Investors in Applied Materials (NASDAQ:AMAT) couldn't have asked for much more out of their company's fiscal third-quarter 2006 earnings release. The company "beat" both Wall Street's and its own estimates for both quarterly sales and earnings, and grew its gross margin 420 basis points in comparison to last year. Unfortunately, it wasn't Q3 that investors were worried about, but Q4 and beyond.

With the well-publicized price war between Intel (NASDAQ:INTC) and AMD (NYSE:AMD) heating up, and the lower prices resulting from this war expected to spur demand for PC chips, investors were hoping to hear Applied Materials reiterate its past expectations that demand for its chipmaking equipment was growing. Instead, CEO Mike Splinter called himself "less optimistic" than just a few months ago, and pronounced market conditions "challenging." He further predicted only flat sales (year over year) for next quarter, and $0.29 to $0.30 per share in profits.

Now here's the strange thing: Very often, when a company reports a strong past quarter, but predicts a weak one, its shares will immediately plunge. One would have thought a price collapse especially likely here, because Applied Materials coupled its weak forecast with an announcement that its CFO, Nancy Handel, intends to leave the firm early next year, and Wall Street usually views such departures with extreme suspicion.

And yet, although the stock didn't surge, neither did it fall. So it seemed to this Fool that there had to be something extra-special good in Applied Materials' news that took the sting out of the forecast for investors. Looking deeper, I found nothing definite, but the free cash flow situation, at least, looks good.

Free cash flow
Combined cash, equivalents, and short-term investments declined about $500 million since last quarter. And yet, Applied Materials spent $300 million to acquire Applied Films, $500 million on share repurchases, and another $78 million on dividends during fiscal Q3. That cash levels dropped only $500 million suggests that free cash flow generation was very positive. (Speaking of which, the reason I'm speculating about free cash flow, rather than spelling it out, is because the firm declined to include a cash flow statement with its earnings release.)

In comparison with last year, accounts receivable increased 50%, and inventories rose 25%. Large numbers both, but when compared to the 56% year-over-year sales growth, this suggests that the company is having little difficulty selling its products, and that its quality of earnings is strong. All that looks to have been enough to save the stock from the expected thrashing. This time.

What were we looking for from Applied Materials, at T-minus one day? Check our math at "Foolish Forecast: Applied Materials Ready to Leap."

In "Is Applied Materials a Buy?," fellow Fool Dan Bloom sounds an ominous note on what could happen if Applied Materials fails to beat its conservative estimates three months from now. Beware, because "semiconductor investors tend to be nervous types."

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Fool contributor Rich Smith owns shares of Intel. The Fool has an ironclad disclosure policy.