Lam Research Corp (LRCX) — Q1 2016 Earnings Call Transcript

Thank you, operator. Thank you, and good morning, everyone. With me today are Martin Anstice, President and Chief Executive Officer of Lam Research; Rick Wallace, President and Chief Executive Officer of KLA-Tencor; Doug Bettinger, Executive Vice President and Chief Financial Officer of Lam Research; and Bren Higgins, Executive Vice President and Chief Financial Officer of KLA-Tencor. Prior to turning the call over to Lam and KLA management to share their perspective on this exciting business combination, I will read a few preliminary legal notices of the proposed transaction. The proposed transaction will be submitted to the stockholders of each of Lam and KLA for their consideration. Lam intends to file with the SEC a registration statement on Form S-4 that will include a joint proxy statement prospectus of Lam Research and KLA-Tencor. Investors and security holders of Lam and KLA are urged to read the joint proxy statement prospectus and any other relevant documents that will be filed with the SEC carefully, and in their entirety, when they become available, because they will contain important information about the proposed transaction. The materials to be filed by Lam and KLA with the SEC may be obtained free of charge at the SEC's website at www.sec.gov. In addition, security holders will be able to obtain free copies of the joint proxy statements prospectus from Lam or KLA by contacting Lam or KLA Investor Relations through the Investor Relations contact page on each company's website, investor.lamresearch.com or ir.kla-tencor.com. This call may include forward-looking statements that involve risks and uncertainties. These include statements regarding future outcomes and events, including: the time and the parties' ability to close the transaction; the anticipated benefits, technological advances and synergies to be realized as part of the proposed transaction; and the anticipated structures of future combined operations. Actual events or results may differ materially from those described in this call due to a number of risks and uncertainties detailed in documents filed by Lam Research and KLA-Tencor with the SEC, including Form 10-K filing, Form 8-K filing, filings under rule 425 and the joint proxy and registration statements the parties expect to file. With that, I'll turn our call over to Martin Anstice.

Thank you, Audrey. I would like to start this morning by thanking you for joining us at short notice. Today, we announced that Lam Research and KLA-Tencor will be combining. We believe that this transaction will allow us to deliver compelling value to a transforming semiconductor industry by combining industry leaders in wafer processing and process control to help our customers address their most difficult challenges. Together, we will deliver unmatched capability, creating a new paradigm for process and process control, delivering optimized results in partnership with our customers by reducing variability and accelerating yields, helping our customers extend Moore's Law and performance scaling generally. The new company will have increased breadth and scale, both valuable components for sustaining long-term growth. The technical competency and capability of the combined company, which is illustrated by our respective product leadership positions, will benefit our employees, customers, and stockholders alike. We are confident that together, we will deliver higher levels of innovation and collaboration than would be possible as independent companies. We are certain that, just as we identified the need for closer alignments of deposition and etch, which resulted in our successful merger with Novellus, the opportunity for closer alignments between process and process control creates an exciting opportunity as the drive to reduce variability at the atomic level becomes central to our customers' high-volume manufacturing success. The transaction offers compelling financial opportunities, including the expansion of our served market and substantial synergies. We expect to realize $250 million of cost synergies within 18 to 24 months of transaction close and $600 million of revenue synergies by 2020. The transaction will be accretive to our non-GAAP earnings and free cash flow per share during the first 12 months of the transaction. If I could direct you to Slide 5 of our PowerPoint deck today, here are a few of the highlights of the transaction. KLA-Tencor stockholders will receive $32 in cash and 0.5 shares of Lam Research per KLA-Tencor share, effectively valuing the company at $67.02 per share or $10.6 billion, using Lam's stock price as of October 20. On a pro forma basis, KLA shareholders will own approximately 32% of the combined company. Both boards have unanimously approved the transaction and, pending customary regulatory and shareholder approvals, we expect to close in mid-2016. The combined company will be called Lam Research. We strongly believe this is the right combination for our industry at the right time. The powerful drivers of Cloud's mobility and IoT are firmly established and growing. The demands of these segments, higher performance, lower power, and smaller form factors, increase the economic and technical challenges faced by our customers, providing a catalyst for broad industry transformation. Our customers and their customers both demand new levels of innovation and collaborative engagements as they continue to scale with new materials, the transition to 3D device architectures, multi-patterning imaging, advanced packaging integration schemes, and next-generation memory solutions. The ability to differentiate in these technology inflections increasingly lies at the intersection of process and process control. Together, we will be much better positioned to meet these challenges by combining best-in-class process performance with industry-leading metrology, inspection, and analytical capability. We seek to create unmatched and complementary capability to enable atomic level processing. I am looking forward to formally welcoming the KLA-Tencor employees to our new company. These are 2 companies with similar cultures and values, geographic proximity, with a passion to contribute and win, and to take pride in doing things the right way in the interests of our customers. I look forward to listening, learning, and building a strong team together with them as we create a more exciting future. And before handing the call to Rick, I want to thank him personally, and also his team, for their leadership and vision in creating a great company and working with us to put together what we believe is an extremely compelling transaction. Rick, over to you.

Thank you, Martin. This is truly a transformational day in the industry and for both companies. I spent 28 years at KLA-Tencor, and I've seen several industry transformations. But in my opinion, this combination has the potential to be the most transformative, both from a capability and from a timing perspective. Our customers are on the cusp of ramping some incredibly complex technologies, with roadmaps for advanced development over the next decade already in place. And KLA and Lam's combined capability to partner with our customers on improving the manufacturability and the yield of these technologies will be a powerful value creator in the space to a degree that neither of us could achieve as standalone companies. The SAM expansion that's been experienced by Lam, driven by the inflections of 3D device architecture and multi-patterning, will complement KLA-Tencor's strong presence in foundry and logic, and create both SAM and market share expansion opportunities for both companies. We're proud of what we've built at KLA and the value that we've delivered. The scale achieved by combining with Lam substantially enhances our future value creation potential, making this transaction a win both for today and for tomorrow. KLA's strong results and guidance today, and the confidence we have in continuing our growth in 2016, are a direct result of our efforts with our customers in the last decade to enable industry transitions and scaling. I want to recognize our employees whose dedication to excellence across all aspects of the organization have made this performance possible. Through the discussions we have had to date with Lam, it's been reinforcing for me that the capability and the culture of our companies are very similar. And that will be a key component to the success of this combination. I also want to thank Martin for his leadership, and I am very confident in the success of this company under his leadership as we go forward. And with that, let me hand it back to Martin.

Thanks, Rick. As we have said many times, our guiding principle for effective consolidation in our industry is first focused on the legitimacy of innovation strategies and the opportunity for sustainable value creation from the perspective of our customers. With this threshold validated here, we are excited to deliver compelling value to all stakeholders by combining the established leaders in deposition, etch, clean, inspection, and metrology. However, the rationality of this transaction lies in our belief that the combination is substantially stronger than the sum of the parts. By joining the critical device manufacturing areas of process and process control, our 2 companies combined will become a more knowledgeable, more capable, and closer partner to our customers, better positioning us to innovate the solutions required to meet the industry's needs together. For example, in logic and DRAM multi-patterning, as we highlighted at our Analyst Day in July of this year, the key challenges faced in high volume manufacturing for multi-patterning schemes are variability and costs. By more effectively linking the process control expertise of KLA and Lam's strength in process around critical technology inflections, we can improve efficiency and utility of metrology information for optimization of the unit process at a much greater depth. This represents the potential for faster and better solutions for our customers and opportunities for differentiation and profitable growth for us. It is already clear that the level of integrated controls we will be able to deliver becomes even more critical at 7-nanometer and beyond, where substantially high levels of control of patterning processes will be required in support of our customers' roadmaps. In the 3D NAND space, high aspect ratio structures and long process times increase costs and complexity. We plan to utilize our combined leadership capability in deposition, etch, and metrology to innovate and develop process control capability for 3D NAND structures to help enable cost-effective vertical scaling. Our increased scale and breadth will enable multiple value creation drivers. From the market perspective, when we combine Lam's inflection-driven SAM expansion, which we believe extends throughout this decade, with KLA's strong presence and new product momentum in wafer and mask inspection and optical and overlay metrology, we expect to compete for more than 45% of WFE by 2018. Worthy of note is the complementary nature of our presence in the WFE market. Lam has historic strength in memory applications and has made meaningful progress in the logic segments of WFE over the last several years. Lam also has technology inflection growth drivers in logic and memory both with multi-patterning process flows and 3D device architecture. KLA has a relatively stronger presence and opportunity in the logic segments with exciting new product introductions. The wafer fabrication equipment segments complement is a powerful commentary on the combined company's opportunity to sustain growth through the specific investment cycles of our increasingly large and consolidated customers. We also see meaningful costs and revenue synergies available, including $250 million of annualized cost synergies realizable within 18 to 24 months of closing as well as a strong revenue synergy opportunity of approximately $600 million by 2020, made possible by strengthening unit process performance and value of our core product offerings. Finally, our shared and well-established operating excellence combined with our deal-specific commitments to prioritize deleveraging our balance sheet supports our commitments to profitable growth. All of these value-creation drivers will reside in a business with increased diversity of people, product portfolio, market segments, and customer exposure. More opportunity, no question. With that, let me turn the call over to Doug. He will cover the financial details of our transaction as well as offer a brief review of our September quarter performance and December 2015 outlook.

Thank you, Martin. I'll begin with the transaction summary that you can find on Slide 12. Lam Research plans to acquire all outstanding shares of KLA-Tencor in a cash and stock deal, valuing KLA at $10.6 billion or about $67.02 per share. KLA-Tencor shareholders can choose to receive the equivalent of $32 in cash and half a share of Lam Research common stock, which will be subject to proration as detailed in the merger agreement. To finance this purchase, Lam will issue around 80 million new shares and approximately $3.9 billion in new debt while aiming to maintain an investment-grade rating. The combined company will have a robust cash position of roughly $5.3 billion and strong cash flow generation. We aim to begin reducing our debt soon after closing, targeting to lower our gross debt-to-EBITDA ratio to below 2.5 times as quickly as possible. We project $250 million in annualized cost synergies within the first 18 to 24 months post-close and approximately $600 million in annualized revenue synergies by 2020. We expect the acquisition to enhance both earnings and free cash flow per share in the year following the closing. The merged entity will retain the Lam Research name, and Martin Anstice will serve as CEO, leading a team that represents both companies across all functions. Lam's Chairman, Steve Newberry, will remain in his role, and two board members from KLA will join the new board at closing. Both companies' boards have unanimously backed the transaction, which will need standard regulatory approvals and the endorsement of shareholders from both Lam and KLA. We have begun the integration planning process, aided by our geographical proximity, a strong history of collaboration, and experience in integrating companies. We anticipate timely approvals, allowing us to fund and close the transaction by mid-2016. Martin highlighted many financial advantages of this acquisition, and I would like to elaborate on our vision for the financial model of the combined entity. This includes significant revenue opportunities and enhanced business diversity. The complementary market leadership of both companies, with no product overlap, positions the combined firm to capture about 45% of the wafer fab equipment market by 2018. It will also generate around 25% of its revenue from its larger installed base, balancing exposure among various customers and segments. By 2017-2018, assuming a $35 billion wafer fab equipment market, we expect combined revenue of about $10 billion and industry-leading performance, with non-GAAP operating margins around 27%. These profit levels will allow us to maintain strong R&D investments while delivering unmatched technology and productivity offerings, leveraging the merged strengths to meet customer needs. Martin mentioned the value creation potential for the combined company. Beyond the broader market and revenue synergies, we will increase returns through balance sheet deleveraging and continue our capital return strategy, including sustaining quarterly cash dividends aligned with Lam’s current practices and favoring share repurchases once we hit our leverage target. As Lam's CFO, I'm excited about this transaction from a financial perspective, presenting excellent growth investment opportunities and added value for our customers, employees, and shareholders. Now, let me provide an overview of our September quarter results, guidance for December, and some preliminary thoughts on 2016. All figures will be on a non-GAAP basis. The September quarter was another impressive one for Lam, featuring record revenue and operating income. Our results were at or above the midpoint of our guided ranges in all areas. September quarter revenues totaled $1.6 billion, and system shipments were $1.58 billion, both aligning with our guidance midpoint. As anticipated, memory shipments were stronger during the quarter, making up 72% of total system shipments compared to 16% in the previous quarter. NAND and other nonvolatile memory constituted 40% of these shipments, primarily focused on 3D NAND investments. DRAM shipments comprised 32% of system shipments, slightly down from 37% in the prior quarter. Shipments to Foundry customers represented 18% of system shipments, while logic and other segments accounted for 10%. Non-GAAP gross margins were 46.5%, near the high end of our guidance due to a favorable product mix and strong manufacturing efficiency. Operating expenses were $364 million, leading to an operating income of 23.8%. Non-GAAP earnings per share of $1.82 surpassed the high end of our guidance. Moving on to December, we expect sequentially lower shipments, forecasting about $1.275 billion, plus or minus $75 million. Revenue is anticipated to be around $1.41 billion, again plus or minus $75 million. We project a gross margin of 45.5%, with a variance of one percentage point, operating income of 20.5%, and earnings per share of $1.42, plus or minus $0.10. The results from September and the midpoint of our December guidance set us on track for our third consecutive calendar year of 20% revenue growth, supported by our strong positioning amid technology shifts. Looking ahead to 2016, while it's early for precise numerical forecasts, we remain optimistic about a healthy level of investments across various segments next year, based on market demand and discussions with our customers. In the NAND sector, we foresee positive momentum from ongoing 3D NAND deployments to support the expanding SSD market. With about 10% of the installed base being 3D capable by the year's end, we expect continued strong investments. In DRAM, our customers appear disciplined in aligning supply with demand, with anticipated investments in 20-nanometer conversions due to high returns at this node. Initial shipments for 1x nanometer DRAM are also expected late in 2016. In the Foundry segment, investment efforts continue to focus on FinFET adoption among various clients. Development for the leading edge in the transition from first to second generation FinFET is on track, which we believe will lead to 2016 shipments with 10-nanometer capabilities. Considering these trends, we preliminarily anticipate 2016 wafer fab equipment spending could be flat or slightly down; however, we expect our serviceable available market to increase year-on-year, as a larger portion of WFE spending will target critical technology inflections. Lastly, I would like to note that the outlook I provided is based on a stable macroeconomic environment.

Thank you, Doug, and good morning, everyone. Before I get started, I just want to highlight that the reconciliation of U.S. GAAP to non-GAAP results can be found on our website, kla-tencor.com. Q1 was a good quarter for KLA-Tencor, with the company delivering results above the guided range for bookings and non-GAAP earnings per share and with revenues finishing at the top end of the range of guidance, demonstrating KLA-Tencor's market leadership, the strength of our business model, and solid operational execution. My comments on the quarter will be focused on the non-GAAP results, which exclude the adjustments covered in the press release. Revenue for the quarter was $643 million, and fully diluted non-GAAP earnings per share was $0.71, above the top end of the $0.46 to $0.66 guidance range. New orders in Q1 grew 8% sequentially to $725 million and finished 32% above the midpoint of order guidance. We experienced good momentum in order activity in the quarter, and demand was strong across each of our end markets, highlighted by strong foundry demand for both leading-edge and 28-nanometer requirements as well as incremental upside in 10-nanometer mask inspection demand. We are particularly excited about the strong demand we are experiencing for leading edge mask inspection tools to support 10-nanometer development, as we had our strongest quarter for this product family since December of 2011. With the deployment of multi-patterning and other advanced device architectures in leading edge, logic, and foundry, radical design is becoming increasingly more complex. The upside in mask inspection demand not only reflects KLA-Tencor's technology and market leadership in this key inspection market but also indicates our customers are moving forward with their schedules for 10-nanometer development in calendar year 2016. As we look ahead to the December quarter and into next calendar year, we expect continued order momentum. We are on track to ship multiple units of Gen 5, our latest generation broadband plasma wafer inspection platform, in the December quarter and expect the combination of new product demand in optical wafer inspection as well as the mask inspection demand I just discussed to set the stage for what we are planning to be a solid year in 2016. Foundry was 44%, the new system orders in September, and up strongly on a sequential basis, both in terms of percentage of total orders and absolute dollars compared with the June quarter. Memory was 37% of new orders for Q1, with the majority of the demand focused on NAND activities. Logic was 19% of new system orders in September, consistent with our original view of timing of initial shipments for 10-nanometer development for both logic and foundry customers. These orders are expected to ship in the middle of calendar year 2016. Turning now to the distribution of orders by product group: wafer inspection was approximately 43% of new system orders; patterning, which now includes radical inspection, was approximately 30%; service was 25%; and non-semi was approximately 2%. Total shipments in the quarter were $635 million and within the guided range of $610 million to $690 million. In total, we ended the quarter with $1.3 billion of total backlog, comprised of $1.1 billion of shipment backlog or orders that had not yet shipped to customers and expect to ship over the next 6 to 9 months; and $214 million of revenue backlog or products that have shipped and invoiced, but have not yet been signed up by customers. Looking forward, we are modeling December quarter shipments in the range of $660 million to $740 million. Turning now to the income statement. Revenue was $643 million, finishing at the top end of the range of guidance for the quarter. Gross margin was 58.7%, slightly up compared with the June quarter on lower revenue, benefiting from a more favorable product mix and lower parts expenses in our service business than we originally modeled in the quarter. We expect gross margin to be in the range of 57.5% to 58.5% in December. Total operating expenses were $206 million, down $8 million compared with the June quarter, finishing below our guidance of $212 million and approximately $34 million lower than the September quarter of 2014. The lower operating expense levels we are seeing today are the results of the cost actions we took earlier this year. We expect quarterly operating expense levels to remain in the range of $205 million to $210 million over the next several quarters. Our effective tax rate was 22.6% in the quarter, in line with our long-term planning rate of 22%. Finally, net income was $112 million or $0.71 per fully diluted share, and we ended the quarter with 158 million fully diluted shares outstanding. I'll now turn to some brief highlights from the balance sheet and our cash flow statement. Cash and investments ended the quarter at $2.3 billion. Cash from operations was $194 million in the quarter, and free cash flow was $186 million. In the quarter, we paid $82 million in regular dividends and repurchased 143 million shares of our common stock in the period. We also made a supplemental payment of $40 million towards our outstanding term loan. In conclusion, although there is always some uncertainty as to the pace and magnitude of industry CapEx in calendar year '16, given our market leadership, new product revenue and with the benefit of our leaner cost structure, KLA-Tencor is well positioned for strong relative performance in the coming year. Now for guidance for the December quarter. Bookings are expected to be flat at the midpoint compared with Q1, and in the range of $625 million to $825 million. Revenue for the quarter is expected to be between $670 million and $730 million with non-GAAP earnings in the range of $0.75 to $0.95 per share. This concludes our remarks on the quarter. I'll now turn the call back over to Martin. Martin?

Thank you, Bren. As should be clear from our comments this morning, we see substantial value creation opportunities ahead for our organization, our customers, and our stockholders by virtue of combining Lam Research and KLA-Tencor. We recognize both the opportunity and challenge of combining 2 large companies, and we understand that our demonstrated execution is a necessary component of sustaining and building trust with all stakeholders. As demonstrated with the integration of Novellus and subsequent outperformance, we are confident and completely invested in meeting that expectation and sincerely appreciate your ongoing support. As was just summarized by our 2 CFOs and standalone company's press release today, the headlines of current and short-term future performance are clear. Both companies reported and guided a strong first half '15, second half '15 revenue balance. Both exceeded earnings guidance in the September quarter and exceeded earnings consensus for the December 2015 quarter. Profitable growth is again reinforced by demonstrated operational excellence and leverage from flexible business models in both companies. New product introduction is a prevalent theme for the combined portfolio going into 2016, a year where we aligned to the consensus of flat to slightly down WFE with the second half '16 slightly stronger than the first half of '16. Significantly, at the combined company level, we anticipate a growing SAM calendar 2016 over 2015. For Lam, in large part, this is the inflection story generating outperformance opportunity; for KLA, in large part, this is a commentary on mix and new products with slightly stronger allocation to logic spending than memory when compared to 2015. Longer term, the strategic rationale and growth opportunities lay in our combined ability to create a new paradigm of process enablement to support our customers as they address unprecedented economic and scaling challenges in their industry. As a combined company, we will continue our focus on technology leadership and investments critical to success in the inflections of today and tomorrow, enhancing our ability to deliver value to customers while also expanding our SAM and strategic relevance. We also remain committed to operational excellence and profitable growth, with returns enhanced both by achieving the cost and revenue synergies available in this transaction, and by continuing our commitments to returning additional value to stockholders. In closing, the combination of Lam Research and KLA-Tencor will allow us to move faster, innovate better, scale efficiencies, and ultimately provide more value to our customers, their customers, and our stockholders. We are very excited to get started on this journey. And with that, we are happy to take some questions.

Martin, I guess first question, when you talk about the revenue synergies, can you help us understand a little bit how you're thinking about the revenue synergies for in situ versus standalone tools in the combined entity going forward?

Yes, Jim. I think the way we think about it is that in the world of the complexity that I described for our customers, there's tremendous uncertainty about a lot of things, the materials, processes, device architectures, and structures, and to some extent, there is uncertainty relative to how they solve some of these problems. So putting ourselves on the inside of this conversation is the space we want to be where whatever trajectory is valuable to our customers from an integrated perspective, standalone perspective, real-time process control perspective, we will have put together a portfolio of tensors, algorithms, analytics, software, and process and metrology management systems where we can respond proactively and, I think, beat expectations. So we're not planning to go to market with the answer to this question. We have lots of ideas, and we have lots of strategies in place already. But as you know, in this industry, responding to the needs of customers and supporting their choices is an important foundation of success.

That's incredibly a helpful perspective. And as a follow-up sort of staying on the same topic, can you help us think a little bit about the general trend that you and others have discussed towards integrating process control with processing tools, whether it's in situ or standalone versus kind of the historical customer thoughts or concerns around kind of having their process control and neutrality, if you will? In other words, having a neutral process control provider, is this just a dynamic where the process control requirements and the processing requirements are getting so stringent that customers kind of have to give up some of their desire to have neutrality with their process control provider?

Yes, just to clarify, this is not about dominance. It's about providing more choices and solutions for customers. There is clearly some momentum in the discussion around integrated and real-time process control. I believe it's still early in this process. This combination puts us in a position to be central in enabling customer choices, which is the right place for us to be.

My first question, Martin, is about the growth rates of the two companies. Over the last five years, Lam and Novellus have grown at a mid-5% CAGR, while KLA has grown at about half that rate. Based on the industry guidance you've clearly outlined in the analyst days over the past two to three years, Lam seems well positioned to benefit from the changes happening in the industry. As you consider the growth rate of the combined company, will it slow down after acquiring KLA? Can you help us understand how you are thinking about the impact on your growth in relation to the acquisition?

Yes, I think as we tried to articulate in the prepared comments, I mean, we're really excited about the opportunity. And stating the obvious, this is about absolute dollars of growth, not percentages. I mean, that's the fundamental measurement of performance of companies. And we see a tremendous platform of foundation in both companies for growth. I think we articulated slightly different reasons why in the '16 and '15 comparisons, both companies outperformed. The inflection story of Lam that we've talked about for many years is still a great platform and a great story and long may that continue, and we're supplementing that with a new product wave from KLA-Tencor, and we're supplementing that with more balance from a segment exposure point of view, and in the '16 to '15 transition, that is a very positive momentum for the KLA company and in turn, combined company. So we're really pleased about the growth trajectory, the profitable growth trajectory of both companies.

And then as a follow-up, one question for Rick. If you could discuss your Gen 5 platform as it is about to be introduced, why sell the company at this point when you have a great product story coming up next year?

Well, the Gen 5 is doing extremely well. We've had several customer engagements as we've talked. And we mentioned in the prepared remarks, we will be shipping those initial shippers by the end of the calendar year. So I'm very excited with that. I really look at this combination not as selling the company, but becoming part of a big industry powerhouse, really, where we're going to be able to provide great solutions for our customers as they work towards their challenges that they're facing in Moore's Law. And I think that this enables the industry to move forward, and I'm very excited about it. So I view it as the right next step for KLA-Tencor and for Lam.

This is Bill Peterson for Harlan. And congratulations to both Lam and KLA teams on the deal. I wonder if Martin or Rick, you've had conversations with customers and how are the customers viewing this transaction? And part of the question is because, obviously, last year, 2 industry leaders tried to combine, and it didn't happen, and there were some thoughts that some of the larger customers did not really – were keen on the transaction. So I wanted to get your perspective on how customers view this potential transaction.

Yes, I think I'll take this one. I mean, I have and I think I've even spoken to this on prior calls, I spent a lot of time in the last 4 to 5 years dialoguing with the customers around their strategic challenges and how we might contribute to creating value and choices and solutions as part of that. And I think every customer in the world is going to articulate a value proposition around controlling process and that is a fundamental component of value. There is obviously no product overlap here between these 2 companies. It's about adjacency. And it's about complement. There is geographic proximity, which makes the integration risk profile dramatically different than the other transaction that you referred to. So my instinct is from the conversations that I've had with customers, there is going to be a lot of support for this, and I think in large part, that's a commentary on the motivation. So the motivations that we've stated, I hope, are really clear. This is about enabling the future of long-term success for our customers and in turn, creating opportunity for us. And that bias to focus on the customer to build customer trust, to give them choices is everything about the values, the culture of KLA-Tencor and Lam Research, and that will continue.

Yes, I don't think we’d add anything to kind of existing public disclosure on puts and takes. But the headline today is we support the consensus opinion of flat to slightly down of WFE. There are kind of a couple of elements to that. One of them is meaningfully less DRAM investment next year, meaningfully more NAND investment next year and kind of flattish microprocessor and logic and foundry to maybe slightly up. So that's a headline that I think is kind of well established. As Doug said in his prepared comments, a very important headline to remember is in that context, KLA-Tencor and Lam Research both are projecting SAM expansion year-over-year, and both of us are projecting market share expansion as well. And I didn't comment about market share, but our customary 1% to 2% market share target is kind of a platform of growth for us there. So hope that helps. I think we have to take the next question in the interest of time.

So I have 2 questions. Number one, Martin, can you talk about the dividend policy for the combined company?

Tim, I'll take it. This is Doug. As we look forward, we're going to continue essentially the dividend level that Lam has today. And as we've described before, we understand the expectation that dividends grow over time and we will have a bias to continue to do that. I want to emphasize though, Tim, that the main priority, at least in the near term, first and foremost, is going to be the profitable investment in the business; second, is going to be deleverage the balance sheet; and then third, is going to be return to equity holders. So that's kind of how we're thinking about it, at least until we get to that leverage target I communicated, of 2.5x gross debt-to-EBITDA. We're going to prioritize paying the debt down.

And relative to that 2.5x ratio, we're targeting 12 to 18 months to get to that point.

Got it. Okay. So my second question is really about the timing of the deal. I believe this deal makes a lot of sense. But why now? Is there a perspective on EUV? Did something change in the marketplace over the last couple of quarters? I'm curious, why now?

Well, I'm sorry to say it's not because you said you like the deal. The why now answer is pretty straightforward. This is a commentary on opportunity. It's a commentary on capability of combined companies, and it's a commentary on the need from our customers and the industry. The foundation from 2 standalone companies is strong and architecting strategic change of this nature is better done from a position of strength. And so we see a tremendous opportunity. We do believe, as I said, there will be support, there is support, for this type of combination, which respects and promotes the long-term interest of our customers. And we certainly believe, having executed not quite on the same scale, but executed a merger integration with Lam and Novellus, we have an experience. We have a competency and capability to make sure that we do not compromise on commitments made to customers as standalone companies and we execute better and stronger together.

I guess, first question, Martin, just taking a step back, the narrative for Lam over the last 2 years was best growth in the industry, leveraged all the right technology transitions. And with this transaction, that narrative seems to be changing a bit. And so curious, what do you see in the future? And/or what has occurred that changed a bit? Is it the fact that we're maturing? Or challenges to Moore's Law? Is it a vision that scale, increased scale is really necessary to compete in that world? We'd love to hear your thoughts.

Well, actually, I would probably contend the premise in your question. I don't think this is a fundamental recharacterization of the message from our company. We're absolutely focused on our performance. We're absolutely focused on operational excellence. We're absolutely focused on expanding profitability faster than we are revenues. And I think there's plenty of opportunity to do that as a combined company. This is a very strategic transaction. It is a commentary on a long-term commitment to our customers. And for sure, scale and breadth of portfolio is better than not. For sure, as I said, we have more diversity, more competency, more capability, more learning. The quality of fundamental research and product and services development will be higher as a result of this transaction. But I think at a very fundamental level, the outperformance commentary of this combined company is still a great value proposition.

Yes, CJ, if I was you, I'd model something partway between both companies. Obviously, part of when we do integration, we'll be working on some tax planning. But for modeling purposes, I'd split the difference right now.

Martin, can you compare this deal to the Novellus deal? When I look at cost synergies and product overlap, they seem very similar, although there's no product overlap. The revenue synergy is a bit challenging to grasp since it appears that LAM has not been successful in expanding the process control area with its process equipment capability. We would like to understand what two or three applications you are considering for revenue synergies, and I have a follow-up.

I believe the key point to address in this comparison is that we are larger, which leads to increased expectations. I concur with your assessment. The question then becomes: how does our strategy differ from that of our competitors? Our primary focus is on achieving excellence in unit processes. Both companies hold strong positions in the market. As we have mentioned previously, leadership positions are essential. We need to provide customers with choices and acknowledge their ability to create competitive advantages just as we do ours. With this mindset, there are numerous opportunities for us in 3D device architecture and the logic roadmap. We can open new process windows, offer more reliable solutions, and overcome the historical challenges associated with optimizing engineering processes and process control. This will mark the first time a company has had the capabilities and expertise that we aim to deliver to our customers.

One other thought. As you know, the adoption of inspection in measurement in memory manufacturing is lower than it is in logic and foundry. It's my belief that one of the reasons for that is, particularly in 3D NAND, is the fact that we're held off from the process. I think this combination allows the inspection of metrology to much more be part of the integration of those, and that becomes more important. It's not like our customers aren't struggling with the yield on 3D. We know they are. But I think this enables us to provide more capability, helps them get their yield, and at the same time provides market opportunity for the combined company. So I think that's really exciting.

Great. As a follow-up, could you comment on the NAND spending environment for next year? ASML mentioned last week that NAND spending, particularly on 3D, could be lower than this year, considering one fab is already fully operational and there's a brownfield fab. We would like to hear your thoughts on NAND spending in light of that flat-to-down outlook.

Yes, we don't align to the statements and the representations you just made at all. So our view of NAND spending in calendar '16 is that it is higher than the calendar 2015 spend level. About 95% of the spending is invested and directed to the 3D device transition. We see a universal commitment to that technology transition from our customers, and I think the commentary from almost every customer around the importance of this transition is a very positive one. We believe that the 3D NAND chip capacity by the end of this year is around 160,000 wafer starts per month, and our best estimate is somewhere between 350,000 and 400,000 wafer starts by the end of next calendar year. And we would expect somewhere similar to, or maybe a tweak more, capacity in qualification at the end of next year compared to this, and that's really just a statement on kind of what is normal in a transition of this scale. So the 3D NAND investments, we think, is a very prominent theme and one that we're well positioned for.

A couple of quick questions. One is, clearly, both Lam and KLA as standalone companies have had a very product-focused approach. But when I look at the Lam-Novellus deal, it does got out of certain products like PVD to get the ultimate synergies. I'm wondering, to the extent you can answer, are there any products that exit now that you have KLA under your belt to get revenue or cost synergies? And then I have a follow-up.

I wouldn't consider the PVD decision as a crucial factor in delivering synergies since it was a relatively small investment. However, both companies are well-managed and take strategic and operational planning seriously. They maintain high standards for future investments. Overall, the roadmaps of both companies hold equal value when combined as they did separately. Consequently, our strong executive team from this merger will continue to refine our approach based on customer feedback and new opportunities. The main takeaway is that everything remains as it currently is.

Got it, got it. And then as a follow-up, what is the breakup fee that is involved in the deal? And were there other businesses that you looked at that you had thought would have been more attractive? Or do you think this was the way given the size and scale required?

The breakup fee is quite standard, and you will see it once we file a prospectus. It's approximately $300 million, just under that amount. Martin, would you like to add anything?

No. Nothing to say.

This is the right deal at the right time, Krish.

I just had a follow-up question on the potential EPS value created from the merger, Martin. I think Doug may have said it, WFE is $35 billion, then you could hit an operating margin target. And I'm getting to a combined EPS of around $8 or so, which assumes a higher share count and some more interest expense from the debt. So that looks like it's higher by about 10% to 20% than the Lam EPS potential that you shared at SEMICON West. So my question is, just want to make sure that we were in kind of the ballpark of where this potential EPS could be? And is this one of the reasons why this combined company is better than the standalone?

Yes, Stephen. I provided a model that indicates $10 billion and 27%. There are considerations to bear in mind, such as the interest rate on the debt being in the mid-high threes as a percentage, and I've already mentioned the amount of debt that needs to be raised, so you can factor that in. We have stated that the deal will be accretive within the first year and will increase in accretion over time. While I won't confirm the specific numbers you just discussed, this is an accretive transaction that benefits shareholders and the combined companies. We are very enthusiastic about our outlook.

Okay. And then Martin, you know there's a general market perception out there that KLA's market is in decline, and I think you did a pretty good explaining why you disagree with that. Could you share any color on what the customers may think of this deal? And the customers also encourage you to consider merging with KLA?

I don't know that I would go quite as far as your last question. But as I said in response to a similar question earlier, I spent a lot of time dialoguing with customers in the last few years around strategic opportunities for our company to gather their perspective and their requirements and their motivations and to integrate that because I want, appropriately, customers invested in the success of our company, in whatever form that exists. And I believe that there is a very compelling perspective from customers around value from opening up process windows, delivering more predictive results on a wafer. And to Rick's points, technology enablement is the first contribution for us to make; productivity is the second. And there are as many economic challenges in the future of our industry and our customers as there are technical. And we think this is a very fundamental paradigm that the combination allows us to pursue.

And not to be a downer, but I was wondering if you could maybe take a stab at giving us an idea of what your target model might look like if demand is not $35 billion WFE? Like, what if it's $30 billion? Can you give us maybe a ballpark view on what the target amount might look like in that range?

Yes, it will be lower, Wes. I think if you're really kind of want to do scenario planning, you can look at the public commentary from both companies. We've both had financial models that have been out there. You can kind of look at the way I'm putting the 2 together in the $35 billion scenario, Wes, and I think you can kind of smooth between what you think the world looks like just by doing that.

Okay. Fair enough. And then just on the revenue synergies, the $600 million. I was wondering if maybe you could help us understand a little bit more specifically where the opportunities are. Is it primarily just the new value of the combined solutions, or do you see a specific segment? Do you expect to grow a bit faster than you could comment on? And just a little more color on how you get to that $600 million in revenue synergies.

Frankly speaking, there's a limit to how much of that conversation I want to have. We've done a lot of work in preparation for this conversation to validate the $600 million. And obviously, there is a competitive component to messaging in the public domain. So Slide 8 in our deck today, which describes how we plan to deliver differentiated technology solutions together, is the best way to answer the question. We do see there are very important opportunities to use metrology information to strengthen the fundamental value proposition of deposition, etch, and clean solutions in the logic space around FinFET and next-generation gates. The multi-patterning process flow is not the cheapest process flow in the world, as everybody has discussed. And so any opportunity we have to improve productivity, increase yields, and open up process windows is a tremendous value proposition. That will be new products and services, I hope, over time and more capable etch and deposition and clean systems. In 3D NAND, I think Rick already answered the question. There are opportunities in 3D NAND. It is illustrative where one company gets earlier access to an inflection in the industry, and we have an opportunity here that kind of normalized to make sure every part of process, process control combined company gets early access to technology inflections and get in the best position possible to make appropriate investments and deliver differentiated solutions. So a broad cross-section of plays, fundamental value will strengthen what we have. Second is supplement. And we will be taking a very measured approach through that. As all of you know, it takes a long time in this industry to deliver new capability, which is why the revenue projection is biased to the beyond 2018 reference point.

Martin, maybe for you. You guys have obviously displayed the growth, particularly for yourselves in the etch and deposition market and the SAM story you detailed. Maybe going back to your talk about innovation, accelerating and the revenue synergy potentials, do you believe some of your SAM expansion potential can, I guess, pull process control or maybe get it out of the current rut that it's in, and maybe help grow that SAM as well?

I'm not sure I exactly get your question, but I mean, do I see SAM expansion opportunities in the process space of the company? I think the answer to that question is yes. And we're also not going to get so specific. So again, the headline here is to increase the competitiveness, increase the competency, and capability of the established portfolio in both companies by virtue of more learning and more understanding, and great teams that are really excited about an opportunity to work together. We obviously have had very limited interactions of technology teams in preparation for this announcement, but some and I would say the appetite and the enthusiasm in that community to create value and ways that are not available to standalone companies is extraordinary. I mean, I am really excited about what we're going to see when really smart people get together and finally have an opportunity to do something they've not yet had an opportunity to do. SAM expansion, market share, new products, new services, a lot of work, and we're going to be very focused on doing the right thing to support choices and value for customers.

Great. That's helpful, and then maybe for Doug, specifically on the cost synergy targets you've outlined of $250 million. These are obviously 2 very different companies in terms of process and process control. I guess, what are some of maybe the high-level cost synergies that we can look at today in terms of that target that you're setting out there? Because there's not the immediate process synergies that you can get like you've seen in other deals. What are some of the steps that you'll take to get to that target?

Yes, Patrick, at this point, we've done a reasonable amount of homework. That was part of the diligence process that we went through. When I look at the cost synergies, I think about 1/3 of it comes from the cost of goods sold line. There's some commonality there. Although, as you know, there's not a ton. 2/3 of it probably comes from operating expenses, and that's going to have a heavy bias towards the SG&A functions and probably not a whole lot in R&D. Half of this will be headcount, and half of it will be non-headcount-related synergies, at least the way we're looking at it today. And we're going to be very light on R&D. I mean, the objective here isn't to do a whole lot in R&D. So we'll be very careful about how we're looking at that area.

And just to repeat what I hope is a very clear headline: This is not about reducing cost. It is a necessary component of bringing 2 companies together, but this is all about creating a fundamental new value proposition in our industry to benefit our customers, very strategic. So please help us not lose sight of that message.

Thank you. And good morning.

All right. Once again, we'd like to thank you all for joining us today. A replay of our call will be available on lamresearch.com. Thank you, operator. That concludes our call.

Thank you.

Thanks, everyone.