KLA-Tencor F2Q06 (Qtr Ending Dec 31, 2005) Earnings Conference Call Transcript (KLAC)

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 |  About: KLA-Tencor Corporation (KLAC)
by: SA Transcripts

KLA-Tencor (NASDAQ:KLAC)

Q2 2006 Earnings Conference Call

January 26th 2006, 5:00 PM.

Executives:

John Kispert, President and Chief Operating Officer

Rick Wallace, Chief Executive Officer

Jeff Hall, Chief Financial Officer

Analysts:

Suresh Balaraman, ThinkEquity

Edward White, Lehman Brothers

Timothy Arcuri, Citigroup

Bill Lu, Piper Jaffray

John Pitzer, Credit Suisse First Boston

Brett Hodess, Merrill Lynch

Steve O'Rourke, Deutsche Bank

Raj Seth, SG Cowen

Robert Maire, Needham & Company

Jay Deahna, JP Morgan

Ben Pang, Prudential Equity

Shekhar Pramanick, Moors & Cabot

Michael O'Brien, Bear Stearns

Timm Schulze-Melander, Morgan Stanley

Steven Paleyo, Soleil

Ray Kukragia, WR Habmrecht

Gary Shway, CIBC World Markets

Stuart Muter, RBC Capital Markets

David Duley, Merriman

Bill Ong, American Technology

Mark Fitzgerald, Banc of America Securities

Philip Lee, JP Morgan

Operator

At this time I would like to welcome everyone to the KLA-Tencor Corporation Q2 2006 earnings conference call. Operator Instructions I would like to turn the conference over to Mr. John Kispert, President and Chief Operating Officer. Please go ahead, sir.

John Kispert, President and Chief Operating Officer

Thanks. Good afternoon and welcome to KLA-Tencor's second quarter fiscal year 2006 earnings conference call. Again I'm John Kispert. Joining me on our call today is Rick Wallace, our CEO and Jeff Hall, our CFO. We're here today to discuss our fist quarter results for the period ended December 31, 2005. We released these results this afternoon at 1:15 p.m. Pacific time. If you haven't seen the release you can find a copy at 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 specific progress and strategy. Afterwards, Jeff will review the financial results for our second quarter and then we will open up the call for questions until 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 two weeks. On the website you will also find a calendar for investor events and presentations at investor conferences. You will also find links to KLA-Tencor's securities filings. In those filings you will find descriptions of risk factors that can impact our future results. As you know, our future results are subject to risk. And any forward-looking statements we make are subject to those risks. KLA-Tencor cannot guarantee that those forward looking comments can come through. And although we take on no obligation to update those forward-looking statements you can be assured that any updates we do make will be broadly disseminated and available over the web. With that, I will turn it over to Rick.

Rick Wallace, Chief Executive Officer

Thank you, John and thank you for joining our second quarter FY '06 earnings call. Today I will be talking to you about the current environment and our outlook for 2006, an update on KLA-Tencor products, the financial highlights for the December quarter and our guidance for the March quarter. Jeff Hall will then take you through the details of December results and then we will take your questions. 2005 saw a bottoming of orders for semiconductor capital equipment in the March and June quarters with strong growth re-established in December. KLA-Tencor revenue grew in 2005 in spite of the decrease in capital spending by semiconductor fabs. Our customers continued to invest in process control to speed their yield learning on 90-nanometer and ensure the qualification of next generation 65-nanometer fabs.

The outlook for 2006 is even brighter. Semiconductor revenues are expected to grow a little faster in 2006 than the 7% growth of 2005. Most forecasts are in the range of 8 to 10% growth per semi revenues. While capital expenditures decreased in 2005, we expect them to grow in the range of 5 to 10% in 2006. The drivers for growth continue to be the transition to new 300-millimeter fabs, the growth of consumer electronics and the 200% bit growth of NAND. Memory was the strongest segment in the December quarter with significant NAND flash spending. But for the year as a whole, both memory and logic were above their long-term averages in 2005. Foundry was the lowest segment in 2005 at 24% of bookings but increased to 30% in December. While foundry increased orders from the low point of June, they are still below their average and we would expect them to increase orders as we go through 2006.

Although most of the increase in booking comes from additions to current manufacturing capacities, our new tools are having great acceptance in 65-nanometer fabs where the yield learning challenges are the greatest. Our 2800 Brightfield inspection tool has won awards, head-to-head comparisons with competitive tools, orders, and repeat orders in 65-nanometer fabs. With its superior performance in capturing all types of defect, the 2800 is becoming the standard tool for yield learning at 65-nanometer. Our Puma 9000 darkfield inspection tool has demonstrated the highest defect capture at the highest throughputs, D-RAM, flash, and logic manufacturers all ordered Puma tools this quarter for their 90-nanometer manufacturing fabs as well as 65-nanometer yield learning.

Measurement of critical dimensions at 65-nanometers is a major yield challenge for our customers as they need to make more measurements to control the shrinking lithography process window and they need to make new types of measurements such as image profiles. Our Spectra CD optical CD tool is finding increased adoption in 65-nanometer fabs as it makes all the measurements required at higher speeds and lower cost per measurement. Our E-beam based ECD 2 is also increasing its adoption at 65-nanometer as it provides better productivity through automation and matching and better measurements on difficult to measure structures. Staying on Moore's Law presents many technical and financial challenges to our customers and as 2006 proceeds, those challenges will start to come from 45-nanometer. We have been investing in the development of a complete suite of inspection and measurement products for 45-nanometers and we will introduce many of them in the first half of 2006.

Now turning to the financial highlights for the December quarter. Our net orders were 513 million, up 17% from September. Revenue of $488 million was up $4 million from last quarter. Net income was $102 million or $0.50 per diluted share excluding non-cash equity based compensations. Including equity compensation net income was $77 million or $0.38 per diluted share. The same as the September quarter. Orders grew in December as our customers increased their investment in process control for leading edge capacity ramps and for yield learning at 65-nanometer.

Looking ahead to the March quarter our guidance is as follows. Bookings in the range of up 15% plus or minus 10%. Revenue to be between 500 million and $510 million. And EPS in the range of $0.54 to $0.57 per share. Now Jeff will provide the details for bridging this operating EPS to GAAP EPS. We look forward to a second quarter of strong growth in our business. Our customers have been investing prudently in capacity over the last year. Fab utilization is at very high levels and customers have near term and strategic needs for increased 300-millimeter manufacturing capacity. Process control continues to be a growing part of their investment. Now I will turn the call over to Jeff Hall.

Jeff Hall, Chief Financial Officer

Thank you, Rick. As Rick discussed, we are seeing an increasing level of bookings as our customers ramp 60-nanometer production capacity and 65-nanometer yield learning. As a result of this increasing demand from our customers we have begun to increase our production levels after three flat quarters.

Turning to the quarter, let me remind you that we implemented FAS 123R in the September quarter and therefore the results we announced earlier today reflect the expensing of share based compensation. As you know, the implementation of FAS 123R impacts our financial statements in numerous ways. Which means current GAAP results are not comparable to those of previous years. Therefore consistent with the current Last Call I will focus my comments on the operating P&L, that is excluding share base compensation. And I will then discuss the impact share base compensation had on those results. We believe this approach best meets the needs of investors and analysts for comprehensive, compliant, and comparable data.

As Rick mentioned, net bookings for the December ending quarter were 513 million which is roughly 17% higher than the September ending quarter and 7% higher than one year ago. This number also includes $4.7 million of orders that have been debooked in accordance with our booking policy that restricts actual booking to a set criteria. The set criteria mandates that technical specifications are signed off. Valid terms and conditions are finalized and delivery is scheduled within 12 months.

We ended the quarter with approximately $755 million worth of backlog for unshipped orders. Remember, we do not include any service, consignment, or unreleased systems in this backlog number. This order of order backlog allows us to smooth our factory utilization and provide predictable execution from our supply chain. In addition, we have $412 million of deferred revenue that is related to products that have been shipped but not signed off by customers. This is invoiced systems revenue deferred under SAB 104. It includes no service revenue and is made up of tools delivered but awaiting written acceptance from the customer. We remain confident that we have a strong backlog shippable over the next six to nine months and our ability to maintain this significant level of both shipment and revenue backlog continues to help KLA-Tencor sustain profitability throughout any business cycle.

The regional distribution of orders for the December quarter was as follows. The U.S. was 17%. Lower than its historical average of 25%. Taiwan was 18%, lower than its historical average of 20%. Korea, China, and Singapore combined were 32%, higher than their historical average of 20%. Europe was 12%. Lower than its historical average of 15%. And Japan was 21%. Slightly higher than its historical average of 20%. The product distribution of orders was, wafer inspection was approximately 45%. Reticle inspection was 23%. Metrology was 13%. Data storage was 2% and service was 17%.

Turning to the income statement, revenue for the quarter was 488 million. Up about 1% quarter to quarter and down 8% from the same quarter last year. Gross margin was 56.9% for the quarter compared to 57.1% in the prior quarter. Operating expenses including both SG&A and R&D were 165 million. This expense level was up 2% quarter to quarter consistent with our forecast. This reflects our discipline in maintaining a balanced cost structure while we continue to focus on investing in new engineering programs and increasing application support of 300-millimeter ramps around the world. For the quarter, other income was $16.7 million and the effective tax rate was 21.8%. For FY '06 we anticipate that our tax rate will continue to be approximately 20%, plus or minus a few points depending on the renewal of the R&D tax credit and the resolution of various tax audits currently underway in multiple jurisdictions around the world. Net income for the December quarter was 102.5 million or $0.50 per diluted share.

The impact of non-cash equity based compensation reduces this number by $0.12 per share and the approximate breakout is as follows. Cost of goods sold, $0.03. R&D $0.06. SG&A $0.08 and there was a tax benefit of o$0.05. In the March quarter we expect ongoing expense for share based compensation to also be about $0.12 the same as it has been for the last five years. We also expect to have an additional $0.03 to $0.04 of share based compensation as a one-time charge related to the retirement of our prior CEO.

Turning to the balance sheet, cash and investments ended the quarter at 2.2 billion an increase of 44 million quarter to quarter. During the quarter, we repurchased stock valued at approximately 49 million and paid a dividend of 24 million. Inventory increased by 16 million to 412 million. This inventory growth can be attributed to increases in raw materials and work in process as we began to significantly ramp our production facilities during the quarter. Accounts receivable finished the quarter at 372 million, up 65 million from September. The increase from the previous quarter is attributable to higher revenue in Japan where normal payment terms are longer than in other regions. Capital additions related to fixed assets were approximately 18 million for the quarter. And depreciation was 13 million. So on a net basis including retirements, fixed asset increased by 5 million over the quarter. Head count ended the December quarter at 5570. Up 130 from September, mostly to support our production increases, field support, and new product introductions.

In summary, we have had flat shipments in revenue over the past three quarters and are just now starting to increase production and shipment. And as a result of our backlog management we have been able to continue to fund our advanced development projects. So as revenue increases we will be able to keep our operating expenses near current levels, creating strong incremental margins going forward.

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

Questions & Answers

Operator

Yes, sir. Operator Instructions Your first question from Suresh Balaraman with ThinkEquity.

Q - Suresh Balaraman

Rick, you talked about the industry growth at 5 to 10% for CapEx. Any thoughts on how the PBC segment should grow in 2006? Thanks.

A - Rick Wallace

Yes. What we see in 2005, let's start with that, process control, KLA-Tencor grew at about 6% and the industry was down 4%. We think that trend of continuing to see growth expansion as a percent of the total capital will continue and our estimates now is that KT and process control should be able to grow at about 5% faster than industry CapEx. So if we end up at 8%, of course that would put us at 13, anywhere 13 to 15%.

Operator

Your next question comes from Edward White with Lehman Brothers.

Q - Edward White

Hi, was wondering if you could characterize the customer climate right now? Clearly a better environment than we have seen during the early part of last year. But as you look at their plans and what they are trying to do, how would you characterize the environment to give some sense as to sustainability?

A - Rick Wallace

Hi, Ed, thanks for the question. I think that the customers are -- have been very I guess cautious, prudent in their investments. But now are more optimistic than they have been in sometime and we are seeing that reflecting in the order activity. I would say that they are more positive. We do see the right kind of discussions happening. If you go back nine months the discussions were about capital expense and operate expense and now it's more about slots and support and how we can get tools to meet their needs. I think it's gotten more positive and we expect that to go on for sometime. Generally at this phase of the ramp, this is pretty early in a ramp and especially one that has had such modest investment levels coming off of modest investment and plus you have got high capital -- high utilization going on, now too. So pretty positive and pretty much across the board. The one area that hasn't really turned on or we don't forecast turning on is foundries which have been below their historical average.

Q - Edward White

Thank you.

Operator

Your next question comes from Timothy Arcuri with Citigroup.

Q - Timothy Arcuri

Hi, actually I had two quick things. Number one, can you tell us what the shipments were and can you guide shipments? Thanks.

A - Rick Wallace

The shipments for the quarter were 450 and looking forward, looking for 530 in the next quarter.

Q - Timothy Arcuri

Okay. And then last thing for me, you gave us the orders by foundry, you said that 30% of the bookings were foundry can you complete that and give us what the percent for logic and also memory. Thanks. And if you can break memory out by D-RAM and flash possibly.

A - Rick Wallace

Yes. Sure.. So we said that we had about 28% of logic. Foundry was about 30% and memory was at 42 and about 50% of the memory business was NAND.

Q - Timothy Arcuri

Great. Thanks.

Operator

Your next question comes from Bill Lu with Piper Jaffray.

Q - Bill Lu

Congrats on a nice quarter. Just a quick question. The midpoint of the guidance puts you at 590 for bookings next quarter or for this current quarter. Assuming that it stays about that level or above, how would revenue trend for the rest of this year?

A - John Kispert

Bill, John Kispert. Tough to tell. Obviously it goes up. With SAB nowadays it's when the customers actually sign off on it and as you know we have a lot of systems out there that need to get signed off. We have a lot of new product introductions that we've shipped that are still in our inventory too that will get signed off. I would say it's going to get higher as you get out into the June quarter. Again, difficult to tell exactly how much higher until we get actually into the quarter and we are talking to customers about what they are going to accept.

Q - Bill Lu

So if I compare the shipment to revenue conversion rate now versus a year or two years ago it would be about the same?

A - John Kispert

Shipment to revenue conversion rate, I'm not sure exactly what that means, Bill.

Q - Bill Lu

Just acceptance I guess, SAB 101 acceptance.

A - John Kispert

Yes. My point is I think it's difficult to draw on anything historic in this environment. We've shipped a lot more out there the last couple of quarters than you normally would in a flatter period like this. Some of this stuff is going to get signed off. I don't know if it's the June quarter or the following quarter in September is the answer and I don't know how to give you an algorithm to close on to.

Q - Bill Lu

Okay. Thanks a lot.

A - John Kispert

Other than I think it will be higher than the run rate we just gave you.

Q - Bill Lu

Got it.

Operator

Your next question comes from John Pitzer with Credit Suisse First Boston.

Q - John Pitzer

Good afternoon, guys. A couple of questions. First, when you start looking at bookings numbers at these levels, this plus or minor 10% variance you put in your guidance is really now starting to become meaningful numbers. I think if you look at the guidance for March the difference between the high and the low end is about 130 million. Is there really that much variance in your business today or can you help us understand why you are giving such a wide range on that and then I have a quick follow-up.

A - John Kispert

Hey, John, John Kispert. It's really about a $60 million range the way I look at it. We told you 15%. If I just off the top of my head guess -- think about the number of opportunities we have for this quarter, I can think of four to maybe five opportunities that are well over $60 million. So the orders are much bigger in this environment. Why? Because there are more capacity buys at 300-millimeter. As we've talked about many times before we hate putting the Company at risk as far as trying pull in orders in the quarter to make a number. We feel real confident with the 15% and we see more upside than downside at this point. But 15% moving up from there is probably the best way to think about it.

Q - John Pitzer

Great. And then quickly, guys, typically you tend to weather the downturns better in the process equipment group but because of that you tend to undergrow sort of trough to peak. Help me understand what kind of alpha you guys might have to bridge that gap this time as the process equipment space begins to heat up.

A - John Kispert

Yes, I think there's two things and it's really the maturation of process control over the last five to ten years. Our adoption in production environments is much higher than what was, let's say in the four or five years ago. That is there's more inspection, more metrology per wafer per die. So that certainly will help us. The second piece that we've talked a lot about in the prior conference calls is our shipment level has been higher as we put out a lot of new products. And these are products we haven't announced yet. Over the next couple of quarters moving into Semicon West there will be more product introductions from KLA-Tencor around metrology and wafer inspection and a lot of those tools have been shipped already and so those -- and they're in our inventory right now. They are not in orders or revenue and those will turn on us to Bill's prior question too and that will certainly help growth on the high end.

Q - John Pitzer

Thanks, guys.

Operator

Your next question comes from Brett Hodess with Merrill Lynch.

Q - Brett Hodess

Good afternoon. Given the bookings and the shipment trends, it's pretty clear that you are going to go over your revenue peak from the last upturn. And in conjunction with that, with the rationalization you have been doing in your product platforms and whatnot, where are margins going to go? Last time we hit the peak it was like over 59% and it looks like you are going to be able to gain a lot of leverage. Can you talk a little bit about how we are supposed to model margins as we move into this upturn.

A - Jeff Hall

This is Jeff. Our business model still holds. As we grow revenue and shipments into this upturn we are going to continue to deliver 60 to 70% incremental gross margins. We are going to start to see cycle times come down by 20 to 30% here pretty quickly, cost across our supply train start to drop, our support costs per unit fall, and that drives us into the 60 to 70% that we continue to drive all of our businesses to.

Q - Brett Hodess

So given that, that says that where the revenue rates are likely to go to that you will pass through the 60% gross margin mark this year?

A - John Kispert

Brett, it all depends on obviously the top line. I mean, I don't know what you have in your modeling for our top line, but Jeff's point is whatever the top line is, you can add from this point going forward roughly 60 to 70% roughly incremental gross margin.

Operator

Your next question comes from Steve O'Rourke with Deutsche Bank.

Q - Steve O’Rourke

Good afternoon. Thanks for taking my question. I think you had commented that Taiwan is still pretty weak. Can you help us understand from your perspective what's going on with the foundries right now. I mean, TS&C this morning mentioned they were at 104% utilization. It seems like you should be seeing orders coming from this region.

A - Jeff Hall

It's a great question, Steve. We had 30% of our bookings last quarter were in foundry, but we said that that was below our historical average. And frankly in our March quarter we actually see it coming down from 30%. So they have been very cautious. The other factor with the foundries is we don't have a lot of visibility because they don't necessarily have a lot of visibility into their ordering pattern. And when they do order, they order big. So we are expecting sometime in 2006 that they are going to turn back on, but we are not modeling in the first quarter.

Q - Steve O’Rourke

Would this be one of these $60 million orders or so or is it bigger than that for KLA?

A - Jeff Hall

Well, it certainly wasn't in the 60 million I was referring to because it's not -- we don't see it there. But you'd have to ask them, Steve.

Q - Steve O’Rourke

Okay. Thank you.

Operator

Your next question comes from Raj Seth with SG Cowen.

Q - Raj Seth

You mentioned you see foundry mix in March coming down. Can you tell us what you think logic and memory do as well and maybe tell us where they go.

A - Jeff Hall

Sure. Yes, as I said, foundry is somewhere around 25%. I think logic is also going to be around 25% and we think memory is going to be strong. What we see right now is memory around 50% probably 30% of that will be NAND. So we do see some significant D-RAM spending also in the March quarter.

Q - Raj Seth

Okay, thanks. A follow-on if I might, today how much of your business is driven by 65 and I'm curious as you have gotten more experience at that node, what do you think your opportunity is per fab relative to 90-nanometers at 65?

A - Jeff Hall

Yes, sure, about 30% of our business is at 65 and below right now. And there is increasing opportunity as we look forward. John has actually worked on this model. John, you want to take that one?

A - John Kispert

We have talked a lot through the years about a 90-nanometer and we expected about $250 million opportunity for us per fab as each fab actually fills out and fills up which has taken longer over the last couple of years. When we model the same -- and granted it's early for 65-nanometer, we see it increasing for us by about 20% to about 300 million per fab. Again, it's on average fab logic, memory, and foundry. And it's still early obviously, Raj. We haven't done a 65-nanometer fab yet so it's hard to tell.

Q - Raj Seth

Okay. Great. Thanks.

Operator

Your next question comes from Robert Maire with Needham & Company.

Q - Robert Maire

Yes. As NAND flash becomes a larger percentage of your business, are there any particular requirements that are different for NAND flash that change the concentration of product to NAND flash manufacturers or makes them more apt to spend earlier. Some of them are obviously running some relatively aggressive design rules here. Are they more aggressive in spending for metrology and causes control upfront? Could you give us a little into that?

A - Rick Wallace

Sure. The NAND is a great example of Moore's Law, pushing people to advance design rules and also at the same time they've got this time to market challenge. So we do see aggressive spending in order to ramp up and they are pushing their design rules harder especially now. So it's more the design rule phenomena than it is anything about the NAND process design per se, but they are running at leading edge and they have a very aggressive time horizon so ramping quickly is a big challenge for them as they go forward.

Q - Robert Maire

Is there any equipment mix differential in NAND towards one type of product or another that is different than a logic or foundry that you see?

A - Rick Wallace

No, not for us. Again, it's more based on the fact they are pushing the design rules forward.

Q - Robert Maire

Thank you.

Operator

Your next question comes from Jay Deahna with JP Morgan.

Q - Jay Deahna

Two questions. The first one is, LAM gave a scenario of CapEx to be 7 to 10% up this year with wafer fab equipment up 15 to 17% and edge up more than that. The numbers you gave was process control compared to CapEx. Can you give us your sense as to where you see WFE versus CapEx and if process control can be above WFE?

A - Rick Wallace

Yes. I hear your question. We do think that process control is going to be above WFE in terms of modeling WFE at 15 to 17%. Boy, that would be great. I think that is a big number. But it's so far out. We are looking out. We can see margin gets a sense of what's going on in June, but beyond that it's pretty much speculation. Other than customer body language which as I said is positive.

Q - Jay Deahna

Rick, do you think that WFE though is higher than CapEx this year wherever it plays out because there is more equipment than bricks and mortar and then the second question that I had is do you think that the sequential growth rate in orders is likely to be higher in the second quarter calendar than it is in the first? And that's it for me.

A - Rick Wallace

Okay. I guess the first part of the question, I don't know. There is a lot of factors in there the test percentage that people are doing, different types of fabs. So not in a great position to talk about that. Second quarter what I can tell you is the June quarter for us has historically been stronger than the March quarter. And we don't see any reason why that that pattern would change this year.

Q - Jay Deahna

And you are referring to the growth rate and not the absolute level of bookings?

A - Rick Wallace

I'm referring to the absolute level of bookings, yes. Stronger June quarter. But obviously it depends -- we have this range and it depends where we end up inside of that range what kind of growth rate we see. But high utilization, a lot of customer confidence. So it feels pretty good.

Q - Jay Deahna

Thank you.

Operator

Your next question comes from Mark Fitzgerald with Bank of America Securities.

Q - Mark Fitzgerald

Can you give us some idea as you ramp to the 500 million level what's happened with R&D and SG&A expenses?

A - Rick Wallace

Sure. Jeff..

A - Jeff Hall

Yes, I got it. Because of our backlog management we have been able to keep our funding for new projects high. So we -- at 165 million we don't think we have to increase much, 2, 3% from here as we move forward.

Q - Jay Deahna

SG&A?

A - Jeff Hall

Same. SG&A in the same range, 75 to 80 million.

Operator

Your next question comes from Ben Pang with Prudential Equity.

Q - Ben Pang

Question, a follow-up on the foundry situation. Can you give a little bit more color about why their mix is different because they still are at 90-nanometer, they're also pushing 65-nanometer. Exactly why would their mix be different because it seems like they also don't, similar to Logic in terms of the metal layers and things like that. Why is it really -- why has it been lagging now for a little while? Thanks a lot.

A - Rick Wallace

If by mix you mean why aren't they spending as a larger percent of the total?

Q - Ben Pang

Correct.

A - Rick Wallace

I don't know. I guess you'd have to ask them. They have been very careful in terms of their spending and very prudent. So I think that -- you listen to them now and their utilizations are running very high. Don't know why they are not spending more but I suspect, as we said, we are going to see that happening in 2006 probably not in Q1. Probably after that.

Q - Ben Pang

Okay. Thank you.

Operator

Your next question comes from Shekhar Pramanick with Moors and Cabot.

Q - Shekhar Pramanick

Afternoon, Rick, could you talk about the reticle inspection business. Is that following the same cycle as wafer fab investment cycle given the tools are really high priced and would you be having some more newer tools? Any color you could give there about how the orders might look there?

A - Rick Wallace

Yes, Reticle Inspection, I guess I say high value. We do have high value tools in reticle Inspection and we are both dealing with more and more challenging designs, the lithography designs are really pushing the reticle technologies and that's driving our reticle business. Also we are seeing reticle business in the fab lines. So we have that expansion as well. It looks good and we think that reticle is a solid business going forward and we'll benefit from this cycle as well.

Q - Shekhar Pramanick

So is reticle inspection investment cycle is basically coinciding with WFE or is there some kind of a lag or any different pattern there or it's the same?

A - John Kispert

Hey, Shekhar, John Kispert, I think the interesting thing about the orders we have gotten over the last couple of quarters out of our reticle inspection business is they really are around -- more around 90-nanometer and 65-nanometer. Just a little bit in the 65-nanometer. It's still more capacity buying that's going on. And the bulk of 65-nanometer and 45-nanometer is still in front of us. And it's kind of -- to your point, I think your question is that you tend to see that start before you see the wafer, in our case the wafer inspection in metrology pick up after it, why? Because people are qualifying the reticles and preparing for a ramp. We haven't seen that really pick up yet at the 65 node.

Q - Shekhar Pramanick

Okay. Thanks.

Operator

Your next question comes from Michael O'Brien with Bear Stearns.

Q - Michael O’Brien

Hi, thanks. Maybe you could just talk a little bit about Japan, that has been relatively strong over the last year or so. Do you see the projects? Can you move forward there? And do you think your historical average goes up a bit as Japan tries to take a leadership position again?

A - Rick Wallace

Yes. We are modeling Japan that the March quarter somewhere around 20% and we finished at 21% last quarter and that is right at historical averages. It's lumpy. We do see projects moving forward there, we also have wafer manufacturing there and we've got reticle manufacturing there as well. But it is off of its historical number -- or not historical but the numbers we saw over the last several quarters. It's down some. But pretty solid. We think it will probably revert more to the norm of 20%.

Q - Michael O’Brien

So you think it stays in this as opposed to going back to the higher percentage than it was some of the quarters last year.

A - Rick Wallace

Correct.

Q - Michael O’Brien

Thanks.

Operator

Your next question comes from Timm Schulze-Melander with Morgan Stanley.

Q - Timm Schulze-Melander

Congratulations on the quarter. I just want to come back, I think to this foundry question here. LAM research clearly driving for very strong bookings from the foundries and you guys do have longer lead times than them. So it does seem a bit strange and maybe this is kind of a hangover from Semicon Japan. But could one logical explanation not be that either you are seeing market share erosion at that customer base or maybe there is a delay in order placement lost they're evaluating rival tools. How should we think about that? Thanks.

A - Rick Wallace

Yes, we model as we said at 25%. We don't see any evidence of share erosion. In fact quite the opposite. The last several weeks and few months we have seen continued success as I mentioned of our 2800 product in Puma gaining acceptance. So I don't think it's that. I think that our forecasting window is, as John said, there are large orders that can come in, in and out of the quarter. So in terms of specifics, we may also be doing better in other regions. I'm not really sure how to address it. It's not due to share loss. We will get the business when they spend the money.

A - John Kispert

Timm, John Kispert. I think if you looked at just the raw dollars, we give you the percentages and the totals and you just do the math you'll see that foundries have been increasing steadily for us for the last couple of quarters.

Q - Timm Schulze-Melander

Maybe I did the math wrong. I just sort of did it back of an envelope, it looks like it's down about 4% sequentially at the midpoint of your guidance. Maybe I did the math wrong.

A - John Kispert

Yes. It's up. It's up, Timm. And I think if you just did the dollar values on that you'd see that it's rising quarter on quarter the last couple of quarters. And we bottomed out and it's more than double than it was two quarters ago.

Q - Timm Schulze-Melander

You said foundry was going to be what percentage of bookings in the March quarter?

A - Rick Wallace

About 25.

Q - Timm Schulze-Melander

And you said it was 30 in the prior quarter?

A - Rick Wallace

Correct.

A - John Kispert

But the guidance was also higher.

A - Rick Wallace

The guidance was higher. That's a flattish number.

Q - Timm Schulze-Melander

And when I do the math I get to about 147, plays about 154. Maybe we can follow-up offline.

A - John Kispert

My point is you just go back two quarters and you will see that it's up much higher over the last two quarters. That's all.

Q - Timm Schulze-Melander

Great.

Operator

Your next question comes from David Duley with Merriman.

Q - David Duley

Congratulations on nice numbers. I hate to beat the dead horse with the foundry, but I am just going to come back to an observation about the numbers. I think last quarter you mentioned that kind of the swing factor in your order rate, the 5% plus or minus 10% was the foundries and clearly foundry bookings did increase sequentially I think by my math about 51%. From 101 to 152 million. However, orders in Taiwan were down sequentially by 23%. So it is a little -- I guess we got the foundry bookings that we all thought, but I kind of thought the foundry bookings would be coming out of Taiwan. What is your observation as to when you think the Taiwanese bookings would start to increase, which I guess means we are trying to figure out when is TSMC going to place their orders with you and I think there's a general thought out there that they've started to pass out orders to other players and it seems unusual that you don't have them.

A - Jeff Hall

David, it's the reason we give a range in our guidance, too. We are fully engaged with them. I feel real good about how we are positioned. Clearly in the foundry numbers that you guys got this quarter and in Taiwan numbers you got this quarter is a bunch of business from the largest foundries in Taiwan. And I expect us over, as Rick said over the next six months or so for it to get larger. The prediction of that I guess we are probably a little bit more reluctant to say which quarter it is. If it's this quarter or the next.

Q - David Duley

Okay, fair enough. Just one final thing for me. Can you -- just observation on the U.S. bookings being down sequentially. I obviously think Intel increasing its CapEx substantially would we might see this number revert upward later on in the year? And then just remind us what were your peak order rates in 2000.

A - Jeff Hall

Sure, on U.S. we did see U.S. as down as a total percent last quarter. We were at 17% but we are forecasting strong U.S. business this quarter probably close to 35% of our overall business. In terms of peak, John, you got that?

A - John Kispert

High 600s. I think it probably got up to 700 in one quarter, but high 6s is what it was peaked. Just off the top of my head in history.

Q - David Duley

Thanks a let. Again, congratulations.

A - John Kispert

Thank you.

Operator

Your next question comes from Steven Paleyo with Soleil.

Q - Steven Paleyo

Jeff, you have $11 a share in cash. Why not get more aggressive with the stock buyback. You guys' share count is essentially flat over the last few years when companies like Novellus have managed to get theirs down by about 15%. I would think this would be particularly important since you guys are relatively a little bit more heavy in the option expense and how it impacts KLAs P&L. I also have one more follow-up if I could.

A - Jeff Hall

Well, we were the first in the industry to have a dividend three quarters ago, $24 million a quarter of dividend. We have a systematic buyback plan. Since we implemented our systematic buyback plan we've bought back about 17 million shares at an average price of $38. Over the last two years fully diluted share count is flat. We are in the market every day buying back shares and we are going to keep doing that.

Q - Steven Paleyo

Well maybe these are actually then, interrelated. When I look at your gross margins including options I think your gross margins are around 55.5% or so of the quarter you just reported. If you are about to book roughly almost 600 million in orders, I assume that 600 becomes revenue at some point. At a 65% drop through, incremental drop through that would mean I think gross margins including options would go to about 57, 57.5%. A, does that sound right to you and I guess these two questions are really interrelated, but are there any other areas you guys can do to make up maybe another 200 plus bips of gross margins including options to actually hit a 60% including options?

A - Jeff Hall

I'm not going to question your math, Steve. If your math is correct, it's correct. It sounds all right to me. I think the question is what are we doing to focus on gross margin basically going forward to get some more--?

Q - Steven Paleyo

Well, I mean it's interrelated with the options as well. So I'm looking at it all in here and all in I think your gross margin 600 million are probably closer to around 57, 57.5 rather than the talk of our kind of 59, 60. I was just wondering is there any other cost control? Anything else you guys can do to actually do it even to approach a 60% gross margin like you were talking about before, even including option impacts.

A - Rick Wallace

I guess one thing I would said is we've had this option impact for as long as I have been in the Company. I mean we've had options so it's always been there. It's just now that we are using Black-Scholes to tell you what the number is. But having said that, as you know don't take our eye off the gross margin. I will take you through a couple of the programs that are in the Company today to drive -- continuously drive down our cost per unit. One, and probably the most important is our common platform. We've cut the number of platforms in the Company over the last five years by about 30 to 40%. And that, of course, is going to speed up the learning not only in manufacturing and in service but also with our customers.

There is a quicker time to learn how to build and maintain our equipment over time. And you are going to have a more common supply chain with the obvious pricing leverages there and the quickness. The second thing is a cycle time reduction which I think everybody knows is a big part of the leverage in the equipment industry. Especially in times like this when things start to pick up. You can see very quick material changes in the cycle time not only of building and installing but maintaining the equipment across the Company. And we've really focused on that as far as our training is concerned. You can see that in the head count we -- less head count per revenue dollar and so you will see that continue over the next couple quarters and so we are comfortable. So that's just two things I picked, Steve. I can give you a couple more but we are real comfortable with the margin expansion moving forward and passing a lot of that value back on to our customers.

Q - Steven Paleyo

Great. Good quarter and congratulations to you on your new roles there. You guys sound like a solid team. Consistent message. Congrats.

A - Rick Wallace

Thank you.

Operator

Your next question comes from Ray Kukragia with WR Hambrecht.

Q - Ray Kukragia

Good afternoon and thank you for taking my question. Again, congratulations on solid numbers. Could you share some thoughts on any strategy that you might have for the back end process control now that you are not foreseeing all this? And also if you could give us any update on the competitive landscape and the inspection area I believe one of your competitors has put out some eval tools which is getting pretty good reviews. Thank you.

A - Rick Wallace

Thank you for the call and the question. On your two questions. Back end, we've said all along that there are different ways to look at these markets and these are really make/buy choices and we evaluate the different points of entry. So I'm not going to tip my hand and say how we are going to do it but you can rest assured if there is an attractive market and one we think makes sense we will pursue it. In terms of bare wafer, we always have competition and really no change in that. Our market share in bare wafer continues to be strong and really we are driving adoption of our new technology and the SP 2, very strong both with the wafer manufacturers and semiconductor manufacturers. So we expect customers to look at alternatives but we continue as you know to work very hard to win their business and so no real change in our performance there.

Q - Ray Kukragia

Thank you.

Operator

Your next question comes from Gary Shway with CIBC World Markets.

Q - Gary Shway

I've got kind of a simplistic question. Let me run it by you. If I look at your guidance for bookings of 600, that's roughly 10% below kind of your prior peak of 680. And if I look at my numbers for CapEx, CapEx in '06 is going to be roughly 5 to 10% below the peak in 2000. So when you guys look internally at your sizing activities, how do you justify kind of running at a 600 to kind of $700 million bookings run rate for the rest of this year? Do you kind of look at it from the standpoint of end customers like memory coming down but foundry and logic customers filling the gap in the second half? Or is there a more philosophical reason why you think you could run at this kind of level for a sustainable period of time?

A - John Kispert

Hey, Gary, John Kispert. The way we look at it is really we take a much simpler approach and we just talk to our customers and stay close to our customers. And add it all up and try to explain to you guys from what we see. And we've found through the years that that's the only way to do this. We could try to predict the second half and how high is high and how quick could we get to different highs. But instead what we try to focus on because we just -- through the years have realized that that's just not going to create any shareholder value. The way to do this is to stay close and to build a very flexible organization that can react quickly in either direction. So to say that we kind of model out over the next couple quarters as far as how high our orders could be, it's just not the way we look at things. We will take it a quarter at a time and build our capacity model around that. Did I answer your question?

Q - Gary Shway

Yes. And just from a philosophical standpoint do you think that one reason you could kind of run at sustainably higher levels is that, A, maybe there is a higher kind of inspection metrology intensity at 65, 45-nanometer or B, maybe you guys are rolling out so many more compelling products on a more regular basis that there is just inherently chip makers are less able to kind of reuse tools in inspection metrology from you compared to process equipment.

A - Rick Wallace

Gary, I think you hit the two key points. And the reason we bring out the new tools is because we have to bring out new capability to meet those demands at 65 and 45 and there is no question our customers are finding more and more challenges as they go to their advance design rules and asking us and working with us on providing those technologies. So part of our investment level, most of our investment level in R&D is to get those tools out and get those tools to market and as we said earlier you are going to start seeing those come out in the next couple of quarters as we roll out these new products.

Q - Gary Shway

Is there a way I can sneak in one more question?

A - Rick Wallace

A real quick one, Gary.

Q - Gary Shway

If you look at any bucket whether it is memory, foundry, logic, wafer inspection, reticle inspection, metrology or any region is there any top two buckets that you can think of right now that you could probably exceed the prior peak in terms of orders?

A - John Kispert

Gary, that's a hard one. I don't have that kind of data in front of me. I will tell you we have people running every one of those businesses and every one of those regions and that's certainly their quest. And again it's back to when our customers want it and then of course our goal is to make sure they adopt as much as possible.

Q - Gary Shway

Okay, awesome. Thanks, John.

Operator

Your next question comes from Stuart Muter with RBC Capital Markets.

Q - Stuart Muter

Thanks a lot. Good afternoon. Couple of quick questions. First, following up on the question about reticle inspection. Do you think it can be a strong bookings in March and then secondly how is the demand from the Japanese wafer manufacturers? Thanks.

A - Rick Wallace

Sure. Thanks for the question. Reticle inspection continues to do well and we expect the March quarter to be somewhere in the 15 to 20% of our overall business. Japan, as I said, we do see the wafer manufacturing supporting this 300-millimeter ramp and so we have got good business there. I think the one thing on wafer though, is the wafer capacity buys we probably had saw a stronger quarter in wafer capacity buys last quarter and so we do see that leveling off a little bit but we see some activity in the wafer fabs there as well.

Q - Stuart Muter

Great. Thank you.

Operator

Operator Instructions Your next question comes from Bill Ong American Technology.

Q - Bill Ong

John, the reticle business, any of these applications addressing the flat panel display market and if not is there an opportunity there?

A - Rick Wallace

Hey, Bill, it's Rick. No, not really opportunities in flat panel. There may be opportunities but it's not where we are focused right now though. We are focused on semi and we have enough challenges to address there.

Q - Bill Ong

Great. Thanks.

Operator

Your next question comes from Philip Lee with JP Morgan.

Q - Philip Lee

A couple questions on gross margins. Can you give us a little bit more color on why gross margins went down this quarter again? And then secondly, you said you said you will be ramping new products. Is this going to be a net positive because the design common platforms or is this going to be a net negative because you are going to be ramping up the manufacturing learning curve?

A - Jeff Hall

Let me start with the gross margin question. What happened in December is exactly what we would have expected to happen in December. It's the beginning of an up cycle. We have got a bunch of new product coming out. Shipments and revenue have been flat for the past three quarters. So as we started to significantly increase our production we saw about $1 million of ramp related costs start to hit. Things like overtime, NPI materials, early stage systems testing. That stuff starts to hit the cost line and we are still ramping and the revenue hasn't come through yet. So as the revenue starts coming through like John was saying and I was saying earlier, cycle times are going to drop dramatically. The costs are going to drop across our entire supply chain. The support costs per unit go down. And we are headed for 60 to 70% incremental gross margin going forward from here.

Q - Philip Lee

Would you say that the new products that you are introducing structurally have a higher margin than what they replaced?

A - John Kispert

Hey, Phil, it's John Kispert. Certainly they are designed and we pointed them at markets with that in mind. What is always difficult until you fully ramp the products is to see exactly what the unit cost is going to be over time. Right now I don't see any reason why they won't be, given the common platforms and some of the things we have talked about. But you can never be sure until you have been through the ramp with the next generation of platform, next generation of the product. Right now it looks pretty good to us.

Q - Philip Lee

Thanks, guys.

A - John Kispert

I think we have time for one more question.

Operator

You actually have no further questions, sir.

John Kispert, President and Chief Operating Officer

Great, thank you very much for everybody participating on the conference call today. Our next conference call is currently scheduled for April 27, and we look forward to speaking with you next quarter.

Operator

This concludes the KLA-Tencor Corporation Q2 2006 earnings conference call. You may now disconnect.

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