Earnings Call Transcript - AMAT Q4 2021

Operator, Operator

Welcome to the Applied Materials Earnings Conference Call. I would now like to turn the conference over to Michael Sullivan, Corporate Vice President. Please go ahead, sir.

Michael Sullivan, Corporate Vice President

Good afternoon, everyone, and thank you for joining Applied's Fourth Quarter of Fiscal 2021 Earnings Call. Joining me are Gary Dickerson, our President and CEO; and Bob Halliday, our Chief Financial Officer. Before we begin, I'd like to remind you that today's call contains forward-looking statements, which are subject to risks and uncertainties that could cause our actual results to differ. Information concerning the risks and uncertainties is contained in Applied's most recent Form 10-Q and 8-K filings with the SEC. Today's call also includes non-GAAP financial measures. Reconciliations to GAAP measures are found in today's earnings press release and in our quarterly earnings materials, which are available on the IR page of our website at appliedmaterials.com. And now I'd like to turn the call over to Gary Dickerson.

Gary Dickerson, President and CEO

Thank you, Mike. I'd like to start by thanking our employees for delivering the best year in Applied Materials history while navigating a dynamic and challenging environment. Demand for semiconductors and wafer fab equipment remains very strong. And in fiscal 2021, we generated $23 billion of revenue, which represents 34% annual growth. In fiscal Q4, we hit the midpoint of our earnings guidance despite larger-than-expected supply chain constraints. These constraints worsened in the last few weeks of the quarter as we experienced delayed shipments from several suppliers. Without these supply shortages, we estimate that our Q4 revenues would have been at least $300 million higher. We expect supply chain headwinds to persist into fiscal 2022, and mitigating them remains our top priority. For this reason, I'll begin today's call by providing some additional details about the industry's supply dynamics, both near term and longer term. Next, I'll describe the demand outlook, which is very strong and broad-based. I'll then talk about the progress we're making against our growth strategy and how Applied Materials is positioned to outperform the market over the coming years. I'm also happy to welcome Bob back to the CFO seat while we conduct the search for our next CFO. Later in the call, Bob will share his perspective on the state of the business and provide color on our financial performance. So let me start with the supply side of the equation. Applied has made and continues to make strategic investments in our own global manufacturing infrastructure, so factory capacity is not a limiting factor for us. Like many in the industry, the primary challenge we face today is the availability of certain silicon components. For Applied, our issues are relatively narrow, and we are proactively collaborating with our suppliers and directly with the chip companies to find solutions and work around bottlenecks. I deeply appreciate their partnership and teamwork as we navigate these unprecedented circumstances together. Looking further ahead, I believe we will see permanent changes in the way supply chains are designed and operated. In the semiconductor industry and beyond, there's a shift from just-in-time to a just-in-case approach, which will require higher levels of inventory, more built-in redundancy, and more burst capacity. Because the economic value of capturing upside opportunities far outweighs pure efficiency savings, we're also seeing changes in supply agreements across the ecosystem as companies place a premium on having preferential access to capacity. In addition, our customers are providing us with longer-term visibility, and we are collaborating more closely than ever when it comes to capacity planning. On top of that, the strategic importance of semiconductors is now recognized at a national level. Over the next few years, as incentive programs become available in the U.S., Europe, and Asia, we expect to see a trend towards regionalized supply chains that are more resilient, but also increased capital intensity. Now I'll characterize the demand environment, which is extremely healthy. The pandemic has accelerated the digital transformation of the economy, fueling semiconductor consumption and driving the need for next-generation silicon technologies. As a result, we see wafer fab equipment spending for calendar 2021 up around 40% year-on-year, in other words, in the mid-$80 billion range and constrained by supply, not demand. There is still a long way to go before supply and demand are balanced, especially as demand drivers continue to grow. We, therefore, expect wafer fab equipment spending to be up again in 2022. While we're currently focused on resolving near-term challenges, it's important to recognize we're only at the beginning of major technology and market inflections that will play out over the next decade. As everything gets smarter, from our phones to our cars to our homes, we see a combination of unit growth and increasing silicon content per unit. For example, if you look at this year's high-end smartphones, by dollar value, the application processor semiconductor content is up about 20% compared to last year's models, and RF content increased at twice that rate. And in data center applications, the average DRAM and NAND content per server is also growing at a 20% compound annual growth rate. As more and more smart devices are connected at the edge, they are driving exponential growth in machine-generated data that must be stored, moved, and processed. Then to create value from these vast volumes of data, new AI computing approaches are being developed, fueling further demand for current and next-generation semiconductors. When I talk with customers, their message is clear and consistent. They are investing strategically to be in the best position to capture value as these long-term secular trends accelerate. In our core market, foundry/logic is about 60% of wafer fab equipment spending in 2021, and we expect it to remain at this level or higher over the next several years. Within foundry/logic, the spending mix is relatively balanced between the most advanced nodes where we see a fierce battle for leadership playing out in ICAPS. ICAPS nodes serve the fast-growing IoT, communications, automotive, power electronics, and sensor markets. In memory, supply and demand fundamentals remain healthy, and we expect investments to be up next year, although not as much as foundry/logic. Finally, capital intensity is also providing an important tailwind. With the deceleration of traditional Moore's Law scaling and the transition to the new PPACt playbook, complexity is increasing. Simply put, more innovation is needed to get from one node to the next. And this higher complexity translates to higher capital intensity. Against this backdrop, I'll now describe Applied's performance and progress towards our strategic goals. In fiscal 2021, we grew semiconductor equipment revenues almost $5 billion or 43% year-on-year, outpacing the market growth rate during that period. However, as I described earlier, we were unable to fully meet demand in our fourth quarter due to component shortages, and we expect to remain supply constrained going into fiscal 2022. As a result, we've grown our backlog at a company level to $11.8 billion, which is up 77% compared to the same period last year. Our near-term results do not fully reflect the underlying strength in our business or the progress we're making against our long-term strategy. As a reminder, our strategy has three pillars: first, to be the PPACt enablement company and provide the foundation for customers' power, performance, area cost, and time-to-market road maps; second, to shift more of our business to subscriptions; and third, to generate incremental free cash flows and profitability from our businesses in adjacent markets. We've aligned our organization and investments around these critical focus areas and are demonstrating strong momentum. Applied's PPACt enablement strategy is built upon three differentiated elements. We have the broadest and most enabling portfolio of unit process solutions. We can co-optimize and integrate these technologies in unique and highly enabling ways. And we're focused on time-to-market acceleration with our AI(x) or Actionable Insight Accelerator data platform. Starting with our unit process tools. Demand in our traditional leadership areas is very strong. Our epi and thermal businesses both grew 70% this fiscal year, and CMP grew more than 60%. And in our targeted growth areas, we expect our process diagnostic and control revenues to be up more than 60% in calendar 2021. Packaging is another very exciting area for us. Our equipment revenues are up more than 55% year-on-year, and we're on track to exceed $800 million for calendar 2021. We're also bringing highly enabling future technologies to market through a combination of organic R&D and strategic partnerships. Moving to our co-optimized and integrated products. The customer pull for these solutions is strong and increasing for future nodes. Co-optimization allows us to see and solve higher-value problems for customers, speed up commercialization of new innovations, and capture more of the available opportunity. One example is dielectric materials where we're driving parallel innovations in materials deposition, modification, and removal. Our CVD group has more than 15 new materials either in development or recently released. These enable new structures or manufacturing techniques in both foundry/logic and memory. The revenue opportunity we've opened up for the co-optimized etch and CMP steps is almost twice as large as the market for the stand-alone deposition equipment. Another example is advanced patterning where we're co-optimizing CVD, ALD, and CMP with our Sym3 etch, enabling us to gain more than 5 points of share in patterning this year. Integrated Materials Solutions, or IMS, go one step beyond co-optimization by combining multiple processes with customized metrology and sensors in a single system typically under vacuum. With IMS, we can target the most complex and valuable challenges in the new PPACt playbook. For example, this year, we delivered five new low R, or low resistance metallization integrated solutions to customers that address next-generation applications in foundry/logic, DRAM, and NAND. This included our copper barrier seed IMS that combines seven different process technologies in one system under vacuum, ALD, PVD, CVD, copper reflow, surface treatment, interface engineering, and metrology. This enables a 50% reduction in interconnect resistance at the most advanced foundry/logic nodes and creates a multibillion-dollar opportunity for Applied Materials over the next five years. The final component of our PPACt enablement strategy is time-to-market acceleration. New digital tools that accelerate R&D, technology transfer, and high-volume manufacturing are a major focus area for our customers. In the coming years, these technologies will have a huge impact on productivity and innovation to commercialization speed. They will also play a key role in making regional supply chains economically competitive and sustainable. Our AI(x) platform brings together process tools, sensors, metrology with data analytics and machine learning. We currently have 25 AI(x) R&D acceleration engagements with leading customers, and we now expect that number to triple over the next 12 months. Another highlight for 2021 is the progress we're making with subscription revenues. In our service business, we've already converted a significant percentage of our spares and service revenue from on-demand to long-term service agreements. We now have nearly 15,000 installed base tools covered by these agreements, up 12% year-on-year. The tenure of these agreements has grown from 1.9 years at the end of 2020 to 2.3 years today, and our renewal rate is about 90%. Several customers have highlighted how these long-term agreements have allowed them to better manage disruptions in parts supply and technical support during the pandemic. Before I hand the call over to Bob, I will quickly summarize. As the digital transformation of the economy accelerates, demand for semiconductors continues to grow and is significantly outpacing supply. We expect supply shortages of certain silicon components to persist in the near term, meaning that we don't expect to fully meet demand in Q1. Managing these constraints in partnership with our suppliers and chip makers is our top priority. Looking beyond the near-term disruptions, I feel very positive about the future. Longer-term secular trends are driving the semiconductor and wafer fab equipment markets structurally higher. And at Applied, we're making significant progress towards our strategic plans. We are in the best position to accelerate our customers' PPACt road maps and grow significantly faster than our markets over the next several years. Now I'll hand the call over to Bob.

Bob Halliday, Chief Financial Officer

Thanks, Gary. I want to begin by saying I'm very happy for the opportunity to work with all of you again. I have three main messages today. Number one, demand is very strong and growing, and I think it's likely to remain strong in 2022 and beyond. Number two, supply chain constraints are impacting our ability to meet all of our demand in the near term. Number three, Applied Materials is making very good progress toward our financial targets, and we're in a great position to return capital to shareholders. I'll cover each of these topics in order and give you our guidance. And then Gary, Mike, and I will help with your questions. I'll begin by giving you more detailed insights than we typically share about the demand for our products and its sustainability into 2022. Specifically, our Semi Systems revenue grew by 43% in 2021. Our Semi Systems orders grew by 78% for the year. In fact, our Semi Systems orders grew in every quarter. In Q4, they were up 136% year-over-year. Looking ahead, we currently expect our orders to be higher in the first half of fiscal 2022 than in the second half of 2021 across Semi Systems, AGS, and also Display. In short, the demand environment is very strong. What's happening on the demand side is that all of the trends Gary and I talked about years ago are playing out in an even bigger way than we imagined. First, semiconductor demand is higher because we're designing more intelligence into practically everything that gets built and sold. Second, equipment capital intensity is higher. We don't have wafer size increases anymore, and the industry has run out a number of efficiencies, including fab automation, industry consolidation, and the foundry model. Used equipment is now scarce. So even in the ICAPS markets, customers are buying new equipment and spending more. The industry is adding more wafer capacity to keep up with demand, particularly in foundry/logic, and we believe spending will remain strong. Specifically, the industry grew foundry/logic wafer starts by around 40% over the past five years alone. At the end of our fiscal year, overall fab utilization for the industry increased to the highest level of the past decade. We see foundry/logic continuing to grow as a proportion of the industry's mix. Five years ago, foundry/logic represented around 53% of WFE spending. As of 2021, it's grown to 60% of WFE, and we see it being even higher into the future. Even with higher wafer capacity and high utilization, we have a global semiconductor shortage that's affecting a wide range of industries, including our own. Industry-wide, we are tracking 59 fab projects with available and announced expansion capacity of 3.5 million wafer starts. These projects represent potential equipment spending of around $300 billion in future years. All of this data leads me to believe that demand is likely to remain strong. Now I'll give you more insights into our own supply situation. In Q4, our Semi Systems backlog was at record levels and growing quickly. In our guidance for Q4, we targeted modest Semi Systems revenue growth. We also widened our overall guidance range due to our concerns about the supply chain. Toward the end of Q4, we experienced later-than-expected deliveries of the components we need to complete and ship our build plan by the end of the quarter. The reason for the delays is that our suppliers couldn't get enough parts from their own suppliers, which include chip makers and distributors. The supply issues are directly related to the semiconductor shortage, particularly in logic, power, and analog ICs. Not all of our semi businesses were affected in Q4. Our process control, CMP, etch, and packaging businesses beat our revenue targets. Yet our overall Semi Systems revenue was $293 million below the midpoint of our expectation. The full semiconductor revenue impact of the shortages during the quarter was well above $300 million. In Q1, we are guiding for sequential growth of around 3%. We have the internal capacity to easily ship several hundred million dollars more of semi equipment, but we are planning for only modest supply increases. Looking ahead, I believe WFE spending will be up again in calendar 2022 and will remain strong, particularly for foundry/logic, both at the leading edge and ICAPS notes. I also believe Applied's business will be higher in the first half of calendar 2022 than in the second half of calendar 2021, both in Semi Systems and AGS. Next, since it's the end of our fiscal year, it's a good time to assess the progress we're making towards our 2024 financial model. In April, we outlined targets to grow our revenue, profitability, and earnings in a variety of WFE scenarios, including a base case of $85 billion and a high case of $100 billion. With everything we're seeing in the industry today, our high scenario of $100 billion is increasingly likely. One year into the long-term plan, we've made good progress, increasing revenue by 34%, non-GAAP gross margin by 240 basis points, non-GAAP operating margin by 540 basis points, and non-GAAP EPS by 64%. We believe our Semi Systems group is well on track to its growth targets based on our strong product road maps and the deep customer engagements Gary described. We believe AGS can exceed the growth implied in our model after growing by 21% this year alone. In fact, AGS had record backlog of over $4.33 billion at the end of the year. Seventy-two percent of the Q4 backlog was subscription business with terms of 1 to 3 years, and 65% of new subscription bookings were multiyear. While our focus is on recurring revenue, AGS also includes our 200-millimeter equipment business. Our 200-millimeter business has been growing along with the rest of the ICAPS market, approaching $650 million in WFE revenue in calendar 2021. Turning to our profitability metrics, we expect to achieve our non-GAAP gross margin target of 48.5% once the near-term material and logistics cost headwinds subside. We also feel confident in our non-GAAP operating margin targets. The Semi Systems group increased its operating margin by 590 basis points this year, while AGS delivered record operating margin of 31% in Q4. A major focus for us is increasing the display group's margin to between 25% and 30%. And we plan to be in that range by the second half of 2022. Another of our targets is to return 80% to 100% of free cash flow to shareholders. In fiscal 2021, we generated a record $4.77 billion in free cash flow, and we returned 96% mainly through stock buybacks. We ended the year with over $5 billion remaining in buyback authorization. And given the strong demand outlook and our view of the intrinsic value of the company, we expect to continue to be aggressive with the program. Now I'll share our Q1 business outlook. Given the supply chain challenges, we expect to modestly increase revenue to $6.16 billion, plus or minus $250 million, or up around 19% year-on-year. We expect non-GAAP EPS to be around $1.85, plus or minus $0.07, or up around 33% year-on-year. Within this outlook, we expect Semi Systems revenue of around $4.46 billion, up 25% year-over-year. We project AGS revenue of around $1.33 billion, up 15% year-over-year. We expect Display revenue to be around $350 million in Q1 and higher as we progress through the year. Applied's non-GAAP gross margin should decline to around 47.4%, primarily due to higher near-term cost headwinds. We plan to increase non-GAAP OpEx to $970 million, which is around 15.8% of revenue, below our long-term model target of 16%. Our guidance also assumes a 12% non-GAAP tax rate. Finally, along with Gary, I'd like to thank all of our teams and partners for their hard work in a challenging environment. Now Mike, let's begin the Q&A.

Michael Sullivan, Corporate Vice President

Thanks, Bob. Operator, let's please begin.

Operator, Operator

Our first question comes from C.J. Muse with Evercore.

Christopher Muse, Analyst

Welcome back, Bob. I'm sure you're happy to be back from the golf course. So I guess a couple of part question on supply constraints. You talked about not being fully resolved in January. Do you expect it to be resolved in April? And how are customers reacting to the shortages? Are they waiting on a full suite of tools? Or are they taking whatever tools they can get? And then, I guess, lastly, considering the backlog that you highlighted and also that longest lead time ASML is essentially sold out for all of 2022, it certainly looks like your visibility extends now into 2023. Can you speak to that?

Bob Halliday, Chief Financial Officer

Thanks for having me back. There are a few key points to discuss: supply chain, the overall demand environment, and visibility. First, regarding the supply chain, we managed it quite well for about 11 months, but it started to decline toward the end of the quarter. We are now focused on this issue. Our short-term management for the upcoming quarters involves prioritization, project management, and execution. We have implemented a weekly review of our performance related to receipts, shipments, shortages, and specific suppliers, with Gary closely monitoring it almost daily. You might wonder why we expect an improvement in Q1. Some of our public suppliers are showing an average increase of 3% to 5%. We believe our allocation will surpass that. We have effectively allocated resources internally and are collaborating with our suppliers to increase demand. Additionally, in the first two weeks of the quarter, receipts rose by about 15% compared to the previous quarter. The issues we faced were mostly manageable though scattered, with a significant impact from shortages of electronic components used in our products. We are closely tracking around 100 components, particularly 10 that caused problems at the quarter's end, especially regarding PLCs. We are monitoring our top 10 suppliers and another 200 components to ensure nothing worsens. Overall, I feel optimistic about the robust demand, a solid backlog, and increasing orders each quarter, leading to a strong outlook for next year. I believe the supply chain will improve gradually throughout the year. As for visibility, our range of tools is being well-received by customers, who are taking whatever products they can get. We aim to manage the backlog carefully while making consistent progress over the year.

Gary Dickerson, President and CEO

C.J., this is Gary. I'll add a little bit more. I've met with all the CEOs of our top customers, leading technologies and ICAPS here in the last quarter. And what I would say, certainly, the supply situation is challenging, but really no change in terms of the customer demand for the products. And some of the tools that, again, as Bob said, it's not a broad-based issue. Some of these tools are the ones that are most enabling from Applied. And again, nothing has changed relative to that demand.

Operator, Operator

Our next question comes from John Pitzer with Credit Suisse.

John Pitzer, Analyst

Bob, welcome back as well. It's great working with you again. My guess is you're going to get multiples of C.J.'s questions on the supply side. But I'm just kind of curious, Bob, to follow up, as the supply chain gets better, do you think by the April quarter, there's a big step function pickup to the $500 million, plus or minus, that you can't ship in sort of October and January? Or will it be a little bit more linear than that as supply comes online? And then to your point earlier, Bob, about the backlog, just how do you safeguard against sort of a frothy backlog in this kind of environment? There are impressive numbers. But typically, when customers can't get what they want, they tend to order more than they need. So how are you safeguarding against that?

Bob Halliday, Chief Financial Officer

So in terms of rate of recovery and confidence in the backlog and kind of the double booking question, I think, is the question. So in terms of rate of recovery, what we're modeling from discussions with suppliers and our suppliers' suppliers and our internal analysis, which we're doing the best we can to model this, and we believe it's accurate, we think Q1, the rate recovery, if you look at it, our Semi business is up a little over 3% equipment. And that's about what the industry is quarter-on-quarter. Our AGS business is a little bit lower because it's 14 weeks last year in Q1 as the Chinese holiday falls into Q1 this year. But if you look at the rate of recovery, we think it goes up a little over 3% in Q1. We think the equipment business picks up a couple of points more every quarter and builds more momentum later in the year. Now as we get more visibility, next quarter, I'll be more confident in those numbers. But that's the kind of acceleration we're picking up in shipments. We hope to do better. We might do better, but that's what we're modeling.

John Pitzer, Analyst

We think the rate of recovery goes up a little over 3% in Q1. We expect the equipment business to improve a couple of points more each quarter and gain more momentum later in the year. With increased visibility, I'll provide more confidence in those numbers next quarter. This is the kind of acceleration we're experiencing in shipments. We hope to perform better; we might do better, but that's our current model.

Bob Halliday, Chief Financial Officer

I don't think double booking is a problem right now, John. If you look at the breakdown between memory and foundry/logic, foundry/logic accounted for 60% of the business this year, and we actually expect that to increase next year. Public statements from TSMC, Intel, and other major foundry/logic manufacturers indicate they are committing to multi-year spending on wafer front-end and have strong business prospects. We anticipate that foundry/logic will grow as a percentage of our mix next year, while memory is expected to be slightly up, particularly in NAND, with a small decline in DRAM. We think this outlook is reasonable and do not expect any issues with double booking. We see a slight downturn in China next year.

Operator, Operator

Our next question comes from Stacy Rasgon with Bernstein Research.

Stacy Rasgon, Analyst

Could you discuss how the constraints are affecting the services business? It's not only about services; hardware and other factors play a role too. Is the services sector experiencing an impact from these constraints? Would it perform better without them? Additionally, how do you envision the future development of services as you address these constraint issues next year?

Bob Halliday, Chief Financial Officer

Our services business is performing exceptionally well this year, with a 21% increase. We are on track to meet our 2024 targets, and we anticipate exceeding the necessary compound growth rate of 7% per year, likely achieving double-digit growth in services this year. Our service business comprises various elements, including a 200-millimeter tool business, contract services spanning 1 to 3 years, and time-and-material arrangements. We believe that our service business will see strong growth in double digits this year. Customers have expressed appreciation for our service teams for transitioning them to parts service contracts over the past couple of years, ensuring they are well-supported with parts. Consequently, we do not foresee supply chain challenges affecting our service business significantly.

Stacy Rasgon, Analyst

And Bob, how would you guide services in fiscal '22 as a percent? Low double digit?

Bob Halliday, Chief Financial Officer

Yes, I think it's low double digits growth.

Operator, Operator

Your next question comes from Vivek Arya with Bank of America.

Vivek Arya, Analyst

Just a clarification. What do you expect Display to do overall in this fiscal '22? And then my question is, this year, we have seen your foundry customers raise their prices. Fabless customers, IDM, they are raising their prices. What about the equipment side? How much pricing power do you guys have that can help mitigate some of these supply chain issues? Because you did mention kind of a hit on your gross margin. So as you start to see some of the supply situation recover, should we expect this combination of pricing and the supply side to help you to cover gross margins quickly? Or will the gross margin recovery take time?

Gary Dickerson, President and CEO

Vivek, this is Gary. Thanks for the question. There's two parts to this. I'll take the first part, and then Bob can take the second part. Relative to Display, we've talked about that many times, really good adjacent market where we can take our semi deposition and e-beam technologies into a market with larger substrates. For '21, as expected, we're on track for a little over $1.6 billion in revenue and maintaining strong share of our served market. We think '22 is a little higher than '21, more second half versus first half. And as Bob also discussed in the prepared remarks, we're on track to achieve our target for higher profit and free cash flow in the 25% to 30% range exiting 2022. And then Bob, you have the second part.

Bob Halliday, Chief Financial Officer

In terms of your second question, it's kind of a broader gross margin question. So if you look at gross margins this past year, we're up 2.4 points, which is great performance. We're on track to hit the model, which is, I think, about 48.5% in the out years. We're a little soft right now in Q1, and that's all supply chain stuff. As we go out through the year, we expect gross margins to rise up again as we get the supply chain issues behind us. In terms of the things that impact gross margin, we did a lot of good things in 2021. We had very good cost reduction. We had high-value products and services. We sold to the customers, and we recognized that value back from the customers. And then we have pretty good volume and mix, which helped too. If you look at prospectively, the cost reduction is a little slower. We will continue to realize high value with the customers. We share that value, and we think that's going to help our margins. And if the costs continue, we may even have that discussion at some point.

Gary Dickerson, President and CEO

Yes. So margin's kind of flattish in the first half and then maybe a little better in the second half if we keep the supply chain.

Bob Halliday, Chief Financial Officer

Yes, I think so. And I think the year is a little better than this share overall by the time we're done.

Gary Dickerson, President and CEO

Okay. Any comments on pricing? I think Vivek was kind of...

Bob Halliday, Chief Financial Officer

Yes, we look to share value with customers, and I think that's worked for both of us.

Operator, Operator

Our next question comes from Toshiya Hari with Goldman Sachs.

Toshiya Hari, Analyst

Bob, welcome back. Gary, in your prepared remarks, you talked about localization of semiconductor capacity going forward. Obviously, there's a lot of talks in the United States and Europe, in Asia as well, more recently, Japan. How are you thinking about the potential impact from all these projects? I think from a timing perspective, most of us are thinking 2023 or even later. But based on what you know, all the discussions you're having, how are you thinking about that? And sort of related to that, how should we think about the competitive threat from the local Chinese semi-cap companies? I know they've been around for a very long time. And up until this point, there remains a very significant gap between incumbents like yourselves and them. But how concerned should we be as we think about your business over the next 3 to 5 years?

Gary Dickerson, President and CEO

Thank you for the questions, Toshiya. Regarding the localization of supply chains and the CHIPS Act, this is certainly beneficial for our business. We are currently in discussions and, as I mentioned earlier, I have met with the top CEOs over the past quarter. As they transition to new locations, it presents an opportunity for us to support them, particularly through our services business. We are closely collaborating with these customers as they implement their plans. They are also focused on cost, cultural differences, and other factors, which opens up significant opportunities for us, not only in our traditional services but also in areas like AI(x), Applied Actionable Insight Acceleration, where there is a strong emphasis on expediting R&D ramp and optimizing high-volume manufacturing in new locations. This really creates a great chance for us. Additionally, the CHIPS Act promotes faster innovation and commercialization by governments, and we are engaged in in-depth discussions with several leading technology companies that will likely provide opportunities for Applied. When it comes to the China equipment suppliers, every customer is concentrating on power, performance, and cost. We emphasize PPACt, where the 'T' is crucial. Issues like low-resistance wiring are significant challenges in the industry where we excel, as well as advancements in gate-all-around transistors, memory scaling, and packaging, which are very complex. Companies that excel in power, performance, and cost tend to dominate the market. Therefore, I believe Applied is in an even stronger position moving forward compared to our past standing against local competition.

Operator, Operator

Our next question comes from Krish Sankar with Cowen and Company.

Sreekrishnan Sankarnarayanan, Analyst

Bob, welcome back. I just wanted to check on the fact that some of these constraints are pushing out revenues into next year, and it looks like maybe in the first half of next year, the WFE run rate could hit $100 billion. So I just wanted to figure out from your vantage point, how do you think about that? And you also mentioned that you're trending towards our target model, but obviously, the margins are impacted because of constraints. And the target model at $10 in EPS and $100 billion in WFE. How much discount should we give to that $10 in this constrained environment?

Bob Halliday, Chief Financial Officer

We believe WFE will increase next year. While we mentioned in our script that it could go up, we prefer not to be overly specific at this point. We're looking at an increase of around 10% for next year, and we're quite confident about that. The visibility seems better for the first half of the year, where we have robust orders and booking potential. We also anticipate that the second half will show even stronger bookings than we currently have. Feedback from customers has been positive, especially in the foundry and logic sectors. Regarding the model, a $100 billion target seems realistic nowadays, although I'm not sure it will materialize next year. If we do reach that $100 billion, it would help us meet the model expectations, including the $10 target. I believe we can achieve that.

Gary Dickerson, President and CEO

Yes. Maybe I can add, Krish, one more thing relative to 2022 and then going forward, backlog for us is very strong. Again, I've met with all of these leading customers, foundry/logic, memory, ICAPS. And as Bob mentioned earlier, if you look at what they're publicly talking about in terms of their investments over multiple years, it's very, very strong. And some of this, obviously, I can't share publicly, but I have very high confidence that the business is going to remain strong through '22. And right now, '23 also looks good for us. And certainly, again, if you just look at all the public statements from those customers, again, they're not planning on a short cycle. They're planning to be ready with capacity to capture the opportunities.

Operator, Operator

Our next question comes from Timothy Arcuri with UBS.

Timothy Arcuri, Analyst

Welcome back, Bob. I have a question regarding WFE share. Gary, you've discussed it extensively. It appears that your share this year remains flat in the range of 20.2% to 20.3%. However, that doesn't accurately reflect the situation because you would have achieved an additional $300 million in October. I'm curious if you could provide an adjustment for January. What would January's SSG have looked like if you had the supply? Would that guidance of $4.45 billion have been approximately $300 million higher? I'm trying to understand how to increase your share estimation because it’s clear that on an adjusted basis, you've gained considerable share this year.

Gary Dickerson, President and CEO

Yes, Tim, thank you for the question. Q1 would have been significantly higher, as Bob mentioned. Demand is certainly much greater than supply. We outperformed in 2019 and 2020, and we are on track to outperform in 2021. We feel optimistic about 2022 and beyond. However, I prefer not to get into specifics beyond what we've already shared on the call. Q1 would definitely have been significantly higher, moving into 2022. Regarding different aspects of our business, we have discussed wiring resistance in foundry/logic, which poses a significant challenge for our customers as they shrink features and resistance increases. We provided details about our copper barrier seed tool featuring seven technologies worth billions. In the prepared remarks, I mentioned that we are delivering five of these innovations to customers and while we haven't quantified all aspects, they represent substantial value where Applied uniquely supports solutions for wiring resistance; one example is a 50% improvement in resistance. Looking at gate-all-around, we are optimistic about our position in the transistor market for gaining share, representing a $1 billion opportunity. Concerning our FinFET position, we believe we are well-positioned to gain further share. Our etch share in foundry/logic is increasing, along with our EUV etch share, and our overall business has risen by more than 60%. Our integrated solutions are in a very strong position. I provided insights on co-optimization and highlighted opportunities in the memory market, where we also see significant potential. So, Tim, I am very confident about our future position.

Michael Sullivan, Corporate Vice President

Yes. And Tim, I'd add one more thing for you. So I know in the past, instead of waiting for Gartner group to come out with market share, what you always did is you took our fiscal Q2 through fiscal Q1 as a proxy for our revenue. And what's interesting is what we did back in February, we kind of disclosed in our conference call. And then in April, I wrote everybody that we've made a similar adjustment ourselves. So what we're now doing is our calendar year revenue for VLSI share purposes. It's now based on our financial reporting in fiscal Q2 through fiscal Q1. And one benefit of that change is that as soon as we guide Q1, which we just did today, now you can forecast our WFE revenue for share purposes, and you can make an apples-to-apples with the peer group. And then I just wanted to call your attention to one other number in the script today. Bob sized our AGS 200-millimeter revenue at around $650 million for the calendar year. So now you have all of the numbers that you need to make a share assumption. So I just wanted to give you that background. And we look forward, Bob and I, to seeing the investors at your conference.

Operator, Operator

Our next question comes from Harlan Sur with JPMorgan.

Harlan Sur, Analyst

Bob, welcome back to the team. Regarding the chip shortages, you mentioned that some areas have not been as affected, such as process control, CMP, etch, and packaging systems. However, this does leave areas like deposition implant, thermal processes, and others. I'm curious about the implications for your end markets in terms of which are becoming more affected, considering the variations in etch deposition, patterning intensities, and system configurations. Are foundry and logic more impacted? How about memory or ICAPS? Is it a widespread issue across all customer segments? Additionally, is your display business experiencing any impact?

Gary Dickerson, President and CEO

So Harlan, this is Gary. First off, I would say that Display is not being impacted. Relative to the different device types, I don't know that I would separate one versus the other relative to the impact. Just as an example, in the foundry/logic business, ICAPS in Varian, our business in ICAPS, our share is up significantly in our implant market, and our revenue is up 4x over the last two years. So again, I think that when you look across the different products, there are specific components. It's not broad-based. But again, I wouldn't necessarily say that it's one market or another when you look at the impact.

Operator, Operator

Our next question comes from Joe Quatrochi with Wells Fargo.

Joseph Quatrochi, Analyst

I wanted to double-click on your expectations for first half calendar 2022 being above second half '21. Does that apply to memory as well? Or should we think about that growth being mostly foundry/logic-driven and maybe memory is more second half-weighted?

Bob Halliday, Chief Financial Officer

In 2021, we saw stronger performance in memory during the first half, while foundry showed improvement in the second half. Our memory NAND was particularly strong in the first half, and DRAM gained strength in the second half. Looking ahead to next year, we anticipate a relatively flat year, with memory likely being more weighted towards the second half. We expect foundry to maintain strong performance throughout the year, although we do not foresee significant changes. Yes. I think overall, WFE is up. I think foundry is a bigger percentage. I think memory is kind of flattish, ends up a little bit. DRAM is down a little bit. I think the split within next year, my memory is a little better in the second half, but I'm not sure.

Operator, Operator

Our next question comes from Patrick Ho with Stifel.

Patrick Ho, Analyst

And likewise, Bob, I guess one rodeo wasn't enough for you. So welcome back. Maybe just following up on the AGS side of things. Given the high utilization rates, the high demand for chips today, have you seen any incremental type of pickups in your services business just because your customers are trying to keep their tools running as best as possible? Are you seeing any incremental pickup in subscription businesses just because of the current environment?

Bob Halliday, Chief Financial Officer

Yes, the answer is yes. I'm not sure if I covered it completely during the call, so I'll share some data. We looked at sustainability in various areas such as bookings, backlog, and order rates. I also focused on the growth in wafer starts and tool utilization. Tool utilization at the end of the fiscal calendar year was at an all-time high over the last 11 years across all device types. This gave me confidence that the current situation is sustainable and beneficial for our service business. Additionally, the growth in wafer starts, which I mentioned in the call, is approximately 40% for foundry/logic and about 20% for memory since 2016, especially strong in 300-millimeter wafer starts for foundry/logic. Regarding your question, Patrick, we grew our service business by 21% last year and are aiming for about 12% this year. High utilization rates and the growth of foundry/logic tools have contributed significantly. We also performed well in etch in previous years. Furthermore, we increased both the duration of our contracts from 1 to 3 years and our subscription revenue business, which indicates that the sustainability of our service business looks promising.

Gary Dickerson, President and CEO

Patrick, this is Gary. Just one other comment. In the discussions I've had with all of the CEOs, one thing that was pointed out was that having these subscription agreements and forecasted parts management, they said we're profiling better than others because they have those parts there. So from a supply standpoint, they said that was a big differentiator and gives them more conviction to continue and expand that type of approach.

Operator, Operator

Our next question comes from Quinn Bolton with Needham & Company.

Quinn Bolton, Analyst

I just wanted to ask about your outlook for China next year. In 2022, you said it would be down slightly. Wondering if you could give us a little bit more color what's driving that decline. Is it just digestion of capacity put in place this year? Do you see any political or export control impact or perhaps a trend towards supplier localization in China next year?

Bob Halliday, Chief Financial Officer

Let me provide some information. In China, it's expected to be down somewhat next year but remains fairly strong. Looking at the trends, spending by local companies is increasing compared to international companies, rising from the high 70s, about 77% this year to around 82% next year. Regarding the mix in business, it is similar to global trends, shifting slightly more towards foundry and logic. This year, it was about 52% memory and 48% foundry, and next year it is expected to shift to around 52% foundry. While DRAM is anticipated to decline slightly in China next year, foundry is on the rise.

Operator, Operator

Our last question comes from Sidney Ho with Deutsche Bank.

Sidney Ho, Analyst

I have a question regarding process control. You mentioned that process control was not affected by supply constraints, and it is now expected to grow about 60% this year. Additionally, you indicated that the number of AI engagements could potentially triple next year instead of just doubling. Could you clarify how these engagements influence your revenue growth potential? Do they typically result in revenue within the same year or over several years? Do they expand the overall market size or merely create an opportunity for Applied to capture more market share? Also, how do you measure success with these engagements?

Gary Dickerson, President and CEO

Yes, this is Gary. Thank you for the question. The fastest-growing segment of our PDC business is the e-beam product family, where we have a strong leadership position and have gained significant market share. Our advantage lies in our imaging resolution and speed, with a 50% resolution advantage over competitors thanks to our coal field emission technology. We expect continued strong growth in 2022 as well. Co-optimizing with e-beam is crucial; for instance, in capacitor scaling, we are combining a new material called Draco with innovative etch technology. Optimizing these processes is highly complex, as it involves adjusting multiple parameters to improve yield as quickly as possible within broad process windows. This synergy with e-beam is vital for developments in capacitor scaling and gate-all-around technologies, along with understanding multi-dimensional patterns across chips and wafers. Our unique imaging capabilities with the e-beam system, combined with AppliedPRO for process recipe optimization under AI(x), are key focuses for our customers. This is driving growth in our PDC business and presents significant value capture opportunities with our IMS and co-optimized platforms, amounting to billions of dollars. This serves as a tailwind for us, benefiting various advancements in technology. We anticipate an increase in engagement levels from 25 to 75 next year, which should translate into substantial wins in major technology advancements, contributing significantly to our customers' success. This is very synergistic with our overall strategy and growth potential.

Michael Sullivan, Corporate Vice President

Thank you, Sidney. And Bob, would you like to help us close the call with some summary thoughts?

Bob Halliday, Chief Financial Officer

I have some summary thoughts. First, I want to say it's great to be back. We have a strong team, including Gary. When I think about my return, I feel a bit like Arnold Schwarzenegger in The Terminator – I'll be back. Unfortunately, everyone recalls Welcome Back, Kotter, but I'm back anyway. Now, let's discuss our three main points. Our markets are strong and in great shape. We believe WFE will grow next year and is positively biased through 2023. Second, Applied's position is solid. Our demand is strong, our orders are great, and our backlog looks excellent. The demand mix is very favorable for us, particularly in foundry/logic and advanced devices like ICAPS. Lastly, regarding our financial performance and capital returns, I was impressed to see our gross margins increase by 240 basis points this year, with operating margins up by 540 basis points or 5.4%. Last year, we returned 96% of our free cash flow to investors, and we anticipate a really strong cash flow this year. Overall, the company is fundamentally in great shape. While we face supply chain challenges, we take full responsibility for resolving these issues and meeting customer needs. We are committed to making significant progress in the next quarter or so. Fundamentally, this company is in great shape, and I look forward to working with all of you again.

Michael Sullivan, Corporate Vice President

All right. Thanks, Bob. We'd like to thank everybody for joining us today. A replay of the call is going to be available on our website by 5 p.m. Pacific Time today. And Gary and I look forward to seeing many of you at the Credit Suisse Conference in Scottsdale in just a little while. And so happy Thanksgiving, and thank you for your continued interest in Applied Materials.

Operator, Operator

Thank you. This concludes today's conference call. Thank you for participating. You may now disconnect.