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KLA-Tencor Corporation (NASDAQ:KLAC)

Bank of America Merrill Lynch Global Technology Conference Call

May 9, 2012 12:30 ET

Executives

Ed Lockwood – Head of Investor Relations

Mark Dentinger – Chief Financial Officer

Analysts

Krish Sankar – Bank of America Merrill Lynch

Krish Sankar – Bank of America Merrill Lynch

Welcome. I’m Krish Sankar from BofA Merrill Lynch. The next company presenting is KLA-Tencor and we are fortunate enough to have Mark Dentinger, the CFO; and Ed Lockwood, the Head of IR for KLA. And they are one of the leaders in process control, yield management, and inspection for the semiconductor and related industries.

I am just going to let Ed talk for a little bit and then we’re going to open it up for the Q&A format.

Ed Lockwood – Head of Investor Relations

Thank you, Krish. Before I begin, just a reminder that today we are going to be making forward-looking statements as part of our discussion, and as such those forward-looking statements are subject to risk and uncertainty. So, please refer to our periodic filings with the SEC for some specific disclosures related to those risks.

So, I think the highlight of the KLA story today is about growth. And you really don’t have to look much further than the current headlines to see some of the major drivers that are helping to drive our – deliver our strong top line performance in this cycle. I mean, it’s everything from capacity constraints at leading-edge foundry to a heightened competitive environment in logic, to the continuing cadence of increasing cost and capital intensity at the leading-edge amongst all of our major end markets that are helping to drive higher adoption of process control. And for KLA share gains as the market leader in process control. And that’s translating to better than industry revenue growth for the company in this cycle.

Just for a point of reference, calendar 2011 revenue for the company was a record $3.2 billion, that represented 27% annual growth year-over-year in calendar '11, and that was in an industry environment, where aggregate growth was about 10%. So, clearly, we are benefiting from higher adoption in our space and we are seeing more of this trend towards process control of becoming more and more of a best tools business, which favors us.

Now, in this growth environment, the company continues to perform at a very high level in terms of – from a financial point of view with better than industry margins, profitability, and very strong cash flows, with management committed and – to returning value to shareholders in form of a dividend and a buyback program. So, in this cycle, the story for us is about better-than-industry average growth. And as we look ahead, many of the factors that have gotten us to this place today remain intact.

A high concentration foundry and logic business in this cycle certainly favors KLA-Tencor, as those end-markets tend to be the highest adopters of our tools, increasing complexity at the leading edge with more critical layers driving more process control in the fab, and creating the need for more sophisticated process control technologies. Again, moving to our favor is the market and technology leader in process control. And overall that leading to share gains for the company. So, as we look ahead, I think we are well-positioned for this relative strength for the company to continue, as many of the cycle dynamics that we’ll talk about today seem to be intact. And we feel like we are in the midst of a long-term cycle that’s going to reflect the same type of demand environment that we are seeing today.

So, from an investment point of view, I think that the opportunities remain strong for KLA and we are very excited. We are pleased to see our long-term growth strategy is bearing fruit and we are looking forward to the future here from a very strong position.

Krish Sankar – Bank of America Merrill Lynch

Good, Ed. So clearly, I think you highlighted logic foundry is helping you guys. I mean, everyone is well aware of all the issues like the fabless guys are facing, the challenges at the foundries. So from your standpoint, what do you think is the main issue at 28-nanometer? Is the yield a bottleneck, or is there something else going on? And just because you have a high-k/metal gate added into the mixture, is that like becoming more challenging for the foundry? Your thoughts on that will be appreciated.

Ed Lockwood – Head of Investor Relations

Yeah, sure. One thing that’s constant in our industry is change. And we talk about increasing complexity at the leading edge in logic, it’s not only in advanced patterning litho, but there is new complex structures being introduced into the advanced logic designs, 3D structures, high-k/metal gates. All new technologies haven’t been adopted that are proving complex challenges for our customers to yield. So, I think that what we’re seeing is the typical early yield challenge pattern of – in our business. It’s compounded by the complexity from a technology point of view that our customers are facing. It’s compounded by the competitive pressures. It certainly puts a sense of urgency in the market leaders and foundries to have these well-capitalized new entrants coming into the market and in logic. And that’s placing a priority on our tools, and frankly our tools are on the critical path to their success. So I think that that’s one of the major factors that’s been driving our relatively strong adoption.

Krish Sankar – Bank of America Merrill Lynch

And in the foundry space, obviously, TSMC has a 28, you’re seeing the other guys migrate to 28, like (indiscernible) UMC, GlobalFoundries, even Samsung heading down the path. From your vantage point, do you think the issues that you’re facing, each of these individual customers at 28, are they similar? Are they all isolated that each of them have the own specific set of issues?

Ed Lockwood – Head of Investor Relations

Well, they seem to have their own specific set of issues around the same problems. So high-k/metal gate implementation is not unique from one customer to the next in foundry. So, I think they’re all facing essentially the same challenges.

Krish Sankar – Bank of America Merrill Lynch

But didn’t Intel migrate high-k/metal gate 45-nanometer? So, I mean it seems like they had a much easier way to get over that issue with the foundry guys. Why is that?

Ed Lockwood – Head of Investor Relations

Well, I mean, I think that you’re right. I mean that’s the one exception. Intel has definitely – definitely has the technology lead. And I think, again, let’s add that to the list of challenges and sort of – that are creating the sense of urgency amongst the foundries in that the logic capability of Intel is very strong. So what is that that Intel has? What’s their secret sauce? I think it’s just related to their discipline, to their copy exact process, to their expertise in this space that has given them that advantage.

Krish Sankar – Bank of America Merrill Lynch

And is it fair to assume that one of the things that the earnings call came out was the challenge of high-k/metal gate is a very metrology-intensive versus a poly gate. And was it a similar challenges with metrology or more metrology intensity you saw when Intel adopted it too or do you think its more foundry specific?

Ed Lockwood – Head of Investor Relations

A good point, it helps to highlight the fact that our metrology business has been operating at record levels. I mean, in one of the shifts in and sort of the – in the complexity in this cycle is related to shape control, which related to implementing 3D structures, to implementing high-k/metal gates. And it’s interesting to us because what’s happening is metrology, which in the past has been more of a capacity focused tool is becoming more of a technology development tool, which means higher margins, which means more favorable market position for the technology leader. And so I think that’s reflected in the strength in the metrology business that we have today.

Krish Sankar – Bank of America Merrill Lynch

And just along the path, one of the general senses of KLA is that you guys benefit when there’s a technology transition, but once customers iron out those issues, you don’t get the same jump when you use expanded capacity. So with that framework in mind, obviously, let’s assume a scenario where all the high-k/metal gate issues are solved at 28. And it looks like I think TSMC has publicly said at 20 they’re all going to be all high-k/metal gate. So do you think that they’re going to do a lot of reuse of the toolset? Do you think like their lessons learned at 28-nanometer will help them at 20-nanometer case for high-k/metal gate?

Ed Lockwood – Head of Investor Relations

No, I think...

Mark Dentinger – Chief Financial Officer

There’s a good chance they’ll have other problems.

Ed Lockwood – Head of Investor Relations

Yeah, I mean...

Mark Dentinger – Chief Financial Officer

I mean, that’s – recent history suggests that a node transition introduces all sorts of complexities that have to get dealt with, and process control is the way they attack it in the most cases. So that may be one example where they do it with that, but the reality is, is that there’s a lot of other stuff that has to happen to make a node jump.

Ed Lockwood – Head of Investor Relations

We have through-silicon via coming. We have advanced patterning litho, multi-patterning coming at 2X below 28-nanometer. There will be – Mark’s right. I mean, held in isolation if there was one customer, or one customer for us, I’m sure they would like to settle down at a certain node and may be as profitable as they can, but that’s not how this industry works.

Mark Dentinger – Chief Financial Officer

Yeah, and the competition won’t let them. Somebody will force the – will advance the ball with economics as the driver, ultimately.

Krish Sankar – Bank of America Merrill Lynch

Yeah. And then one of the general sense is that you guys are more foundry intensive and not have a lot of footprint on the memory side. And if going down the technology node adds more complexity and it helps process control, looks like the NAND guys are way ahead of the curve in terms of technology. But it’s not like the NAND guys are buying a whole lot of process controls. So why is there a difference in memory? And do you think down the road memory spending will actually benefit you guys?

Ed Lockwood – Head of Investor Relations

In memory, I think that that – I think we’re – memory is not immune to the Moore’s law. In fact, this next step in memory designs includes 3D structures, vertical NAND. And the shrink at 2X nanometer is also creating new deep activity issues that they haven’t faced in the past. And it’s our view, and we’re working very closely with these customers as they start to roll out development of 3D structures, that we’re going to see higher relative adoption in memory for process control given the increased complexity, and given this whole new flavor of design around stacking around vertical structures. We’re going to see that.

And we’re also going to see a better, improved market position in memory, because this general trend towards a best tool, towards technology capability, toward less price sensitivity and placing more of a premium on performance, certainly favors KLA-Tencor. And from our view, we think it’s a good setup. And frankly our forecasts for memory for calendar ’12 show relative strength compared to ’11, so we think that we’re beginning to see the benefit of that rollout, and we’re beginning to have good visibility into it because of the adoption that were seeing for our latest generation brightfield tool. So that’s helping to give us better visibility into how that adoption’s going to work out. So we like how the memory demand for process control is going to trend, and we certainly like our market position from a technology point of view in that space.

Krish Sankar – Bank of America Merrill Lynch

And you said that calendar ’12 memory will be better than calendar ’11, what drives it? Is it just NAND or do you think it’s DRAM?

Mark Dentinger – Chief Financial Officer

Well, it’s – for one thing, you’re bouncing off a fairly low number.

Krish Sankar – Bank of America Merrill Lynch

Okay.

Mark Dentinger – Chief Financial Officer

Yeah, so it’s – that’s part of it. And sooner or later they’re going to have to invest. But as it is right now, particularly the DRAM players have been kind of – been quiet, at least for us most of this year. And at some point they’ll get back onto the investment cycle, and we’re hoping to get our fair share.

Krish Sankar – Bank of America Merrill Lynch

So I mean, since you guys are more levered toward technology, whom do you think will be the first to come, DRAM or NAND?

Ed Lockwood – Head of Investor Relations

In what way?

Krish Sankar – Bank of America Merrill Lynch

In terms of spending, like you know?

Ed Lockwood – Head of Investor Relations

Oh.

Mark Dentinger – Chief Financial Officer

Well, NAND has been lumpy. They’ve had periods of time where they’ve – we’ve had pretty good quarters with NAND. DRAM has been down a little bit more. If DRAM gets pricing sorted out, I mean it looks like it’s bottoming out right now in terms of spot pricing. And you get a little bit of consolidation between LP to Hynix getting financing, and so on and so forth. Those conditions should improve the demand side and give these guys a little bit more confidence to begin to make capital investment. But not going to happen, I don’t think, in the next six weeks. But second half of the year it’s possible it could go up a little bit, but 2013 could be better.

Krish Sankar – Bank of America Merrill Lynch

Let me ask probably some more longer-term focused questions. You highlighted about this challenges like TSV. So if you look at the different technology and other inflections coming up for the industry of TSV, EUV, 450-millimeter down the road. Can you just tell us how KLA – how it impacts KLA in either direction, either from like a cost standpoint and then from a revenue opportunity standpoint down the road? And what are the challenges in getting to those levels?

Mark Dentinger – Chief Financial Officer

Well, the cost picture isn’t good. They’re all expensive, and consistent with prior technology shifts, you have to be investing far out in front. The closest thing we can see right now is probably 450-millimeter. We even, in our un-patterned inspection tool – we call it Surfscan. We’ve even got an order that’s either going to ship or revenue this quarter. I think it’s going to ship this quarter, a 450-millimeter base tool. And this tool is used to qualify incoming wafers to the manufacturer. So we would see this in advance. And we have to re-modify our handler line and so on and so forth. But generally speaking, most of these transition nodes should be pretty good for us. You do have to make a few assumptions. One is, is that inspection intensity is linear.

The second is, is that if you’ve got a bigger wafer that’s now going to be 2X-plus the size of the prior generation, and you’ve got linear inspection intensity, you’re going to have that many more – that much more process control that you’re going to have to throw to it. So we think it probably augers well for us, and probably better for us than maybe some of the other equipment manufacturers that tend to be more area based. But as with any transition, and I would use EUV as the test case here, when you try to figure out at this stage of the migration how expensive is it going to be to basically have tools ready when EUV hits in mass, if you will.

The number that initially rolls up is mind boggling. It’s just staggering in terms of the amount of R&D you have. But the problem is, right now, it’s an unconstrained question to our development team. So as constraints get built in, as they get clear about exactly what the requirements are, and as the customers come to us and say, look you got to be able to have a tool that does this, we need X amount of throughput, so on and so forth. As that happens, the R&D number tends to shrink over time. But this pattern has repeated itself numerous times in our corporate history where, again, the walk-in number initially from the lab is just beyond our wildest imagination. Has people wondering, well, will people – will your customers co-invest? Will there have to be some other means that a consortium has to pull together?

All of those things turn out to be somewhat true in this thing. But at the end of the day, we wind up usually constraining the problem down, investing far in advance of it. And if you’ve got the right products and the products work out of the gate, when the technology hits, you’re in a position to – you’re really in a position to take advantage of it economically. Thus the performance in terms of gross margins, and so on and so forth. But it’s no different today than I think it has been before, but the numbers are bigger and the bets are bigger.

Krish Sankar – Bank of America Merrill Lynch

And then for – in terms of EUV, when you look at EUV, it’s like the first time it will all be done in vacuum, so it brings a lot of more challenges. But the flip side of the argument is you have fewer mask sets, so probably that helps in the defectivity side. So have you guys ever done any quantification of the incremental opportunity for you guys when the industry moves to EUV? Or is it too early to figure it out?

Mark Dentinger – Chief Financial Officer

We’d attempt to, but there is too many variables. And again, we generally think it’s probably good for us, because the migration will introduce its own set of new problems, things that we haven’t even imagined yet. But to try to constrain it and try to quantify it, especially when you’re thinking multiple years out in advance when it gets here, again, in math, it’s an educated guess at best, and I wouldn’t want to share it.

Krish Sankar – Bank of America Merrill Lynch

And then for 450-millimeter, right, when you go and look at it longer-term, clearly every equipment guy has to probably put incremental R&D spend into it. So how do we think about it like is this going to be R&D as a percentage of sales and you’re going to invest opportunistically? Or could it become a scenario where it becomes like time to have to invest for EUV, same way all the equipment guys have to invest to for 450, irrespective of what the cycle is doing at that point? So how do you think about R&D going forward?

Mark Dentinger – Chief Financial Officer

We’re likely to invest regardless of where the cycle is. That’s probably our mindset moving into our next fiscal year, which starts in July, and I presume it will be true in 2013. Unless we wind up facing some sort of a stall cycle like we saw in '08, where the financing markets just freeze for a period of time and whatnot, our mindset right now is, is just that we’re likely to have to continue the research and development. And it will get bigger in absolute dollars between now and over probably the next six to eight quarters to deal with these technologies.

And therefore our operating expenses may behave independently of what our top line and gross margins are doing. And the reason we say that is, is that you just have to be there when the next generation of technology gets pulled. Now that’s our mindset and we can afford to do it. When you have 55%, 60% gross margins, you can afford to do it in most revenue scenarios. And we’ve got a lot of cash that is designed obviously to buffer us through that. But it’s the mindset right now, could change obviously, but I suspect that’s what’s going to happen in 2013. You’ll see our research and development numbers continue to increase.

Krish Sankar – Bank of America Merrill Lynch

Is that a mindset you’re seeing across the industry, whether it’s applied to Intel or do you think – or even if it’s like a smaller company? They feel like they have to do plenty of the R&D at this point irrespective of their size, or else they’re going to lose out in like opportunity five, 10 years down the road?

Mark Dentinger – Chief Financial Officer

I don’t know what the – I don’t know what the investment perspective/mindset is of some of the other companies, but I would think that the companies that are in a dominant portion of their space right now have to believe that they have to be on the leading edge of R&D. That is what has distinguished the market leaders for a long period of time, and I can’t imagine – I can’t speak for Applied – I just can’t imagine that they aren’t thinking the same way. You just – you couldn’t afford to lose out to somebody else who makes the investment and then runs the space for a period of time, and you basically miss a transition. And I think our customers basically understand that as part of our model, and they on one level tolerate our profitability because they understand we’ve got to invest far in advance of it. So there’s a symbiotic relationship, and at some level if we couldn’t afford to do that, it would be the customer’s problem. So…

Krish Sankar – Bank of America Merrill Lynch

And are you seeing – is there like a certain deadline, like by end of 2013, you had to have like a pilot line build up for this? Or are there any such deadlines? Is it just more like we’re going to start investing at some point, it’s all going to come together?

Mark Dentinger – Chief Financial Officer

No, every product group has its own set of product roadmaps with deliverables, and we’re in negotiations, or, negotiations – we’re in discussions with our customers about when we’re going to get certain trial phases, when we’re going to beta, when we’re going to alpha, so on and so forth. So there’s individual lines, and then we have, in the Chief Engineers Group, we’ve got somebody tracking how all of the products are moving down the line, because you’ve got to get the handlers ready before you’re going to be able to get to the next level of optical inspection ready, and so on and so forth.

So, there’s both a micro discussion occurring between individual product lines and what customers want in time, and there’s the macro strategy of making sure that we’re moving down the 450 path, if you will, in lockstep with each other. So that two – products don’t trip over each other. We’re ready with this, but something else is holding it up. So, it’s a complex process, but again the market sends you a pretty definitive signals. Unlike a lot of other industries, your customers send you very, very defined signals about what needs to be ready, when. You want to get to this node on this timing, particularly the big customers. They’re fairly defined about things. You got to be here on these things with these requirements, and so it is in that sense very much a joint effort.

Krish Sankar – Bank of America Merrill Lynch

And then from 450, like just one last question on the 450, when you guys are investing for the – like 5, 10 years down the road, it’s your view that there’re going to be really three customers or do you think more than three customers will be there?

Mark Dentinger – Chief Financial Officer

Well, if you were to just to follow the curve, maybe there’d only be one, right? I mean if you just did what they – the way that the industry is consolidated. But that’s an unlikely outcome, too, and it’s always hard to see the next formation of a GlobalFoundries, or it’s always hard to see who else may come into the business. But advanced semiconductor manufacturing is one of the few places a lot of the technology companies that are already in this business at some level can go for real growth. I think it’s what forced Samsung into it; it’s what would have some of the other companies looking into it.

It’s unlikely that some – that the rest of the players who are in a position to potentially come into this business are just going to cede it to somebody else in saying, well, it’s just too big and too complex. There’s real growth there these days. Companies that are already in this business are going to take a hard look at getting into it. Do I see 15 players or 20 players? Absolutely not. But I would be surprised if it shrinks down to just one or two. So that’s a convoluted answer that doesn’t really answer it on point. But I would say that there’s enough money in it probably where there will be an oligopoly-like environment.

Krish Sankar – Bank of America Merrill Lynch

Got you. See, if there is any other questions in the audience. Did you find one?

Question-and-Answer Session

Unidentified Analyst

Great, thank you very much. So just a first question should be the long-term acumen order outlook? So for instance, the last fiscal year your revenue hit the record high at over $3 billion, but the growth was driven by memory or NAND flash or logic area. And then what could be the growth driving forces for the next two or three years continuously? Maybe NAND flash or maybe application process to logic area and then I have some other questions.

Mark Dentinger

Yeah, so you’re asking what was the – what were the growth components for last year and what will lead us into the future?

Unidentified Analyst

For next?

Mark Dentinger

Yeah, so if we go back to the 2007 boom that was pretty much – that was a memory-led boom, and this has clearly been foundry. Foundry is much, much stronger in this up-cycle since the mid-2009 on. Going forward, we suspect the foundries are still going to continue to be a big piece of the equation. Logic will always be there at some level, with hopefully multiple players involved. Memory will come back at some point; they can’t afford to sit out forever. And although NAND is choppy, it too has a lot of – the long-term growth prospects for NAND are pretty good, given the evolution of pads and phones. So I don’t know exactly what the mix is going to be, but it’s hard to believe there’s going to be a massive tectonic shift in the distribution of what we’re currently seeing. And part of it is, is that because capital intensity in general in the foundry business may be just higher going forward then it’s been in the past. And then it’s a question of how the economics get distributed.

Unidentified Analyst

And then maybe my second question is, these days Qualcomm, Samsung, they are really emphasizing one-chip solution, more integrated chip, baseband plus, application process chip, even plus the memory chip. In that case, front-end versus the back-end, which inspection, defect inspection, could be more important going forward? And then maybe in two or three years, I’m sure that the 3D coming and also the TSV also coming. So in that case, again, the front versus back-end inspection, which way is more important?

Mark Dentinger

Yeah, it’s a good question. I’m not absolutely certain where it would be in the future, but your – I’m drawing the inference from your question that you think more back-end inspection is going to be required, and that’s possible, that is possible. We do have a play in back-end inspection. It’s not as deep as our play obviously on the front-end. But it is possible that that could evolve that way, if in the basic design of the chip and the integration into the unit, it’s more hard-wired, if you will, than has historically been. So, it’s a possibility, sure.

Unidentified Analyst

Maybe one last question is, when I discuss whether some back-end or testing of some of the companies, particularly for Samsung or Qualcomm, they are saying that the wafer-level testing or inspection is getting more important rather than individual chip basis, because individual chip means it takes more time, longer time. So what could be the overall trend for the testing or back-end inspection plus as wafer level is more important or...

Mark Dentinger

I don’t know, that would be a good trend for us if that were true. Because both un-patterned and patterned wafer inspection is a sweet spot for us, so that wouldn’t bother us at all if that turned out to be the case, yeah.

Unidentified Analyst

Okay, great. Thanks.

Unidentified Analyst

I understand that you guys probably have frequent conversations with your customers like the TSMCs, the GlobalFoundries, the Samsung's, do you guys have frequent conversations with the fab – your customers or either fabless guys? Or have you seen any interest from their end to engage you in conversation, after all the yield issue?

Mark Dentinger

Yes. But I wouldn’t want to talk about specific customers. But yeah, but they’re increasingly curious about what’s happening in their manufacturing processes, and they understand that the company that’s hired to go find the defects becomes very, very important in understanding what their – what the yield challenge is and how well the units are working. So the answer is sure, we hear from them once in a while.

Unidentified Analyst

And I don’t want to know the details of the conversation, but just trying to get a sense of – is it more like to try to understand what the challenges are where you are heading? Or do you think it’s more like just to keep and check the supply to make sure that they’re being priced the right way?

Mark Dentinger

It’s probably a little bit of both, but I would say more the former than the latter. I think that the economics of this industry are fairly visible to people, especially if you’re on the inside of it, who’s drawing what. It’s a small community when you get right down to it. But what’s happening in the fabs, and what that means in terms of the inference, in terms of how they enter into the arrangements with their production companies and what not, all of those questions are very, very curious to them. And obviously it affects their economics deeply. So the answer is yes, they’re asking a lot of questions about that, sure. But I don’t know if it’s any more now than three years ago.

Unidentified Analyst

Okay. And then in terms of, if you look at the challenges that’s going on for the fabless guys and on the supply side, I don’t know if you guys are the right persons to ask, but I’m just kind of curious, on the back-end testing side, the fabless guys actually purchase test equipment and put it at the old fabs as a consignment kind of an approach. Do you think they’d ever do that at the front-end? You want me to take a crack at that?

Ed Lockwood

Yeah.

Mark Dentinger

Maybe, but I think it’s a way off, if it’s going to happen. The front-end guys are much better capitalized than the back-end guy.

Unidentified Analyst

Okay.

Mark Dentinger

As a general rule, the back-end market’s just much, much smaller. So that’s a question of who’s in the best position to finance the deal. And I just suspect right now, again, if you look at the big players here – are much better capitalized. And we would – we do have some interest in keeping a very tight linkage between us and our customers in terms of ownage and all this sort of stuff. It does add other complexities like revenue recognition, cash flow, credit worthiness, and who’s bearing all of that respect. And generally speaking, I think that the front-end guys are just much bigger. So it’s a ways off if it’s going to happen.

Krish Sankar – Bank of America Merrill Lynch

Alright.

Unidentified Analyst

Maybe, I think Krish already mentioned that the -- we need to make us need high-k/metal gate first or gate last, and also the EUV may be coming. But the question is, already existing wafer inspection tours, is it okay to use – to be used continuously particularly for the high-k/metal era rather than the polysilicon era? I think the inflection point for the logic chip for foundry area, all the chipmakers now implementing 2X node, using totally different metals. But the question is whether your tools can cover these kind of new materials for the chip manufacturing process?

Mark Dentinger

Is it a question about how our tools are being deployed on the leading edge?

Unidentified Analyst

No. My question is TSMC – Samsung claims they have already inspection tools.

Mark Dentinger

Yeah.

Unidentified Analyst

But they are implementing 32 node high-k/metal and then they are also implementing 2X node high-k/metal rather than traditional polysilicon type. So in that case, do they need new inspection tools or just okay with already existing?

Mark Dentinger

Yeah, part of the problem is you’re asking a customer specific question. I want to try to steer a little clear.

Unidentified Analyst

Maybe try something...

Mark Dentinger

The answer is, is that in some cases the inspection challenges are different, but that doesn’t necessarily mean that they don’t – that we don’t have other tools that they may be interested in to solve their inspection need. So I’ll leave it as a general answer like that. You can tell from our published data that they’re still buying a lot of tools.

Unidentified Analyst

Well, maybe other way we can say, as long as chip size becomes smaller, definitely we need more advanced immersion tools from KrF, ArF, obviously double patterning, and then EUV coming. But why do your chipmakers need more advanced inspection tools? What kind of technologies will lead more advanced inspection tools? Or maybe how about if we use continuously currently available tools rather than upgrading?

Ed Lockwood

I think one way to approach this answer is to look at the fact that with each successive generation, with the introduction of these new types of complexities, these new types of architectures, it typically requires us to have a specific new flavor of the tool. So the answer is, no, you can’t substitute a prior generation tool that works in node-specific applications for these next generation needs. The tools have to be specifically tuned or specifically focused on those applications.

And in our customer collaboration effort, we’re working two generations ahead with our customers to help anticipate those needs. And frankly one of the adoption drivers that’s helping to drive growth in our core markets is coming from the fact that these, the implementation of things like high-k/metal gates is requiring a new tool set in order to make that adoption.

Mark Dentinger

Now we do sell upgrade kits and whatnot to deal with specific problems. So we do build off of one platform. We will build upgrade options that allow them to attack different types of problems. But that’s basically on a basic platform. You’re talking about a platform leap. It’s really, basically you need to move platforms over time and get new tools in to do that. Now I understand your questions, yeah. Okay?

Unidentified Analyst

I definitely wanted ask a question on the competition. And very specifically when you look at like your big picture sample like vertical and the inspection side, that's bit of applied want to find how that is going on? And then as you keep coming down like the market size, there is definitely the 3D coming up more and more. There are some backend free inspection companies, like there’s a guy in Korea called Korean, which is a much smaller market, but like they’re doing pretty well there. And then all the way down to E-beam inspections, a much smaller market, but you keep hearing every once in a while about this Taiwanese company Hermes that keeps popping up every now and then. And it’s a smaller market, but they seem to be gaining share. So just want to find out your thoughts on like from the big to the small market, how you guys are doing and what’s going on?

Ed Lockwood

From a competitive point of view, I mean, I think that the most obvious, and I think the most significant impact that you can see in terms of driving share gain for KLA, and if you look at the Gartner data I’ll reference that. Share grew from 52% to 56% in calendar 2011. And frankly that didn’t incorporate what I’m about to talk about, which is a very strong competitive position we have with our latest brightfield tool. We only started booking this next-generation brightfield tool in the December quarter. So it’s not going to show up in the revenue – in the industry revenue numbers until this year. But I can tell you that the market feedback in terms of customer adoption of this tool versus Applied Materials has been very strong. It’s stronger than we have seen in a very long time, and this is in brightfield, which is one of our core markets.

And in metrology, you talked about 3D structures, you talked about overlay, advanced patterning, our metrology business is operating at record levels. I talked a little bit about what one of the drivers of that being that it’s becoming more of a technology tool and less of a capacity tool now. And it’s also moving more towards where we can differentiate on technology, which is helping to drive adoption and also helping to drive strong financial performance for us in those markets.

I think across the board, the trend towards increasing complexity really favors KLA. I mean, we have the market presence, we have the customer collaboration that gives us a two-generation lead in helping to understand what our customer needs are and that’s – and we’re also executing well in terms of meeting those specs. And I think that that’s going to be borne out as we move through the cycle. I think we’re going to see the share trends continue to be strong, and as these new technologies are introduced, it’s another opportunity for us to really sort of maintain if not strengthen our position.

Mark Dentinger

And with all of that said, Hermes is a viable competitor in E-beam inspection.

Unidentified Analyst

Okay.

Mark Dentinger

Yeah, they’re legit.

Unidentified Analyst

Got it. And in terms of more of shorter term question, your March orders came towards the lower end, and then you gave a certain guidance for June. I mean, it’s still like March plus June seem to be within the original range people had in mind. But generally June is always seasonality favors June quarter. Is there any reason to think this June will be different?

Mark Dentinger

Yeah, well, we can update guidance here. So we’ll stick with the original guidance. Historically, it’s been a little bit stronger, but that’s probably just the cycle time and the buying at the end of our fiscal year. It may line-up a little bit better with the capital procurement cycles of the customers, but we factored that in when we issued the guidance. So I mean, there’s no change to the guidance now. So, I would say at this point, we think that June will shape up just like Junes in the past have shaped up, which historically have been a little bit stronger.

Unidentified Analyst

And in terms of your backlog, you clearly have like $1 billion-plus, $1.2 billion-plus in backlog. And let’s assume a scenario where maybe things do slow-off in the back half of the year. How do you think about the backlog and like is there – do you guys always like to maintain a certain amount or is it more like – how does that roll-off?

Mark Dentinger

Yeah, it’s a popular question. I think it’s a little understood. We don’t actually set out to try to actually maintain a certain level of backlog. It turns out just to be the arithmetic function of the fact that there is a certain amount of incoming orders that takes us a while to build and ship the tools and it takes us another step because of our pretty conservative revenue recognition policy to get the tools signed off. So backlog is just a function of how fast the orders are coming in versus how fast we can ship them. And it’s tough to work it down when you’re booking $800 million to $900 million a quarter because our manufacturing capacity is probably at that level. So, we just can’t push a lot more through at this level.

I presume, if the orders were, the order book were to trail off, we would be able to work it down some, but we’re in no temp – we are in no sense right now trying to hold up, keep the backlog maintained as some sort of function to the future – future outlook. We’re trying to move the tools as fast as we can, and frankly we got customers calling us daily saying, reminding us that that would be a good idea. So I mean, we’re doing everything we can to get them out. So there’s no targeted level of trying to get that done. It just happens to be a byproduct of the fact that our cycle times tend to be three to six months to produce and another two to three months to revenue.

Unidentified Analyst

Got you.

Krish Sankar – Bank of America Merrill Lynch

Just to follow up on that, what does it mean for the shipment profile for second half? And are you sort of maxed out, and you’re saying that it flattens out from here? Or how should I think about it?

Mark Dentinger

Yeah, well, I can tell you what the capacity is probably, including services, is probably something short of $1 billion. We think the natural capacity is probably $900 million-ish or so. It’s possible, depending on the mix of products; we could ship more than that in a particular quarter. But that gets out to about as big as it’s been historically. And we may even press that this quarter. That’s the maximum we can ship. So if we wind up with a strong booking quarter in our second fiscal quarter, the June quarter and what not, that means we’re going to have to continue to ship pretty aggressively for the second half of calendar 2012. That’s easiest way to think about it. And we’ll do it as fast as we can.

Krish Sankar – Bank of America Merrill Lynch

So thank you very much, and I think we’re out of time.

Ed Lockwood – Head of Investor Relations

Thanks, Krish. Thanks, everybody.

Krish Sankar – Bank of America Merrill Lynch

Thanks, Mark.

Mark Dentinger – Chief Financial Officer

All right. Thanks, Krish.

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