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KLA-Tencor (NASDAQ:KLAC)

F1Q07 Earnings Call

October 24, 2006 5:00 pm ET

Executives

Jeffrey Hall - Chief Financial Officer

Richard P. Wallace - Chief Executive Officer, Director

John Kispert - President and COO

Analysts

Timothy Arcuri – Citigroup

Gary Hsueh - CIBC World Markets

Robert Maire – Needham

RJ - JP. Morgan

Edward White - Lehman Brothers

Peter - Steven O'Rourke

Jim Covello - Goldman Sachs

Raj Seth - Cowen & Co

Satya Kumar - Credit Suisse

Stuart Muter - RBC capital markets

Dave Duley – Merriman

Mehdi Hosseini - Friedman Billings Ramsey

Steven Pelayo – HSBC

Stephen Chin - UBS

Presentation

Operator

Good afternoon. My name is Derrick and I will be your conference operator. At this time I would like to welcome everyone to the KLA-Tencor 2007 conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a Question and Answer Session. [Operator Instructions] Thank you. I will now turn the conference over to Mr. Jeff Hall, Chief Financial Officer. Please go ahead, sir.

Jeffrey Hall - Chief Financial Officer

Thank you, Derrick. Good afternoon and welcome to KLA-Tencor's First Quarter 2007 Conference Call. I am Jeff Hall, the Chief Financial Officer and joining me on our call today is Rick Wallace our CEO and John Kispert our President and COO. We're here today to discuss results for the period ended September 30, 2006. We released these results this afternoon at approximately 1:15 p.m. Pacific time. If you haven't seen the release, you can find a copy of on our website, www.kla-tencor.com or call 408-875-3600 to request a copy.

Rick will lead off today’s call with a discussion of industry developments and KLA-Tencor's progress and strategy. Afterwards I will review selected financial results for the first quarter and then I will open the call for questions until approximately 3:00 Pacific Time. On the investor section of our website, you will find a simulcast of this call which will be accessible on demand for replay.

On the website you will also find a calendar for invest or events and presentations at investor conferences. You will also find links to KLA-Tencor's security filings. In those filings you will find description of risk factors that could impact our future results. As you know, our future results are subject to risk. Any forward-looking statements we make are subject to those risks. KLA-Tencor cannot guarantee that those forward-looking comments will come true, and although we take no obligation to update those forward-looking statements, you can be assured any updates we do make will be broadly disseminated and available over the web.

Before I turn the call over to Rick, let me remind you that as we’ve previously announced, we are in the process of restating our financial statements and expect to record non-cash, share-based compensation charges that are not anticipated to exceed $400 million. Let me also remind you that as a result of the pending restatement we are you unable to provide detailed GAAP or non-GAAP financials for the quarter ended September 30, 2006.

On this call we will not be able to provide any specifics about our gross margin, operating expenses, inventory, taxes, or other item that might be affected by share-based compensation. All numbers for the first quarter discussed on this call are not final and should be considered estimates. Let me also remind you that we recently announced the special committees investigation is nearly complete. We are now starting to get the data we need to begin the restatement process and the team here is geared up and working hard to complete the restatement as soon as possible. There is still a substantial amount of work to be done. Remember we are looking at 40 quarters of data from time periods up to ten years ago. We need to determine not only what share-based accounting charges should be, but also how those charges impact cost of goods sold, inventory, R&D, SG&A, taxes, and many other income statement and balance sheet items.

In addition, as you know, we converted to one common ERP system about two years ago. Because the time periods in question are up to ten years in the past, we have to retrieve data from multiple legacy ERP systems which are no longer in use. As a result of these factors, we are currently targeting to be complete with the restatement process in January. With that, I will turn it over to Rick.

Richard P. Wallace - Chief Executive Officer, Director

Thank you, Jeff, and thank you for joining our quarterly call for the first quarter of FY '07. Today I will be discussing the highlights for the September quarter and guidance for the December quarter, updates on key product activity, and an update on our ADE acquisition. In the September quarter the Company continued doing well strategically, technologically and financially. As you already know, with the pending restatement there is a limited amount of financial information we can disclose at this time. The Company has continued to focus on executing our strategy which is producing excellent financial results.

Let me start with the quick rundown of the numbers, and then I will provide my perspective on them. Orders for the September quarter were $647 million, down 20%. Revenue was $630 million, and shipments were $652 million. Remember September orders are typically down 10% to 15%. They were lower than our outstanding June quarter but $647 million continues to show the strength of KLA-Tencor's broad process control business.

Memory customers made up 46% of the orders, down from 60% in the June quarter. Logic customers were also strong making up about a third of our orders, and Japan was our single largest booking region at 35% of orders. The quarter continued to show the critical need for yield management and process control to ramp 90-nanometer production, to drive yield improvement at 65-nanometer, and to get 45-nanometer into product qualifications. More than one customer reported a significant benefit from our yield management capability. For example, a major memory customer saw critical yield limiting defects in three key process steps around the transistor utilizing our Brightfield 2800, resulting in a 20% yield improvement. This is the benefit we strive to deliver and are always please to hear when it is being realized.

The outlook for December shows memory staying steady, particularly in Taiwan and Korea and strength in logics. We see some shift in capacity occurring from NAND flash to DRAM which we believe can have a short-term impact on bookings as customers qualify fabs before ramping. From our perspective, we continue to see a healthy semi industry but with some softness in specific markets. Current projections are for semi revenues to be up 7% to 10% in 2006 and 2007.

Fab utilization levels continue strong, and we are still tracking 17 new 300 mm fabs schedule to qualify by the end of 2007. The well understood story is NAND bit growth. What is now emerging is strong DRAM bit growth for 2007. Let me now give you a couple of updates on our product activity. Our latest Brightfield defect inspection system, the 2800 broadband tool continue to demonstrate its superiority, and sensitivity, defect capture and speed.

Over the last quarter we saw continued adoption of the 2800 series system across a broad customer base. This has been and continues to be a strong product area of the company. We are particularly excited over the performance of our latest Darkfield inspection tools, the Puma 9110 and 9130. These systems utilize our new streak inspection technology and deliver significantly greater performance. The two tool solution enables our customers to optimize the cost of inspection.

In the September quarter we saw it happened market validation of our unique two-tool solution. On October 12th we completed the ADE acquisition. We are excited to have this team in business opportunity now be a part of KLA-Tencor. ADE's products are critical to the control and yield management of silicon wafer production. We anticipate strong growth in silicon wafer manufacturing as the semiconductor industry continues its conversion to 300 mm and as other markets such as solar become a larger consumer of silicon wafers. We are now focused on a successful integration of ADE and continued support of our new customers.

The industry focused on strengths is continuing to 65-nanometer and below now accounting for 55% of our business. Yield at 65-nanometer sincerely still in the steep learning part of the curve with most customers still well below 50% yield. 45-nanometers starting qualification and the problems and challenges will be significant. We are actively working with customers on multiple aspects of 45-nanometer adoption such as transistor engineering and immersion lithography. As always we have a number of new products under development and plan several new product introductions over the next several months that are critical to 45-nanometer.

Wrapping up, let me give you our projections for December including ADE. Orders up 10% plus or minus 10%. Revenue up between $650 million and $675 million. The Company is strongly positioned to continue the growth in yield management and process control by enabling our customers to go meet their challenging business needs. The technical challenges faced by our customers are daunting, and our products play a key role in overcoming the hurdles. 2006 is shaping up to be a very good year, and at this time the fundamentals for 2007 continue to look solid. Memory logic and foundry business all have sound under pinnings, and the push to advance the latest technology is unabated. We have continued to execute on our business and look forward to having a complete discussion of our results in the near future.

Now I will turn the call back over to Jeff Hall.

Jeffrey Hall - Chief Financial Officer

Thank you, Rick. As Rick mentioned for the September quarter net bookings were 647 million, this is at the bottom end of our guidance range as a result of orders in Asia that moved into the first part of the December quarter. As you know, every quarter we review our backlog in detail and book in accordance with our booking policy that restricts actual booking to the set criteria. The set criteria mandate that technical specifications are signed off, valid terms and conditions are finalized and delivery is scheduled within twelve months. This quarter there were no orders debooked as customer orders and shipments scheduled remained firm. We ended the quarter with approximately $1 billion of backlog for unshipped orders. Remember, we do not include any service, contract, consignment, or unreleased systems in this backlog number. In addition, we have $503 million of revenue backlog related to products that have been shipped but not yet signed off by customers. It does not include service revenue and is made up of tools delivered but awaiting written acceptance from the customer.

Our ability to maintain this significant level of both shipment and revenue backlog continues to help KLA-Tencor sustain high profitability throughout any business cycle. Since this is the first quarter of a new fiscal year for us, we have updated the five-year averages we use for bookings comparisons. The regional distribution of orders for the September quarter was as follows: The U.S. was 20%, lower than its historical average of 25%, Taiwan with 10%, lower than its historical average of 20%, Korea, China and Singapore combined were 22%, higher than their historical average of 20%, Europe was 13%, higher than its historical average of 10%, and Japan was 35%, higher than its historical average of 25%. The product distribution of orders was wafer inspection at 52%, reticle inspection was 16%, metrology was 15%, data storage was 2%, and service was 15%.

Now let me turn to the income statement. As Rick said, revenue for the quarter was $630 million, up 9% quarter-to-quarter and up 30% from the same quarter last year. Operating margins for the quarter excluding share-based compensation met or exceeded our internal targets for the quarter in most areas as our team continued to execute well driving continued cycle time and cost improvements. Other income for the quarter was 22 million as the interest rate earned on our portfolio increased.

Turning to the balance sheet, cash and investments increased by 100 million quarter-to-quarter after paying a dividend of $24 million. Cash ended the quarter at $2.4 billion, and as Rick noted, on October 12th we closed the ADE transaction which reduced cash to $2.05 billion. We believe that this level of cash is more than we need to run the business and have been working diligently with our board to determine the optimal capital structure. We're looking forward to announcing and executing on our plan once our restatement process complete.

Accounts receivable finished the quarter at 415 million, down 25 million from June as a result of strong collections. Capital additions related to fixed assets were approximately 12 million for the quarter and depreciation was 14 million. On a net basis including retirements, fixed assets decreased by 1.5 million over the quarter. Head count ended the December quarter at 5,944, up 40 from June, primarily to support our production increases, field support and new product introductions. The majority of this increase was for people at customer sites at our new manufacturing facility in Asia.

As you know, we are currently in the process of integrating ADE into KLA-Tencor. We're learning more about their financials every day, and based on the preliminary assessment of how we will integrate their financials into ours, we believe the integration will have several impacts on the December and future financial statements.

First, ADE is a profitable and well-run business, and as a result we expect it to be immediately accretive to our earnings excluding deal-relate charges. Second, we are in the process of assessing the fair value of all the assets and liabilities of the acquired business and preparing the detailed purchase price allocation. We expect to record both one-time accounting charges related to the acquisition as well as have ongoing non-cash charges for the amortization of intangibles. We will cover the details of these charges when we have finalized the amounts on our next quarterly call.

Finally, as Rick said our guidance is, orders expected up 10% plus or minus 10% and revenue expected to be between $650 million and $675 million. This guidance includes ADE for the period from October 13th to December 31st. For this time period our current estimates for ADE are bookings for the partial quarter are expected to be approximately 30 million, revenue for the partial quarter is expected to be approximately $20 million. Gross margin is expected to be slightly dilutive to KLA-Tencor margins. R&D, SG&A are expected to be approximately $10 million. We are integrating this business into KLA-Tencor and will not break out these numbers in future quarters.

This concludes our remarks on the quarters. We will now open the call for questions. Before I turn the call over to Derrick to give the polling instruction, let me request that you refrain from asking multipart questions to give others some time, as always, we are all on a tight schedule. So, Derrick, can you begin the polling, please?

Question-and-Answer Session

Operator

Your firs t question comes from the line of Tim Arcuri with Citigroup.

Timothy Arcuri – Citigroup

Hi guys, a couple of things. First of all, when you look at bookings in the September quarter, they came in 5% less than what you thought they would, and when you strip out ADE, it looks like they're a smij less than December what you were thinking as well, so what change during the last few weeks, what customer group changed, maybe at the end of September, and what's your outlook for that particular customer group into December? Thanks.

John H. Kispert

It was for the September question, it was order that went right down to the last few moments of the quarter, and we actually booked it already into the December quarter. That was the 5% difference in the September quarter. Going into December and that by the way was foundry in Asia. Going into the December quarter, if there has been a change in the last 30 days, and I think there has been, it’s has been around certainly around NAND. We see some of the projects that we had been working on just getting slightly smaller. I don't think there is a big change, but we've seen that slow down right now looks as though – and is probably affecting us a little bit in our guidance for the December quarter.

Timothy Arcuri – Citigroup

So, I guess, John, it is not that the projects are pushing out, it is that the opportunities a little bit smaller, is that --

John H. Kispert

Yes.

Timothy Arcuri – Citigroup

Okay, thanks a lot.

Operator

Your next question comes from the line of Gary Hsueh with CIBC World Markets.

Gary Hsueh - CIBC World Markets

Thanks for taking my question. Quick question here, I think we're in a little bit of uncharted territory. You guys are kind of sustainably running at backlog levels roughly a billion dollars. Assuming you can sustain a billion dollars kind of backlog level for unshipped orders, what's sort of the natural steady state shipment number and I guess more importantly what is the natural kind of steady state revenue number we should be kind of looking at here?

Jeffrey Hall

Gary, it’s Jeff Hall. The way we run the business, we've been doing it this way for a long time. We keep five to six months of unshipped backlog and we keep three to four months of revenue backlog, and so with our billion dollars that we have today and 500 million of revenue backlog, if you keep modeling us that way, you will end up -- depends on where you think orders are going to end up, but as you model that through, you can end up with a pretty reasonable estimation of where we're going to be and of course these numbers all exclude the service which is about a $100 million a quarter for us these days.

Gary Hsueh - CIBC World Markets

Okay Jeff, I guess there is a lot you can do here with the numbers. Looking at what could be backlog levels at the end of December, I could hit anything from a 700 to 750 in terms of revenue. Is that too high or is my math wrong?

John H. Kispert

Gary, it is a function of deliveries to our customers and where they're ramping. I would think from what we see today, if we look at the installations that we have in front of thaws we see shipments and installations going up in the December quarter, we actually see them going up again in the March quarter, so that backlog should work down that given those dates today, and let's just assume we hold orders flat which I don't know if that's going to be what happens, but we have to deliver that stuff over the next six to nine months.

Gary Hsueh - CIBC World Markets

Okay. It sounds like shipments rising in March; there is a lot of fuel here to drive revenue levels higher from your guidance for December.

John H. Kispert

Certainly if shipments go up, revenues should go up, too, but I would caution you that it is driven more by what our customers needs are and when they sign off on these things, and our ability to predict it.

Gary Hsueh - CIBC World Markets

Okay. Thank you.

Operator

Your next question comes from the line of Robert Maire with Needham.

Robert Maire – Needham

Two quick questions. You‘d mentioned you expect to get the restatements done by January. Can you remind us as to the current deadline for filing with Nasdaq or what the status of discussions with Nasdaq are and a follow-up to a previous question, you had guided to flat to up 10% so if we back out the 5% for ADE that gets added in, that would be flat plus a minus 5%, is that the right way of thinking about it?

John H. Kispert

Robert, I will take the second question. The way I look at it is without ADE we probably up slightly 5%, somewhere between flat and up 5% in the middle of the range today. You add ADE in, it is up 10% middle of the range. Does that make sense?

Robert Maire – Needham

Got it. Very good.

Jeffrey Hall

You know, this is Jeff Hall. On Nasdaq it is pretty much working out exactly the way we told you on the last call. We certainly been in discussion with Nasdaq, and keep working through the process with them. They know our timing on the restatement, and we expect to be done in January and don't expect to have any issues.

Robert Maire – Needham

Is it open ended or is there a specific date they have in mind?

Jeffrey Hall

There is not a hard date at this point. It is a process based on a whole bunch of different factors.

Robert Maire – Needham

Okay. So if then beyond the January date, they're okay with that so far?

Jeffrey Hall

Yes, yes.

Robert Maire – Needham

Thank you.

Operator

Your next question comes from the line of Jay Deahna with JP. Morgan.

RJ - JP. Morgan

Good afternoon. This is RJ calling in for Jay. A couple of questions. First one regarding the outlook. Given your visibility, can you give us some idea of what the volume ramp looks like for 65-nanometer logic going forward? What kind of time frame do you see and what would be the breadth or strength of that volume ramp up?

John H. Kispert

RJ, was there a second part to your question?

RJ - JP. Morgan

Yes. The second part is as you move towards that, give us some color about if you're seeing any kind of ASP progression. Are you seeing higher ASP's going to 65-nanometer.

John H. Kispert

Great questions, RJ. I think on the first one we certainly see 65-nanometer continuing to ramp, and I think we talked about earlier in the call the fact that what we see there is people are still pushing hard on yield, and so there is opportunities ahead of us to help our customers ramp their yield. At the same time they certainly see a lot of demand for 65-nanometers. So, we think continued ramp over the next several quarters of 65-nanometer.

I think the other part of the question, the second part was ASP growth. We are seeing strong performance of our newer products, so those continue to demand strong ASP's, and I think our competitive position demonstrates the fact that not only are we maintaining strong share, but we're also able to realize that value from a customer perspective, so we do see ASP's continuing to be strong as we support 65-nanometer, and of course our latest generation products like the 2800 and the Puma that we talked about earlier play strongly into the 65-nanometer ramps, not just for logic but certainly logic is a big part of that.

RJ - JP. Morgan

So does that mean we would see orders maybe in Q1 of '07 calendar Q1?

John H. Kispert

For the 65.

RJ - JP. Morgan

Yeah, volume.

John H. Kispert

We're already seeing some of those and continue to ramp, I think about half our orders now are 65 and below. So absolutely we're seeing some volume. As you know, there is a long tail. Some people are doing 65 earlier than others, and the other ones are coming on but absolutely that's where we're seeing orders from.

RJ - JP. Morgan

Okay. Thank you.

Operator

Your next question comes from the line of Edward White with Lehman Brothers.

Edward White - Lehman Brothers

Hi. Thanks. I was wondering if you could talk a little bit about the relative strength in bookings in Japan, whether that was just sort of lumpiness in the quarter or something unusual going on there, and then secondly, can you talk a little bit about the relative difficulty for semiconductor manufacturers, whether the 65-nanometer cycle seems to be more difficult or the 45-nanometers and as you look at it from a yield standpoint, which do you think is going to be more challenging and present more opportunity?

John H. Kispert

Thanks for the questions. Japan -- Japan just continues to be a strong region for us, and I think there are a couple of reasons for that. Not the least of which is the wafer manufacturers continue to invest as they see demand for 300 mm wafers, and of course a big part of our wafer business comes out of Japan. The other part of that is the reticle manufacturing, and we see continued interest in pushing new capability for our reticle manufacturers as they bring on the latest technology nodes, and finally the wafer semiconductor manufacturers themselves are spending, so Japan was a strong region, and I don't think it was just lumpiness, I think it just showed overall strength in those three verticals that we're in. The other question about the yield transition, the early signs are 45-nanometer is going to be significantly more challenging than 65, and it is still early because people are just starting to qual some of their processes around, and we don't even see full flow yet on 45-nanometer. But no question, some of the challenges associated with the new lithography tools coming on, immersion technologies and some of the new materials, I think there is definitely opportunity for us to help our customers solve some of those problems. So we think 45. We're encouraged by the opportunities in 45-nanometer, but 65 is where the bulk of the investments are right now.

Edward White - Lehman Brothers

Great. Thank you.

John H. Kispert

Thanks, Ed.

Operator

Your next question comes from the line of Steven O'Rourke with Deutsche Bank.

Peter - Steven O'Rourke

Hi. This is Peter for Steven O'Rourke. I had a question about your backlog. Can you give us a composition of how much of your backlog is from memory and if you could, what do you expect the percentage of shipments going forward to lean more favorably towards memory or do you expect memory shipment to say roll off as further you go out?

John H. Kispert

Hey, Peter, John Kispert. I don't have an analytical answer for you. I can do it more by feel. Generally the memory shipments are more time sensitive, and so the delivery dates are sooner and quicker, quicker turns in the manufacturing and installation business, so although memory as you know has been roughly 50% of our business, 40% to 55% of our business, 60% of our business last year, it is tough to get generally turned much quicker, and that's what I would suggest to you over the next quarter or two. I would tell you as a rule it’s generally foundry and foundry can play in the same model except that's not ramping right now, and logic probably a little bit longer lead time over a long period of time, logic probably space in our backlog a little bit longer. Is that all right?

Peter - Steven O'Rourke

Yep.

Operator

Your next question comes from the line of Jim Covello with Goldman Sachs.

Jim Covello - Goldman Sachs

Good evening, guys, thanks so much. Couple of quick questions. Jeff, you mentioned on the balance sheet 2 billion plus is a little bit more than you think you need to run the business. Any idea what level you think is more appropriate to run the business, and then as you've worked with the Board to work through the ideas, any thoughts on the best Avenues of returning cash to shareholders?

Jeffrey Hall

Thanks, Jim, good question. As we look at capital structure and what's right for KLA-Tencor, really three different things we're looking at. First is what is the cash generation through the various cycles. Obviously in history we've been very profitable, generated a lot of cash and doing a lot of things to really drive the profitability higher going forward, so cash generation looks good going forward. Next big issue is uses of cash. As you know, Jim, we're not very capital intensive. But we do see some interesting targeted growth opportunities. I think ADE is a great example hereof a chance to use our cash to grow the top line and in an immediately accretive way.

Finally, how do you put those two things into a model to determine the optimal cash structure for KLA-Tencor. That's something we've been spending a lot of time on here internally, and certainly have been through numerous scenarios and theories and thoughts with our Board and working through what we think the optimal capital structure is. You know, we haven't exactly finalized 100% on the execution plan, so I don't really want to preannounce here, but I think it is a reasonably safe bet that cash is coming down pretty significantly from where we are today. As soon as we get through the restatement, you will see us come out with an announcement about what we're going to do and start executing on it and driving us to what we think is a more optimal structure.

Jim Covello - Goldman Sachs

Terrific. And then just real quick, around related to the same topic, what kind of for modeling purposes, what kind of increase in OpEx should we be thinking about that you either will have had or will have around the cost of the options investigation because it sounds like obviously it is a pretty intensive situation?

Jeffrey Hall

So, Jim, we took an accrual for expenses back in our June quarter. It is the way we do things here, our accounting policy is to come out and accrue for the next twelve months of expenses, so we took a number there, and we think that's going to be the extent of the charges as we go through there and don't expect a big over hang going forward for several quarters.

Jim Covello - Goldman Sachs

Terrific. Thanks very much.

Operator

Your next question comes from the line of Raj Seth with Cowen & Co.

Raj Seth - Cowen & Co

Jeff in the answer to your last question you talked about opportunities to drive leverage higher and increase cash generation, et cetera, I wonder if you can talk a little bit about what some of the activities are in the short-term that you're pursuing to drive better leverage and perhaps just to make the compare easier, talk about what you think the opportunity is from a gross margin, maybe operating margin perspective on revenue similar to the last quarter you fully reported, how much better you think margins would be say a year from now after some of this restructuring?

John H. Kispert

Hey, Raj, John Kispert. Do you find if I answer it.

Raj Seth - Cowen & Co

No. Great.

John H. Kispert

We've been evaluating and piloting a number of things over the last year or so, and we're now definitely seeing financial benefits as well as operational benefits and then frankly cultural benefits. I would also say we now have fairly healthy respect for the risks of poor execution on some things, so we've begun in the last couple of months really to accelerate on a number of fronts and off the top of my head I will list a few of them off to you.

The first one is we're aligning our management, what we call our management profile, spans of controls, we definitely want to flatten the organization, and we're going to be doing more of that, and take out layers globally, and so we're executing on that. Another big effort has been aligning our service absent sales organization to mirror the customer base as the customer base moves around and making that more efficient. That is in full force.

As we've discussed in the past calls we're moving investment in manufacturing and development capabilities to low cost regions, and we talked to you about India and China, Singapore, Malaysia, and of course Moscow where we have different development efforts and different manufacturing efforts ramping now. We've moved to smaller facilities across the Company, and that will continue as we can make our footprint a little bit smaller and more efficient. We've moved a lot of our -- and begining to move more of our non-core functions to these low cost regions. We're accelerating our volume with these overseas suppliers that we've been working with as we talked about in the past we've moved our supply base to low cost regions, and now we're accelerating the volume, and I think we're feeling real comfortable with the quality and reliability we've gotten in the recent ramp from the newer supply base.

The other thing we've talked about to remind folks is with more and more our technical support and our application support is outside of California. It’s more and more right next to our customer, and all around the world, and that has is advantageous. That's where the acceleration -- when I say acceleration, that's what we're focused on now and we're doing a lot more, and you will hear more about it over the coming years. I would say that it’s not a big bang. We're not sprinting to this. It is more like a marathon. We are accelerating it, but I don't expect a big dramatic change the next quarter or two, but I think over the next two to three years we'll -- the customers will see benefits, our suppliers will see benefits, employees will certainly see benefits, and shareholders will see benefits.

Raj Seth - Cowen & Co

John, you've put a model out there at 900 to a billion dollars which has pretty heady operating margins, et cetera. Is there a way just for comparison purposes and I understand it’s going to take awhile to execute on all these initiatives as say $600 million, something close to revenue levels that you're showing now, how much would you expect in terms of incremental margins operating in gross margin from these initiatives, let's say a year from now?

John H. Kispert

A year from now? Let me answer it this way, Raj.

Raj Seth - Cowen & Co

I guess I am trying to separate out the effect of higher volume from the restructuring activity which is hard if I look at a billion dollars number because we haven't soon that before.

John H. Kispert

Exactly right. Clearly folks listening to the call know the company well, know we have a financial model that leverages very well, and we're trying to continuously improve upon that. The way we originally put it together is these efforts that we're talking about half of -- when you looked at that model we talked about Semicon, about half of the benefit was going to come from volume, and the other half was going to come from these efforts. Your next question I think was how much is in gross margin. How much is in operating? That's tough for me, Raj.

Raj Seth - Cowen & Co

That's fine. I wasn't trying to split the two. That's fine. That's helpful.

John H. Kispert

Does that make sense.

Raj Seth - Cowen & Co

Yeah. Thank you.

Operator

Your next question comes from the line of Satya Kumar with Credit Suisse.

Satya Kumar - Credit Suisse

Thanks. Could you give us shipment guidance number for December -- and able to quantify what you thing bookings might look like by memory, foundry and logic in December?

Jeffrey Hall

Yeah Satya, it’s Jeff. Shipments we’re looking at between 675 and 700. What was the second half of the question?

Satya Kumar - Credit Suisse

Bookings by memory, foundry logic in December.

Jeffrey Hall

For December we've got --

John H. Kispert

It’s about the same.

Jeffrey Hall

About the same, 45% memory.

Satya Kumar - Credit Suisse

Okay. When I look at process control as a percent of equipment spending, it increased pretty dramatically back in ’01 and '02 but you can argue since then it sort of remained fairly constant as a percentage of total equipment spending. First of all, is that a fair assessment or not and if not, where do you see process control growing as a percent of equipment CapEx over the next several years do you still see that out growing CapEx?

Jeffrey Hall

Sure, Satya, good question. I think you're right. Have you to look further back and what you see is there are times when we see a significant increase in the overall percentage and that flattens for while, and then as customers find the new challenges in particularly it happens around no transitions, and I think that the upcoming no transition that we believe will drive acceleration again is around 45-nanometer. The reason we're seeing that is there are just additional challenges, more new materials coming on, the lithography problems are getting more challenging, and the focus on time to market for our customers means they're really going to work hard to bring up the new technologies quickly. So, from that standpoint, we think that we do see the ability to outgrow the overall CapEx over the longer period of time as a result of those technological changes that our customers are going to be dealing with.

Satya Kumar - Credit Suisse

Okay. That's helpful. If I can squeeze in one last thing, what kind of tax rates do you think we should be using for modeling purposes and how much can you talk about it and does it have any relationship with the option expense that you will start reporting once you start filing your reports?

Jeffrey Hall

Satya, tax rate forecasting is always a difficult thing because the governments are involved and rules and changes. The obvious thing at the moment is the R&D tax credit hasn't been renewed. Just ignoring that for a second, if you look back over the past several years what we call our natural tax rate that we talk about in our K's and Q's when we publish those has been in the high 20's to about 28% here recently, and I would say going forward that's about the best estimate based on what we know. Obviously there are a lot of things up in the air with the stock options, so I don't think stock options would have a big impact on that tax rate in the future years.

Satya Kumar - Credit Suisse

Thank you.

Operator

Your next question comes from the line of Stuart Muter with RBC capital Markets.

Stuart Muter - RBC capital markets

Thanks. Good afternoon. A quick question, what were your shipments in the September quarter and how is the management of your lead time considering the fairly high level of shipments that are occurring right now?

Jeffrey Hall

Stuart, shipments were 652 in September, and I am going to let John take the second half here.

John H. Kispert

Stuart, I think your second question is right on it, its is probably the biggest challenge we've had the last three months is with the ramping of the newer products is how to keep cutting the lead times down and taking care of the needs of our customers. They've come down nicely. We've seen cycle times reduce as much as 50% on some products. As depending on what the delivery dates are, that's the name of the game right now on delivering for these ramps, getting it there when they want it, I am happy with where we're at. We're exactly where we plan, but wasn't for lack of effort over the last 90 days by the team.

Stuart Muter - RBC capital markets

Okay. And did you think you've lost any business because of the lead times?

John H. Kispert

That's kind of a golden rule at KLA-Tencor, don't lose business because of lead times. I know of no instances where that's happened. We will figure it out. I don't foresee that happening, Stuart.

Stuart Muter - RBC capital markets

Great. Thank you.

Operator

Your next question comes from the line of Dave Duley with Merriman.

Dave Duley – Merriman

Good afternoon. I was wondering you talked about your orders in the December quarter on a product line basis. Can you talk about them on a geographic basis, which geographic regions in the September quarter will be up or down and a quick follow-on, someone asked the question about capital intensity at 45-nanometers. Maybe you can compare that to 65-nanometers, and will we see an increase in the number of tools between those technology nodes or an increase in opportunity from you and what are some of the apps we might be added at 45 that weren't at 65?

Jeffrey Hall

Dave, I’ll take the more quantitative one, first question. I think U.S. will probably be a little bit higher where we're targeting right now be about 25% of the total. Medical business in particular look strong this quarter there, and I think the logic business for KLA-Tencor will be stronger. I think the big change for us quarter on quarter September or December quarter will be in Japan where you will have a digestion period as you can imagine after a nice run of two or three very strong quarters, it will certainly slow down a little bit, and it is brought based. It isn't one piece there. It is just that business has been so good for a period of time.

I think Taiwan will see a nice pop back up, and it’s primarily memory, and there is certainly some foundry business as we talked at the beginning of the call that is already slipped into the quarter. I think Korea there is probably be up quarter on quarter. As I off the top of my head as I look down the list here, the other pieces are relatively flat, that’s Singapore, China, Malaysia and Europe, relatively the same sized businesses.

Dave Duley – Merriman

Okay.

Jeffrey Hall

Same kind of mix.

John H. Kispert

Dave, your second part of the question which was the capital intensity as it relates to process control, at 45-nanometer what we're seeing are more and more technical challenges for our customers, whether it is measuring higher precision, better overlay, or defectivity, and the results is we're seeing customers want our latest technology. In fact, some technology we're just now bring to go market which have more capability and more features, as a result we get not only more option which drives unit growth, but also pricing growth. We see leverage both in the ASP and also in the growth of units.

Dave Duley – Merriman

Okay.

Operator

Your next question is from the line of Mehdi Hosseini with Friedman Billings Ramsey.

Mehdi Hosseini - Friedman Billings Ramsey

If I were to take mid-point of your guidance range and strip the ADE, seems like bookings for the December quarter are down by about 15% since the peak of June. Is that the kind of correction we're seeing in this new environment and going forward you may not see the 30, 40, 50% correction from the peak to the trough, and then as follow-up question, Taiwan in the Q1 was 65 million in bookings. Is the lowest over the past four or five quarters, and you said you're going to see a pop in the December quarter, but would it be realistic to expect Taiwan in terms of dollars of bookings to go up towards 200 million given what you see out there?

Richard P. Wallace

Yeah, Mehdi, this is Rick. I will take part one and John will take the second part of your question. In terms of peak to trough, you know, it’s really hard for us as you know to forecast. They're generally a lot of theories out there that say that we'll see more muted overall ranges in the cycles. The other factor that you have to remember is KLA-Tencor even when things soften, people continue to invest for two things, one is just technology and the capability to support the new technologies that are coming online which means we continue to see investment in R&D. We also see that the 45-nanometer challenges that the people are facing are going to drive them to invest as well, so what might be typical of the broader industry we think will probably do better in terms of this particular upcoming cycle as a result of the product positions that we have in the segment that we play in.

Mehdi Hosseini - Friedman Billings Ramsey

But your customers have historically invested for the future generation. I am just trying to figure out the capacity part of the cycle. Are the cycles more muted? Should we expect kind of a 10 to 20% correction from the peak to the trough? Is that the new reality?

Richard P. Wallace

You know, I think it is real hard for us to predict that. Right now that seems to be the case, but I think that you have to really go through these, and every cycle tends to be a little bit different. Certainly what we're seeing in terms of our customers, what they're telling us is they want to make sure they have the capability to continue their yield work, and that's why we're seeing continued demand, but I would hesitate to try to predict overall cycle behavior being different.

Mehdi Hosseini - Friedman Billings Ramsey

Got it.

Richard P. Wallace

John, do you want to take the other part, Taiwan.

John H. Kispert

Mehdi, the question on Taiwan was fundamentally whether what the next two quarters sizing up to look like?

Mehdi Hosseini - Friedman Billings Ramsey

And also extending that, with $65 million in bookings the lowest over the past five quarters, and given what you see in terms of opportunity in Taiwan, memory and foundry, would that be realistic to expect Taiwan bookings to get close to 200 million over the next several quarters?

John H. Kispert

I don't think that's out of -- that's the high-end of the range. That's certainly a number that's durable either this quarter or the March quarter. The opportunities are clearly there. It gets down to the timing of the orders in which quarter, but I think you're in the right realm of the opportunities that are there.

Mehdi Hosseini - Friedman Billings Ramsey

Okay.

John H. Kispert

I think the big question for what it's worth and for us is more difficult for us to predict over let's say the next three to six months is the foundry spending in Taiwan, and we're doing well there, particularly as Rick was pointing out in 45-nanometer kind of investments and still 65-nanometer, but the more capacity like buys are still very difficult to try to predict.

Mehdi Hosseini - Friedman Billings Ramsey

Gotcha. Thank you.

Operator

Your next question comes from the line of Steven Pelayo with HSBC.

Steven Pelayo – HSBC

It looks like shipments are higher than revenue and is bookings are higher than shipments. Are you guys going to build backlog and deferred revenues yet again and then you hinted that March shipments are up from here. I am trying to figure out where these revenues can go as you guys continue to actually build deferreds and backlogs as opposed to actually getting it through the top line.

Richard P. Wallace

Thanks, Steve. You know, it is like we alluded to, you know our model pretty well. We try to keep our months of shipment backlog in the five to six months in revenue in three to four. It is going to play out based on where bookings go from here. We're not going to really move away from that model. That's the model that has over time allowed us to smooth execution out of our manufacturing base, smooth our supply chain, allows us to keep R&D flat through any cycle which allows us to keep and extend our leads. It’s business model that let's us get out there and incremental operating profit of 50% to 60%. It is really hard to name a number without knowing all the orders are going quarter by quarter, but if you keep modeling us as 5 to 6 and 3 to 4, you will get pretty close because that's how we're running the business internally.

Steven Pelayo – HSBC

If you can clarify one thing for me, could you help us understand -- I understand you're going to give us more details in January and more optimal capital structure, but if we were just trying to think a little bit about it right now, you've got $12 a share in cash, generating, I don't know, a couple hundred million in operating cash flow at every quarter and – 200 million, (inaudible) per quarter, do you need half that amount if I was trying to put it over and under on it right now, is it pretty safe to say half that amount would be all KLA would need?

Richard P. Wallace

You know, Steve, it is like I said, we're not 100% finalized on the execution plan and really don't want to get out in front of it and preannounce it. When we're ready to make an announce, we'll come out and tell you exactly what we're going to do and how we're going to do and as usual be very upfront and transparent about what we're doing and why.

Steven Pelayo – HSBC

Can't blame a guy for asking.

Richard P. Wallace

Thanks, Steve.

Operator

Your next question comes from the line of Stephen Chin with UBS.

Stephen Chin - UBS

Great. Thank you. Rick, I want to come back to an earlier comment you made in your opening remarks about as NAND shifts over to DRAM, additional qualifications need to be done. Are you implying that there could still be a memory equipment order pause somewhere down the line?

Richard P. Wallace

What we're saying certainly that's part of what we're seeing is a shift to softening in NAND and the DRAM picking up the slack. That is what's in our forecast right now. That's what we're talking about for December, yes.

Stephen Chin - UBS

I guess you said that December memory orders be similar to the levels they were here in the September quarter, so doesn't seem like there is any material fall off.

Richard P. Wallace

Not from present level. I think it’s part of what we've seen and part of what we saw? September.

Stephen Chin - UBS

Okay. And just as a follow-up to that, can you share the estimated split between NAND and DRAM in the September quarter and what you foresee that to be in the December quarter?

Richard P. Wallace

Yeah. In -- we saw overall we had about 46% of our business in September was for memory and 33% of that was in NAND, so that was the trend that we saw that was down. My point was June was higher. We were at 62% for overall memory and 50% NAND, so that's really the softening we saw from DRAM moving from NAND to DRAM, and we don't see any reason that that's significantly going to be different in December. Remember there are a number of dual use fabs, so customers always have the option for redeploying based on the market condition that is they see between DRAM and NAND.

Stephen Chin - UBS

Okay. That was helpful. Thank you.

Jeffrey Hall

Derrick, I think we have time for one more question here.

Operator

Your final question is a follow-up question from the line of Tim Arcuri with Citigroup.

Tim Arcuri – Citigroup

Hi, guys, when you look at foundries, and you look at how soft bookings have been, and I think a lot of bulls have argued that foundries never really spent much money, and the capital intensity there never really got high enough, yet they're not ordering any equipment, so what's changed there? It seems like something has changed in the foundry business such that the orders have in fact pulled back as much as they have in pretty much every other cycle yet they never got quote as overheated this cycle as they had in prior cycles. Thanks.

John H. Kispert

Tim, I am not going to be -- this is John Kispert. It’s difficult for me, God knows I talked to many of you about this over the last two years because we've all talked about this, I remind you in our case that at 20% of our orders, it’s still over 100 million out of the foundries, and it was a quarter for us this last quarter where we saw over 50 million of it kind of move out of the quarter and into the December quarter, so that it’s very sizable business for us still, but what we haven't seen are the larger capacity like ads that we've seen in the past accident back in '04 for instance, and the good news of course is that the feeling is eventually that will adjust and change, and we'll see that the pick up. We don't see that today, though. It seems pretty flat to us for the foreseeable future with great business for us, challenging issues, things that we're working on with all of the foundries, but not a big pick up.

Tim Arcuri – Citigroup

If I can just sneak in one last thing, there is a piece of your backlog sitting in inventory. Can you help us size what the dollar value of the backlog sitting in inventory is? Thanks.

John H. Kispert

Tim, it is for everybody else listening out there, there is part of our backlog that doesn't get counted, and that's shipments that have left the factory here, and it is next generation products. We're always focused a generation or two in front of what we already announced, and we call them alpha and beta products out there. Particularly as Rick was mentioning, when you start a transition towards in this case towards 45-nanometer, that inventory will grow for KLA-Tencor because the next generation products are leaving the factory. They're not in backlog. We haven't counted them as orders. They're sitting in inventory and we're working with our customers. The level right now Tim, is about average for the backlog that we have today. Earlier last year it was higher. It has come down kind of quarter on quarter just a little bit as we started to ramp into 65-nanometer. I wouldn't expect to see a big pop in that to the extent it comes down. We're always adding also every quarter, but it is not a large number. It is kind of a run rate number for KLA-Tencor, and it is not a number we've ever given out nor do we plan to keep giving out because it is really competitive for us.

Tim Arcuri – Citigroup

Thanks, John.

Richard P. Wallace - Chief Executive Officer, Director

I would like to thank you all for participating on our conference call today. The next earnings call is currently scheduled for January 25th at 2:00 Pacific standard time, and we look forward to speaking with you all again next quarter. Thank you.

Operator

This concludes the KLA-Tencor first quarter fiscal 2007 conference call. You may now disconnect.

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