KLA Corp (KLAC) — Q1 2020 Earnings Call Transcript

Thank you, Christian, and welcome to today's KLA earnings conference call to discuss the results of the September 2019 quarter and outlook for the December 2019 quarter. I recently joined KLA, and today marks my first KLA earnings call. I'm glad to be here and look forward to meeting and talking with all of you over the quarters and years ahead. Joining me on the call are Rick Wallace, our President and Chief Executive Officer; and Bren Higgins, our Executive Vice President and Chief Financial Officer. During today's conference call, we will discuss quarterly results for the period ending September 30, 2019. We released these results this afternoon after the market close, and they are also posted on the Investor Relations section of our website at ir.kla.com. Today's discussion of our financial results and outlook is presented on a non-GAAP financial basis unless otherwise specified. A detailed reconciliation of GAAP to non-GAAP results is in today's earnings press release and the earnings slide presentation posted on the KLA Investor Relations website. Our IR website also contains a calendar of future investor events, presentations including those from our recent Investor Day and corporate governance information as well as links to KLA's SEC filings, including our annual report on Form 10-K for the year ended June 30, 2019. Our comments today are subject to risks and uncertainties reflected in the Risk Factors disclosure in our SEC filings. Any forward-looking statements, including those we make on the call today, are also subject to those risks, and KLA 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'd like to now turn the call over to our Chief Executive Officer, Rick Wallace. Rick?

Thank you, Kevin, and welcome to KLA. Good afternoon, everyone, and thank you for joining us on today's call. I'll start with a brief strategic overview before I cover the business highlights from the quarter. KLA continues to see strong momentum in our business from the secular trends we articulated at our recent September 17 Investor Day. Our performance this quarter clearly demonstrates how KLA is benefiting from our strategies for growth, technology, leadership and operational excellence. We delivered another solid quarter, with revenue in both GAAP and non-GAAP EPS finishing above the range of guidance, a result of strong customer demand for KLA's solutions and focused execution, despite a backdrop that still includes some industry headwinds in key segments. As a global leader in process control and supplier of process-enabling solutions for the data era, KLA remains at the forefront of the most important industry trends and technology inflections in the electronics industry. Our deep collaborative customer relationships, broad IP portfolio and differentiated solutions that address our customers' most complex challenges is the recipe that sustains our market leadership. Our business also continues to benefit from more complexity within semiconductor devices as well as multiple mega trends driving demand across multiple product generations in numerous key industries. Underpinning our success and consistent outperformance is the KLA operating model, which codifies our corporate values and management principles. We have been running the company this way for a long time, but we discussed it much more extensively at our recent Investor Day to better illustrate its power and impact on the KLA business and explain how it represents critical core competencies that we believe can enhance the long-term performance and profitability of acquired businesses. The KLA operating model is essential to align the company on a consistent strategy and execution, heightened accountability and facilitate continuous improvement, while ensuring we always operate with strong financial discipline and rigor. Strategically, we have 4 objectives that serve as our guide and drive our high-performance culture. I also spoke about this extensively at our recent Investor Day, but it's worth reinforcing for those who couldn't attend. These 4 objectives are: market leadership, product differentiation, operational excellence, and attracting and developing talent. We run all our businesses, including acquired ones, with a focus on these key 4 objectives, and it shows in our overall results published today. Before I cover the business highlights for the quarter, I'd like to provide some high-level perspective on the current industry environment. The long-term growth opportunity for the semiconductor markets remains compelling, driven by the proliferation of electronics across more diversified end markets, the introduction of new advanced technologies supporting 5G and artificial intelligence, growing semiconductor investment in China and continued device and process innovation to deliver superior performance and return on investment. KLA's strong results are primarily driven by demand momentum we see due to support, both development and capacity growth in advanced logic. The demand to support advanced logic nodes is expected to remain healthy through the balance of 2019 and into 2020, driven by investment in EUV, competitive dynamics and capacity additions. Given the recent news of increased CapEx investments in 2019 at leading-edge logic and better-than-expected demand from domestic memory customers in China, our outlook for WFE investment in 2019 has improved since our initial view for the year. We now expect WFE levels to decline by approximately 10% to 15% in 2019, with KLA's Semi Process Control business, inclusive of our guidance today, outperforming the broad semiconductor capital equipment market and growing modestly compared to 2018. Now let me cover some of the product highlights from the quarter. KLA's market leadership is evidence of the successful execution of our portfolio strategy focused on differentiation to address our customers' most critical challenges. We're happy with our product positioning and the strong customer acceptance we are experiencing across our portfolio. We continue to see accelerated growth of our flagship Gen5 optical inspection platform, with customers now deploying Gen5 for both technology development and production monitoring at the advanced nodes. Driven by this expanded use case, we expect Gen5 shipments to double in 2019 and adoption to continue to grow in 2020, as customers are under intense pressure to ramp quickly, and KLA's advanced optical inspection platform is on the critical path to their success. The accelerating adoption of EUV and increased investment in leading-edge foundry and logic will continue to drive strong Gen5 demand in the near term. Also, at last month's Investor Day, we announced the first new EBEAM inspection platform in several years. I'm pleased to report that we're receiving very positive feedback from our early customers related to the initial tool performance. KLA's differentiated EBEAM inspection platform works with Gen5 optical inspection platform with seamless connectivity to offer customers the best inspection performance combination at the lowest overall cost of ownership to identify and detect yield killer defects at the most advanced nodes. Demand for mask inspection continues to be a highlight for KLA. In the September quarter, we saw a continuation of the momentum we have experienced over the past several quarters and better-than-expected demand in the September quarter helping to contribute to the revenue upside we experienced in the quarter. We're seeing strong demand from leading foundries for our Teron mask inspection platform for optical and EUV applications and expect this to continue as customers ramp their advanced technology road maps. And finally, KLA's Service business continues to deliver excellent revenue growth performance, while simultaneously generating record free cash flow. Semi Process Control service revenue is on track to top $1 billion in 2019, with over 70% of the revenue generated from subscription-like service contracts. This gives us high confidence that this business can deliver long-term revenue growth rates in the range of 9% to 11%. Several factors drive growth in our Service businesses, including increased complexity of our systems, expansion of the installed base and extended demand at the trailing edge nodes. With high fab utilization in foundry and logic and stable or bottoming in memory, our customers are also looking for opportunities to enhance productivity and extend the life of their installed base. As a result, we see robust service contract penetration, and our Service business is providing a steady recurring revenue stream to our business. In summary, the KLA operating model drives our investment thesis. This is accomplished by driving sustained technology leadership with a strong competitive moat, supported by a track record of free cash flow generation and capital return. Despite near-term headwinds and the industry demand environment centered on the timing of memory capacity investment, KLA continues to execute exceptionally well and deliver healthy relative revenue and earnings growth. Our focus on driving innovation and providing a steady stream of differentiated products and solutions sets the stage for growth in 2020 and positions KLA to achieve the long-term growth targets we established in our September Investor Day. 2019 is turning out to be a banner year for KLA, showcasing the enduring value created by the successful execution of our strategic objectives. Looking to 2020 and beyond, we're very excited about our prospects for growth and market leadership, building on the momentum we've established in our process control markets and capitalizing on the market expansion opportunities from the Orbotech acquisition. We remain impressed with the Orbotech team and excited by market opportunities and technology leadership. Our integration and product synergy programs are on track and progressing well. With that, I'll turn the call over to Bren for his commentary on the September quarter financial results and our December quarter outlook. Bren?

Thank you, Rick, and good afternoon, everyone. Please turn to Slide 10 for a review of the September quarter financial highlights. This was a very strong quarter for KLA, with revenue and EPS each coming in above the high end of our guidance ranges. Our free cash flow results also marked a new record for the company. Total revenue for the September 2019 quarter was $1.413 billion, which was above the range of guidance of $1.31 billion to $1.39 billion. Gross margin for the quarter was 60.8% in the upper end of the guided range for the quarter of 60% to 61%, driven by incremental revenue growth and a stronger-than-expected semi process control product mix. GAAP EPS was $2.16 and non-GAAP EPS was $2.48, both of which were also above the range of guidance of $1.75 to $2.05 and $2.04 to $2.34, respectively. Our cash flow execution was exceptional this quarter, as both cash from operations and free cash flow came in at record levels of $496 million and $464 million. We are proud of our financial results this quarter, and we remain focused on executing across all markets as we move forward, with a focus on our integration and synergy plans for the Orbotech acquisition. A key element of our investment thesis is KLA's commitment to returning cash to shareholders. On September 17, we announced a 13% increase in our quarterly dividend level to $0.85 per share. This marks the tenth consecutive annual increase in our quarterly dividend level, reflecting our confidence in our business strategy, the strength of our free cash flow generation and our ability to grow it over time as well as our commitment to returning value to shareholders. In terms of returning capital to shareholders during the quarter, we were consistent and effective in our execution as we repurchased $228 million of common stock and also paid $122 million in regular quarterly dividends and dividend equivalents upon divesting of restricted stock units. In addition, we reaffirmed our commitment to continuing to return capital to shareholders as we announced, that the Board of Directors authorized, an additional $1 billion share repurchase program resulting in $1.6 billion available to repurchase under Board authorization at quarter end. Please turn to Slide 11 for an overview of the revenue breakdown by reportable segments and key end markets. Revenue for the Semi Process Control segment reached a new high at $1.163 billion in the quarter, reflecting a 16% sequential increase due to strong performance in foundry and logic. As mentioned earlier, our outlook for WFE demand in 2019 has seen modest improvement, supported by investments in EUV technology and heightened foundry demand. Additionally, there is growing demand from native China, contributing to this positive trend, with expectations for this segment in 2019 to remain relatively flat compared to 2018. Foundry accounted for about 44% of semi process control revenue, up from 36% in the previous quarter. Memory made up 43% in September, down from 52% last quarter, while logic represented 13% of total semi process control revenue, compared to 12% last quarter. I'll turn now to the Specialty Semiconductor Process segment. SPTS is a leader in PVD and edge solutions in fast-growing specialty semiconductor applications, like MEMS, sensors, power and RF devices, as well as in advanced packaging markets. Revenue for SPTS was $69 million, up 3% sequentially. While we're encouraged by the market position of these products, SPTS revenue for 2019 has been impacted by ongoing global trade issues and a slowdown in the automotive semiconductor market. Despite these near-term headwinds, we expect SPTS to deliver revenue levels in 2019 that are roughly flat on a pro forma basis to calendar year 2018. Revenue for the PCB, Display and Component Inspection segment was $179 million, down 3% sequentially and in line with expectations. This segment includes the former PCB and display businesses of Orbotech and KLA's component inspection business. Please turn to Slide 12 for a breakdown of revenue by major products and regions. The distribution of revenue by major product category in the September quarter was as follows: wafer inspection was 32%; patterning, which includes reticle inspection, was 27%. Wafer inspection and patterning are part of our Semiconductor Process Control segment; Specialty Semiconductor Process was 4%; PCB, Display and Component Inspection revenue was 9%; other, which includes bench-top analytical instruments and the KLA Pro mature products and enhancements business, was 3%; Service was 25% of revenue in the quarter. In terms of regional split, Taiwan was 27%, China was 24%, Japan was 15%, Korea was 14%, the U.S. was 13%, Europe was 4%, with the rest of Asia at 3%. Please turn now to Slide 13 for other income statement highlights. Total operating expenses were $376 million in the quarter and our operating margin was 34.2%. Other income and expense in the September quarter was $39 million. The effective tax rate was just under 11%, below our long-term tax planning rate at 14% due to a decrease in tax reserves related to the resolution of a tax audit in the U.S. Non-GAAP earnings per share under the 14% planning rate would have been $2.39 per share. Going forward, you should continue to use 14% as the long-term planning rate. Net income was $398 million, and we had 160 million diluted weighted average shares outstanding. Please turn to Slide 14. We ended the quarter with $1.8 billion in cash, total debt of $3.4 billion and a flexible and attractive debt maturity profile supported by investment-grade ratings from all 3 agencies. Please turn to Slide 15 for a review of free cash flow. KLA has a history of consistent free cash flow generation and high free cash flow conversion. Over the past 5 years, we have averaged just over 100% free cash flow conversion. And over the last 12 months, it's been 84%. Our innovation and differentiation in the marketplace are what drives our industry-leading gross margins, and ultimately, our free cash flow conversion. Please turn to Slide 16. KLA continues to execute on its commitment to return capital to shareholders in the form of both dividends and share repurchases. The dividend payout has increased at a compound annual growth rate of 15% since inception. The share repurchase has also increased over the years, with the average price paid to repurchased shares being slightly over $66 since 2010. The only exception to the company's systematic repurchasing activity was during the period when it was blacked out due to merger discussions. Please turn to Slide 17 for December quarter 2019 guidance. We expect total revenue to grow sequentially, roughly 4% at the midpoint and be in a range of $1.435 billion to $1.515 billion in the December quarter. Foundry is forecasted to be about 55% of semi process control system revenue in the December quarter, depicting the strength we continue to see among our foundry customer base. We expect memory to be approximately 36% of system revenue in the December quarter, reflecting continued headwinds we see in the memory market. Logic is expected to be about 9% of semi process control system revenue next quarter. For the second half of the year, we now expect foundry and logic revenue combined to be up over 50% in the second half of the calendar year versus the first half. Based on product mix expectations for the December quarter, we forecast gross margin to be in a range of 60% to 61%. In terms of operating expenses, we are modeling NIM to be approximately $385 million. The higher operating expense level in the December quarter is due principally to the timing of non-headcount-related product engineering expenses for next-generation programs as well as new risk mitigation bubble costs associated with recent actions taken to drive long-term structural cost reduction actions related to leveraging KLA's global footprint to relocate certain manufacturing and engineering activities to lower-cost locations. We would expect to see an impact from these activities through 2020, with the return on these investments beginning in 2021. As we move forward to the March quarter, our expectation today is that operating expenses will return back into the range of $370 million to $375 million, as product development expenses normalize to run rate levels and acquisition synergies offset other costs. We expect other interest and expense to be approximately $38 million in the December quarter and the tax rate to be about 14%. For earnings, we expect GAAP diluted EPS of $2.13 to $2.43 per share and non-GAAP diluted EPS of $2.39 to $2.69 per share. Our EPS guidance is based on a fully diluted share count of approximately 159 million shares. In conclusion, the September quarter result demonstrates strong operating performance and relative strengths for KLA across many critical segments in what remains an environment with some headwinds. With our diversified end markets, continued technology leadership across a broad product portfolio and operational discipline, KLA is delivering strong relative performance, and we are encouraged by the momentum we see in our business. Before I turn the call over to Kevin to begin the Q&A, I'd like to make a few qualitative comments on our outlook for the wafer fab equipment market in 2020. While it is too early for us to provide specific guidance or half-to-half trajectories for the year, we continue to see a strong year for foundry and logic investment, with investment levels consistent with what we've experienced in 2019 as customers continue to progress their technology road maps and a strong demand environment, with improving competitive dynamics in diversified end demand. For memory, we expect a better year in 2020, and disciplined supply management in 2019 has improved the overall condition in both segments. Given the strength of our market position, the purchasing behavior of process control in foundry and logic, improving process control intensity in memory and contributions from new products, calendar 2020 is setting up for another year of relative outperformance for KLA. We'll have more to say on this when we report earnings for December quarter. I'll now turn the call back over to Kevin to begin the Q&A. Kevin?

Thank you, Bren. With that, Christian, we are ready for the first question.

Congratulations on the very solid results. Rick, I want to go back to one of your comments you made in your prepared comments about the Gen5 optical inspection platform. You mentioned that you expect shipments to double in 2019 and for that to still be a good growth driver in 2020. So I guess, I'm trying to get a sense from you, where in sort of the potential of that product cycle over time do you think we are? Maybe using a baseball analogy might be the right way to look at it. And as you think about logic/foundry being strong next year, to what extent is that just a call on logic/foundry CapEx versus perhaps a Gen5 product cycle that's still in the sweet spot and accelerating?

Sure, John. Thanks for the question. Yes, I think if I thought about Gen5 right now and you want to use baseball, it's the third inning. It's relatively early in the life. We're now on the second iteration of that product in terms of a new platform, and there are several iterations to follow. Engineering is being dedicated to that, but we're now starting to see broad adoption and really the beginning of adoption in production, where what we really had been dealing with for the most part, in the last couple of years, was during the development cycle. So we're still early on, and we think it will become a primary tool. We always thought it would become the HVM tool once we got to EUV in ramping in production, and it definitely feels like it's doing that. The upside to that is, we've seen more memory adoption in the Gen5 than we originally anticipated. So that's probably upside to what we had originally envisioned.

John, it's Bren. I want to add that as we mentioned at our Investor Day, there is potential for reticle qualification in the fabs for EUV reticles. As we begin to develop this use case, it focuses on how the tool can achieve full wafer coverage to qualify reticles while they are being utilized in the wafer fab. This presents an incremental opportunity that is gradually evolving, and we believe it contributes an additional growth dimension for Gen5 as it becomes more widely adopted.

That's helpful. Bren, for my follow-up, I want to revisit the operating model you presented at Analyst Day regarding the operating margin bridge between now and 2023. You seem to be ahead of the revenue and operating margin targets set in that model, both for the September quarter and the December forecast. It also appears that December's operating expenses are unusually high based on your comments. Generally, the operating margin target you provided only anticipated incremental margins at the lower end of your historical guidance. I would prefer not to render the model outdated before a quarter is up, but could you discuss whether you see any upside or conservatism in that model shared at Analyst Day?

Yes, John, it's a good question. I mean, I think one of the challenges in putting together the model is it reflects a different mix of business that we have today but also expected moving forward. So clearly, in the September quarter and even in December what's driving our business in terms of incremental growth is the process control part of the business and that is behaving consistent with the historical model that we've had out there. So anytime the mix is shifting in that direction, you're going to see outperformance against the base model. So what we tried to reflect was based on our expectations for growth over time, what the mix of business would do and how that would impact the model. Obviously, there's synergy and other actions that are embedded in that. But anytime we have an inflection driven by the process control part of the business, we're going to see a period of outperformance. But in terms of your long-term view, I think it's the right way to think about it.

I guess, first question, on the foundry/logic side of things, can you speak to whether you're seeing increasing breadth of spending in that category and really focused on the leading edge? And as part of that, if you could speak to also reuse? That clearly was a headwind, basically from 20-nanometer down, but it sounds like 7 non-EUV progressing to 5 EUV, but that's a seismic shift here that is driving a real uptick in process control intensity. Would love to hear your thoughts on both of those things.

Yes, CJ, I'll address the question, and then Bren will provide additional insights. Currently, the foundry and logic market is not very broad, but we anticipate it will expand in 2024. There are several dynamics regarding reuse that differ from previous cycles. Firstly, there is a significant number of design starts, leading to high demand due to the introduction of various devices at advanced nodes. Therefore, we do not expect a substantial repeat of past trends. Additionally, we are experiencing a new product cycle that is introducing many new capabilities. Customers are focused on optimizing their capital and becoming as efficient as possible. However, based on our early observations and the new challenges posed by advanced nodes, even without widespread EUV implementation, we do not foresee a repeat of previous cycles. The expansion of EUV will likely intensify these challenges further.

Yes, I think the big difference between this node, and let's say, 20-nanometer, even down to 14, 16, is we're seeing much broader end market adoption that's driving these design starts through the advanced foundry and the leader there. And so all of that is sort of preventing any reuse as that capacity is deployed to support all that activity, and a high-mix environment puts more pressure on yield and delivering to tight product windows. So it's a good story, and we expect this node to have some legs. And certainly, the investment for N5 is starting to pick up and strong expectations for that.

Very helpful. If I could sneak in a quick second question. You talked about a return to $370 million, $375 million OpEx in March. And I guess, curious, how should we think about potential synergies related to Orbotech as we move through 2020?

Yes, CJ, I outlined it at Investor Day. There's a number of activities that are happening, and we'll see those play through as we move through the year. One of the dynamics that I wanted to put a little bit of extra time into in the prepared remarks was some of the investments that we're making to drive longer-term structural cost reduction, namely, relocating some operations from subscale or higher-cost regions into lower-cost parts of our global footprint. So as you're ramping up one team and ultimately ramp down another team, there's some incremental investment, but those have returns over time. So as I think about that range, I think we're in that range as we move in, based on how we're sizing the business right now and thinking about top line, we'll be operating in that range as we move through the year with the usual program development expenses that could cause you to move one direction or the other. I would think it would probably be lower end or slightly below the range as we move towards the end of the year. At the beginning of the year, it's probably at the higher end.

I just had a quick one, Rick, you kind of spoke about how Gen5 is going to double in 2020. Is that primarily coming from foundry's 5 nanometer? Or is there a significant chunk coming from DRAM adoption, too?

So Krish, the comments indicated that we saw a doubling in 2019 compared to 2018. Although, referring to Rick's earlier point about Gen5, we are really encouraged to see it being deployed into production use cases rather than just for defect discovery and R&D applications. As the print check is implemented, it will support EUV reticle qualification. We anticipate further growth in Gen5 as we approach next year, but we haven't specified how much more. We are shipping both generations to support activities for both 7-nanometer and 5-nanometer processes, but you will notice more adoption of Gen5 in production as N5 progresses.

Yes. And just to add to Bren's point, what happened in '19 also was penetration across almost every customer, major customer, in terms of the early evaluation and use so that sets up the case for the longer run. But that was really a proliferation year for '19, where we got it out and established in all the leading jobs.

Yes, I mean, certainly, Krish, just one other thing, as I look at the order profile, it would imply we're going to have growth in the number of units as we move into next year. I don't know if it will double, but we'll certainly see growth in adoption next year.

Great job on the quarterly execution and strong free cash flow. On EUV litho adoption and your mask inspection business from Analyst Day, I think we could gather that your reticle inspection franchise is going to grow pretty strongly this year, up about 45%. But if I look at the shipment profile for ASML, let's say, over the next couple of years, it's still a runway for very strong growth, around 25%, 30% shipping CAGR. With that in mind, how should we think about the trajectory of your mask inspection business looking into next year?

Yes. I mean, I think, Harlan, you're right. We've had a very good year and a down WFE year in reticle inspection and that's been adoption for the Teron platform, both for optical and EUV inspection support. Some of the drivers moving forward is, yes, the number of scanners but also design starts tends to drive reticle inspection demand. So we would expect to see some incremental demand on the 7-nanometer side as we see incremental capacity there. And then you'll start to see some activity as we move into next year. As we talked about at Analyst Day, we do have a new platform that's specific for EUV inspection that we'll start shipping in 2020 also. So you'll see a mix and match. But as we stand today, I think given what's out there for 7-nanometer and then for the layers that will be happening in EUV, we believe we've got the market pretty well served with the capabilities that we're offering.

Yes, makes a lot of sense. And then on the Specialty Semiconductor segment, you drove pretty good quarterly results despite given the trade headwinds. And so again, if I look at the trends heading into next year, you've got a big step up in RF content, in 5G smartphones, in infrastructure, you've got more power products in auto and industrial, and of course, all this advanced packaging and things like system and package. All of this should provide a pretty good backdrop for growth next year, but wanted to get your initial views in terms of how you're thinking about 2020 for SPTS?

We are relatively new to that business, but as we collaborate more with the team and engage with customers, we see strong potential for growth. As you've mentioned, we faced some challenges in 2019 but still achieved some traction. The outlook for 2020 appears positive for SPTS. Based on our current projections, particularly for RF technology supporting 5G, we anticipate a growth range of 10% to 20% for that business as we head into next year. We are optimistic about this and continue to deepen our understanding of our customers.

Rick, looking at your WFE share this year, it seems like you're on track to gain about 50 basis points. However, many are concerned about foundry CapEx, believing it could represent a near-term peak, especially in the latter half of the year. The capital intensity metrics suggest we haven't witnessed such quarterly figures in the last two decades for non-memory. Additionally, TSMC's CapEx appears to be around $5 billion in Q4, indicating a $20 billion run rate. How do you address concerns that we might be nearing a peak in foundry logic shipments? Is this perspective not in line with your view? Do you anticipate that quarterly shipment rates will continue to rise in foundry/logic next year?

Sure, Tim. It is true that we had considerable strength, but it was not seen across a lot of customers. Some customers are expected to expand next year, and we feel positive about our positioning. We believe the mix between foundry, logic, and memory this year is roughly in line with what we anticipate for next year, which is influencing some of the capacity and intensity we are experiencing. Overall, we feel optimistic about next year. We had a strong second half this year, and we are expecting some expansion. Additionally, some orders from this year will result in deliveries next year, allowing us to realize some of that revenue in the coming year.

No, I think Rick covered it. I mean, look, if you think most of the investment we've seen this year has been from the leader. And so the broadening out across a pretty diversified end demand environment into next year, we feel comfortable given the comments we made in the prepared remarks that we see some sustainability in foundry and logic as we move into 2020.

We did not provide guidance for the individual segments. However, I expect to see a sequential increase in FPD next quarter based on our overall planning. This area can be inconsistent, but looking at the order profile from the June quarter and the associated lead times, those deliveries will take place in December. Since this is a build-to-order business, we typically maintain schedules once we receive orders. Therefore, I anticipate growth in that area. For the upcoming year, I don't foresee a significant recovery in the flat panel business. After six years of growth, 2019 was challenging, and I don't expect much improvement in 2020 either. Our focus remains on the business, and we've been implementing specific cost reduction measures geared towards that segment. Our initial goal is to ensure the business operates at an acceptable level of profitability during these low points and to position ourselves for scaling and driving operational leverage as the business recovers. We are prioritizing these actions, and we will monitor how the situation evolves over time.

Congratulations on the strong growth. I had 2 questions as well. For the first one, I'm curious, what is the right way to think about process control and density in EUV versus non-EUV systems? I imagine EUV was not as big of a factor this year. Do you think it's a bigger factor for you next year?

Yes. Process control intensity for EUV is higher than it is for non-EUV. In spite of the fact that there are fewer layers. I mean, obviously, the value of EUV is a reduction in layers. And so we would see that, that has some mitigating effect on the increased intensity around EUV, but you really get process control intensity in a couple of ways: one, you get it in a mask shop because you have to do more inspection to assure that you have a high-quality mask. And we're still, as an industry, trying to work out some of the challenges, pellicle, nonpellicle and getting mask to be good in the lifetime of the mask; the other thing is in print check to verify and validate that Bren mentioned in an earlier question, we see that as an opportunity and that's been driving process control intensity around Gen5. So overall, it's a plus for some of our businesses, it is a minus for some, but the net-net of it all is process control intensity ticks up in an EUV world as the industry goes forward. And on balance, it's a net positive for KLA.

And my follow-up, how large was domestic China spend for you this year? And just conceptually, how are you thinking about it going into next year?

Yes, it's a good question. Actually, as I said in the remarks, I mean, at the beginning of the year, we thought it'd be down 10% to 15% from a very solid number in '18. And it turned out with some projects that came back into the year, one major one in particular, we're going to end up about flat. And as I look at our preliminary scoping into 2020, and you do have some mix on what kind of projects are going to be invested in, but it looks relatively flat to me again. So I don't see it changing much as we move into 2020. So it's in the $650 million range plus or minus in terms of revenue level for the company. And I would expect that to stay relatively consistent based on what I see today for 2020.

So that is not part of the outperformance assumption for next year?

No, I don't think it's going to decline. It certainly improved performance in 2019. As I consider next year, I'm not counting on a significant increase in business from China to achieve our targets. I anticipate a stable environment in mainland China.

Just wanted to follow up on the question from Vivek about EUV driving higher process intensity. I assume that that's true in the memory side of the business as well. So as we look at EUV insertion in 1Z and then 1 Alpha processes, do you see a meaningfully higher process control intensity in those steps as we see EUV coming into high-volume manufacturing? And then I've got a quick follow-up.

Yes, it's still early for memory. They're trying to understand the role of EUV and how many layers it will involve, but it is certainly a positive driver for us. The interaction between the mask shop and the wafer, along with a reduction in layers, offsets some factors. I don’t see it being a significant change in intensity, just a slight increase. For instance, if the average process control intensity is around 10%, we might see a 0.5 to 1 point rise in overall intensity. This will ultimately depend on the extent of its deployment and the strategies regarding pellicles. It will slightly influence how it affects us.

Okay, great. I have a follow-up question. It seems like you're becoming a bit more optimistic about the memory sector, possibly influenced by local Chinese companies. Could you provide some insights regarding the orders for the Surfscan business? Are you noticing improved activity in the NAND business, or is it mainly limited to specific customers at this time? Would you consider this to be the start of a more widespread recovery?

No, I wouldn't call it that. I mean, certainly, that business inflected pretty strongly through calendar '18, and so it's been down this year. And I would expect to see a little bit of recovery in the wafer part of that, which, ultimately, supports memory in 2020. But right now, I think it's too early to see that impact. So I wouldn't say I see that as a leading indicator of new business. But certainly, given the market position of that product and how memory drives wafers, if you do see a pickup in memory, we will see that business impacted.

Congrats on the results. As it relates to your service business, I was wondering if you could give us an update on some of the capacity idling that you've seen, particularly around the memory side in your installed base? And maybe, how do we think about that relative to your gross margin guide for the December quarter?

Yes, it's a good question. One of the things driving an increase in revenue for the Service segment from one quarter to the next was a reduction in idling, leading to greater capacity utilization. This resulted in additional revenue for the Service line related to the semiconductor business. While there is an impact on gross margin from the growth in Service, it is accounted for in our overall guidance. It's important to note that as our Service business expands, we believe it enhances the overall profitability. The impact on gross margin from quarter to quarter is minimal in terms of our guidance. Therefore, when considering guidance from quarter to quarter, it primarily revolves around product dynamics and how that affects our overall model. Yes, I wouldn’t say it has the same incremental effect we discussed last quarter. We continue to observe that trend, and if I remember correctly, we anticipated an impact of around $40 million for the year related to that issue. There are broader trade challenges, particularly concerning Korea and Japan, which are influencing Korean OSATs. Beyond Huawei, several trade issues are impacting that business. However, in the long run, as customers begin to redesign their strategies to address these challenges, it opens up opportunities for us. This year, those factors are affecting that business, along with some marginal weakness in automotive, which has also contributed to the impact. Despite these challenges, I believe we are still achieving decent results this year considering the current WFE environment, and we expect to see growth recovery next year, as Rick mentioned earlier. This business holds a solid market position, and the long-term drivers like 5G, advanced packaging, and power are promising. We are optimistic about the outlook and appreciate the business model.

Yes. More specifically regarding Huawei, the initial reaction from suppliers was marked by uncertainty as they tried to assess the situation, which caused a standstill. Using a baseball analogy, there was a rain delay while everyone figured out the next steps. Currently, there is more activity in the supply chain, and we believe that the business will ultimately recover. However, it faced greater and prolonged impacts earlier in the year due to this uncertainty. Now that people are adapting, we expect the business to resume its growth.

Rick, maybe first off, in the past, you've talked about increasing metrology intensity on the NAND flash side of things, particularly as layers increased. As the industry starts shipping to 128 layers, do you see any potential new opportunities on the inspection side given the complexity of the layers and the increased number of layers for next-generation devices?

I think the main opportunity is in what's happening on the bare wafer on Surfscan and addressing the flatness requirements as the wafers increase in size, particularly regarding cleanliness and flatness. While it may not be immediately apparent, we've previously expressed optimism about detecting defects and deep trenches, but it's primarily driven by the need for flatness and clean wafers. That's where we really see the potential. Metrology also has some opportunities, as we discussed during Analyst Day regarding our work on CD-SAXS, which presents a great opportunity. However, for inspection, the focus is more on Surfscan.

Great. As my follow-up question, in terms of the domestic China opportunity, obviously, we're seeing some of these capacity built begin and you're benefiting from new capacity build out. But given some of it is also trailing edge logic-type of capacity builds, is this simply because they are new capacity? Or are there opportunities within the, I guess, the foundry and logic segment of that region that you see new opportunities, both for your inspection and metrology products?

Yes. There are several small players that may not be fully scaled compared to the larger companies. This situation creates some inefficiencies in the supply chain for smaller companies trying to support a strategic region, which generates additional demand for us and we are benefiting from it. As these smaller companies work on developing their capabilities, we see opportunities to assist them, which enhances our market share and engagement. Additionally, as China is a significant automotive market, the increase in Specialty Semiconductors presents us with more opportunities in that sector.

Yes, Patrick, I believe this year is a more significant memory year in China. It's not a drastic change; I would estimate that our semiconductor business is around 55% memory and 45% other segments. If we look at 2020, it was fairly balanced. As you mentioned, there's a lot of activity in IoT, and Rick mentioned the automotive sector. The challenges we're facing in logic are more complex due to yield issues. The tools we are transitioning to are designed to be adaptable, helping customers meet their needs and offering upgrade options as they advance their technologies. Ultimately, they are addressing real market demands. They are focusing on specific opportunities, which is positive for the long-term outlook of these investments and their sustainability. Overall, we are optimistic about the situation, and I think it's a blend across both segments.

Congrats on the very strong results. I just wanted to go back to the half-over-half kind of cadence for your business going into next year. You guys accurately called your core process control business being up, I guess, every quarter on a sequential basis, this year, a couple of quarters ago. So I guess the question is, based on customer projects, based on customer conversations, what are your thoughts into the first half of 2020 relative to the second half of '19? Do you think you can grow your business? Or should we be expecting more of a flattish outlook on a half-over-half basis?

I think it's a bit early to guide on the trajectory for the second half or the comparison between halves. How we perform in the fourth quarter will certainly influence how the March quarter shapes up. Across the segments, we see continued and sustainable investment in logic and foundry. If we look at the second half, it is expected to increase by about 20 percent compared to the first half, which indicates that WFE will be higher in the second half compared to the first half. Therefore, we anticipate a growth rate for WFE of roughly 10 to 15 percent as we move into next year at these levels. This suggests that a similar growth is necessary in the second half to maintain this level of business. However, that's about as much guidance as I can provide at this time.

Yes. I guess what I would add to that is we feel pretty good about understanding our position relative to WFE. We're not in a great position to predict WFE. Does that make sense?

Yes, it does. As a quick follow-up, regarding China and native China WFE, I think Bren mentioned that 2020 looks somewhat flat compared to 2019. When considering the mix of spending on process control, could that potentially increase? What are your initial thoughts on that?

Yes, I think it's balanced across the business and we expect a flattish level of business in 2020. I'm not anticipating growth or decline for our business in 2020 at this point. We'll see how it plays out, but that's where we stand today.

Thank you, Christian. And thank you, everyone, for your time today and interest in KLA. Christian, please conclude the call.