KLA Corp (KLAC) — Q1 2017 Earnings Call Transcript

Thank you, Christine. Good afternoon, everyone, and welcome to our conference call. Joining me on our call today are Rick Wallace, our President and Chief Executive Officer; and Bren Higgins, our Chief Financial Officer. We're here to discuss first quarter results for the period ended September 30, 2016. We released these results this afternoon at 1:15 PM Pacific Time. If you haven't seen the release, you can find it on our website or call 408-875-3000 to request a copy. A simulcast of this call will be accessible on-demand following its completion on the Investor Relations section of our website. Today's discussion of our financial results will be presented on a non-GAAP financial basis unless otherwise specified. A detailed reconciliation between GAAP and non-GAAP results can be found in today's earnings press release. These slides can be found on KLA-Tencor's Investor Relations website. There you will also find a calendar of future investor events, presentations and conferences, as well as links to KLA-Tencor's SEC filings, including our Annual Report on Form 10-K for the year ended June 30, 2016. In those filings, you'll find descriptions of risk factors that could impact our future results. As you know, our future results are subject to risks; any forward-looking statements, including those we make on this call today, are subject to those risks, and KLA-Tencor cannot guarantee those forward-looking statements will come true. Our actual results may differ significantly from those projected in our forward-looking statements. With that, I'll turn the call over to Rick.

Good afternoon, everyone. Two weeks ago, we held a conference call reintroducing the KLA-Tencor story to our stockholders, featuring a message that highlighted how our strategies for growth, based on market leadership, customer focus, and operational execution, provided the foundation for the outstanding results we achieved in fiscal year 2016 and set the stage for an exciting future for the company as we move forward. Today, I'm very pleased to announce that we got off to a very solid start in FY17, as KLA-Tencor finished above the midpoint of guidance for shipments and revenue for the first quarter and exceeded the range for non-GAAP diluted earnings per share. September quarter orders came in slightly better than our internal forecast, highlighted by strong foundry demand. These results were fueled by strong customer acceptance of new products and a business model that consistently delivers superior operating leverage, providing the resources to place KLA-Tencor among the top tier of all technology companies in terms of returning cash to shareholders. Our recently announced 4% increase in the quarterly dividend level from $0.52 to $0.54 per share is further evidence of our confidence in the strength of our business and our ongoing commitment to enhance stakeholder value. Our performance in Q1 also affirms KLA-Tencor's ongoing focus on providing value to our customers in terms of meeting market requirements and delivering superior competitive offerings. As in the past, a key contributor to the strong demand we're experiencing today is the success of new products across our product portfolio. Our market leadership is sustained by ongoing successful execution of a product strategy that's focused on intersecting market needs with a portfolio of complementary solutions to address the broad range of yield challenges our customers are facing at the leading edge. And the pace of new product introductions continued at a rapid speed. Over the last 12 months, we have launched two new products in broadband plasma wafer inspection, as well as new products in laser scanning wafer inspection, including review unpatterned wafer inspection and mass inspection. In our flagship broadband plasma optical inspection portfolio, the new Gen 5 platform is currently addressing early yield learning challenges and engineering analysis applications, critical to both EUV and advanced optical lithography design rule development. We have also recently introduced upgraded capability for our Gen 4 product line to meet the high volume in-line monitoring needs of customers who are ramping 10 nanometer capacity. The expanded Gen 4 platform is currently experiencing very strong customer acceptance in the marketplace and is exceeding our own expectations, both in terms of market reception and operational execution. We're also very encouraged by the strength we're seeing today in mass inspection. Our leading-edge mass inspection portfolio is not only being incorporated into our customers' optical mass inspection techniques but is also the preferred technology to support early adoption of EUV as customers work to qualify masks for this very important technology inflection. So to summarize, our Q1 results demonstrate that our strategies are working and the company is operating from a position of strength. As we look ahead to the December quarter and beyond, the stage is set to build on the success and deliver what we expect to be an exciting year for the company in 2017. Given our leading market position, our focus on customer collaborations and our continued operational discipline, we believe KLA-Tencor is well positioned to successfully execute our strategies and achieve growth in calendar 2017 consistent with our long-term revenue growth objective of 5% to 7%. This is against the backdrop of WFE growth forecasted to be in the low to mid-single digits for the year. Now, turning to the guidance for the December quarter; Q2 shipments are expected to be in the range of $800 million to $880 million. Revenue for the quarter is expected to grow approximately 11% sequentially at the midpoint of our guidance to a range of $805 million to $865 million, with non-GAAP diluted earnings in the range of $1.28 per share to $1.48 per share. I will now turn the call over to Bren Higgins for his comments.

Thanks, Rick, and good afternoon. The September quarter represented another solid period of financial performance and operational execution for KLA-Tencor. Revenue was near the top end of the range and earnings per share finished the quarter above the range, driven by strengthening gross margins that continue to reflect strong differentiation of our products in the marketplace. Revenue for Q1 was $751 million, and fully diluted non-GAAP earnings per share was $1.16. GAAP diluted earnings per share was $1.13 in the quarter. In our press release, you will find a GAAP to non-GAAP reconciliation of a $0.03 difference. With the exception of when I exclusively refer to the GAAP results, my commentary will be focused on the non-GAAP results, which exclude the adjustments covered in the press release. In regards to highlights of the Q1 demand environment, we are no longer reporting quarterly booking results or quantifying order guidance in terms of dollar amounts, but we will continue to share our perspective on the current quarterly demand picture to give investors insight into industry trends. End-market mix estimates for the December quarter, based on current forecast: Foundry was 69% of new semiconductor system orders in September; foundry bookings featured strong demands across our product portfolio to support leading-edge development projects, although foundry is expected to decline to 30% of total system orders in Q2 due to project timing. We are currently expecting foundry orders to grow in the first half of calendar '17 compared with the second half of this calendar year. Memory was 15% of new system orders in Q1, with demand evenly split between DRAM and NAND. Memory orders are expected to jump to 60% of the total in December, largely due to a concentration of orders to support a single new memory project build-out in Korea. Logic was 16% of new system orders in the September quarter and is expected to be approximately 10% of the Q2 order mix. In terms of distribution of orders by product group for the first quarter of fiscal year 2017, wafer inspection was approximately 37% of new system orders, patterning was approximately 33% of orders; the patterning order profile includes mass inspection system bookings, service was 28%, and non-semi was approximately 2%. Total shipments in Q1 were $786 million and then the upper half for the guided range of $735 million to $815 million. Looking forward, we are modeling December quarter shipments to grow sequentially 7% at the midpoint and be in the range of $800 million to $880 million. Turning now to the income statement; revenue was $751 million, finishing at the top end of the range of guidance for the quarter. We expect revenue to grow approximately 11% sequentially at the midpoint to a range of $805 million to $865 million in the December quarter, and our current forecast shows revenue levels in the first half of calendar '17 growing in the mid to high single digits compared with the second half of calendar '16, consistent with our long-term annual growth target of 5% to 7% and driven by our strong backlog and expected order profile for the next few quarters. Gross margin was 63.1% in Q1, nearly flat compared with the record gross margin results we posted in the June quarter, in spite of the sequential quarterly decline in revenue. The strong gross margin performance in Q1 reflects the benefit of a more favorable product mix than was originally modeled for the quarter. Lower part expenses in our service business and lower inventory reserve expenses associated with new product transitions; we expect gross margins to be in the range of 62% to 63% in the December quarter, down slightly versus the September quarter, principally due to a less favorable product mix in the revenue plan, offset by an increase in revenue. Total operating expenses were $220 million, down $6 million compared with the June quarter, and operating margin was 33.8% for the quarter. We expect quarterly operating expense levels to remain at the $220 million level, plus or minus a few million the next several quarters and to continue to deliver strong operating leverage in what we expect to be a growth year for the company in 2017. Our effective tax rate was 20% in the quarter, just below our long-term planning rate of 21%. The lower tax rate in the quarter largely reflects the benefit of early adoption of a new accounting standard for stock-based compensation. You should continue to use 21% for modeling purposes. Finally, net income for the September quarter was $182 million, and we ended the quarter with $157 million fully diluted shares outstanding. I'll turn out the highlights from the balance sheet in our cash flow statement. Cash and investment at the end of the quarter was $2.5 billion, roughly flat with the June quarter. Cash from operations was $170 million in the quarter, and free cash flow was $160 million. In September, we paid a total of $89 million in regular quarterly dividends and dividend equivalents for fully vested restricted stock units, and made a supplemental payment of $40 million towards our outstanding term loans. To date, the total amount of payments principally on our term loan has amounted to approximately $214 million since the end of the December quarter in 2014. In conclusion, KLA-Tencor's results in September signal a strong start for the company in FY 17, and coupled with expectations for the December quarter, position the company for strong relative growth versus the wafer fab equipment market in calendar '16. This performance demonstrates the company's market leadership, the strong customer acceptance of a portfolio solution addressing the most critical yield requirements at the leading edge, and our operational core competencies. Given our strong backlog and the expected growth trajectory of new orders, including a book-to-bill forecast of greater than one in the December quarter, and the first half of 2017 order profile that is stronger than the second half of 2016, KLA-Tencor is positioned for a year of solid growth in 2017. With that, to reiterate, our guidance for the December quarter is shipments in the range of $800 million to $880 million, revenue between $805 million and $865 million, and non-GAAP diluted EPS of $1.28 to $1.48 per share, with GAAP EPS of $1.26 to $1.46 per share. This concludes our remarks for the quarter; I will now turn the call back to Ed to begin the Q&A.

Okay, thank you, Bren. At this point, we would like to open up the call to Q&A, and we do once again request that you limit yourself to one question and one follow-up, given the limited time we have for today's call. Please feel free to reach your follow-up questions, and we'll do our best to give everyone a chance for follow-ups in today's call, as time permits. Christine, we are ready for our first question.

Thank you very much. I have two questions. The first is about 7 nanometer technology. The last significant advancement in foundry was 28 nanometer, but recently several companies, particularly TSMC, have indicated that 7 nanometer could be just as important, if not more so, than 28 nanometer. I would like to know your thoughts on the demand for wafers at this node, how much has already been accounted for in the orders you received for the third calendar quarter, and how much remains to be considered. Thank you.

Thank you, Tim. I was in Asia last week, revisiting and getting reacquainted with our customer base, and there is a lot of excitement, I think, about the potential for 7 nanometer to your point. Most of the investment that we've seen so far, in terms of production investment, has been for 10 nanometer; we have seen investment for the development in 7 and even some looking forward to 5, so I think most of what happened was today that we've seen is 10, and we do expect to see continued strength as we go forward in for 7 nanometer. Bren, anything to add to that?

Yes, I think, Tim, you know we've had foundries very strong, and we even know a drop off this quarter, we think we see a bounce back in the first half of calendar 2017. There's always a dynamic about how capacity gets sold by the people following the leaders, and customers will try to optimize their capacity as much as they can. So to the extent they try to use some of that equipment, they may try, but given the challenges in a node and what we're hearing about the size of it, we feel pretty confident about that foundry trajectory into the calendar year.

Thanks a lot. And just a second thing, I wanted to talk a little about memory because it looks like there's some uptake in the adoption of inspection in memory here in the next round of orders; you have cited some big orders coming out of Korea during the fourth quarter. Can you talk about what's going in memory? Is there an uptake in inspection intensity in memory, and particularly why it is happening and can it sustain going forward? Thanks.

Yes, it is not just inspection; I think process control in general, we are seeing some strength. I think it kind of goes across the portfolio. I would attribute the increase in inspection to memory which we have seen some, is more a function of Gen 5, where we've had some placements that maybe in the past might have been served by alternate technologies like EVM, so we've seen some strength. I'll be modest at this point. The metrology is also growing, and a lot of that has to do with some of the challenges in terms of things like registration and so the overlay business and some of the film's businesses, so we're feeling pretty good about it. It's not at the intensity levels of course of foundry, but it is significantly up from where it had been in prior nodes, and then we see strength to go forward there.

Thank you guys, appreciate it.

Thanks for taking my question. Rick, I had a question on Gen 5 just in terms of how you're seeing that adoption of Gen 5 versus Gen 4, and how we should think about the ramp of Gen 5 next year? At the Analyst Day at Semicon, you had first talked about Gen 5, you talked about the potential to gain some of the layers from EVM applications, and is that something that you are already starting to see?

Farhan, thanks for the question. Yes, we feel pretty good about Gen 5. I think that what we were hoping for is to get it out mainly as a discovery tool. So way back in Semicon and 2015, we talked about the discovery market, and our goal over time was to get to 50% of that market served by optical. I think by the run rate we have now at the end of calendar 2016, we're addressing about a third of that market, so I think we've got about a third of that market, and our target remains that by the end of 2017 we will be 50% of that market. Part of the market grew a little bit because EVM was just not capable of satisfying some of it, so there is a gap in terms of functionality in terms of whole wafer but the displacement, I think, is ongoing. We're seeing Gen 5 adopted more broadly. Gen 5 really does not go into production and replace Gen 4 until future nodes when the critical defect size gets smaller, and you can really think about that more in terms of the adoption of EUV lithography. So for now, it's doing what we hoped it would do; customers like what they see. It's a new product, so of course, there are improvements that we need to keep making, but we think we're on track for the plan that we laid out a little over a year and three months ago.

What I really want to add to that is that we're pretty much in line with what we thought would be. We have 4 or 5 units revenue in this calendar year, and then that number would probably double or so, taking 8 to 10 units into calendar 2017. So to Rick's point, given our objectives in 2017, we think that is how the adoption plays out. Most of what we're seeing in terms of 10 nanometer production is really being driven by the Gen 4 product line; reception has just been really strong for that in its capability, so we're really encouraged by that. The extendability, we think, and having this move into seven and the two will be mixed and matched and paired to meet discovery high-end production, and then ultimately high-volume production type use cases.

Got it. And my second question on the foundries, there's been a big growth in foundry investments in China this year. I wanted to understand from your perspective how much of the foundry demand this year is coming out of China foundries? And as you think about the 28 nanometer throughput of those foundries, how do you think that will play a bigger advantage as you typically have a very strong process control intensity at 28 nanometer as some of the first wave of foundry investment that we saw?

So on the foundry business overall, I mean we had a record year in China in FY16, so the year that ended in June in bookings, so those tools will see new revenue through the course of this year. So I would say of our total foundry business in the year, maybe 30%, 35% or so of the total is probably foundry.

Yes, I was there last week meeting with customers, and I believe that the demand for 28 nanometer technology is strong, with significant investments being made. There are many new employees who rely on us for education, training, and support as they ramp up these new fabs, which have aggressive schedules. We anticipate good business and the ability to support our customers throughout this process. The intensity of activity is increasing, especially since many of these facilities are starting from the ground up, leading to a higher demand as we move forward. We are optimistic about the prospects for our operations in China.

Yes, to clarify, I meant 30% to 35% of the foundry business coming from China.

Thank you, that's all.

Good afternoon, and congratulations on the solid results and the great margin profiles. Given the view of WFE growth next year and obviously your business going in line or better than that, we should see the team, you know, roughly around $3.3 billion in revenues in calendar 2017 combination of industry growth, momentum and Gen 4, Gen 5. In your other new products, if you continue to drive better performance in the margin funds, feels like operating margins in that kind of 36% to 38% range would seem achievable. I'm not asking you guys to endorse the $3.3 billion revenue number, but if you were to beat those levels, does 36% to 38% operating margin sound reasonable?

Harlan, it's Bren. So I mean just following the map to the point that we think we are going to grow sort of in line with the market in the next year, and the market forecast that we laid out, you end up with that revenue level I think that's fair. I think we're seeing some tailwinds in gross margin right now that we've seen for several quarters, but I think as we start to transition into some of the newer products, some of the benefits we've seen around warranty and support costs, and efficient cycle times and things like that, I think some of that goes away now. I do think, and as I said in the call a couple weeks ago, I do believe that versus the model we published that we're operating probably a solid 100 basis points above what we had put out there, and I think that is sustainable. So I think some of what we're seeing today will be hard for me to replicate that type of gross margin profound in next year, so that might be a little bit of degradation there. So given that revenue level, the range that you mention probably feels a little bit high, but I would say you're probably in that 35% range plus or minus 100 basis points or so. Now there are a lot of factors in that mix and so on, but that's how I would characterize it.

Great, thanks for the insights there. We've tended to focus on the Gen 5 and the 29-30 and 29-35 upgrade cycles, in some of our most recent reports. But obviously, you guys are driving new product cycles across their wafer inspection, review document inspection and of course your new radical inspection platform. I'm sure you guys track this, but can you give us a view of the mix of your new platform as the percent of your current bookings and maybe some comparison of that to some of your prior cycles?

The comparison will be challenging. I don't have the exact data, but a significant portion of our bookings are for new platforms that have emerged over the past year. Even in slower markets like China, they are investing in the latest generation of tools to harness these capabilities as they advance in the early development of new technology. I would estimate that a substantial part of our business consists of new products, but I can't provide the exact percentage.

Thank you for taking my question. Regarding the foundry opportunity in China, there was an announcement this week about increasing 8-inch and 12-inch capacity. I want to understand more about the customer landscape, particularly how the mix has looked over the past few years among the major clients. Can you provide insights into whether any Chinese foundry customers are fitting into that category?

I guess I'm not sure exactly the question sorry, Stephen, but what…

I'm trying to understand how significant the opportunity in the China foundry market could be.

I see. Well, Bren mentioned the percentage of our business. If we look back at fiscal year 2016, China was our second largest market, partly due to some underspending. China is significant for KLA, and moving forward, we have a combination of investments, even if they are in technology that may be a bit behind. We also have considerable market penetration and share, along with higher adoption due to foundry needs. They are purchasing some of our newer tools, and there is a lot of interest in quickly ramping up these facilities; they are investing heavily, trying to capture market share, and in some cases, meet domestic demand. We feel optimistic about our position there and plan to invest more in supporting the investment cycle in China. This situation is substantial.

But the only thing that I would add is while I think that there are certainly some new development activities happening there as they are ramping these fabs from greenfield state, ultimately. It's serving a global market, and so I think you'll see some movement around in terms of who gets market share, but there will be inflection in the short term and probably some of it doesn't necessarily contribute to supply; but over time, it eventually will. So I think the overall foundry dynamics in the long run will stay pretty consistent, but there is certainly a commitment there and there is focus to Rick's point, not only on the ramping of new technology, but also our market position there is very strong.

Thank you.

Great, thanks for taking my question. So I guess first question on the patterning part of your business; I think on the last call you guys talked about increased focus there on patterning. I just wanted to see you've implied more commentary around that; is there more focus on metrology, and also in terms of financial impact should we expect more R&D spending on that side, which ultimately will increase your OpEx?

I'll take the first part and then let Bren talk about the second part. We're definitely seeing demand associated with multi-patterning and also EUV. And I'd say the EUV work is in the radical space where we do have tools that are dedicated now to EUV in terms of our 6XX and some of our newest 6XX capabilities; people are buying for EUV, so that's early days, of course, for that. In terms of the overall challenge with customers whether deregistration, overlay, film thickness or optical CD, all those things are potential areas for growth. We're doing well; we think there is more upside to them, and we feel good about our competitive position. Now whether or not we see significant increases in the next 12 months, I think over time there is potential to keep that business growing. And from an investment standpoint, Bren, could you talk a little bit about how we thought about that?

Yes, I mean we've got a pretty active portfolio management process here in the company, and I think given the strategic reorganization that we did a year ago, we have the ability to move capital around much more freely than we did in the past. So we will continue to execute our process; we've been investing in those businesses, and we'll continue to do so. I gave some guidance in the prepared remarks around what I expect OpEx levels to be overall; there is a bit of an increase there, and we are trying to drive the focus of that to be mostly R&D with an overall target of trying to get 60% of the R&D expenses or the overall OpEx as R&D.

Okay, great, that's helpful. Now, circling back to China or the increased level of investment we see in trading activities, you've discussed selling new products and the customers purchasing them. However, if they opt for older generation products because they require them for 28 or higher nodes, should we anticipate some pricing pressure on that due to the presence of more legacy tools?

I don't think that's really what we're seeing. I mean right now, we do have some ability to flex the different tool capabilities people need, but a lot of these facilities don't think they are going to stay at 28. So there is a desire to have newer capabilities, and of course it doesn't hurt them to have it when they are doing their 28 work, but they are hoping that they are going to go obviously lower than that. So I think we're in pretty good shape regardless of where they buy in the portfolio. It's not quite the same; I'll give you a very different example. If you think of some of the investments going on in Internet of Things where people maybe an automotive or they are in sensor technology, then we're talking about older tool sets and maybe even some of our KT pro-stuff which is reconfigured or refurbished tools, that's not what we're seeing in our markets in China for the most part; maybe there will be an element of that later, but that's not what it looks like right now.

Great, thank you.

Thanks for taking my question, Rick. Two questions; first, what's the status of the deal with Lam? How much of your effort is focused on putting on the EUV mass inspection, and can you give us some clarity in terms of the line of sight of revenues from this product line as ASML prepares to ship a dozen tools next year? And then I have a follow-up.

We are currently serving the EUV market with the 6XXX series, which has been available for several years, and we have added some capabilities. This product is already part of our portfolio, and it is not related to any discussions with our other companies. We are noticing some demand for it. However, it is difficult to predict when this will ramp up because it has primarily been a part-time application for some customers. Nonetheless, we are seeing dedicated purchases for these tools, and the ramp-up will depend on the number of starts they have for different devices and how many masks they utilize. We are ready to meet demand in a timely manner and are not venturing into new development beyond our current capabilities, aside from some software and algorithm upgrades for that platform. We are not introducing a new platform as discussed in previous years, nor are we developing an actinic inspector; rather, we are enhancing the capabilities of our existing products to support this market.

Then the only other thing on that is that we would add is that they will do flap-down inspection to qualify radicals, certainly for recall capabilities and incoming quality checks where they will basically print the wafer and do Gen 5 inspections on the wafer to qualify radicals as another checkpoint in terms of making sure radicals are good.

Okay, fair enough. Then on a big picture question, I just wanted to understand given that there are so many smaller players in the process control segment; what are your thoughts on consolidation post-termination of the deal with Lam?

It's not really an area we're focused on. I mean, it's possible others might do that, but we feel pretty good about the products that we have, the range that we have, and our ability to satisfy the markets with our organic efforts in terms of process control. So it's not really something we're looking at.

Thank you.

Thank you very much. Rick, first in terms of some of your comments about memory and inspection, given the transitions that are going on, particularly in the 3D NAND front, the capital intensity from metrology has obviously increased, and it makes sense for your overlay data film and even OCD metrology business. What's been some of the key drivers that have gotten at least some Gen 5 evaluations in that marketplace where traditionally they haven't used as much inspection?

I believe the increased interest in newer technology nodes is driven by more customers entering production. Additionally, those already in production are seeking new capabilities, particularly better debugging methods starting from the discovery phase rather than just during production. This advancement allows them to identify issues they haven't been able to see before. Previously, with EVM solutions, they could detect small defects but struggled with obtaining way for signatures. Now, they can accomplish both tasks, finding small defects and getting way for level signatures.

Great. And Bren on the supply chain side of things, you guys have performed really well over the last year in terms of seeing the increases in bookings and shipments and trying to surround very quickly; can you just give a little bit of color on some of the tactics and efforts you've made that have had the quick turnaround you've had in terms of the shipment from bookings?

The NPI process at KLA, which stands for new product introduction, has been exceptional as engineering transitions to manufacturing with our new platforms. Tools are successfully handed over to operations, and we have stable designs. Our marketing and sales teams are effectively managing transitions with customers, which means we are not facing significant inventory issues as we move customers from one platform to another. Thanks to design stability, we avoid the need for retrofit programs and minimize the issues of fixing tools during shipments. This has positively impacted our conversations and our margin profile due to reduced inventory challenges. Additionally, the efficiency in service costs related to warranties and quick tool installations has contributed positively. I am very impressed with the team's ability to achieve this amidst the challenges of integration planning and other distractions.

I think the one other thing is, as we've taken more risk in terms of inventory risk. One of the things we've done is provided more flexibility in the master schedule to be able to react to market demands, especially most of our customers now have a very short visibility into their cycle so we're trying to be prepared so that we don't get caught out not having capacity when it's needed.

Great, thank you.

Hi, thanks for taking my question. Good job on the quarter. Rick, can you talk about the yields that you guys are seeing on 3D NAND over the last year or so? Is that going to be on 3D NAND and the bunch of folders; I'm just curious where you think the yields are broadly speaking on 3D NAND? Will you cover on 3D NAND different from other devices and logic, and what is the status of that?

Yes, considering the small number of players, I will be cautious in my comments. The leaders feel confident in their position, and I won't elaborate further on that. There are new entrants in the market, and we are experiencing success. However, if you visualize a yield curve, there is a long, flat section around zero, and it has taken time for people to troubleshoot the process. A major opportunity for us moving forward lies in the lack of effective defect discovery methods for 3D NAND, as there are currently no tools capable of assisting in debugging. Despite our efforts, when defects are identified, they are difficult to verify because you need to reprocess or flip them to locate the issue. Overall, the initial progress has been slow, but it's improving. Some players are refining their processes; however, as they face the next technical challenges, we expect yield to be a significant hurdle. There is a strong interest in partnering with us to develop solutions, as there is clear demand, but they are certainly facing challenges in making their processes operational.

Okay. And then on the foundry side, we've heard from Lam Research yesterday that they did expectations for next year foundry investments are going to clap down and then they talked about maybe a little bit of digestion and tend not to be driven. And you're expecting to actually get drove in the first half of '17; is your optimism based on the success of your new products or are you assuming the investments at foundries will stay at the level we are putting this year?

I believe our overall perspective on the year hasn't changed significantly. There is potential for growth in foundries as we approach it from the ground up, and we anticipate ongoing momentum. My previous remarks centered on orders, so you'll see those tools start shipping in the latter half of the year, along with stronger foundry shipments and revenue in the second half tied to 7 nanometer activities. I'm not certain how they reach their forecast, but ultimately, I feel we're not too far apart in our assessments and in our outlook for the year overall.

So Bren, just to be clear, do you expect orders in the first half of calendar '17 to be higher than the second half of '16?

Yes, I do, both for overall and within foundry.

Got it, thanks.

Thanks for taking the question. I'll start with one that's pretty high level; it's very nice to hear the confident tone on what can happen in the first half of calendar '17. So the question is, relative to a year ago or a little bit more when you were last providing quarterly updates, has the visibility on the business improved? And if it has, to what extent is that improvement due to industry dynamics versus company-specific, potentially product cycle dynamics that apply for KLA?

I don't think there's been much change; as Rick mentioned earlier, we've tried to be as flexible as possible. We've taken some risks and are managing transitions. Whenever we introduce a new product with enhanced capabilities, there is an associated level of customer demand. So during these transitions, we do notice an increase in visibility. However, we are still responding to our customers, who are dealing with short lead times and expect us to adapt accordingly. We are doing everything we can to be flexible in meeting their needs. Additionally, the situation in China is quite different now, with significant investments and new opportunities emerging. This aspect of our business shows a stronger commitment than we have seen in the past.

That makes sense. The follow-up is a question on products in next year's outlook, so in the year where the business has potential to grow 5% to 7% in line with the target model, the product like Gen 5 can double next year as I think I heard previously. What would some of the other products be that would be driving some of that company-specific growth in a year with a rising top line?

Our target of 5% to 7% growth is meant to be sustained over multiple years. When we established this goal in 2015, we aimed to set up the business to achieve that level of revenue growth while also aiming for operating leverage that's twice the growth rate. Gen 5 will certainly play a significant role, but we will also see some adjustments within the broadband plasma sector. I don't anticipate any major shifts in the overall product mix as we move into the next year. As Rick mentioned earlier, there may be increased investments in radical inspection as customers prepare for more development activities related to EUV, which could influence product demand somewhat, but generally, the product mix should remain quite stable across our various segments.

Thanks for taking my question. My first question is, have you looked at your annualized revenue for your December quarter? You get to somewhere around $3.3 billion. Sorry if the question has been asked before, but if you look at the operating model that you guys put out, you guys should be somewhere around 59% in gross margin. I'm curious if you think this is a kind of permanent step-up in gross margin forecast; what are some of the factors that's driving the upside in your near-term?

Yes, Sidney, we got that question earlier, but just to go over it again really quickly. Yes, we've clearly been outperforming the model. I think some of that is due to some of the maturity of the platforms that are out there; we're transitioning some new platforms, and so I think we'll lose some of those tailwinds we've had. But to the point I made earlier, I think we're operating probably 100 basis points or more over that model, and so as you play that through, I think you will see the same kind of performance in the operating margin line.

Okay, great. Sorry for asking the same question. My follow-up question is, let's go back to the Gen 5 product. It sounds like you guys don't expect Gen 5 to be cannibalizing Gen 4 until EUV is in production, so that would put you in 2018 to 2020 timeframe. But if you go back to when Gen 4 was in R&D mode per se, is that roughly the same kind of timeframe? The same number of tools that you used for R&D before they go to production?

Yes, the key difference is that Gen 4 meets the needs of many customers in the market. There is a desire for increased sensitivity, but the focus is primarily on discovery. If we were to apply the same defects found in earlier nodes to the current nodes, they wouldn't be suitable for large-scale production. The timeline for implementing advanced technologies, particularly EUV, is crucial.

Okay, great. Thank you.

Okay, thank you, Christine, and thank you everyone for joining us on the call today. We remind you an audio reply of today's call will be available on our website later in the afternoon. We appreciate your interest in KLA. Thank you.