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KLA-Tencor Corporation (KLAC)

Q3 2006 Earnings Conference Call

April 27th 2006, 5:00 PM.

Executives:

Jeffrey Hall, Chief Financial Officer

Richard Wallace, Chief Executive Officer

John Kispert, President and Chief Operating Officer

Analysts:

Timothy Arcuri, Citigroup

Satya Kumar, Credit Suisse First Boston

James Covello, Goldman Sachs

Brett Hodess, Merrill Lynch

Jay Deahna, J.P. Morgan

Edward White, Lehman Brothers

Timm Schulze-Melander, Morgan Stanley

Mark Fitzgerald, Banc of America Securities

Michael O'Brien, Bear Stearns

Marisa Hernandez, UBS Securities, LLC

Gary Hsueh, CIBC World Markets

Robert Maire, Needham & Company

Stuart Muter, RBC Capital Markets

Shekhar Pramanick, Moors & Cabot Capital Markets

Ben Pang, Prudential Financial

Stephen O'Rourke, Deutsche Bank Securities

Raj Seth, Cowen & Company

Steven Pelayo, Soleil - Fulcrum Research

Gus Richard, First Albany Capital

Operator

Good afternoon. My name is Derek and I will be your conference operator. At this time, I would like to welcome everyone to the KLA-Tencor Q3 2006 Earnings Conference Call. Operator Instructions I would now like to turn the conference over to Mr. Jeff Hall, Chief Financial Officer. Please go ahead sir.

Jeffrey Hall, Chief Financial Officer

Thank you Derek. Good afternoon and welcome to the KLA-Tencor's Third Quarter Fiscal Year 2006 Earnings Conference Call. I'm Jeff Hall, the Chief Financial Officer and I'm joined here by Rick Wallace, our CEO, and John Kispert, our President and COO. We're here today to discuss our third quarter results for the period ended March 31, 2006. We released these results this afternoon at approximately 1:15 p.m. Pacific Time. If you haven't seen the release, you can find a copy at our Website, http://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 recent progress and strategy. Afterwards, I'll review the financial results for the third quarter and then we'll open up the call for questions until approximately 3 O’clock Pacific Time. On the investor section of our Website, you'll find a simulcast of this call, which will be accessible on demand for approximately two weeks. On the Website, you will also find a calendar for investor events and investor conferences. You will also find links to KLA-Tencor's security filings. In those filings, you will find descriptions of risk factors that can impact our future results.

And as you know, our future results are subject to risks and any forward-looking statements we make are subject to those risks. KLA-Tencor cannot guarantee that those forward-looking statements will come true. And although we take no obligation to update those forward-looking statements, you can be assured that any update we do make will be broadly disseminated and available over the Web.

In an effort to provide additional information to investors, our comments today may include certain non-GAAP financial measure and you can find a reconciliation of these measures to GAAP in our press release. Before we begin, 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.

Consistent with the prior calls, we will focus our comments on the operating P&L, that is excluding share-based compensation. And I will discuss the impact of share-based compensation on those results. We believe this approach best needs the needs of investors and analysts for comprehensive, compliance and comparable data. And with that, I'll turn it over to Rick.

Richard Wallace, Chief Executive Officer

Thank you Jeff. And thank you for joining our third quarter FY '06 earnings call. Today I will be talking to you about the following: First, the current environment and our outlook for the rest of 2006 an update on KLA-Tencor products, the financial highlights of the March quarter, and our guidance for the June quarter. Jeff will then take you through the details of our March quarter and then we'll take your questions.

I'll start by saying, we had a strong second quarter of growth in our business, particularly in bookings. As in 2005, our customers continue to increase their investment in process control to ramp new fabs faster, to solve the difficult yield problems they face at 65 nanometers and to stay on Moore's Law. Today that investment in process control is focused on 90 nanometer capacity additions and the yield ramp requirements of next generation 65 nanometer fabs. Memory was 43% of orders and again, the strongest segment in the March quarter, with significant NAND flash spending.

NAND fabs, both dedicated and mixed with DRAM, were half our memory bookings. Logic at 37% of orders was also strong in March, with the investment in 65 nanometer capacity in the U.S. the strongest region for logic. Foundry was the lowest segment, at 20% of booking. Foundries continue to spend under their historical rates as they cautiously add manufacturing capacity to existing fabs. Foundry fabs are at very high utilization rates and we would expect that an increase in foundry orders as we go through 2006.

Although most of the increase in bookings comes from additions current manufacturing capacity at 90 nanometers, our new tools are having the greatest successes in 65 nanometer fabs, where the yield learning challenges are the greatest. As 65 nanometers, yields increase in 2006, our customers should gain confidence and start ordering for the 65 nanometer capacity ramp. So, the outlook for 2006 is bright and it continues to improve.

Semiconductor revenues are expected to grow faster in 2006 than the 7% growth of 2005. Most forecasts are in the range of 10% growth. We expect capital investment to grow in the range of 10% to 15% in 2006. Several months ago, we were expecting CapEx growth in the 5% to 10% range, so our customers are gaining confidence in their immediate future and with very high levels of fab utilization, the revenue growth plans require investment in new fab capacity. The driver for growth continues to be the transition to new 300 millimeter fabs, the growth of consumer electronics, the 200% bit growth of NAND and the increased investment in process control.

The March quarter was a very active period for new product introductions at KLA-Tencor. And I would like to take you through the highlights from what was a very productive quarter. We extended the speed and sensitivity of our broadband UV visible light bright field platform, with the introduction of the 2367. This tool compliments our previously introduced 2800 full specter Brightfield inspection tool and provides our customers with the capability to speed their yield learning at 65 nanometers, with increased sampling and sensitivity at the lowest cost of ownership.

The initial tools have performed very well on fabs, finding a broader range of defects at faster speeds and competing systems. Leading logic and foundry fabs have already adopted the 2367 in their 65-nanometer yield ramps. The eS32, introduced in February, not only benefit 65 nanometer yield ramps, but also supports 45 nanometer development efforts. The eS32's ability to find a broad range of very small defects and subtle electrical problems on a fast and reliable platform clearly distinguishes it from competitive tools.

Customers, particularly flash and DRAM manufacturers, cite the eS32's superior sensitivity, reliability, throughput, and flexibility when ordering. When combined with advanced software and the MicroLoop test structures, the eS32 provides fast yield learning and a 2 to 8x cost ownership advantage. Logic and memory customers are both using the eS32 to solve yield problems of 65 nanometer transistors such as the integration of nickel silicide and strained silicon to develop their next generation transistors.

We also introduced the STARlight-2 reticle inspection system. STARlight, first introduced in 1993, is the industry standard for contamination inspection of reticles in both fabs and reticle manufacturing. The problem of surface contamination from growing crystals or haze is severe at 90 nanometers on 300 millimeter wafers. These problems are called progressive defects and are caused by a longer exposure of reticles to high intensity light in 193 nanometer steppers with 300 mm wafers. Fabs therefore, require periodic inspection of reticles to detect these progressive defects before they can cause yield or reliability problems. STARlight-2 extends the inspection capability to 65 nanometer reticles. And the new techniques of extreme resolution enhancement that 65 and 45 nanometer will require.

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 pilot line. We have been investing in the development of a complete suite of inspection and measurement products at 45 nanometers. I have just described some of them to you and we will continue to introduce more as we go through 2006.

Now, turning to the financial highlights from our March quarter. Net orders were $614 million, up 20% from December. Revenue of $518 million was up 6% from last quarter. Net income was $129 million, or $0.63 per diluted share, excluding non-cash equity based compensation, which was up 26% from last quarter. Including equity compensation, net income was $98 million or $0.48 per diluted share, which is up 28% from December quarter. Orders grew in March, as customers continued to increase their investment in process control for leading edge capacity ramps, and for yield learning at 65 nanometers. We expect both investments by our customers to continue in the current quarter.

So, our guidance for the June quarter is as follows: Bookings in the range up 10% plus or minus 10%, revenue to be between $560 million and $575 million and EPS in the range of $0.68 to $0.71 per share. Jeff will provide the details for bridging GAAP and operating EPS. We are looking forward to a third quarter of strong growth in our business.

Our customers have invested prudently in capacity over the last year. Fab utilization is at very high levels and customers have both near-term and strategic needs for increased 300 millimeter manufacturing capacity. Process controls continues to be a growing part of their investment. Now, I will turn the call over to Jeff Hall.

Jeffrey Hall, Chief Financial Officer

Thank you Rick. Okay, let me start by going through the quarter in a little more detail. As Rick just said, net bookings for the March quarter were 614 million, which was up 20% from the December ending quarter, and 45% higher than our quarterly results from a year ago. This number excludes $2.1 million of orders that we have debooked in accordance with our booking policy, that restricts actual bookings to a set criteria. The set criteria mandate 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 $836 million of backlog for unshipped orders. Remember, we do not include any service, contract, consignment, or unreleased systems in this backlog number. And as we told you last quarter, we have a historically high level of unreleased products in the field at this time. In addition, we have $430 million of deferred revenue related to products that have not been shipped -- that have been shipped but not yet signed off by customers. This invoice system revenue is deferred under SAB 104. And includes no service revenue and is made up of tools delivered, but awaiting written acceptance from the customer. Our ability to maintain this significant level of both shipment and revenue backlog continues to help KLA-Tencor sustain high profitability throughout any business cycle.

The regional distribution of orders for the quarter was as follows. The U.S. was 33%, higher than its historical average of 25%; Taiwan was 14%, lower than its historical average of 20% Korea was 7% and Korea, China, and Singapore combined were 16% lower than their historical average of 20%, Europe was 11%, lower than its historical average of 15% and Japan was 26%, higher than its historical average of 20%. The product distribution of orders was, wafer inspection was 52%, reticle inspection was 15%, metrology was 15%, data storage was 3%, and service was 15%.

Turning to the income statement. Revenue for the quarter was 518 million, up about 6% quarter-to-quarter and down 4% from the same quarter last year. Gross margin was 57.5% for the quarter, compared to 56.9% in the prior quarter. Operating expenses, including both SG&A and R&D, were 166 million. This expense level is up 1 million quarter-to-quarter, and below our forecast of up 2% to 3%.

For the quarter, other income was 17 million, and the effective tax rate was 14%, slightly better than our guidance of 20%, plus or minus a few points. For fiscal year 2006, we continue to anticipate that our tax rate will be approximately 20% plus or minus a few points, depending on the renewal of the R&D tax credit and resolution of various tax audits currently underway in multiple jurisdictions. Net income for the March quarter was 129 million or $0.63 per diluted share.

The impact of non-cash equity based compensation reduces this number by $0.15 per diluted share and the approximate breakout is as follows: Cost of goods sold, $0.03, R&D, $0.05, SG&A, $0.14 and a tax benefit of $0.07. This includes a one-time expense of approximately $0.04 related to the retirement of our prior CEO, that we told you about last quarter. In the June quarter, we expect expense from share-based compensation to be about $0.12. And going forward, we expect this expense to decline as fewer options are issued and older more expensive options are exercised.

Turning to the balance sheet. Cash and investments ended the quarter at 2.3 billion, an increase of 58 million quarter-to-quarter. Also during the quarter, we repurchased stock valued at approximately 59 million, up 20% from the December quarter, and paid a dividend of 24 million. Inventory increased by 27 million to 438 million, as we continued to significantly ramp our production facilities during the quarter, as a result of increased demand from our customers. Let me remind you that this inventory includes a historically high amount of new products in the field that haven't been counted as bookings or shipments and are not included in backlog.

Accounts receivable finished the quarter at 456 million, up 84 million from December, as a result of the increase in shipment. Capital additions related to fixed assets were approximately 20 million for the quarter, and depreciation was 13 million. So, on a net basis, including retirements, fixed assets increased by 7 million over the quarter. Head count ended the December quarter at 5,770, up approximately 200 from December, mostly to support our production increases, field support, and new product introduction.

This concludes our remarks on the quarter. We will now open the call for questions. Before I turn the call over to Derek to give the polling instructions, let me request that you refrain from asking multi-part questions to give others some time. Derek can you begin the polling, please?

Question-and-Answer Session

Operator

Operator Instructions Your first question comes from Timothy Arcuri with Citigroup.

Q - Timothy Arcuri

Hi guys, couple of things, just the first thing, Jeff, can you tell us what the shipments were and what you would guide shipments to for the June quarter? Thanks.

A - Jeffrey Hall

Shipments were about 530. And looking forward, we think 620 or so.

Q - Timothy Arcuri

Okay. And then, also, can you give us an idea of the -- if you look over the last couple of quarters, about nine months or so, from the baseline of kind of $350 million in inventories, how much of the $80 million worth of inventory build is related to new products that are in the field that are almost -- that are going to be valued at COGS? Is it the entire $80 million increment, or is it just part of that?

A - Jeffrey Hall

It is a good portion.

Q - Timothy Arcuri

Okay. Thanks.

Operator

Your next question comes from Satya Kumar.

Q - Satya Kumar

Yeah, thanks for taking my call. The $0.68 to $0.71 includes the option expense or excludes it?

A - Jeffrey Hall

Excludes.

Q - Satya Kumar

Excludes. Okay, thank you. If I look at your June bookings guidance up 10%, can you help us understand what are some of the moving parts in terms of orders by segment?

A- Richard Wallace

Sure. This is Rick. I think that as we always talk about, our orders tend to come in, in large pieces. So, when we look out, we do see activity in a number of regions and a lot of big products going on. But in general, what we look to from a regional perspective is we do see -- we talked about the ROI, the rest of Asia part going up. We see some increase from about 16% up to about 20%. We see Taiwan roughly flat at about 15%. And it looks to us like we'll see an increase in our business in the -- Japan looks pretty solid as well. And so U.S. it will be about similar, a little bit lower levels. All in all, I think, pretty strong. Memory continues to be strong for us. We're not counting on a lot in terms of the foundries for next quarter. But memory continues to look like it's going to be strong overall, with both NAND and DRAM capacity increases.

Q - Satya Kumar

Thank you.

Operator

Your next question comes from Jim Covello with Goldman Sachs.

Q - James Covello

Good afternoon guys, thanks so much. Quick question. On the -- understanding that the foundries are going to book more as we go throughout the year little bit. At what point do we have to think about their kind of historical levels changing a little bit because they may be thinking about investing differently and NAND just kind of permanently being a bigger part of the equation? Any thoughts there?

A- Richard Wallace

Jim, good question. I think that we really don't understand, overall, how that dynamic has shifted. But what we do see is, NAND's will have to invest if they want to keep up their percent of the overall market. As we said, they've under invested. But it's really hard to see how long this NAND play will continue to go. As there continues to be this huge demand pushing both NAND and also, we see DRAM increasing. So, it is a good question. We haven't really modeled the long-term change but we expect over a few quarters that we might have a better sense of what that is looking like. And of course, now as you know, the foundries are coming into NAND, so they will get part of that business as well.

Q - James Covello

Great. One quick follow-up from me, I don't think I understood the tax rate for June?

A - Jeffrey Hall

About 20%.

Q - James Covello

Okay. And so that implies -- if I work through your model then, your gross margins are up very significantly in June, is that a fair way to think about it?

A - Jeffrey Hall

You've got a model there.

Q - James Covello

Thank you.

A- Richard Wallace

Trust your math.

Q - James Covello

Thanks.

Operator

Your next question comes from Brett Hodess with Merrill Lynch.

Q - Brett Hodess

Rick, given the number of new products that you're talking about, there are 65 nanometer production and 45 nanometer development; can you give us an idea how far you think you're ahead at this point in some of these products versus competition? And if you think you're going to get some additional price and margin leverage from the new rollouts here?

A - Richard Wallace

Hi Greg, great question. I think there are definitely opportunities for us. From my standpoint, it's less about competition and more about meeting some of these new unmet needs especially as it relates to advances in lithography and some of the challenges that people are facing with some of the new materials. But I do think we're in a position to increase our share, especially when it comes to the metrology area, where I think we've got some real opportunities there. But the inspection business continues to look good for us. And I think we're working very closely with our customers on some of these advanced challenges.

Q - Brett Hodess

Thank you.

Operator

Your next question comes from Jay Deahna with JP Morgan.

Q - Jay Deahna

Thank you, good afternoon. A couple of questions. First of all, Rick, you talked about in your opening remarks, process control. I think you said a growing portion of fab investments. Does that imply you believe the percentage of CapEx on equipment in a fab at 65 to 45 for process control is more than it was at 90 and 130? That's number one. And then number two, you talked about customers transitioning their volume purchases from 90 to 65 later this year and foundry is picking up. You've got a bigger outlook for CapEx. Does that imply that you expect orders for the industry to be up in the third and fourth quarter? And specifically, KLA always has this issue where September is the first quarter of the fiscal year. I wonder if you could give some color on your order potential in the third calendar quarter? Thank you.

A- Richard Wallace

Okay, hi Jay, two good questions. Let me take them in order. First, your percent question on process control, we do see that trend increasing. And I think it relates specifically to some of the new challenges people are facing as they go to 65. And we anticipate 45 to be more challenging. And again, that's -- in terms of the advanced design rules, the new materials, the deep subway length litho, we do see increased opportunities, and that increases the tam for process control. In terms of the second half, it looks very good to us right now. I think you know during this part of the cycle, we are still early in this transition to 300 millimeter. And there are lot of fabs that still have to build out and come online and we're anticipating increases in 2007, with a lot of new fabs being planned for 2007. And of course, that means we would see those bookings in the second half. You talked about September, historically, that's been a down quarter for KLA-Tencor. But I'll tell you what we see right now, is September looks good for us and we're very positive on the rest of the year.

Q - Jay Deahna

Does that mean it's up?

A- Richard Wallace

I said September looks very good for us. And as you know, Jay, we don't forecast out six months but certainly a lot of good signs out there.

Q - Jay Deahna

Great. Thank you.

Operator

Your next question comes from Edward White with Lehman Brothers.

Q - Edward White

Thanks. Rick, you talked a little bit about 45 nanometers. Can you talk more about what some of the issues are likely to be at 45 nanometers? And specifically, how your new products may be able to address those issues better than say some of the competitive offerings out there?

A- Richard Wallace

Ed good question. Thank you for that question. I think there's a couple of things happening at 45 nanometers. A lot of new materials coming in. Our customers are, in particular, dealing with two fundamental issues, especially as it relates to the logic. And that is one is the power management. And I think that's stressing new materials, which creates new yield challenges. And that really plays to the flexibility of our product suite particularly things like our broadband DCV inspection system. The other thing that's going on is pushing the lithography, and whether it's 45 or 32, the push toward immersion is going to continue to create new challenges for us. And I think those are going to be both in metrology and also challenges in defectivity. And I think it's not just our new products, but our applications understanding and the close collaboration we have with our customers that positions us well to meet those needs as we go forward.

Lastly, I think that the NAND flash push is pushing design rules. And of course, there's a need for ramping yield quickly, and that also plays to some of our strength as well. So, we feel very good about the new technologies coming on and how they play into our portfolio.

Q - Edward White

Great. Thank you.

A- Richard Wallace

You bet.

Operator

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

Q - Timm Schulze-Melander

Hi, good afternoon guys and congratulations on a good quarter. Just a quick question I mean you've obviously got a lot of moving parts that are going to come through here in the second half, new products et cetera. How much volatility should we or variation should we anticipate in the gross margin? Thank you.

A - Jeffrey Hall

Gross margin, best way for us, doesn't really -- hasn't really changed, 60% to 70% incremental gross margin is how we're going to model our business going forward. We continue to drive the nitty, gritty details to get there. So, I think that's the right way to look at it.

Q - Timm Schulze-Melander

Okay, so, even if you have quarters where you've got sort of increasing contribution from new products and some of those associated costs with low volumes maybe initially, we shouldn't expect you to deviate from that range?

A - Jeffrey Hall

No, I think, 50% to 70% is our number. What we've executed to, it's what we're going to continue to execute to.

Q - Timm Schulze-Melander

Great. Thanks so much.

Operator

Your next question comes from Mark Fitzgerald with Banc of America.

Q - Mark Fitzgerald

Thanks. The way you guys are handling options, by giving us such detail, seems to suggest you think there's an argument for excluding options but when you look at all of your other major equipment companies out there, AMAT, LAN, Novell, so everybody has gone to this method of just including options. So I'm curious why you kind of continue to fight the FASB accounting rules here?

A - John Kispert

Mark, John Kispert. I wouldn't say we're fighting anything, we're just giving what people asked us to give. If you want one flavor, I'll give it to you that way. If you want it a different flavor, we'll give it to a different way. You clearly want it in, I'll make a note of that.

Q - Mark Fitzgerald

Well, I'm saying this for comp purposes, everybody else in the industry has gone this way. I'm not sure why you guys are doing it differently at this point.

A - John Kispert

Mark Fitzgerald wants it in, I got it.

Q - Mark Fitzgerald

And then just one quick question. The 7% tax rate for the current quarter, could you give me a quick explanation of that?

A - Jeffrey Hall

As we've been saying, we've a lot of audits and statute expiring around the world. So we saw a few things close out, we true-up our tax accounts in the quarter, we get a small benefit here in the current quarter.

Q - Mark Fitzgerald

Okay. And would the tax rate of 20% for '07 be a good estimate?

A - Jeffrey Hall

Yes, we think going forward, 20%.

Q - Mark Fitzgerald

Thank you.

Operator

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

Q - Michael O'Brien

Yes, thanks a lot. Just a couple things. First on NAND, I think Rick, you had said, see how long this lasts or something to that affect. Are you getting worried -- I know there's a lot of worry on the Street, by some of a collapse in NAND spending or NAND ordering in the second half. Do you subscribe to that? And then where you said September looks quite good, is it across the board, or is it specifically in memory foundry, Japan, or whoever else you might want to qualify it? Thanks.

A- Richard Wallace

Mike, thanks for those questions. First one on NAND, I think that what's clear is there's increasing demand that has been running now for some period of time at 200% bit rate growth per year. And that looks like it continues as there's just more and more applications. So, our expectations are is that this thing has a lot of legs in it. And the NAND manufacturing, those guys are still profitable and we're certainly getting a lot of requests to support the -- a lot of new projects that extend out into 2007. In terms of the September quarter and beyond, we have pretty -- early visibility is still ways off, but we do see a pretty robust across all the sectors and the regions all look pretty reasonable to us. So, I wouldn't point to one particular area, other than to say that I think memory continues its strength, but it's not just NAND, it's also the DRAM capability. And the anticipation of a lot of expected demand in 2007 as new operating systems come out. And also that NAND kind of taken away some of the memory capacity that had been there in the past. So, I think we're kind of getting an effect from that as well.

Q - Michael O'Brien

Great. Thank you.

Operator

Your next question comes from Marisa Hernandez with UBS.

Q - Marisa Hernandez

Hi, good afternoon. It looks like orders from Korea receded this quarter, and I was wondering whether you could share with us what your expectations for Korea are for June orders?

A- Richard Wallace

Yeah I think I misspoke earlier. The Korea orders are up. I was looking at two lines here. Korea order expectations are up, and again driven they came in strong last quarter. This quarter, they've got a kind of a breather as they absorb some of that, but next quarter looks very good for us.

Q - Marisa Hernandez

Okay, great. And then regarding memory orders in the June quarter, would you expect the split between DRAM and NAND to be about the same?

A- Richard Wallace

Yeah, looks like it to us. And again, as you know, there's some mixed use fabs, but the NAND capacity just keeps coming.

Q - Marisa Hernandez

Okay. And I didn't catch your comments regarding logic outlook for June. Could you comment on that?

A - Jeffrey Hall

Yeah, what we see in logic is actually June to be a little bit lighter than our historical average, somewhere in the 25% range. And we've run historically somewhere around 33, so little bit down. We do see memory, as I said, to be up as the 50% kind of range for the June quarter.

Q - Marisa Hernandez

Sorry, did you say 30% range for logic in June?

A - Jeffrey Hall

The logic at about 25% range.

Q - Marisa Hernandez

25% range.

A - Jeffrey Hall

For June and it was 37 this last quarter.

Q - Marisa Hernandez

Okay, great, thank you very much.

A - Jeffrey Hall

You bet.

Operator

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

Q - Gary Hsueh

Great, thanks for taking my question. If I look at your bookings in December and March and I divide that or normalize that by the total market opportunity in inspection and metrology; it tells me that you're running at roughly north of 60% the mid 60% range. And if I plot this out historically, you typically can't sustain a level above your natural market share of around 45% to 50% for more than a quarter or two. So I'm just on a curious about this ratio. What makes you think that you can kind of sustain it as through these percentage levels in the back half of the year? Is there anything from a product perspective? Are you getting share in any end kind of customers on the back half that might make this year different from any other past historical cycles?

A- Richard Wallace

Yeah, well, I think there are couple of things. It's a good question. One is, as we look out at, first of all, our sense of market share is that we've actually been holding our market share, but we do believe there are opportunities to gain share. So, we actually don't believe this already gone up. We think there's actually potential for it to go up. And the reason we think that is we've got strong new products in our initial entries with those products in the leading edge fabs are showing very good results. So, we're pretty confident that we'll be able to extend that out as people fan those in the manufacturing. So from that standpoint, and I think it is based on being close to the customers, working with them, and building products that they need to support the very difficult challenges that they're facing. So, I think we do have room for share expansion as we go forward.

Q - Gary Hsueh

But do you think the fanout potential is in the second half of this year or the fanout potential is more in '07?

A- Richard Wallace

I think it's gradual. It starts in the second half and keeps building in '07.

Q - Gary Hsueh

Okay, great, thank you.

Operator

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

Q - Robert Maire

All right, congratulations on the nice numbers. In terms of foundries, they've been, as you pointed out unusually conservative and we heard from TSMC this morning that they're running at close to 100%. Do you think this is just a new culture change that goes on forever? And kind of related to that is sort of a follow-up question. In terms of your planning for the remainder of the year and going forward, do you have a point in time at which you think the foundries start to spend again, or is your current going forward assumption that they stay at this low sort of below historical norm, or historical average, 20% level for the foreseeable future?

A- Richard Wallace

First of all Robert, thanks for the comments at the front end of that and thanks for the question. In terms of the foundry, we do model them up a little bit, but relative to what we just booked in the March quarter. But what we don't see is them returning to historical level and we have it modeled that out for the rest of the year. And we think we can still see a pretty strong rest of the year without that happening. Now, in terms of when they return, I don't have a crystal ball. It's very hard to see. So what we focus on is being available to support their needs, having the right products for them, and making sure that we can respond to what has historically been a very quick cycle when they do decide to spend. They tend not to have a lot of visibility and so we tend to have to be very flexible and meet their needs. And we've been we’re going to be there for them when they do turn on. But we're not modeling a lot of upside out of foundries from the current run rates now.

Q - Robert Maire

So just to try to interrupt that, you're modeling sort in the low 20's.

A- Richard Wallace

Right around 25%.

Q - Robert Maire

Okay, thank you.

A- Richard Wallace

Thanks.

Operator

Your next question comes from Stuart Muter with RBC.

Q - Stuart Muter

Yeah, thanks for taking my questions. Just a fairly quick one for Rick first on reticle inspection. With the new STARlight-2 tool, do you expect a kind of surge in orders over the next couple of quarters for that tool, because often you get a surge in reticle inspection associated with certain shrinks?

A- Richard Wallace

We have -- you have to understand that these products, when we announced them is different when they're introduced. And we've had some of these tools with our key customers. So we don't see reticle going up necessarily above the level that we reported for the last quarter. We think it stays in the 15% to 20% range for the next couple of quarters. That being said, it's a very important segment for our customers and especially as they bring out these new devices with advanced RET technology. The other thing that's impacting us, of course, is we are seeing some reticle opportunities in the fab. And we believe that will continue to grow and we think there's more opportunity there as well. So, we don't see a surge as a percentage, but it definitely contributes to the overall story.

Q - Stuart Muter

Okay, that's helpful. And then a question for John. In terms of your shipments, you're getting up pretty high. Are you getting to a point where some customers are getting concerned about lead-time and your ability to meet requests for shipment?

A - John Kispert

No, I think we're doing a pretty good job there. It is not easy, as orders have kind of accelerated here. We're working very hard. Our cycle times in manufacturing with these newer products have come down about 30% in the last month or so. And I think there's probably another 30% that we can take them down over the coming months. So, so far, we're meeting everything. You know this business, there's always pressure to meet quicker turns. But we can turn anything within maybe a 60-day period. And that's really where our leading-edge customers are focused right now, is in that kind of a time period -- cycle time.

Q - Stuart Muter

Okay, thank you.

Operator

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

Q - Shekhar Pramanick

Good afternoon. Two-part question. Rick, you are the most bullish regarding third quarter, particularly about your business in terms of orders. Is that particularly we should read into it, a particular place you're doing really well? And my second part question is that clearly you're holding a market share in different segments, but is there any segment, any geography where you think competition have had a better luck? Thanks.

A- Richard Wallace

Let me start with the first part of -- the end of that question, which was competition. We have stiff competition everywhere and I've been here 18 years and that's been the case. And we expect that to continue. But it drives us harder. And so there's not a particular area, my view is they're everywhere. And we have to keep hard -- working hard to maintain and grow our share. In terms of September, why am I, why I sound bullish? We have a lot of new products that we've just introduced. Those products are going through acceptance and customers are responding favorably to that. So, I think it gives us new opportunity for continuing to expand those footprints as we go forward.

Operator

Your next question comes from Ben Pang with Prudential Financial.

Q - Ben Pang

Hi, thank you for taking my question. A couple of questions here. First, in terms of the growth rate of the process control business, is that primarily still 80% driven by inspection? Is there any growth on the metrology side?

A- Richard Wallace

Yes, there's definitely growth on metrology side. There's a lot of new materials, new stacks, transistors becoming more complicated, overlay. And this is not even factoring in as people go to the sublet exposure overlay, which will create more opportunities soon.

Q - Ben Pang

So, should we expect in the future that the order rates for the metrology are going to start going up as a percentage of the overall orders?

A- Richard Wallace

That's what I'm expecting. So, I mean we're looking at this and we think there's more opportunity for it absolutely.

Q - Ben Pang

Okay. And the second question, also related to the growth rate, how much of the growth are you expecting due to pricing of the new tools?

A - Jeffrey Hall

Yeah. We see some growth there, but I think it's really a question of; can we continue to add more value into the product? So I think it's both an increased application and increased use case. But we have had good success with ASP growth when we add new value to our tools and we're continuing to focus on doing that. That of course becomes more important at 300 millimeter in particular, because our customers have the automation challenges. And so they want more capability on our tools and that drives us in that direction.

Q - Ben Pang

Okay and just a final question of clarification. On the tax rate for the quarter that just ended, on the -- like a continual operations basis, I guess the pro forma, it was 14%, is that right?

A - Jeffrey Hall

That's right.

Q - Ben Pang

Okay, thank you.

Operator

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

Q - Stephen O’Rourke

Hi, good afternoon. Could you comment on what you're seeing in the competitive front in Brightfield inspections, specifically, particularly with respect to Applied and TSK?

A- Richard Wallace

Yeah, sure, Steve. Thanks for the question. Well we see continued attempts to get into that market, because of the criticality of it and the growing uses for Brightfield. But we have done very well with our 2,800 series product. And I think we are uniquely positioned with our broadband DPV there. Added to that, with the product I just talked about earlier today, the 2367 gives us the real high speed capability and still great sensitivity. So, we like our position in Brightfield. But as always, there are people that are pressuring and trying to get into the space. But we've done well in our head-to-head and continue to enjoy good market share there. But we've got to work for it.

Q - Stephen O’Rourke

Fair enough. And one follow-up. How much of your orders were for 65 nanometers or below?

A - Jeffrey Hall

I modeled it somewhere about 30%, which is up from where it's been of course. And we see that number going up as people start getting confidence in their ability to yield and they'll start ramping up the 65 nanometer line.

Q - Stephen O’Rourke

Thank you.

Operator

Your next question is a follow-up question from Timothy Arcuri with Citigroup.

Q - Timothy Arcuri

Hi guys, actually I had two. If I try to project, based upon your bookings will be in June. And I try to project what your shipments will probably be into September. And if I just -- that's kind of already lock in based upon what the bookings are. And if I just flat line that shipment into December, your shipments are going to be up about 35%, 40% year-over-year. If you take some of the other companies like ALAM or some of the other companies out there, the year-over-year growth rate for them just kind of flat lining it out during the back half of the year, is up something like 50%. So, we're seeing equipment this year grow north of 40% year-over-year. How do you think about that holistically relative to the argument that spending out there is pretty rational right now? Thanks.

A- Richard Wallace

I think the first thing you said is, flat line shipments. We don't see flat line shipments. We think shipments are going to continue to grow. We're entering the second half here with 20% plus more backlog than we had entering the first half. So, we think we're going to continue to grow shipments.

Q - Timothy Arcuri

Right, right. Well, I guess that's my point. That if you historically look at year-over-year growth rates and what causes what kind of kills a cycle, so to speak. If you look at year-over-year growth rates and equipment near 50%, that's historically killed a semiconductor cycle. So I guess if you think that your shipments are going to grow again in December, it kind of further argues the point, right?

A - John Kispert

You're assuming that the demand in 2007 backs down and what we see is a lot of activity out in 2007. We think spending will be up and the tools that we're going to book and ship towards the, at the end of the calendar year are going into start headed towards the new facilities.

Q - Timothy Arcuri

Okay and last thing for Jeff. Jeff, what's the trigger to get the products that are inventory to move them to shipments or deferred revenue? Thanks.

A - Jeffrey Hall

Customer -- we release it and the customer signs off, it goes, book, ship, and revenue real quick.

Q - Timothy Arcuri

Okay, thanks.

Operator

Your next question is a follow-up question from Jay Deahna with JP Morgan.

Q - Jay Deahna

Thank you. Two questions. The first one is, with Rick and John now running the company versus Ken and Gary 1.5 year ago or so, what do you view as your top three priorities here and how are they different than the previous regime? That's the first question. Then the second question is, we can look at the change in year-over-year growth rates and this, that, and the other, but at the end of the day, it looks like the capital spending ratio this year is probably going to be about 19% or 20% in total. 16.5% to 17% excluding flash. That seems pretty reasonable to me. Just wondering what your sense is on that? And that's it.

A- Richard Wallace

Jay, great question. And let me take it in a couple of ways. We start with the -- what's the new management looking forward to and what's our sense of priorities and how we're going to run the company going forward? I think there are three things to think about in terms of that. First of all, we are in a great space. Process control, there's a growing need for it, a lot of drivers for it. 300 millimeter conversions are driving us, we have 65-nanometer technology and beyond and all the new materials that are coming on. So, our modeling says process control over the next several years continues to grow faster than CapEx in general. And we've got a lot of analysis to support that. The second one is we're in a strong position, but we also believe there's upside. And there's upside in terms of market expansion, market share expansion. And that has to do with a couple of things. One, is we've got new products and we've got new opportunities through organic growth. We are adopting strategy, as you've seen with the ADE announcement of strategic M&A to help build out our product portfolio. And we think there's opportunities to expand profitably in metrology. And the opportunity to grow from a standpoint of an overall percent of a growing market. And the last one, we are pretty confident of our business model. We've got the best business model in the industry. But as we've look at the last four months, we actually see opportunities to improve upon that business model going forward. And I think there's not only top line growth we can drive, but through the business, throughout the organization and the company, we see ways to drive our bottom line growth and actually grow earnings faster than we grow the top line. So, from the standpoint of what John and I and the rest of the team are focused on, it's really those three things. One is playing out our position in a very strong space. Second, is leveraging our market position and growing it. And lastly, improving on the business model and delivering more earnings. So that's the -- those are the three main things we're focused on. In terms of your question about the percent spend, I think your math is right. I agree with that, it's a very rational upturn. And from our perception, it's got a lot of legs in it. From our last - looking back and the previous one, and John, I've been doing this a while, three different cycles, we see a lot of legs here and we're probably two quarters into what historically could be a 10 or 12 quarter run in terms of the overall cycle. So, we like our position and we like where the industry is right now.

Q - Jay Deahna

Okay a quick follow-up, if I could. The first one is, on your ability to grow your earnings faster than your revenues. We've seen a number of new products introduced recently and probably several more between now and SemiCon West for 65 and 45 nanometers. Can you start to harvest some of that from an OpEx perspective into some margin leverage? And going forward here for the next year or so, do you see more margin leverage coming from gross or operating or some sort of a combination? And the last question is, John if you could hop in here and give us your perspective, your view of the company, or the market or whatever from your new position and how you view differently? Thanks.

A- Richard Wallace

Let me take the first part of that and then give John the second part. First of all, we've talked a lot in the past about our leverage on the gross margin, incremental gross margin, but we think as importantly, is the leverage on the operating margin. And that's an area that we've focused a lot on. And you're right, we do see opportunity, and I think we see short-term. But more importantly, what we see as long-term sustainable improvement in that overall business model. And that's what we're really focused on. And that's a lot of what John is going to be focused. And let him take that part of it.

A - John Kispert

Jay, I think we're at a part of the cycle where we've been before, which, we're pushing real hard to increase our shipments. We see customers that, as they're making transitions, we're encountering newer defects and newer measurements that we're fortunately positioned well for. Our focus right now is on 45-nanometer, frankly, as far as next generation products and the things that we need to be positioned for. I think we're in really good shape for the 65 nanometer transition. The newer products that you'll hear about in the next couple of quarters are all focused on the 45 nanometer challenges. And those are exciting. I'm sure you've spent a lot of time on the litho issues. And that plays very well to our inspection portfolio and our metrology portfolio. The changes in the transistor with materials we talked a lot about. And as Rick mentioned before, that in and of itself will drive a bunch of metrology business that we've been focused on for as far as our private portfolio for the last year or so. So, we think we're well positioned. Now, it's about execution and that's really what we're going to be focused on for the next 6 to 9 months.

Q - Jay Deahna

Thank you.

Operator

Your next question comes from Raj Seth with Cowen & Company.

Q - Raj Seth

Thank you. Rick, in answer to a couple previous questions, you talked about an increase in fab projects in '07. I'm curious if you can quantify what you're seeing? I know it's early. But how many projects, greenfield projects, do you see out there? How does that compare with this year? How many are memory, how many are logic?

A- Richard Wallace

Yeah, good question. We model right now, there's about 55 active 300 millimeter projects going on around the world. It ranges quite a bit. When we look forward to '07 and again, no crystal ball, but as we look out there and talk to customers and model it, we see somewhere around 15, which is significantly up from what's happened in 2006. A lot of 2006 has been about really build-out of fabs that were built previously. But we do see new greenfield opportunities, as I said, on the order of 15. And we see about 11 of those being focused on memory. So, there's still a lot of opportunity there as well.

Q - Raj Seth

Thanks. Appreciate it.

Operator

Your next question comes from Steven Pelayo with Soleil Securities.

Q - Steven Pelayo

I'm just trying to understand your guys gave guidance here. If we look at it just purely on a GAAP basis, you talk about $0.12 on expense, so that's $0.68 to $0.71 is really somewhere around $0.56 to $0.59 or so. I think the midpoint of revenue is called up 10% about 570. You talked about a 20% tax rate, assuming OpEx is maybe up 5% when revenues were up 10%. The last lever to pull there is gross margin. So, it's really going back to Jim Covello's question. You responded with, you have a model. It doesn't seem to work here. It would imply that to get into the midpoint of that bottom EPS line guidance, that you'd have to have like an 85% drop-through in incremental gross margin. That's almost 59% gross margins, to make it work. Is that what you guys are effectively saying here or do I just -- somehow the math isn't working for me?

A - Jeffrey Hall

I think the math isn't working for you. $0.60 to $0.70 incremental gross margin, I think maybe you're maybe a little high on fixed costs. We said no more than 2% or 3% in fixed costs from here. And it drops through at about $0.70.

Q - Steven Pelayo

And once again, a 20% tax rate on a GAAP basis?

A - Jeffrey Hall

Yeah, I'm sorry, operating is what I'm looking at. So GAAP, a little bit lower than 20%.

Q - Steven Pelayo

That's where I think I probably need to make up most of it. Excellent, that's all I need. Thank you guys.

A - Jeffrey Hall

Thanks.

Operator

Your next question comes from Gus Richard with First Albany Capital.

Q - Gus Richard

Hey guys, when I go and look at the foundry market, it looks like 0.13 and 18 is really, really tight. 90 doesn't look quite as bad. As we get a shift from maybe memory and microprocessor towards foundry, is the incremental spend going to be as much per square inch of silicone?

A - John Kispert

Hi, Gus, John Kispert. Yes, it's generally about the same. It all depends on the device, as you know in foundry. Particular foundry might be really focused on, but generally, I think the way to think about it is the adoption rate for process control for KLA-Tencor is about the same.

Q - Gus Richard

I was talking just total CapEx, but it's the same for process control as well?

A - John Kispert

Yes.

Q - Gus Richard

Got it. All right, thanks.

A- Richard Wallace

Hi Derek, I think we've got time for one more question here.

Operator

Your final question is a follow-up question from Timm Schulze-Melander with Morgan Stanley.

Q - Timm Schulze-Melander

Great, thank you. Maybe just one thing, on behalf of everybody on the Street, just wanted to wish Cary Halsted all the best on his retirement. And then I had two quick follow-ups. The first was could you just repeat this best for the most quarter orders between logic memory and foundry? And secondly, how should we model as Japan increases importance, how should we model the changing relationship between shipments and revenues? Thank you.

A- Richard Wallace

Okay I'll take the first part and let Jeff take the second. We said that the split in March quarter was 20% foundry, 37% logic, 43% in memory. And of the memory, we said 50% was NAND and 50% was DRAM. And Jeff?

A - Jeffrey Hall

Timm, on the second one, I don't see any change on our business model going forward.

Q - Timm Schulze-Melander

Okay, great. Very helpful.

Richard Wallace, Chief Executive Officer

I'd like to thank you all for participating in the conference call today. Our next conference call is currently scheduled for July 27th and we look forward to speaking with you next quarter. Thank you.

Operator

This concludes the KLA-Tencor Q3 2006 Earnings Conference Call. You may now disconnect.

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