 million related to certain fixed assets. 3 Results for the three months ended August 1, 2010 included asset impairment charges of $110 million and restructuring charges of $45 million related to a restructuring program announced on July 21, 2010, offset by a $20 million favorable adjustment to a restructuring program announced on November 11, 2009. 4 Results for the nine months ended July 31, 2011 included asset impairment charges of $30 million primarily related to certain intangible assets, offset by favorable adjustments of $36 million related to a restructuring 54 -------------------------------------------------------------------------------- Table of Contents program announced on July 21, 2010, $19 million related to a restructuring program announced on November 11, 2009, and $5 million related to a restructuring program announced on November 12, 2008. 5 Results for the nine months ended August 1, 2010 included asset impairment charges of $110 million and restructuring charges of $45 million related to a restructuring program announced on July 21, 2010, restructuring charges of $84 million associated with a restructuring program announced on November 11, 2009, and asset impairment charges of $9 million related to a facility held for sale. |