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LAM Research Corporation (NASDAQ:LRCX)

Q3 2006 Earnings Conference Call

April 12, 2006, 5:00 PM ET

Executives

Kathleen Bela, Director of Investor Relations and Corporate Communications

Steve Newberry, President and Chief Executive Officer

Martin Anstice, Chief Financial Officer

Analysts

Sedrick Kumar, Credit Suisse First Boston

Gary Shari, CIBC World Markets

Jay Dana, JPMorgan Securities

Suresh Balaraman, ThinkEquity Partners

Timothy Arcuri, Citigroup Global Markets

Steve O’Worth, Deutsche Bank Securities

Mark Fitzgerald, Banc of America Securities

Tim Sorspnijer, Morgan Stanley

Jim Cavello, Goldman Sachs

Brett Hooders, Merrill Lynch

Patrick Ho, Stifel, Nicholaus & Company

David Duley, Merriman Curhan Ford & Co.

Presentation:

Kathleen Bela, Director of Investor Relations and Corporate Communications

Good afternoon and thank you for joining us to discuss the financial results for the Quarter Ending March 25, 2006 and the Business Outlook for the June, 2006 Quarter.

By now you should have received a copy of today’s Press Release which was distributed by business wire at approximately 1PM. We are web casting a slide presentation in conjunction with today’s commentary. The presentation can be accessed through the investor relations section of our website at www.lamresearch.com.

Here today are Steve Newberry, President and Chief Executive Officer and Martin Anstice, Chief Financial Officer.

Except for historical information, the information LAM is about to provide and the questions LAM answers during this call may contain certain forward-looking statements, including but not limited to statements that relate to the company’s future revenue and operating expense, management’s plans and objectives for future operations and product development, management’s plans for continuing the company’s stock repurchase program, global economic conditions including consumer sentiment and customer standing, and the demand acceptance and the competitiveness to the company’s products. These statements are subject to various risks, uncertainties and changes in conditions, significance, value and effect that could cause results to differ materially and in ways not readily foreseeable and which are detailed in the company’s SEC reports. We encourage you to read those reports in their entirety. LAM would also like to disclaim any obligation to correct or update any of the information we are about to provide. Note that this presentation includes certain non-GAAP financial measures which the company believes are useful in analyzing the ongoing business trends. Reconciliations to the most directly comparable GAAP financial measures are presented in the investor relations portion of our website.

This call is scheduled to last until 3 PM. We ask that you limit questions to one per firm. I’ll now turn the call to Martin for a review of the financial results.

Martin Anstice, Chief Financial Officer

Thank you, Kathleen. This afternoon we will discuss our March, 2006 Quarter financial results.

Highlights for the quarter include: the quarter’s growth of 29% sequentially at $520 million; higher operating expenses, as planned, targeted at enabling our long-term revenue growth objectives; leverage through operating income at 25.2% of revenue, representing an incremental flow through of 42% on the sequential revenue growth of 22%; profitability levels and operational asset performance driving cash from operations of $110 million in line with our targeted performance of greater than 25% of revenues in the calendar year; sequential EPS progression from $0.55 in December to $0.65 ongoing this quarter, which was impacted by the quarterly ongoing effective tax rates of 9.8% and 20.6% in the December and March quarters, respectively.

300mm applications represented approximately 73% of total systems new orders. 79% of orders were for applications at less than or equal to 90-nm technology nodes. As we expected, the customer activity through the quarter was positive and broad-based. The new orders market for the quarter was: memory at 53% of systems new orders, IDM/logic 26% and Foundry/Other 21% of the total. Dedicated land application systems new orders represented approximately 1/4 of the memory orders. Geographically, Asia represented 57% of total new orders. Revenue of $437 million slightly exceeded the high point of our guidance range and is generally consistent with previous comments regarding the trends in the past. Acceptance time lines are now down to the one through four month horizon.

On increasing customer demand, shipments at $511 million ramped by more than 30% sequentially. We have again approximately doubled the outfit of our supply chain within a six month period; a repeat demonstration of the operational capability (inaudible) by our business model transition. The ending unshipped backlog remains constant at $404 million. For more complete details on the geographic breakdown of revenues please see today’s press release and our website for a reconciliation of new orders, shipments, revenues, deferred revenues, and backlog.

As presented in our March Investors and Analysts meeting, we targeted operating income levels between 22.5% at $400 million in revenue and 25.4% at $450 million. Accordingly, we see today’s reported results as consistent with those stated objectives.

Profitable market share growth remains a priority. We continue to be focused on our target of delivering operating income exceeding 30% in at least (inaudible) quarter this calendar year. We report gross margins of 50.2% today. Approximately half of the difference to our 50.5% guidance is seasonal and due to the March quarter FICA payroll tax effect, which is (inaudible) to this year by higher than anticipated employee stock option exercise. The remainder is product mix, largely in our staff parts business.

Increasing our investments focused on growth opportunities: few products have available market expansion. This continues to be a problem and part of our message today. In addition, if you will remember that in the last several quarters we signaled an expectation of $8-9 million equity compensation expense and consistently incurred less, at approximately $6 million each quarter.

In the March quarter, our Board of Directors finalized the long-term executive compensation program and stock ownership guidelines for certain executives. The program rewards long-term profitable growth combined with long-term share price performance and was designed to optimize the variability of our expense structure going forward. As a result, the company’s long-term compensation expense recorded in operating expenses this quarter includes $5 million equity and $3 million cash based expense. Combined, these represent a sequential increase of $3 million from the $5 million equity-only expense incurred in the December, 2005 quarter. In addition, as stated in our press release today, equity compensation recorded in cost of goods sold was approximately $1 million in the March quarter; essentially unchanged from the December level.

In our Press Release today, we announced the company’s decision to repatriate up to $150 million of foreign earnings in the June quarter under the provision of the American Jobs Creation Act. The non-ongoing tax expense consequence of that decision was approximately $7 million, as stated in our reconciliation of US GAAP net income to ongoing net income.

Concurrent with funding the (inaudible) in our business and investing in new products, we delivered cash and operations of $110 million this quarter. Imagery performance continues to set a standard for the industry at 6 terms. Our accounts receivable days outstanding was 66 days at the end of the period. We are particularly pleased at the time limits of customer dues at the end of March when our balance of accounts receivable more than 60 days past due was less than $5 million or approximately 1% of total receivables.

In the Quarter, we have received $66 million from the exercise of employee equity plans and we used $74 million to repurchase 1.7 million shares at an average price of $43.36. Our total cash balance, including restricted cash, was $1.1 billion at the end of March. Deferred revenue essentially matches our high water marks in (inaudible) SAB101 at $195 million, with deferred profit balance at $119 million. These balances exclude approximately $90 million of anticipated future revenue value for shipments made to Japanese customers where it has not transferred; these shipments are currently recorded at cost in inventory.

In the quarter, adjustments from backlog were a net negative $2 million, order cancellations were $7 million, capital expenditures were $8 million, depreciation and amortization was $5 million. Employment levels increased by 70 to approximately 2,300 at the end of March, reflecting our commitment to supporting our customers and investing in our growth opportunities. Now to Steve’s comments.

Steve Newberry, President and Chief Executive Officer

Thank you, Martin and you all for joining us this afternoon to discuss the March financial results. This was another solid quarter. I am pleased that we continue to execute well to our business model. Our model is focused on profitable market share growth, leverage growth in operating income as we ramp, and cash generation of 25% of revenue in the up cycle.

Our ability this quarter to deliver operating income at a rate nearly 2 times faster than the rate of revenue growth demonstrates the leverage in our P&L. Our cash generation remains strong, producing cash from operations in March of 25% of revenue and we continue to gain share with 4 new application wins in the quarter. I believe our March quarter results demonstrate our commitment to achieving our business model targets. Today, I’ll recap some of the information we presented at our Analysts and Investor meeting, provide an update on our industry outlook, and close with guidance for the June quarter.

Three weeks ago we hosted an Analyst and Investor event in Shanghai, China at (inaudible) China and presented several new three to five years strategic initiatives for the company. Specifically, we stated we intend to sustain and grow our market share and edge, become a multi-product company by entering the clean and resist strip market segments, execute the next phase of our manufacturing outsourcing strategy by aggressively pursuing global sourcing opportunities, and maintain our focus on achieving leadership financial performance in our sector.

In 2005, we exited the year with book market share of approximately 39-40%. We expect this number to increase by 3-4 points in calendar year 2006 and we expect to accomplish these first year objectives of our 3-5 year plan by cost effectively solving yield and devising a grace in issues at 90 and 65-nm and early positioning for 45-nm applications. We will target new application wins of customers for our current position and customer trust levels are strong. Last quarter I know that we are targeting 10-12 new application wins in the first half of 2006. We are on track to meet that target and as I mentioned earlier, have secured 4 of those wins to date.

I’ll now comment on the industry before closing with guidance for the March quarter. Our outlook for the Wafer fab equipment market remains consistent with our view presented at the Investor and Analyst meeting in March, 2006. Based on our analysis and our customer’s current plans, we expect growth of 20-25% in Wafer fab expenditures in 2006 over 2005, and with that assumption etch could grow 25-30% in 2006 verses 2005.

Our outlook for Memory remains solid. Recent price declines in NAND and FLASH are to be expected given the premium price that the segment has had over the last several quarters. In addition, the impact of the change in the forecast for IPOD has been well managed by our customers and demand for NAND, FLASH devices outside of the IPOD remains strong and represents approximately 85% of the total market. NAND FLASH bit growth is expected to remain close to 200% year-over-year and for DRAM bit growth appears to be a little stronger than expected at 55-60%; therefore, we expect to continue steady investment in both FLASH and DRAM as we go forward.

The Foundry and Logic market segments are also tracking in a positive manner. Foundry customers are beginning to qualify 55-nm devices and Foundries will need to begin investing in that capacity soon. Investment activity across the Foundry companies is expected to be more active in 2006 with spending plan to be up approximately 20% over 2005. Key spending plans by Foundry’s for 2006 while improving, are still expected to be approximately 25% less than what was spent in 2004.

Now, I’ll turn to guidance for the June quarter. Quarter’s up 5-15%, revenue $490-510 million, shipments expected to be up 10-12%, operating expenses at $114 million, gross margin at 51%, and operating margin at 28% at midpoint of the revenue range, EPS up $0.80-0.85¢ per share at an assumed share count of $144.8 million at an assumed tax rate of approximately 21%. This guidance is on target to our P&L for operating income at a $500 million per quarter revenue level. It is a half a margin point shy of our model for gross margin due to an acceleration of plans spare parts pricing reductions into this quarter and going forward. We had a plan to roll with spare price reductions out over the next 4-6 quarters consistent with our global sourcing cost reduction initiative, this accelerated action has been taken in response to customer request for us to speed up our activities relating to their cost reduction programs targeted at reducing fab operating expenses and to preserve and grow spare’s market share in the presence of third party spares provider competition. We believe it is important that we respond to our customer’s request and also to ensure that we are providing them a consistent supply of LAM certified high quality spare parts which are essential to maximizing the performance capability of the LAM product install base.

This action will result in a potential ½ to 1 margin point impact to our P&L model for gross margin throughout the calendar year 2006. It is expected there will be no impact to our operating income performance to model in calendar year 2006. We plan to return to our gross margin model consistent with the speed of execution to our global sourcing cost reduction activities.

In closing, I want to thank our suppliers and most importantly our employees for their continued outstanding efforts on behalf of our customers and the company I believe it is truly a job well done. With that I’ll turn the call over to Kathleen for the Q&A.

Kathleen Bela, Director of Investor Relations and Corporate Communications

Operator, we can begin calling for Q&A.

Question-and-Answer Session

Operator

Our first question comes from Sedrick Kumar, Credit Suisse First Boston

Sedrick Kumar

Steve, can you perhaps give a little color to what is happening in the second half of the year because I don’t think you have guidance for etch which grew about 25-30% and flooding your market share numbers, should we expect some kind of in the September to December time frame for shipment of bookings and if you can comment on how the second half is shaping up?

Steve Newberry, President and Chief Executive Officer

I’ll provide some color for activities that we can see that customers are planning to do in September. But in our business today, looking out beyond really 4 or 5 months is kind of an exercise in crystal ball reading; because while our customers thoughts may at times be communicated, they really sometimes represent maybe more dreams than reality. But I think certainly in the June quarter we have as good visibility as normal and so when I look at September we would expect that if a customer executes to the plans that they are sharing with us now the bookings environment would be higher than what is scheduled to book in June. I think from a shipments standpoint… essentially what we have been doing is shipping at about a one-one ratio to what we book in a quarter; I would expect for us to continue to have shipments that are essentially equal to bookings. I think revenue if you look at where we are now, essentially what is booked in one quarter, essentially the revenue level is what occurs one quarter further out and I think that is a reasonable expectation as it relates to what is likely to occur in September if the customers actually go forward and maintain the plans that they are sharing with us today.

Sedrick Kumar

Ok that is very helpful. Can I have a quick follow-up? You mentioned a little bit about non-FLASH holders being 25% of the memory outers. It looks like that declined and the DRAM portion has gone up. Given that LAM is so seasonal do you see any change in the buying patterns from the chip companies i.e. or are the chip companies looking to build more flexible products or flexible fab in the power building DRAM applicants in both NAND and DRAM or is that or are you seeing any trend on that front?

Steve Newberry, President and Chief Executive Officer

Well I think that some of the fabs out there have the flexibility to do product switch between NAND and DRAM. The trend over the last couple of quarters has really to be building dedicated fabs that are essentially set up to optimize the efficient production of NAND and DRAM. I think what we are seeing is that the vast majority of customers at we are targeting to add capacity and Wafer start outs for NAND are going forward. I think that in any market where customers are doing both that you’ll typically see, depending upon their market share, depending upon what business levels they’re winning in a given time frame that sets the ability to perhaps switch a plan that was designed for NAND and then convert it and actually buy it for DRAM. That’s not a very difficult thing for them to be able to do and with the lead times as short in the industry as they are today, I would expect that we will see that from time to time but for the most part the planning that occurs is going forward as they originally planned.

Operator

Our next question comes from Gary Shari, CIBC World Markets

Gary Shari

Thanks for taking my question. Steve, I’d just like to follow-up and maybe kind of play the border bucket game in Q3 and you know what’s sort of driving orders to the up sequentially in September if orders are following on for NAND and FLASH but and maybe DRAM and maybe Foundry can kind of pick up, can you kind of help me out here I am sort of struggling with this.

Steve Newberry, President and Chief Executive Officer

Well I think that, I am not sure that the assumption that orders for NAND and FLASH are necessarily going to fall off, as Martin outlined in the March quarter our orders as they relate to NAND verses DRAM we are actually stronger in the March quarter for DRAM then they were for NAND. And, when I look at the June quarter we’ll actually see that where the NAND orders in June will be 55-60% of the memory orders and memory will be about 61% of our order book in June.

As I look at what the customers are planning to do in the June time frame and what they are talking to us about what they are planning to do in the September quarter, NAND is going to be a consistent, a steady investment plan in the next two quarters if they execute to their plans. I don’t see at this time that there is a fall of in orders rates for NAND.

Operator

Our next question comes from Jay Dana, JPMorgan Securities

Jay Dana

Good afternoon, two questions here; the first one is looking a little bit longer out for memory, and I think you eluded to this a little bit in your prepared comments; how do you see the overall memory environment right now compared to say what we saw in the mid-90s when we had three solid years of growth driven primarily by Windows 95 and PCs? So, the ability of tools for memory for next year. And then secondly, it looks like the spending ratio outside of NAND and FLASH for the rest of the industry is somewhere in the 17% range this year; pretty low by historical standards. I’m just wondering what you see blooming out there for DRAM in particular as it comes and then Foundry’s and IDM as we look into perhaps later this year into next year. Thank you.

Steve Newberry, President and Chief Executive Officer

Jay, I think your questions are really excellent questions because I think that when I look at what’s going on in the business today and in the industry to me it’s not really what’s going on, on a quarter-by-quarter basis that’s really important, it’s what’s going on from a fundamental basis in terms of the vice design and consumer product use. When you look at that, certainly the demand profile for NAND FLASH is awfully positive and awfully encouraging over a multi year perspective.

When I look at comparing the memory market today verses the memory market in those explosive growth years of 1994-1995, the thing that has struck me is that this is a much more measured investment activity. You know, back in those days we had the semiconductor industry largely driven by memory and largely driven by the fact that a lot of the second and third tier players were really investing, we’re investing 25-27% of semiconductor revenues in capital expenditures and we also saw that in 1999 & 2000 not driven by memory of course but driven by logic business for networking and the whole .com boom, but what I’ve been really pleased to see is that while we’ve had a significant increase in the output of the NAND FLASH devices and the NAND FLASH market, when we look at the total investment I expect that we are going to be at about 20% semiconductor revenue for Cap-X this year and so I think that the industry in the 2003 & 2004 behaved in a very measured way for the most part.

The Foundries got a little bit ahead of themselves in 2004 and when I look at how the industry is behaving through this particular cycle, it’s a far more measured response and clearly there’s an acceleration of order activity in capacity additions but it is commensurate with the acceleration in the demand for units in the end markets there.

I think your question about the steady ratio at 17%... based on our calculations that’s exactly or very similar to the number that we’ve come up. If you take the investment in NAND FLASH it looks to be about $10 or $11 million and if you end up somewhere around $18-20 million in revenues you take that out of the equation, the investment on the remaining 230 at about $38-39 billion is 17%. That is a historically on the very low end of investment and I think that while the industry collectively is more efficient, 17% to me is not a sustainable level of investment. I think that investment level will have to come up sometime as we go forward in the future, exactly when that’s going to occur, I can’t predict but I think that’s a good indicator of the long-term health of the current investment levels that we are seeing.

Operator

Our next question comes from Suresh Balaraman, ThinkEquity Partners

Suresh Balaraman

Can you give us some thoughts on your plans for the resist strip and historically those statements have been pretty low margin and how does the time goal of going with profitable growth? Thanks.

Steve Newberry, President and Chief Executive Officer

Ok, so your question was what our plans are for the resist strip business?

Suresh Balaraman

Yes, how do you manage a challenge of keeping the profitability levels up to grow the resist strip business? It is a pretty commoditized business and historically the margins have not been that big in the segment.

Steve Newberry, President and Chief Executive Officer

I think one important thing for us to note is that we are not intending to enter into the stand alone, high volume strip market that the current companies that you are talking about play in. We’re focusing on bringing enhanced capability to our customers, primarily with integrated action strip, and expanding the number of applications where that economically is present both in a capital cost Wafer and on a multi-chambered X-system. And more importantly, as we get into some of the really advanced 65 and 45-nm structures, yield issues become much more difficult to achieve in the process. Windows have narrowed and so the benefits to the customers of using onboard integrated strip whether its in-situ in the X-Chamber or with a dedicated strip chamber, I think we are going to grow in applications.

There is one primary stand alone dedicated strip that is a very difficult process on a going forward basis, which is the post-implant strip. As you get to 45-nm it is going to require a different capability be present in the strip chambers that are being utilized today. The capability is present in the kinds of etch chambers that we make and so therefore that market is moving in our direction as a function of a technical requirements and the hardware configurations that have to be present in order to achieve it.

And so as a result of that, our margins are targeted in the first year or so to be in that 45% range as we introduce the products and work with our customers to qualify them and then I would expect as a function of the differentiation that may occur with the particular capability that those margins can move up and be similar to the margins that we see in the etch business today.

Operator

Our next question comes from Timothy Arcuri, Citigroup Global Markets

Timothy Arcuri

Hi, actually I have two things. Number one, Steve, if I just take the shipment numbers for 2005 and if I grow them by even 30% this year and I take your shipment number for the first half of this year, it implies that shipments are going to decline by something like 30 or 40% in the second half verses the first half. I guess number one, is that the wrong math?

Steve Newberry, President and Chief Executive Officer

Yes, I would, if you take our first half shipment numbers which are at the, are you talking about the shipment numbers now or revenue?

Timothy Arcuri

Shipments, so I am just trying to basically see the full-year market projection and I’m trying to see if what’s been guided for the first half of the year and just trying to figure out what has to happen to back-half of the year and it looks like there has to be a pretty big decline in the back-half of the year to get to that to kind of keep the full-year number that low.

Steve Newberry, President and Chief Executive Officer

Well I think that, if you take that our shipments are going to grow 10-12% in the June quarter from the 511…let’s take 10% because it makes the math easy, that says you’re going to ship about 560 million in June. If we targeted that our bookings will grow 5-15%, then our September shipments are going to essentially mirror that. So, our September shipments are going to be very similar in terms of their level of shipment activity and then if our September bookings are up from June, then I would expect that that will drive a shipment level in December that will mirror the September bookings. So, if you kind of extrapolate that you end up where we think that the first half shipments and the second shipments are going to essentially be about equal.

Timothy Arcuri

Ok, great I guess that would mean then that for the full-year Wafer fab equipment number would have to be a heck of a lot higher than your 25-30% year-over-year number and have to be something more like 50-60% based on those numbers, I guess that is where I am going.

Steve Newberry, President and Chief Executive Officer

Ok, I hear what you are saying. Well here’s the thing, if you have Wafer fab equipment up 20-25, because in an up turn the etch component of that moves from about 12.2% of Wafer fab equipment to about 12.8-13%, what happens is if you have 25% wafer fab equipment growth you are going to get 30 maybe even 32% etch growth. If you then combine that we are going to pick up full four margin points. If you end up where the etch market is somewhere around $3.7-3.9 billion depending upon whatever numbers you want to use for what 2005 etch market was, if you then take and look at that as being something that we will ship at a 40-41% market share, then you are going to end up where our growth rate in etch at 30% plus the four margin points. And, the four margin points is going to be another $150 million in revenue for the year. So the leverage gets to be pretty strong and the numbers move up very strongly right along the lines of what you are talking about. Does that make sense?

Timothy Arcuri

No, it does, it does. I guess if I could just ask one more quick one. If you compare the sequential solution and if you look at how much the industry is shipping in the first half of this year relative to the back half of last year, it looks like the shipment rates and the shipments equate to capacity edition, it looks like the sequentials are roughly the same as they were in 1995 and 1998 and 2000 and 2004. So I guess, what’s the view on whether we’re going to have a little capacity digestion here in the back half of the year before it gets better again?

Steve Newberry, President and Chief Executive Officer

Well I think that what you have is, if you take the first two or three quarters, I think that the ramp rates that you described are in fact at that accelerated level. I think the difference is that what happened in 1995, 1996, 1999, 2000 is that it just kept going that way that you had three, four, five quarters of this 20%, 30% on top of each other. I think that when you get into that kind of situation then you really run into the rift that you’re adding capacity at a rate that’s much faster than one demand can in essence stay equal to.

If we look at where we are today with all that’s shipped in the second half of 2005 and what has now shipped in March, which really is not obviously come on line in terms of adding to capacity, the utilization rates in the industry are very healthy, they are very strong. When you look at the projected demand growth and then you take the March shipments and you say that’s going to add to capacity out-book capability in the June time period, again those things seem to be pretty much in sync.

The one thing that I think is very important is, we are coming off a very relatively low investment period in 2005, where the semiconductor players revenue actually grew very strongly and back in those time frames capital investment as a percent of semi revenue was 25-27%. Back in 1999 & 2000 I think it was even 28% or 29%. I mean, it was very high and here we are we’re sitting here with we have this acceleration, but it’s on an investment level of only 20% of semiconductor revenue. So, those things are in very good balance with each other and I think they are very important elements to look at.

Operator

Our next question comes from Steve O’Worth, Deutsche Bank Securities

Steve O’Worth

Thank you, just a follow up on a lot of this discussion on sort of investment levels here. There have been some comments from people in the industry as well as elsewhere that Foundries simply have to invest more based upon how they’ve invested over the past few years. One, do you believe that, do you think that they are under investing or are they investing rather wisely at this point, we shouldn’t expect that kind of a pick up?

Steve Newberry, President and Chief Executive Officer

I think that’s a good question because I think a lot of people have been thinking about what the foundries invested in 2004; which I think it was about $9.7 billion. There is no question that that level of investment for the Foundries was getting out in front of themselves and I think that they had anticipated that the up turn in that 2004 time frame was going to sustain itself but it didn’t.

So Foundries then significantly pulled back investment in 2005 to about $5.7-5.8 billion and as a function of that they really kind of let this whole activity in demand growth grow into their base. The Foundries exited 2005 in a really good state overall and there are obviously some companies on some technology nodes that have different utilization challenges. But overall, the Foundry utilization -- particularly on the leading edge -- is very strong. Even at 130-180-nm nodes it is a very strong Foundry demand environment going on. So, I think that in my view the Foundry investment coming up about 20% in 2006 over 2005 an interesting thing is that even at that level, that probably takes their investment up to approximately $7 billion.

At $7 billion they’re still 25% below the amount of money that they invested in 2004. When I look at the Foundries I think it’s very logical that with the demand that they are seeing that they are going to be investing at that 20 maybe 25% increase over 2005. I think that the one thing that the Foundries have learned is they don’t need to buy in large 10-15,000 Wafer start chunks. They tend to buy today in 3-5,000 Wafer start chunks. The cycle times are so fast their ability to get those pieces of equipment qualified and ramping and output is so fast, that we really operate now to a much less speculative environment in terms of capacity ads. It’s much more synched to the end demand that they are getting from their customers.

Steve O’Worth

Ok and just a quick follow-on to that do you think it’s fair to say that all that’s said what we’ve really been seeing is a capacity digestion created for the Foundries for the past year or two and if we’re going to see a capacity digestion period it is probably going to be driven by memory?

Steve Newberry, President and Chief Executive Officer

Well what you said for the first part about the Foundries is true,.What they were doing with the capacity of digestion period where they were really working off whatever the excess capacity they had and letting their Wafers start to grow into that. In terms of memory, I don’t understand the context about memory.

Steve O’Worth

If we are at risk of any kind of a capacity digestion later in 2006 going into 2007 for example, the most likely scenario would be that it will be memory enthused.

Steve Newberry, President and Chief Executive Officer

Oh, ok, I really didn’t think that the investments since about 50% of the overall investment is going into memory that if memory gets ahead of itself then that will be where the problems are in the industry, is that what your question is?

Steve O’Worth

Right, I look at sheer Wafer starts going in for memory.

Steve Newberry, President and Chief Executive Officer

Yes. If you end up where there’s a fall of in demand or a significant slowing of the growth rate relative to demand for either DRAM or NAND FLASH, then you obviously have the potential that they would have to slow down their rate of investment and allow that unit output demand to catch up. I think that there’s always the potential that in any given period whether it’s a three month period or a six month period, that something like that could occur. But again, I think that the rate of investment in memory -- while it seems aggressive -- is actually being put in, in response to the fact that they have unit output demand that’s running 14-15% per year; which is much higher than the typical 9-11% that memory was seeing. And obviously, NAND FLASH is a big part of that DUA and bit growth is very strong; at about 55-60% it’s even stronger than what people have been forecasting, which is probably around 50. So, you know we’ll have to watch it and I think people are looking at it pretty carefully and we’ll just have to see what happens. But as it states right now with where we are right now, things are pretty balance right now.

Operator

Our next question comes from Mark Fitzgerald, Banc of America Securities

Mark Fitzgerald

Two quick questions on the memory side. In previous quarters, Steve, you commented that you couldn’t sort out the NAND and DRAM purchases out there. So I’m curious at this point, why you can decipher with such accuracy the split at this point; and I have a quick follow-up.

Steve Newberry, President and Chief Executive Officer

Well I think actually for the last couple of conference calls we’ve broken it out. What happened now is that in the memory business when NAND was first starting to ramp they were basically utilizing their existing DRAM line and then they were adding various pieces of equipment to kind of create the ability to run NAND down an existing DRAM line. But, as the industry and the unit demand grew, customers started ordering for dedicated NAND FLASH lines and dedicated DRAM lines and they communicate that to us and we know what the configurations are that are different between a NAND line and DRAM line. So that’s what’s changed in the last 6-9 months so now we are able to break that out pretty readily.

Mark Fitzgerald

And then just a follow-up, the cancellations at $7 million in cancellations, where did they come from?

Martin Anstice, Chief Financial Officer

To your question there, we had 2-million of adjustments which are essentially kind of price suggestments. The cancellations where both, as it turns out, Foundry cancellations. But in and all of itself that’s not very meaningful; neither were competitive losses. One of them was a cancellation from a customer and then the customer reordered a very different specification and if they do that simply as a change order we never record it as a cancellation; it is just an adjustment. In this particular example, they cancelled and then replaced the order with the new specifications. So one was just a trade out the other one was again a Foundry customer, one system where they concluded they had ordered one too many. So, neither were competitive situations very, very (inaudible), two systems.

Operator

Our next question comes from Tim Sorspnijer, Morgan Stanley

Tim Sorspnijer

Hi, good afternoon, two very quick questions if I may. You referenced price cuts in the service instead, can you just give us some sense as to those cutting prices at what technology node that you sort of most focused and could you just give us a sense of what those revenues what proportion of your overall revenues service accounts for and then I have a quick follow-up.

Steve Newberry, President and Chief Executive Officer

Ok, Tim, one we are not doing it on service per say, we’re doing it on spare parts only not service labor in any specific way. The area where we are focused is really on our 2300 product which really makes up a significant part of our customer’s 130-nm. Fundamentally for quite a while now, which really started in the down turn of 2001-2003, customers’ business models started to change. Because, the growth rate was kind of slowing down and going up and down customers got very focused on what’s happening to their fab operating costs and a process started then where we would work with them on cost reductions, whether it was via pricing or parts lifetime or looking at alternative materials. That continued for a while and then we went into the 2003-2004 ramp and, once again, now I think that what you have is a situation where the semiconductor business is very competitive a lot of what goes on out there is more commodity related. So therefore the focus on cost in the fabs across the whole variety of product lines and applications is very strong.

So what’s different today is that in the last couple of years a so called third party spare parts pretty much localized business has sprung up. In the industry there’s probably a $2.5-3 billion parts business that’s out there for the industry as a whole. The customers working with us working with them have really started to take a stronger look at spare parts and the impact of their business. We got together at the end of the quarter, we’ve looked at the actions that we have taken; we looked at the actions that we were planning to take as it related to responding to our customer requests and responding to the competitive situation. We just fundamentally decided that we wanted to really be a lot more aggressive and one, build on the customer trust that we have by demonstrating to our customers that we were really going to be a supportive partner in their efforts to get their fab operating costs lower. And, we wanted to basically make it much more difficult for these third party suppliers to compete for that spare parts business and essentially really ensure that our customers would be able to continue to have a source of high quality and reliable delivery from LAM. I think that we also fully expect and we have in the cases where we did some of the early roll out of this is we’ve won back market share, we’ve gained customer commitments that we’ll get all of their spares business when they may have outsourced 10 or 20% of it as a function of the actions that we had said we were willing to take. So when I look at the opportunity for incremental revenue and incremental operating profit dollars and the result in an increase in EPS I think it’s a good thing to do financially, I think it’s a good thing for the customers, and I think it’s a good thing for us overall in terms of EPS growth.

Tim Sorspnijer

I guess with the production being so one steady nanometer and below I mean we need relatively new products, I mean wouldn’t somebody be infringing your patents or you IP if they were really reverse engineering does that count for your equipment.

Steve Newberry, President and Chief Executive Officer

That’s an interesting and very complicated subject. There are cases and there are situations at times when our patent or our IP have been violated and in fact we have instigated some legal actions and it had in fact had been successful and protecting some our IP as it relates to the parts business. Many parts, it’s not necessarily against the law, if I understand the legal aspects of this, to go and take a part and reverse engineer it and redraw it. I think that one of the issues here is that sometimes a part gets made it appears and may physically look like it’s the same part but actually there may be some trade secrets embedded in how that part is manufactured, or what the actual properties of that part are. And so in the semiconductor business, which has many, many high purity materials it’s a difficult process to get a spare part qualified but obviously it is possible to do.

Most of that competitive risk is really occurred in more a commodity parts areas because some of the suppliers having two years ago trying to get into some of the more high value added proprietary parts found that one they couldn’t make them or two the violation of the IP wasn’t something they wanted to enter into and so a lot of what’s going on now is kind of outside that space for all the reasons that I noted.

Operator

Our next question comes from Jim Cavello, Goldman Sachs

Jim Cavello

Good afternoon, thanks so much for taking the question. Steve can I probe a little bit about the rationality of the spending and let me just, here if we think about it this way, we had gone unprecedented declines in pricing in two of the key markets in the first Quarter being NAND FLASH and micro processors and those customers continue to be very, very aggressive even accelerating the spending from pretty healthy levels to begin with, is that rational?

Steve Newberry, President and Chief Executive Officer

I don’t know you’re going to have to ask them in the face that some of those price declines is irrational. All I can tell you is from things that they tell us when we have these discussions, one is that yes there has been significant price decline in NAND FLASH, but it’s still more profitable than DRAM and some would even say much more profitable than DRAM. Two, the reality is that they were making very high margins because they were -- over the last six-nine months -- that environment of demand was greatly stripping supply and whenever that happens, prices are pretty high. So what we’ve seen is that clearly that the supply has ramped up and it’s still short of the demand, but that and then you have more players that are in the market now, there was only two or three about a year ago and now there’s going to be five or six, so all of that competition is a logical expected decline as it relates to NAND FLASH.

And micro processors, I mean, I really can’t speak too much on that because we don’t really focus too much on the economics because it’s really two players. We kind of just look at what’s going on overall in that market and clearly it was one of them we have a good position, the other one we don’t have a position, so we don’t spend too much time on micro processors, so I really couldn’t comment on that for you.

Jim Cavello

Steve, if I could follow-up on the pricing on the NAND side and the margins, I mean if you look at it in pretty real time basis, certainly the excess margins were true last Quarter, you look at our real time basis and actually some of these companies are losing money, you look at a micron report from this week, so that’s why I get into the questions about that rationality, yes they continue to accelerate the cap-x, I mean that’s were I get into the questions on the rationality. It’s one thing when they were making such profits and now some of them are losing money.

Steve Newberry, President and Chief Executive Officer

Micron right now from a revenue standpoint, if my information is correct, probably has less than 10% of their revenue is coming from NAND because they just recently took some of their DRAM capacity in their Virginia facility and started to convert it over to NAND and micron is largely done in DRAM and other specialty memory products so I can’t speak for them other than to say that I think that micron which just recently announced if everybody read, believes that the economics in the NAND market where there’s over 100 different customers that you can sell directly into and that’s kind of what exists today and it expected to be much larger over the next couple of years that the pricing tower for the players in the NAND FLASH market is going to be much better than in the DRAM market where you really only have about five major consumers of all the volume DRAMs and those guys have the pricing power and the elasticity of what they put into their products that makes the DRAM market very difficult at least from the perspective of micron.

I think that again, in my discussions with the players, I specifically have asked the questions is 200% bit growth really what’s occurring, if so, why. The answers that we get are embedded in the comments that we’ve made at the Investor and Analyst meeting and in today’s conference call, they believe that the growth rate that’s occurring is still significantly greater than the amount of investment that’s been put into adding capacity for output. That’s all I can tell you.

Operator

Our next question comes from Brett Hooders, Merrill Lynch

Brett Hooders

Thank you, just two quick ones. First, given the very short acceptance times the one-four months you mentioned earlier, is there really any difference between booked and shipped market share and etch any more?

Steve Newberry, President and Chief Executive Officer

Yes, there is because you book it and you will ship it two, three, four months later and then you’ll accept it another one-four months later, so from booking to revenue acceptance you still have six, seven months of lag, so yes there is still a big difference between book and revenue. There’s less difference between shipped market share and revenue market share but it’s still exists in the two-three month average lag time.

Brett Hooders

And then the second just quickly, it looks like you know with matching some of your shipment rate with you bookings rate roughly that your backlog going to stay looks like it will stay fairly stable around this level the next few Quarters, is that accurate and if not or should I say wouldn’t you want to be building some backlog I think at this point given the higher revenue run rates?

Steve Newberry, President and Chief Executive Officer

I’ll let Martin talk about the specifics of the backlog, but as it relates to building backlog, those were maybe the good old days although let me tell you what happened. Whenever you built up backlog, that generally was what you ended up getting cancelled on you because back in those days when you had six and seven months of backlog and customers were ordering for delivery nine months out, etc., that’s how we all got in trouble because they were ordering all based on speculation and not real demand that they were getting from their customers, so I think that actually the fact that we have very short backlogs in our case probably around 10 or 11-weeks is a reflection of the fact of why change your fast, the turns are fast, but their order decisions are really now much more based on a reality of what they see and not nearly so much about the speculations so with that now I’ll have Martin address the rest of it.

Martin Anstice, Chief Financial Officer

I think that maybe that best answers the question quite honestly, I think that the convention that we all got used to is, when we as an equipment company offer a three lee time our customers tend to take advantage of that and so you know my take is with that in mind which is taking the customers behavior and one of our kind of principal operational objectives is to balance our business and try and target as close to a one-to-one ratio on shipments booked to bill, you should extend the backlog of the company to continue to be in the two to three month range and you should continue to see us target a shipment bill close to one. And, you know when I look at the forecast that’s in place in the company, it looks pretty stable, but the basic answer to the question in the backlog going to move with the bookings environment with a one Quarter lax. Hopefully that helps.

Operator

Our next question comes from Patrick Ho, Stifel, Nicholaus & Company

Patrick Ho

Quick question for you Steve, in terms of the 5-15% orders outlook that you gave, now that we are getting into these bigger numbers and on the 15% side you started to push I believe $600 million dollars of booking, what I guess is the swing factor that can lead you from I guess the low end or the high end when you get when you are between Quarters are complete?

Steve Newberry, President and Chief Executive Officer

I think that a lot of reasons that I gave guidance at the 5-15% is that customers are ordering in some respects in some areas $50 million sometimes more, but a $30-50 million dollar order is not uncommon and all it takes is one of those that was supposed to come in at the end of the Quarter and it doesn’t and all of a sudden now instead of being at your mid-point at 10% a $30 million dollar order is you know 3 or 4% or I’m sorry about 5 or 6% and if it’s a $30 million dollar Quarter actually comes in earlier, then you can see how easily you could swing plus or minus 5%. So, I think that’s really the reason for kind of providing some flexibility there and you know where we are actually going to come out it’s just not predictable when one order slides one way or the other.

Ok, that’s really helpful. And a second question and maybe Martin can give a little color on this, in terms of the gross margin will you continue to see gross margins progress upwards, but you did mention that the spare parts are you’re going to I guess take a little more aggressive pricing in that, what’s offsetting against allows you to continue to grow margins over the next three Quarters?

Martin Anstice, Chief Financial Officer

You know, I think the answer to that question is kind of defined by two things. One of them is, there is some economy of scale consequence of having a bigger business. Clearly at these levels that benefit is a reducing economy of scale which is why when I shared the gross margins scenarios in Shanghai a few weeks ago, I was very deliberate about the choices that I made and so we had 51½% and the 52 at the 550 revenue level and so as Steve had talked about a little earlier there are kind of two parts to this decision. One of them is the decision to work with customers aggressively, proactively, and work to reinforce and gain share positions which is the AFC on the revenue side of the equation and as you might remember in Shanghai (inaudible) early our Vice President of Operations discussed our global cart sourcing initiative where we are pursuing a 1-2% point revenue cost reduction play in the next couple of years and our ability to accelerate that is fully a focus and a priority as we proceed in the next coming Quarters.

Kathleen Bela, Director of Investor Relations and Corporate Communications

Operator, we have time for one more question.

Operator

Our final question comes from David Duley, Merriman Curhan Ford & Co.

David Duley

Yes, good afternoon and thank you for the opportunity to ask the question. I was wondering you gave us your booked market share in the etch market at 39-40%. Could you give us a little more granularity as what you think your share is in the dielectric side, and one other follow-on question from that is the current order guidance that you have, I believe that exceeds your peak order number in 2000, can you give us some commentary where you think the how the overall industry is going to see their peak or is this unique to LAM with it’s market share growth?

Steve Newberry, President and Chief Executive Officer

Ok we’ll work on the data for the second one and I’ll answer the first one while we do that. Yes, for 2005 our book market share we believe about 39-40 and since recently a number of market research firms have come out with their revenue based market shares, both of those firms indicated that we grew our market share 15% from 2004 to 2005 which essentially puts you in the 36% type of range for revenue. I think that the situation for us in dielectric is that our market share is right around 30-31% at the end of 2005. When I talk about our targeted 10-12 new application wins in the first half, some of those are clearly targeted at winning additional market share in dielectric because our market share in silicon and metal is in the mid to high 40s and so clearly there’s a larger target market opportunity in dielectric and we are clearly pursuing that.

As it relates to bookings peaks from the prior 2000 time frame, we had a new orders peak $553 million in December of 2000 and so if you take the mid-point of our guidance at 10% over 520 that will get you to 572 so clearly we have an opportunity to have the bookings in the June Quarter be a new order peak for LAM. As it relates to the rest of the industry, you know I really can’t speak for that for other people, because I think as we talked about earlier what a company ends up booking is a function of the markets you serve and the growth rates of those markets, it’s a function of your market share growth and certainly for us you now etch is a market that’s growing faster than the overall investment our market share, we believe, continues to grow at a good clip. So those two things combined I think give us an opportunity to have a higher level of bookings in this cycle than perhaps some might have.

Kathleen Bela, Director of Investor Relations and Corporate Communications

Ok, we’d like to thank everyone for joining us for today’s conference call. We look forward to speaking with you again next Quarter.

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Source: LAM Research Corporation Q3 2006 Earnings Conference Call Transcript (LRCX)
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