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KLA Tencor Corporation. (NASDAQ:KLAC)

F3Q08 Earnings Call

October 30, 2008 5:00 pm ET

Executives

Ed Lockwood - Senior Director of Investor Relation

Richard Wallace - Chief Executive Officer

Mark Dentinger - Chief Financial Officer

Analysts

Jay Deahna - J.P. Morgan

Jim Covello - Goldman Sachs

Timothy Arcuri - Citi

C.J. Muse - Barclays Capital

Satya Kumar - Credit Suisse

Steve O'Rourke - Deutsche Bank

Gary Hsueh - Oppenheimer and Company

Brett Hodess - Merrill Lynch

Krishna Shankar - Banc of America

Stephen Chin - UBS

Mahesh Sanganeria - RBC Capital Market

Raj Seth - Cohen and Company

Mary Lee - Stifel Nicolaus

Malik

…2008. We released these results this afternoon at 1:15 Pacific Time. If you haven't seen the release, you can go and find it on our website at www.klatencor.com or call 408-875-3600 to request a copy.

Rick will lead off today's call with highlights from the quarter; updates on the current market environment and provide guidance for the December quarter. Afterwards, Mark Dentinger will review the preliminary financial results for the quarter, and then we will open the call for questions.

On the Investors section of our website, you will find a simulcast of this call, which will be accessible for 90 days. On the website, you will also find a calendar of future investor events, presentation and investor conferences as well as links to KLA-Tencor's SEC filings, including our most recent annual report on Form 10-K for the period ended June 30, 2008. In those filings, you will find descriptions of risk factors that could impact our future results.

As you know, our future results are subject to risks. Any forward-looking statements, including those we make on this call today are subject to those risks. KLA-Tencor cannot guarantee these forward-looking statements will come true. Our actual results may differ significantly from those projected in our forward-looking statements; and although we take no obligation to update those forward-looking statements, you can be assured that any updates we will do will be broadly disseminated and available over the web.

With that, I will turn the call over to Rick.

Richard P. Wallace - Chief Executive Officer

Thank you Ed, good afternoon everyone and thank your for joining us for our Q1 earnings call. Today I will discuss highlight of our performance in the September quarter, give an update on the current market environment and provide guidance for the December quarter. In Q1 KLA-Tencor maintained our market share leadership, while at the same time leading our financials target for the quarter on the phase of the pervasive industry write-down and announcing global economic uncertainty. We expect the oversupply and device inventories, reduced consumer demand and limited access of financing will continue to constrain our customer capital investments for the foreseeable future. So we even with low order levels across the board today and with visibility very limited our customer continue to invest in technology development of leading edge devices which benefit KLA-Tencor. Our strategic focus in these challenging is the strength in KLA-Tencor competitive position and laid the foundation for superior growth once industry growth resume.

Our market share leadership, the exceptional value of our technology and our strong balance sheet provide the resources to continue to invest in growth, to invest in advancing our technology roadmap and to maintain a high level of customer focus while others are scaling back. We also provide the flexibility to manage the business to breakeven profitability road better and in spite of the weak demand environment and the great degree of uncertainty as to the duration of this downturn that persist in the market today.

Now turning to more detail on the September quarter results. Starting with the numbers, revenue in Q1’09 was $533 million and net income of $55 million or $0.32 per diluted share excluding onetime charges. We generated approximately $81 million in cash flow from operations in the period, and $1.3 billion in cash and investments as of September 30th.

New bookings in the quarter were $325 million, down approximately 33% from June and below the range of guidance. Q1 bookings reflects seasonality we typically experience in our first fiscal quarter in terms supply by increasing inability our customers to deploy capital in the phase of the unfavorable economic environment which resulted in weak demand across all sectors and geographies in the quarter with exception of logic. In the month of September we saw further push out for memory and foundry orders with customers these projects into 2009. Although we think demand has reached minimum levels necessary to sustain our customers advanced development investment, this ability remains weak, and we expect the general reluctant among our customers to invest will persist for the foreseeable future.

Looking at the Q1 demand texture in the individual end market, where I think orders were strong once again coming in at 77% of the total as Logic continue to push investment and leading edge development. Memory was approximately 16% than the orders in Q1. The memory industry continues to grab a little prolonged inventory oversupply condition with result in pressure on pricing and margins significantly impacting economics in this market. This coupled with concern that weakening global economy will further dampen consumer demand has led to a significant pullback in capacity investment and memory, with memory customers scaling down CapEx budgets and delaying previously plan program well onto 2009.

Additionally, we would expect that recent consolidation trend and the memory market to continue as the industry works to rationalize capacity. In the interim, we expect market leaders to remain focused on the device strength and increasing yield to improve margin, which we believe will benefit KLA Tencor.

Foundry bookings were down sequentially in the September quarter at 6% of orders. Foundry capacity utilization is expected to trend down in the near term in conjunction with declining demand for both mainstream and leading edge products impacting equipment demand in this market.

Overall, despite of the poor visibility we are experiencing today across our industry, process control remain key success factor to our customers, as they advanced their technology roadmaps with the leading edge.

Although investment levels are low today, we are maintaining pricing discipline in our market leadership and our indispensability to our customers remained a powerful competitive differentiator for KLA-Tencor.

Looking ahead to the rest of calendar year 2008 and into the first half of 2009, we see real evidence today of the meaningful near term improvement in the demand environment. Taking this into account we are taking actions to manage through this uncertain economic time and then capitalize on opportunities for KLA Tencor to sustain and grow our market leadership in this downturn, and position the company even more strongly in the future.

I would like take you through some of the key areas as focused as we manage through this period. Number one, we are focused on our core businesses in this period of compressed capital budget. Leveraging our strong balance sheet, our market leadership, the breadth of our global field support infrastructure and our product portfolio to support our customers’ investment and advance technology development while also addressing the high numbers on cost. This will further strengthen our position for the next phase of capacity investment on our industry when it again materializes. Number two; we will continue our high phase of investment in R&D, while the declining demand environment is putting pressure on the R&D budgets elsewhere in our industry. We intend to maintain our relatively high levels of the investment technology of the same time in proving efficiency in our R&D effort, advancing our technology leadership, and pushing a product roadmap that addresses our customer requirement in end cost to and beyond.

These investments are targeted not only advancing KLA Tencor’s leadership and our core market but also focus on supporting technology development and integration activities among our recently acquired businesses which are key components for our long term growth strategy.

We acknowledge that the decision to invest for growth in this environment while the trade off in terms of near term earning power, but we think over the long term these actions will help to further strengthen our competitive position and provide a catalyst for accelerated growth in this next investment cycle.

Third, we intend to continue to focus on advancing on our diversification's strategy. Our end market profile has change significantly since the last major down turn in 2009, then we have addressed five or six primary segment focused on wafer inspection, reticle wafer and metrology market, and these businesses accounted for about 80% of total revenue. Today we have 10 primary engines for growth at KLA Tencor, and we diversified into adjusted market such a wafer metrology, mass metrology, back end packaging, solar and high brightness LED.

Our strategy to broaden our footprint opens up access to market to an attractive growth and profitability characteristics to drive our future performance. While these new growth engines have also been subject to the current economy downturn, they should help reduce our exposure to the volatility of the wafer front end market when more normal demand conditions resume.

The final success factor for KLA Tencor in this environment was our strong balance sheet and operating model. As I mentioned we are investing today across our portfolio to support our long term strategic growth objectives. In addition, we are also committed to managing the business to deliver breakeven profitability or better. To that end we are currently in the process of implementing additional cost reduction action in support of that objective.

In conclusion, no doubt times are tough today, and visibility into a sustainable recovering demand is still very limited. But we believe KLA Tencor is operating from a position of strength, and have a right strategy in place to weather this storm.

More importantly, in challenging environment presents unique opportunities for KLA Tencor to capitalize on our competitive advantage in terms of technology, market leadership and financial strength, position us for success in the future when a healthy demand environment resumes.

Now discuss our outlook for the December quarter. We were in guarded on our outlook as we expect the demand environment to remain unpredictable for the foreseeable future with CapEx limited to technology investment programs, and longer term visibility virtually non existence. In terms of guidance, new orders in the current quarter are expected to be flat compared with September, plus or minus 10%. Revenues are expected to be between $410 million and $430 million. A non-GAAP EPS at break even plus or minus $0.02 excluding onetime charges.

Now I would like to introduce Mark Dentinger. As many of you know Mark joined KLA Tencor in September as CFO and in the past two months he is already making an impact and helping to navigate through these challenging time. I would like to once again to welcome Mark to the team. Mark.

Mark Dentinger – Chief Financial Officer

Thanks Rick. Revenue for the quarter was $533 million slightly above the guidance range we provided in July of 510 to 525 million and fully diluted GAAP EPS was $0.11. Non-GAAP EPS was $0.32 at the low end of our guidance, but was impacted by circumstances that drove our tax rate up on to almost 37%, a 7 point higher than the 30% range we got it in July. A higher than anticipated tax-rate reduced EPS by $0.03 in Q1. Absent this issue non-GAAP EPS would be in $0.35. We will discuss tax issue in more detail later in the call. The differences between Q1 GAAP and non-GAAP numbers are acquisition related charges are $40.3 million or $0.17 per share after tax. Stock-option restatement related charges are $3.8 million or $0.02 per share after tax. In this stocks revenue severance charges of $4 million or $0.02 share after tax.

In our press release you will find a GAAP to non-GAAP reconciliation which address at the adjustments I've just mentioned in more detail. The remainder of my comments will be on the non-GAAP results which exclude the adjustments I just mentioned, but improved stock-based compensation. We continued the acquisition of Vistec's MIE business unit, here after refer to as MIE at the end of September. So the MIE results have a negligible impact on our income statement in Q1, other balance sheet includes the MIE assets and liabilities as of quarter end.

In terms of financial performance we made our target for Q1 in a difficult environment. Our market position in all products and businesses was consistent with the last several quarters. Despite of the tough environment we view downturns as an opportunity to strengthen our position; it will have a strong set of products for next generation production notes. While the economic instability which began impacting our business several quarters ago continued in Q1 and grow with an unprecedented level of caution by our customers in making capital investment decisions. The number of fab expansion projects that had appeared solid for Q1 back in July pushed out of the quarter driving lower than expected new order level this quarter. In this environment customers are only investing in advanced technology node development, while we expect most of these order wins will lead to future capacity business of KLA Tencor as these nodes ramp to production, they are small today and resulted in new order of $325 million in Q1, down 33% from the June quarter and below our guided range of a decrease between 5 and 25%.

Additionally we scrub our backlog quarterly to reflect only orders with the leadership in the next full of month. We do this -- decided the company properly, both in manufacturing and operating expenses and to send clear demand signals to our supply chain. In Q1 we initiated $60 million of backlog reduction largely to reflect shipment delays from certain customers. We expect the majority of these orders to reenter our backlog over the next six months as new delivery dates firm.

We ended the quarter with $811 million in total backlog after adjusting for customer initiated delays, acquisition related adjustments, and foreign exchange impact. The $811 million in backlog at September 30 include $250 million of revenue backlog for product that have been shift in voice but have not yet been signed off by customers, and $561 million in a orders that had not yet shift to customers.

We expect the majority of the unshipped backlog to ship over the next six to nine months. The approximate regional distribution if new orders the quarter, quarter change in regional distribution was as follows. US is 45% in Q1 up from 33% in the June quarter. Europe was 4%, down from 6% in Q4 of ’08, Japan was 21% up from 15%, Korea was 13% flat versus last quarter, Taiwan was 6% also flat as last quarter and the rest of Asia was 10% down from 16% in the June quarter. The approximate distribution in new orders in Q1 by market vise, based on inspection with 30% down from 45% last quarter, reticle inspection with 10% flat versus last quarter, metrology was 14% down from 20% in the prior quarter, and storage, solar high brightness LED and other non-semi was approximately 9% up from 2% last quarter. Service was 31% in Q1 up from 23% last quarter.

45 nanometer and below development and pilot activity was roughly 85% of the semiconductor system orders received in the quarter. This order was roughly 75% in our June quarter. As we move forward, visibility into a meaningful turn in the business is well and we do not anticipate significant improvement in new order in Q2. We will continue to manage the company inline with these business levels until and up during the gathering.

Looking at our income statement, revenue for the quarter was $533 million; this is down 10% from last quarter and down 32% from Q1 of last year. Non-GAAP gross margin was 54.9%, down 170 basis points from the June quarter. The gross margin decline is due to a higher percentage of service revenue, condition from recent acquisition, and lower manufacturing capacity utilization. In the December quarter we expect gross margins to decline further due to the three factors. One, the revenue mix was shipped earlier as we expect product revenue will decline a $100 to a $120 million while service revenue will be roughly flat. Two, we will include the MIE results for the fourth quarter and we will transition MIE to our customer acceptance driven revenue recognition policy both of which will be margin dilutive. And three, lower manufacturing capacity utilization will also create a margin pressure. As anticipated in the July conference call, operating expenses were $209 million up $16 million from the June quarter as we absorb the full quarter in Q1. R&D was a $104.5 million in Q1 offsetting $0.3 million from June due to ICOS, as well as continued investment in key researching development and application for next generation technology. SG&A for the quarter was a $104.4 million, up $9.1 million from last quarter.

In Q2 we anticipate that operating expenses will decrease by $5 million as we begin to see the benefit of synergies with recent M&A activities. In addition, we will initiate a number of cost cutting measures design to reduce operating expenses in the next few quarter. In total the acquisitions of ICOS last quarter and MIE in September will lookout for about $24 million of our operating expenses in the December quarter. Other income for the quarter was $4.2 million, impart due to an $8.5 million onetime recover of VAT taxes which was anticipated when we issued guidance last July. In Q2 we expect other income in expense to decline approximately $10 million resulting in a net chare of $6 million as the interest expense on our long term that exceed the expected deals on our marketable securities.

The non-GAAP tax rate was 36.7% in the quarter, almost seven points higher than the 30% range we discussed in the call last quarter. This unanticipated increase the roles because of investment declines and our deferred compensation program which are not deductible for income tax purposes but are included in pretax income. Investment balances in this program are formerly, fairly stable and historically the effective changes in the investment portfolio have impacted our tax rate by less than one percentage point. Presuming a recent volatility in equity market size we would expect this tax rate effect to return to prior level.

Looking forward to Q2 more pretax profit combined with the impact of recently US legislation renewing the R&D tax credit will increase volatility and our tax rate which will make it more difficult to forecast. In the December quarter our projected tax rate will be between 0 and 10%, in the long run we expect our non-GAAP tax rate to return into 30% range. Non-GAAP net income was $35 million and $0.32 per share in Q1. These numbers include stock-based compensation of almost $28 million. In the December quarter we expect expenses for stock based compensation to be approximately $25 million.

Turning to the balance sheet, cash and investments ended the quarter at $1.3 billion, a decrease of $273 million quarter-to-quarter. Cash flow from operations was $81 million in Q1 versus a $188 million in Q4 of ’08. During Q1 we repurchased a $177 million of stock, we paid a cash dividend of $26 million, and we used a $127 million in net cash to acquire MIE. Accounts receivable ended the quarter at $370 million down $122 million from the third quarter. MIE added $15 million to the quarter end balance, MDA sellers were 80 days versus 83 days at the end of June.

Inventory increased by $44 million in the last quarter, including $36 million from the MIE acquisition and ended the quarter at $504 million. Net capital expenditures were $10 million, $7 million within core business and the remainder to the MIE acquisition. Fully diluted shares in Q1 were just over a 174 million, versus a 178 million shares in Q4. In the December quarter fully diluted share are expected to be about 172 million. Total headcount ended the quarter 6306 and increase of 246 from June acquisition. The MIE acquisition added 344 people and this is partially offset by a 98 reduction in the rest of KLA during Q1. Funding our visibility demand for semiconductor based product is limited. At this point we don’ not expect any meaningful capacity related spending to occur for the remainder calendar year and into early 2009. KLA’s non-fundamentals are compelling and we are confident in our new product pipeline for KLA Tencor and acquired businesses.

We remain cautious in the near term outlook given the uncertainties surrounding the next few quarter and we expect new orders in the December quarter will be technology focused consumer to the level we experienced in Q1. We are adjusting our near term revenue expectations downward, and we will continue to run a company later design to maintain sufficient backlog in key research and development investment. For the same, we are undertaking a number of measures which aim low a clearly operating expense run rate to the 165 to $170 million range over the next nine months. These measures will be broadbased and focused on acquisition synergies, administrative support, sales and channel efficiency, operation and non-core engineering activities.

Due to the timing of these actions as well as other legal and contractual factors, there will not be significant cost reduction in the December quarter. However, we do expect to see progress in these efforts beginning in the March quarter.

In summary, our guidance for Q2 hits. New orders are expected to be flat plus or minus 10% versus Q1. Total revenue between $410 and $430 million and non-GAAP EPS which include stock based compensation that excludes onetime charges in the amortization will be approximately breakeven plus or minus $0.2. This concludes our prepared remarks on the quarter, and we will now turn the call back over to Ed to begin the Q&A.

Ed Lockwood - Senior Director of Investor Relations

Okay, thank you. At this point we would like to open up the call to Q&A and we ask once again to please request that you limit yourself one question given the limited time we have today. Please feel to re-queue for your followup and we will do our best to get everyone on todays call. Operator we are ready for our first question.

Question-and-Answer Session

Operator

[Operator Instruction]. Your first question comes from Jay Deahna with J.P. Morgan. You line is open sir.

Jay Deahna

Okay, great. Thanks very much. Yeah, back in the spring and in summer there was a lot of delays and a lot of concern about KLA potentially loosing market share in photomask inspection and I think actually concerns about losing share and break field wafer inspection popping an equation as well. Just kind of wondering, if you could give us an update on a competitive landscape and if you have seen any competitive pressure in those areas? And if you have been able to hold your share, maybe seeing any pricing pressure negatively impacting margins as a result of somebody being out there that’s more competitive than they have been in the past?

Richard Wallace

Sure, yeah it will be my pleasure to say, absolutely there has been a focus on market share on our side over the past several quarters as you mentioned. We continue to do well and I think that this environment has changed somewhat our strategy and that many time our customer have reduced CapEx budgets. So you will find that there are occasions when we are providing capability and perhaps reconfigure it, or taking off some options of the tool and avert in the certain price points. More limited by driven by our customers need to really meet their budget. From an overall market share, we are pleased with our physician and how we have done, but in this kind of environment you have to battle for every order and then at certainly what we are out there doing.

Jay Deahna

So when the market share gets recorded for this year, and the spring of next year do you expect you share to be higher or lower or about the same as it was last year. And are you actually experiencing any pricing or potential margin pressures as a result of competition that you would deal with at normal?

Richard Wallace

Yeah, I think that we don’t expect to see market share decline. As I said sometimes there are some cases where we reconfigure tools to provide capability, those could result in having a short term margin impact that you get back in the long term when you provide upgrades. So balancing overtime we don’t see that being a significant factor for us. But there is definitely a increase competitive landscape based on the fact that there is not as much buying and customer have more time to evaluate tools.

Jay Deahna

Okay. and then lastly, can you given us an update on your move to Singapore and what the impact is on your margins now and what is expected to be in the next cycle compared to what they would be if you maintain your domestic manufacturing?

Richard Wallace

Absolutely, sure. The products that we moved to Singapore and they are now assembled products, but most of them are relatively higher volume oriented to our capacity buys. So when we were running at higher revenue levels then we had said we got about 100 basis points out of the move to Singapore. Actually has revenues come down as we are forecasting in this slowdown, that affect is somewhat minimized by the fact that we are just running over volumes. However, when we reaccelerate in the next cycle that’s when we expect to see the 200 basis points that we originally had forecasted for that move. But we are not going to see that until we come out of the other end of this downturn.

Jay Deahna

Okay. Thank you.

Richard Wallace

Thank Jay.

Operator

Your next question comes from the Jim Covello with Goldman Sachs. Your line is open sir.

Jim Covello

Guys, good afternoon. Thanks so much for taking the question. If I could ask about the cash and the plans on the buyback on one hand the stock is down a lot, so if you are buying back stock before. Obviously, this looks like a attractive level to you. On the other hand, you want to manage the cash balance in this environment. So how you will balance those you know, to stands your e question. And then if I can just ask my followup at a time. And its kind of follow up on a Jay's question relative to -- can you talk a little bit about the technology competitiveness. I understand that you are deconfiguring systems telling customers instead of budgetary constraints, but what are the issues you are dealing with on a competitive environment, both against reticle inspection and break field inspection? Thanks so much.

Richard Wallace

Sure Jim. Good questions. First on the buyback, yeah we have been, we do buyback shares in the last quarter. However in the last few weeks and we have curtailed our buyback as we look out -- and this is so much economic uncertainty, we have curtailed that in anticipation just trying to get better clarity on what's going on. And so in terms of the longer term macro affects. So right now we are in a mode of concerning cash given the current environment and certainly we will be in a position to return back to our mode of buying back shares once we get better clarity. But right now there is just seeing, so that uncertainty, but we thought that was the most prudent thing to do. In terms of the competitive front and the technology that we are seeing, not really a big difference, as I mentioned in the prior question of Jay, you know, we do see competitive pressure, we always see competitive pressure and it’s get tightened in an environment where people have more time to evaluate tools. We do see the differentiation and the new tools that we brought on in reticle Inspection the WPI options that we have added to 5X devices gotten very good attraction in the market and we have some extensions to our roadmap as well as new products that we are working on. So we fell very good about our technology position. We also think that for our competitors its going to be increasingly challenging to maintain their investment levels as we go through this down turn.

In terms of bright field again good progress there. We feel very confident in the latest what we have seen in terms of market share evaluations. We continue to differentiate and for many other customer the buys that they have right now are really technology focused. And so it does on one hand they are short on capital on the other hand they really want to make sure they get the best possible and that’s why we believe that our market share is holding up in this environment.

Jim Covello

Great. Thank you so much.

Richard Wallace

Thanks Jim.

Operator

Your next question comes from Timothy Arcuri with Citi. Your line is open sir.

Timothy Arcuri

Hi, two things. Number one, Rick can you give us shipments and can you give us what you think shipment will be in December. And then I had a second question?

Richard Wallace

Yeah sure, actually I will let Mark, handle that one.

Mark Dentinger

Yeah, shipments for the quarter were about 420 million Tim. We are not over guiding the shipment number into December, simply because it’s not a particularly meaningful leading indicator of exactly what the revenue follow on is going to be. But we will continue to guide the order flow and the revenue numbers. The 420 was the shipping number for the quarter we just completed.

Timothy Arcuri

I am sorry. Why would shipments not be a good indicator of what the future revenue is going to be?

Mark Dentinger

Yeah, because there are a wide variety of different possibilities as window shipments can turn into revenue. And the shipment is not necessarily a short term leading indicator of exactly when those orders are going to turn into revenue. And for the time being at least we think it is prudent to not guide that exclusively, especially with the economic uncertainty that’s out there.

Timothy Arcuri

Okay. I guess, you know, question for you Rick. Maybe I misheard you answered from the first question. But it seemed it just -- my question is around the profitability versus market share. And I guess the last five maybe years or so, KLA would have never consider a cutting price to key market share. And I guess, answering the prior question, it sounds like you were maybe hinting or saying that in some cases you have done that and maybe that’s not what you meant to say it, but maybe I have misheard it, but I am wondering what your thought is around the kind of balance between profitability versus market share? Thanks.

Richard Wallace

Yeah, sure. Timothy, now I have been here for 20 years and this is absolutely what we have done in the past. When times are slower we tended to deconfigure tools in order to make sure that we have sockets and run the business. Longer term of course we get that profitability back, if there is any short term hit on that due to configurations. We also offer more split for our customer during this period of time. Now we think that that will translate again into the similar performance we had in the past. There is really no change in our operating model that more consistent with this part of the cycle.

Timothy Arcuri

Okay, thanks.

Operator

Our next question comes from C.J. Muse with Barclays Capital. Your line is open sir.

Richard Wallace

C.J.

Operator

Sir, your line is open. Since we have no response from C.J. Muse, we will go on to Satya Kumar with Credit Suisse. Your line is open.

Satya Kumar

Yeah, hi, thanks. You know, just I was looking at your comments on bookings, you mentioned that into March, you don’t really expect the significant recovery. I suppose that your revenue levels this will address the 325 to 350 in the last quarter. Earlier on I think you mentioned that you expect to remain above breakeven to the first half next year, you are guiding to breakeven at $420 million run rate now, what type of OpEx would you expect to see in the first half or there is something else that’s helping maintain breakeven in the March quarter, can you explain the linearity of the cost reduction efforts?

Mark Dentinger

Yeah, sure. We are taking action as we said in March prepared comments that we will get our fixed cost in the 165 to 170 range down from 209 in Q1, that’s the significant reduction. We also believe that we will be able to do better than 325 and 350 in revenue, but the lower modeling right now we believe that was a current plans that we have and where we still have backlog that we can utilize through this next couple of quarters that allows us to revenue slightly above bookings, we will be able to improve to fund our profitability as we go forward.

Satya Kumar

Dou you see 165 will get during this last quarter itself?

Mark Dentinger

165 to 170 by the June quarter.

Richard Wallace

That will be the run rate at the end of the June quarter.

Satya Kumar

Okay. In terms of the gross margins since the December, I was wondering if you could quantify that a little bit more, I guess, like a 500 basis points decline in the gross margins from September to December to get to your breakeven sort of EPS levels. How much of that is the changes in pricing and how much of that is volumes subscribing that?

Mark Dentinger

Probably the biggest factor is actually next. So we have the series becomes the larger mix as we bring down the revenue, as you know, and from that strength of margin the other thought is we do have some happening in the near term, we’re also at this point still integrating the Vistec and the ICOS business which initially and totally work through some of the synergies will help margins that are dilutive to the overall model.

Satya Kumar

And lastly Rick, you inventory base went up quite significantly, it seems like it’s a higher level in the last 10 to 13 year something like that. Is this acquisition related, or is this also paid to this push offs that you are seeing, the additional ease out that you are providing to your customers now that you are classifying that as inventories, can you provide some granularity on that?

Richard Wallace

Yeah, as I said 80% of the inventory increase was related to bring on, the balance sheet of the MEI Vistec acquisition for the quarter. The balance of the increase was very nominal, and of course, we are catching up as a downturn real time and we would expect to control that number going forward fairly carefully. But most of the change in the quarter and most of what we drive the term slowdown was a function on bringing on the acquisitions.

Satya Kumar

Got it. Thank you.

Operator

Your next question comes form Steve O'Rourke with Deutsche Bank. Your line is open sir.

Steve O'Rourke

Thank you good afternoon. And just as a source as a follow on to the last question, I think last call you talked a bit about inventory from data shipments in the field, how much was out there and when you expected to turn?

Richard Wallace

Yeah, the inventory data shipments are not calculated in our backlog that is true, and we would expect to beta returns to turn with the rest of the business at approximately the same levels we had experience with everything that’s going on right now, which means that they will probably turn a little bit slower in light of the downturn then they might have historically during a upturn. And visa versa where there would upturn return you could expect to see those flip a little faster?

Steve O'Rourke

Do you have a higher number of data shipment in the field or data tools in the field then you normally do?

Richard Wallace

At this phase we have a number of new product introductions, yes that’s true.

Steve O'Rourke

Okay. And one a followup on a separate fund, you talked about technology buys only in orders, and if I understand the numbers correctly in your prepared remark. If I back out service it sounds like what I call maintenance equipment spending is about $200 million for KLA in the quarter. One is that that like we had think about it? And two, do you think maintenance CapEx is kind of trending down when you consider number of customer for example?

Richard Wallace

No, I mean, right, now it is correct, now I don’t its trending down. There is just such very little spending out of the foundry sector and out of the memory sector last quarter and it was certainly dominated really the logic stand. So the other guys I think didn’t. In these times they tend to be pretty lumpy. So I think that’s part of what we are seeing, but overall I don’t see it coming down, I see there is some pressure to go up, I wouldn’t say its materially going up overtime, but I don’t think it’s the right time do you think $200 million number is kind of a pretty good maintenance CapEx number based upon your business now?

Mark Dentinger

That’s similar to the way we are looking at next couple of quarters, yeah.

Steve O'Rourke

Thank you.

Operator

Your next question comes from Gary Hsueh with Oppenheimer and Company. Your line is open sir.

Gary Hsueh

Hey, thank you. That’s Gary Hsueh. Rich, just a quick question to revisit this competition decontenting sort of issue that was brought up. If I look at memory as a percent of the total and absolute value, I just have never seen memory bookings in any one quarter reaching level this low for your guys. And just by way of comparison, in 2002 and 2003, your memory orders by math hit a trough of around $60 million and that’s when TMSC was spending on average roughly about $1.3 billion in CapEx. I know like this year, TMSC is still spending 1.8 billionish in CapEx and they are ratcheting it down to 1.4 billion. So the CapEx environment is arguably a little bit better. But why are we seeing such a lower foundry order number? Is it because the share loss the foundries or is it because of decontenting or is it simply because foundries are seeing less of a need here for inspection and metrology?

Richard Wallace

So I guess, lastly Gary, you are talking about memory and then you switched to foundry?

Gary Hsueh

I am just focusing on foundry. I am just wondering why your foundry orders are at these low levels, levels that haven’t seen before even in ’02, ’03 when the CapEx environment was pretty much the same?

Richard Wallace

Yeah, sure. Well, foundry was 35% in June, Gary and 6% in September and we think it’s back to 15% in December. So I think it’s hard to realign into one quarter’s data on this because it ends up being pretty lumpy. And look across 2008, there is no question that process control has outperformed other sectors in terms of the foundries, which have been generally very down. As you know, the way foundry guys report, they report revenues different than the actual bookings that are going on. So we are talking about when we get these numbers of bookings on. I am quite sure there are very few orders placed in the September quarter out of the foundries.

Gary Hsueh

Okay. So just once again, just the orders up to $20 million level going to the roughly on the $50 million level compared to a trough of $60 million in ’02, ’03, it’s just the lumpiness in the foundry business, nothing else?

Richard Wallace

Well, I think that you will find out one of the foundry players, their CapEx, the other guys actually have been pretty constrained in their spend. So I think one of the questions will be, will there will be broader spending overall from foundries, but there is no question that foundries with utilizations where they are right now and their expectation on demand have been very constrained on their capital.

Gary Hsueh

Okay. And just my last followup here. What do you think is the mix in your orders in December between memory and logic since you provided foundry?

Richard Wallace

Sure. We think logic is probably about 55% and we see memory about 31%. On top of all of that we have 25%, which is non-semi.

Gary Hsueh

Okay, great. Thank you.

Operator

Your next question comes from Brett Hodess with Merrill Lynch. Your line is open sir.

Brett Hodess

I know that you said you are going to need your cost structure down to 165, 170 fixed cost range by the end of next June and that includes all of the acquisitions at that stage. Can you talk a little bit about what your gross margin structure will look like once you get these things all integrated, so what the need break-even level might be overall?

Richard Wallace

Sure Brett. I think there is a couple of things. One, obviously some of the things we are doing in cost exposure, the 165, the 170 we are talking about fixed cost. Obviously, we are also working hard to reduce the overhang that we have, the overhead that we have in the gross margin line. When we model whole thing out that we break-even somewhere between 350 and 400 million in terms of revenue. And depending on – we think the June quarter is when we can get our fixed cost down in the 165 range.

Brett Hodess

So exiting the June quarter and 350 to 400 will be break-even?

Richard Wallace

Correct.

Brett Hodess

Okay. And if you look at the impact of mix, you talked earlier on margin. Is the impact bigger across your semiconductor equipment portfolio or is it more an issue of the mix between obviously no services, lower gross margin, but the other markets that you are going into now, some of the LED, solar, back-end and things like that.

Richard Wallace

Yeah. It’s really hard to say different products at different points have different margins based on new product, old product. I would say it’s pretty close to being the same. In general, the gross margins often a function of Just getting cost out of the system and less dependent on the existing market. When we take acquisitions in, we find there is a number of things that we can do to reduce their cost but it just takes a little time to do that. Several other things we get, for example, just out of our leverage of our buying and that’s one way that just the procurement side we can reduce our cost and drive up margins and acquire businesses.

Brett Hodess

Thank you.

Richard Wallace

Thanks Brett.

Operator

Your next question comes from Krishna Shankar with Banc of America. Your line is open sir.

Krishna Shankar

Hello guys. Can you hear me?

Richard Wallace

Yes.

Krishna Shankar

Well, I have got a couple of quick questions. How do you think about KLA Tencor going forward into the next three to four quarters. Is this 130 million run rate sustainable or do you think there is going to be some modest growth in it? And then I have a followup.

Richard Wallace

Sure, Krish. There is no question that our customers while they are constraining their capital, most of them are trying to do everything they can to get cash out of their existing assets, which means running their factory, which means creating the opportunity for service. So we do see some opportunity to grow the service business in this environment. On the other hand, it’s also an environment where our customers are really looking for cost and efficiency improvements. So we have to improve our operating model and service as well in order to see the revenue growth in order to continue to build that business over time. But yes, we do think we can grow off our current levels.

Krishna Shankar

If I look at the bookings in the quarter and then the mix you provided for memory and foundry, it’s sort of pretty low level. So heading into calendar ’09, which do you think is actually going to turn around, back to normalized levels? Is going to be foundry that’s going to turn around or memory?

Richard Wallace

Krish, we are not predicting. I have no idea given the macro environment that we are in right now. You got to talk to customers and they are all I think scratching their heads trying to figure out where that’s coming. What you would say if you just back off and you went on fundamentals and not factoring the macro economic situation, you would say that the foundry guys are under-investing relative to the needs to go to advanced design rules. And at the same time the memory guys while they were heavily investing are certainly in a period now of under-investing as well and they will want to ramp up their advance design rules. But when and how that catalyst hits, we really don’t know, which is why we are sizing the business the way we are.

Krishna Shankar

Okay. And just a last question. In the December guidance, you said that full quarter of the MIE business, how much the drag in terms of basis points is it on the gross margins, is it like a 50 basis points or 100 basis points drag?

Mark Dentinger

Well, I did indicated in the prepared remarks that there is about $24 million in OpEx that will come in as a result of both the Vistec and the MIE acquisitions in the December quarter. So you can figure from that, if approximately half of that would be, you probably get about a two point effect.

Krishna Shankar

And what were the gross margin line, the OpEx is that 24 million?

Mark Dentinger

It’s still dilutive at the gross margin line, but the exact percentage is hard to figure it out.

Richard Wallace

And again, as I said, our goal over time is to get it so there won’t be and we believe we have plans in place, that’s just going to take some time.

Krishna Shankar

Thank you.

Operator

Your next question comes from Stephen Chin with UBS. Your line is open sir.

Stephen Chin

Hey, great. Thanks. Maybe to help out on these Reticle inspection questions and maybe you can give us an idea of how many customers have taken KLA’s new reticle inspection product, I think you call up this side as Wafer Plane Inspections roll in. When do you think that Reticle inspection will be 10% of sale?

Richard Wallace

Okay. So the WPI, Stephen here is not a new tool, it’s an application and upgrade to the existing installed base to the 5XX. So we have a lot of sockets out there where we can provide that upgrade and that provides additional capability. I don’t have the specific numbers of how many, but we are definitely seeing a large adoption. One of the attractions that it has for our customers is it is a relatively low cost ways to improve the capability. So in this environment, we do see adoption of it. However, that being said, the Reticle guys are not in a mode of heavy spending at this point. And so, on one hand it’s attractive, on the other hand they are pretty constrained with their capital as well.

Stephen Chin

Okay. Just another followup question on the questions about Singapore. I guess I didn’t you understand, are you planned to accelerate the product to move out to Singapore or are you thinking about halting this product move to Singapore temporarily and the impact to gross margin there.

Richard Wallace

Yeah, we are not changing our plans at all. What's changed is given the volume of the overall business, the effect of the Singapore operation is less in a declining revenue environment than it is when we're accelerating and growing. Since most of the buys we said are technology-oriented buys at this phase, those are not products that are typically built in a high volume manufacturing environment like Singapore. Those come more out of the California because they are radical cools, high end wafer inspection tools. So that changes the impact Singapore will have. It will be most impactful when we're back to a higher volume environment.

Stephen Chin

But no change to the schedule of how the products get outsourced out there?

Richard Wallace

No, no change.

Stephen Chin

Okay. The last question I have is on the balance sheet cash. Since you said you're curtailing the stock buyback. You also have plans to curtail the dividend payment?

Richard Wallace

We don't have any plans right now to change the dividend payment.

Stephen Chin

Okay. Thanks.

Operator

Your next question comes from (Inaudible) Malik, you are line is open sir.

Malik

Hi thanks for taking my questions. The BB&T market is quite fragmented. There are a bunch of smaller players. Are you seeing any indication from your customers that they are concerned about those guys – they want to take business to you guys? And then I have a follow-up.

Richard Wallace

I'm sorry. Which market -- do you mean process control?

Malik

Yes.

Richard Wallace

Oh, yeah. And concerns about our customers about dealing with smaller players?

Malik

Right.

Richard Wallace

Yeah, I think that's definitely true. And in this environment, one of the concerns a lot of customers have is the economic viability of their supply chain and so we are absolutely seeing that from our customers, as that's one of the things that we're finding that it affects us in two ways. One, we've been asked to look at some distressed assets, and the other is when we are dealing with customers, we are finding that's a differentiator for us.

Malik

And then can you comment on your acquisition appetite? I mean I understand where in balance sheet there cash preservation mode, but can you comment on that and do you consider EDS based to be a adjacent to your core competency?

Richard Wallace

I would say from an appetite perspective, we're in the I did just in phase right now having just quite in this debt and while we're always open to opportunities there were out there right now I think the focus for us is to integrate the acquisitions that we've recently done and to focus on our core businesses and streamline our cost structure.

Operator

Your next question comes from Mahesh Sanganeria, your line is open, sir.

Mahesh Sanganeria

Thanks very much. I'm a little bit confused about the operating expense questions. If you can give some clarifications. First, to start with, in your EPS guidance, is that pro forma and exclude the amortization of intangibles?

Richard Wallace

Yes. It excludes the amortization of intangibles, but it does include the stock-based compensation.

Mahesh Sanganeria

Okay, so what is your recurring amortization of intangibles going forward? You added a lot of intangibles to your book.

Mark Dentinger

Yeah, we amortized about 7 million this quarter on a recurring basis and we added $33 million in one-time charges associated with the MIE acquisition this quarter. So you can figure that going forward, it will be something north of the seven as we start to amortize the amortizable portion of the MIE acquisition.

Mahesh Sanganeria

Okay, and for your target for 165 to 170 in fix fixed costs, does that include stock option expense and amoritization and -- or is that excluding that?

Mark Dentinger

Consistent with how we actually present the numbers on a non-GAAP basis, it would include stock-based compensation, but it would exclude the – effect ignitable.

Mahesh Sanganeria

And so what is that number as of today, the fixed cost? What is the run rate right now?

Mark Dentinger

We reported in this quarter, I believe it was about $209 million, but we did indicate that there were certain phenomenon associated with the acquisitions that we're still digesting, so you can figure that we're moving from the 209 to a run rate of 165 to 170 by the end of Q4.

Mahesh Sanganeria

The number you reported was OpEx, not -- is that what you are calling fixed costs also?

Mark Dentinger

Yeah, unfortunately, that's true. They are interchangeable. It's really the operating expenses as you read down the income statement.

Mahesh Sanganeria

Okay and you said that you are going to increase by how much for the December quarter?

Mark Dentinger

It will decrease slightly. We estimated about $5 million.

Mahesh Sanganeria

Okay, thank you. Thanks a lot.

Operator

Your next question comes from Raj Seth. Your line is open, sir, and he is from Cohen and company.

Raj Seth

Rick, can you talk little bit about the pace of technology transitions in the industry, any change at all in this kind of environment? Clearly in logic over the last couple of years if you look at starts, the distribution of people at various notes has broadened, but are you seeing each at the leading edge any kind of change in the speed with which people are adopting new technology? Thanks.

Richard Wallace

Yeah, Raj, not in development, certainly not the customers we're talking to, and I've been on the field quite a bit lately. And what I'm finding is that's the one conversation everybody's excited to have, is their work on Advanced Technology. When you talk about capacity, it's a different conversation, but there's a lot of push towards getting to the next technology node. Certainly among customers that I've talked to in both memory and foundry and logic, all three, their focus is how do we get to the next node, even if they have very constrained capital, that seems to be the one area that they continue to be focused on.

Raj Seth

Any of these guys thinking about skipping nodes, you know, where there's not enough volume, I don't know, at 35, looked like it's just kind of skipping, at least in logic?

Richard Wallace

Well, there's one major player who has talked about half nodes and I'm sure you're aware of that.

Raj Seth

Yeah.

Richard Wallace

The 40-nanometer, so there's certainly that talk. I think that's more of a decision, at least what I'm seeing, is based on what the fabless guys are looking for less so than what the customers were directly talking to. We seem to be very focused on getting to their next node. And I've had a number of meetings recently where people are talking about their 3 X, but also their 2 X technology nodes and, you know, the plan is to continue those investments. I do think that you're right. There are some fabless guys that have looked and are considering doing, at least skipping half a node.

Raj Seth

And last question, if I could, lamb in their call talked about their expectation whenever it is we returned to more normalized spending levels, that capital intensity in this industry is probably more like 16 to 18%, obviously inflated in the recent past because of the memory cycle. Do you subscribe to that view, or do you have a view of your own?

Richard Wallace

I, I think that the 17%, the midpoint of that is a reasonable number. When I do our long-term modeling, when I think long-term, I actually think there are factors to push it up and there are ones to push it down, as I think 17% is not a bad number. I do think you will occasionally, and who knows what the next one will be. You'll find there's increased entries into the market which for some period of time may drive that number higher as we saw in memory, but from a going forward kind of average level, I do think 17% is a reasonable number.

Raj Seth

Right. Thanks.

Operator

Your next question comes from C.J. Muse, with Barclays Capital. Your line is open.

C.J. Muse

Yeah, good afternoon. Can you hear me now?

Mark Dentinger

Hi, CJ.

C.J. Muse

I guess first question, in terms of the service business, what kind of growth do you think we could see here in calendar '08 and I guess given more subdued outlook now for the industry, what kind of growth do you think also for calendar '09?

Mark Dentinger

Well, calendar '08's not a the lot left, so I think we're pretty close on that one. You know, what we said I think at Semicon is we've been seeing growth in the 11 to 14% range over time. I would expect that to slow in the, in calendar '09 and probably higher single digits would be the growth rate I would see because there's clearly pressure from customers to manage all their expense, including service. But we still think it's a growth business, but probably somewhat slower, then resuming once we see overall industry pick up.

C.J. Muse

Can you elaborate on what's driving the growth? We're seeing from plenty of other equipment companies where that's declining year on year and I guess is that installed base coming off warranty, offering other services, is it some of the acquisitions coming in? Can you help me understand the growth a little bit better?

Richard Wallace

Sure, CJ. Our business is different from service perspective than many of our peers, and the reason for that is we don't sell consumable. And so I think what a lot of -- what they see is consumable will reduce in periods of slowing where ours is really line fix and we have a larger installed base. The other thing that's driven some of our growth recently is we acquired companies that have large install base that weren't offering services for those and we're actually able to bring value to that and drive that. Additionally driving increased services as we go forward, and even including some upgrade opportunities for the more mature tool sets. So I think all those factors differentiate our service and make its counseling story in this kind of environment.

C.J. Muse

Good. Great. Into some other acquisition, what kind of revenue contribution should we see for ICOS and Vistec in Q4 or down the Q4?

Richard Wallace

Yeah, we don’t write them out, but I would say that those businesses are seeing similar kind of pressures to what we are seeing elsewhere. One think I am kind of striking is the solar business for example, we are seeing pressure in that market as well as I think the capital concerns are some of the solar companies are delaying actually some solar project. So I think there is a good solar business and we see some growth in that and catching near term is under a fair amount of pressure. We don’t break it out, but I would say its kind of consistent with what those business is gaining with the applied factor everybody else of the effects of the downturn if that make sense?

C.J. Muse

Correct. And then last housekeeping. You might have said, and I apologize if you have, could you tell me what the backlog and deferred revenues were actually in the quarter?

Mark Dentinger

Yeah, the total backlog at the end of the quarter was $811 million and we split that $250 million into the shippable backlog and 561ish in the orders taken but not shift yet

C.J. Muse

Okay, and that doesn’t include, that’s just product on the new service?

Mark Dentinger

That’s right, we always different we reported that.

C.J. Muse

Great thank you.

Operator

Our last question comes from Mary Lee with Stifel Nicolaus. Your line is open.

Mary Lee

Hi, I am in for Patrick Ho. Just a quick question, are you planning any shutdown during the December quarter?

Richard Wallace

Hi Mary we are shutting down for three Thanksgiving and we have a shutdown for four days around the Christmas holiday.

Mary Lee

Okay great thank you very much.

Richard Wallace

Thank you.

Richard Wallace

Okay great. Operator, thank you very much and thank you all for your participation in todays call. And this concludes the call for today.

Operator

This concludes today conference call. You may now disconnect.

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Source: KLA Tencor Corporation. F1Q09 (Qtr End 9/30/08) Earnings Call Transcript
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