KLA Corp (KLAC) — Q2 2017 Earnings Call Transcript

Thank you, Mariana. 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 second quarter results for the period ended December 31, 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 at www.klatencor.com. A final cast 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 of GAAP to non-GAAP results can be found in today's earnings press release at KLA-Tencor's IR 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. Today, I am pleased to announce KLA-Tencor's business continues to perform at a very high level, and we delivered another outstanding result in the December quarter, exceeding our guidance for shipments, revenue, and non-GAAP diluted earnings per share for the period. In addition, new orders topped $1 billion for the first time in Q2, reflecting KLA-Tencor's market leadership and the critical role our process control plays in enabling our customers' success at the leading edge and in legacy nodes. For the full year in calendar 2016, KLA-Tencor grew revenue by 14% compared to mid-to-high single-digit growth for the wafer fabrication industry. Our example rate performance both in the December quarter and for the full year in 2016, as a result of KLA-Tencor's market leadership, coupled with our record backlog of over $1.6 billion, sets the stage for another year of strong top-line and earnings growth for the Company in calendar 2017. As our record order and backlog numbers demonstrate, KLA-Tencor is experiencing unprecedented levels of demand in our end markets, particularly in foundry and memory. Memory was notably strong in the December quarter driven by both DRAM and 3D NAND investments in Korea, where we are experiencing higher adoption of bare wafer inspection along with thin turn and critical dimension measurement solutions, as a result of more firms creating deposits in vertical memory. KLA-Tencor's growth and market leadership is fueled by the successful execution of a product strategy that is focused on differentiation and intersecting market needs with a portfolio of complimentary solutions. This ongoing investment in innovation and technology leadership helps to drive these strong results in 2016 and is a critical component of our long-term growth strategies. For example, KLA-Tencor's two latest broadband plasma optical inspection platforms, Gen 4 and Gen 5, together address the most challenging defect detection issues for development and capacity monitoring applications of current and next-generation devices in the marketplace today. We are now on our fourth major product upgrade for the Gen 4 optical inspection platform with multiple tools placed in every advanced production fab in the marketplace. One of the key highlights of the year in 2016 was the successful launch of Gen 5, our new flagship broadband plasma inspection platform. Gen 5 is being deployed by customers to address early yield learning and engineering analysis applications for advanced optical lithography design rules and for EUV development. Calendar 2016 was a record year for the broadband plasma product family, and we see momentum continuing through 2017. In addition to supplying wafer inspection capability for EUV layers, KLA-Tencor is also playing a critical role in radical inspection for EUV. Our customers are relying on us as an interested partner to enable the success of the important technology transition to EUV, a move that will allow for lateral scaling and more economical device roadmaps at the leading edge. The new challenges inherent to EUV's specific process control applications such as mask inspection, radical requalification, and scanner control, just to name a few, present new market opportunities that we believe KLA-Tencor is uniquely positioned to address. Given our market leadership in technology, EUV promises to be a positive catalyst for growth in the advanced process control market and for KLA-Tencor. So to summarize, KLA-Tencor's December quarter and calendar 2016 results demonstrate that our strategies are working and that the Company is operating from a position of strength as we enter another year of expected strong growth and earnings generation. Our business model consistently delivers superior operating leverage, ranking KLA-Tencor among the top tier of leading semiconductor companies, and with our strong leadership position in each of the most critical process control markets. The stage is set to build on the momentum of calendar 2016 and deliver what we plan to be another exciting year in 2017. We believe KLA-Tencor is well positioned to successfully execute our strategies and meet or exceed our long-term revenue growth objective of 5% to 7% in 2017, and what is expected to be another year of solid growth for the wafer fab equipment market. Now turning to guidance for the March quarter, Q3 shipments are expected to be in the range of $850 million to $930 million. Revenue for the quarter is expected to be in the range of $860 million to $920 million, with non-GAAP diluted earnings in the range of $1.42 per share to $1.62 per share.

Thanks, Rick. Good afternoon, everyone. As Rick highlighted in his opening remarks, the December quarter represented another outstanding period of financial performance and operational execution for KLA-Tencor. Shipments, revenue, and non-GAAP diluted earnings per share each finished above the range of guidance in the quarter. This result was driven by strong demand across our product portfolio, with particular strength in our flagship wafer and mass inspection product lines, as well as solid execution and cost management in our manufacturing and service operations. Revenue was $877 million in the December quarter, non-GAAP diluted earnings per share was $1.52, and would have been $1.57 per share at the 21% guided tax rate. GAAP earnings per share was also $1.52. In our press release, you will find a reconciliation of GAAP to non-GAAP diluted earnings per share. With the exception of when I explicitly refer to GAAP results, my commentary will be focused on the non-GAAP results, which exclude the adjustments covered in the press release. Now turning to the highlights of the December quarter demand environment, although we're no longer guiding quarterly orders, we'll continue to share our perspective on the current quarterly end market demand picture to give investors insight into industry trends and KLA-Tencor's performance. We eventually plan to provide end market mix detail for shipments results and guidance and expect to have that information available once we complete an upgrade of our internal analysis systems sometime in the next few quarters. At that time, our end market customer mix, business segment, and regional breakdowns will be provided on a shipment basis. In the interim, we'll continue to provide additional detail on order mix by end market. New orders in the December quarter were approximately $1.1 billion. Memory was 61% of the orders and in line with our forecast for the quarter. Demand was roughly evenly split between DRAM and NAND. We're currently modeling memory orders to be 34% of the total in the March quarter. Foundry made up 37% of new system orders in December, also as expected, and is forecasted to grow to 63% of orders in March. We're currently modeling solid growth in Foundry orders in the first half of calendar '17 fueled by 10-nanometer production and 7-nanometer development from multiple foundry customers and by continued investment in legacy technology nodes. Logic made up 2% of new system orders and is currently forecasted to be at a comparable level in the March quarter. In terms of the approximate distribution of orders by product group for the fourth quarter, wafer inspection was 45% of new system orders, patterning accounted for 35%. Patterning includes orders from our radical inspection business. Service was 18%, and non-semi was approximately 2%. New orders in the first half of calendar year 2017 are expected to be roughly flat compared with the second half of calendar '16. Total shipments were $887 million in the quarter and just above the guided range for the quarter of $800 million to $880 million. Looking forward, we're modeling March quarter shipments to be approximately flat at the mid-point compared with December and to be in the range of $850 million to $930 million. Our current build plans are supporting quarterly shipment levels around $900 million for the next few quarters. Turning now to the income statement. As I mentioned in my highlights, revenue was $877 million in December, finishing above the range of guidance. We expect revenue to be in the range of $860 million to $920 million in the March quarter. Non-GAAP gross margin was 63.8%, a new quarterly record for the Company. The better than expected gross margin performance in December is largely a function of strong product mix on the incremental revenue delivered in the quarter and operating leverage in our manufacturing and service operations. We expect gross margin to be in the range of 62% to 63% in the March quarter, down slightly versus the December quarter due principally to the mix of products we plan to recognize revenue from in the quarter. Going forward, we expect to deliver gross margin results a couple of hundred basis points above our published business model target due to a number of factors including product positioning, new product introduction execution, and cost management. We are currently forecasting gross margin in calendar '17 to be approximately 62% plus or minus 50 basis points. Total non-GAAP operating expenses were $221 million, flat compared with September, and the non-GAAP operating margin was 38.6%. We are modeling operating expense levels of between $220 million and $225 million in the March quarter and in the range of $900 million to $920 million for the full year in calendar '17. Given our gross margin expectations, we continue to deliver operating margins at the upper end or above our published model for the foreseeable future. Our non-GAAP effective tax rate was 23.5% in the quarter, above our previously guided long-term planning rate of 21%, reflecting the higher mix of revenue from products manufactured in the U.S. and other discrete items impacting the tax rate. We are planning for this product mix trend to continue through calendar '17, which will put some pressure on the tax rate. We assume a 22% tax rate going forward for modeling purposes. Finally, net income for the December quarter was $238 million and at the end of the quarter, there were 157 million fully diluted shares outstanding. I'll turn now to the highlights on the balance sheet and cash flow statement. Cash and investments at the end of the quarter were $2.6 billion, an increase of approximately $100 million compared with the September quarter. Cash from operations was $222 million in the quarter. Free cash flow was $214 million. In December, we paid a total of $85 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 on our term loan has amounted to approximately $254 million since it was added in the December quarter of 2014. In conclusion, KLA-Tencor's results in December reflect our market leadership, the critical nature of process control, and our customers' growth strategies at the leading edge and in legacy design rules, and our industry-leading business model. This, coupled with almost $1.1 billion in new orders in the December quarter, positions the Company for strong relative growth versus the wafer fab equipment market in calendar year '17. The current forecast for the wafer fab equipment market is to grow mid-single digits in 2017. Against this industry backdrop, we are modeling the Company's revenue to grow slightly better than the broader market. This performance demonstrates the Company's market leadership and the strong customer acceptance of our portfolio solutions addressing the most critical yield requirements at the leading edge, and our operational confidence. Given our record backlog and expectations for new orders, KLA-Tencor is well positioned for another year of solid growth in 2017. To reiterate, our guidance for the March quarter is shipments in the range of $850 million to $930 million, revenue between $860 million and $920 million, and non-GAAP diluted EPS of $1.42 to $1.62 per share with GAAP EPS of $1.40 to $1.60 per share. This concludes our remarks on the quarter. I will now turn the call back to Ed to begin the Q&A.

Okay, thank you, Bren. At this point, we'd like to open the call up for questions, and we once again request that you limit yourself to one question and one follow-up given the limited time we have for today's call. Feel free to re-queue for your follow-up questions, and we'll do our best to give everyone a chance to participate in today's call as time allows. All right, Mariana, we are ready for the first question.

Rick, I wanted to get a sense of obviously memory orders were really strong last quarter. You guys have talked about that being the case. Is that more cyclical? Or is there something secular going on? I guess I'm particularly asking about 3D NAND because it seems like you guys may be preparing a new solution that's going to help improve yields there. So, I'm sort of wondering what your outlook generally is for how your exposures are going to grow in memory? Thanks.

Thanks, Tim. Yes, we have had some success recently with 3D NAND. I think both in terms of existing products, which we're finding more application for as our customers broaden the technology deployment. The second aspect is some of the yield challenges they are facing. We think that by the end of the calendar year, we will actually have more offerings to support 3D NAND. So, we think that if we execute properly by the end of '17, we should have larger adoption of inspection for 3D NAND, leading to upside to our current levels of concentration.

And I have a question for you, Bren. While others often present their financial models linking revenue to wafer fab equipment, I understand it’s a bit more complex for you due to the varying mix. If wafer fab equipment is projected to be $37 billion, could you share how your revenue might correlate with that? It seems that even without taking any market share, achieving $3.7 billion could be quite attainable in a $37 billion market. I’m curious if you can connect your revenue to wafer fab equipment. Thank you.

Yes, Tim, it's a good question. As we look at calendar 2017, we think WFE is probably up somewhere in the mid-single digits. When we do our math, we end up in the ballpark of $36 billion. Against that backdrop, as I mentioned in the prepared remarks, we think that we should do better than the broader market. So, we're looking at high single-digit growth relative to calendar 2016. We feel fairly optimistic about that. I also said that over the next few quarters, we expect to be shipping consistently in around $900 million. I believe I've got pretty good visibility into my build plans through September. By the time we reach December, we will know how the second half order book ultimately plays out, but I think we're positioned for a good year. Depending on how the second half plays out, particularly around December, the numbers you mentioned aren’t inconceivable if that were to happen. However, we are basing our outlook on a mid-single-digit growth rate.

My first question is on EUV. Rick, you've mentioned that you're seeing good activity for Gen 5 being deployed both for OPC and EUV development. Can you talk about what progress you're seeing there? How far along do you think you are in the qualification process? Is that something that can materialize in 2018 in a meaningful way?

EUV, we've had some momentum based on the fact that there's more activity going on in development at multiple sites for our customers. Gen 5 has now been deployed, especially in the area of qualifying the images printed by EUV lithography. Additionally, we have had some success with our 6XX platform serving the EUV mask qualification market. We believe that as the activity continues to pick up on EUV, this segment of our business should grow over the next couple of years. With high volume manufacturing of EUV expected by 2019 or 2020, we anticipate a ramping of those capabilities and transitioning from characterization into production flow as we proceed into those later years. We expect to see adoption of products like Gen 5 especially in the back end of the line, supporting the ramps in the middle and back end as EUV becomes more prevalent in production.

And then one question on the 3D NAND that you've mentioned for the back half of the year. Could you give us some sense of how big is the growth opportunity for you in 3D NAND, maybe just in terms of what portion of the market you address currently? What sort of opportunity do the new products bring?

Well, Farhan, we've discussed that memory is about half the adoption rate compared to foundry regarding process control adoption; however, it tends to grow faster for two reasons. Firstly, more capabilities are becoming available, leading to broader application as our customers' needs evolve. Secondly, the yield challenges being faced indicate a need for process control solutions that are not currently being utilized. Therefore, we anticipate that the intensity of process control adoption in 3D NAND could contribute to our overall outperformance of the industry. New developments in process control intensity for 3D NAND are paralleling what was previously observed in 2D planar.

On profitability, assuming you guys slightly outgrow the WFE market this year, that would imply roughly $3.5 billion in revenues. You guys drove 38% operating margins in December. Given your guidance for March, should we expect operating margins in the range of 36% to 37%? Is that the way you're thinking about it?

Harlan, it's Bren. Yes, in the prepared remarks, I wanted to provide more perspective on sizing the business as we head into the year. We've been doing a lot of work on our strategic planning, and we have a deeper view of the mix of business going forward around certain products. Given our backlog, we have pretty good visibility into the year. The numbers you provided seem to align with my guidance. While gross margin can vary depending on the product mix, I think your thinking makes sense and aligns with our current outlook. China is still a tailwind for KLA this calendar year. While most of the spending is more focused on legacy nodes, there is ongoing investment. They are investing in both their existing and anticipated future needs, with a focus on continuous advancement.

The second half of '16 was relatively slow in China, as their orders were digested. However, for calendar '17, I believe our native China business will see considerable improvement compared to '16, particularly in foundry.

So, my first question is on your mass inspection product. You talk about how the customer around EUV was seeing several products. Is there a way for us to think about that? How many are you shipping this year?

Historically, there has been a ratio of about ten scanners for one radical tool. However, this can shift, especially during developmental phases. Currently, we are observing more advanced designs pushing limits with EUV capabilities. Therefore, we believe this ratio holds true, but it's certainly dependent on the specific needs of our customers as they ramp their production.

I actually have a question on image sensor customers. We see some higher present sales than in the past. Just wondering if you're seeing anything with customers that could give us some sort of outlook on sales from image sensor customers.

We've had good participation from image sensors, particularly in the IoT and automotive markets. Their demand has been relatively steady and we work closely with these customers as they bring out new technologies. Although this segment has been somewhat episodic, it has been a stable part of our business over the last couple of years.

Rick, a big picture question regarding the last industry ramp of 28-nanometers. You saw a large buying spree particularly from the leading edge that continued for several years. As we transition to 10-nanometers and 7-nanometers, can you touch on the perspective of this node, and could it be as substantial as the 28-nanometer ramp?

It certainly feels that way. When we talk to customers, there are now multiple players actively engaged at 7-nanometers, and while we haven't seen significant buys yet, the 10-nanometer buys have implications for 7-nanometers later. We anticipate a wave of several players pursuing that node, and while it's difficult to quantify, customer enthusiasm suggests a potentially lucrative ramp ahead.

We're absolutely investing more in R&D. Given the revenue level and the opportunities, we recognize the need to enhance capabilities across our portfolio, particularly around EUV and 3D NAND.

For 16-nanometers to 10-nanometers, there is virtually no equipment reuse. The dynamic shifts observed from 20 to 16 are not comparable. New tools will be essential given increased complexity in lithography and the backend as well. While customers aim to optimize capital expenditure, significant transformations at nodes will indeed necessitate new investments.