Ed Lockwood - Investor Relations Rick Wallace - President and Chief Executive Officer Bren Higgins - Chief Financial Officer.

Timothy Arcuri - UBS Harlan Sur - JPMorgan C.J. Muse - Evercore Krish Sankar - Cowen & Co. Toshiya Hari - Goldman Sachs Mehdi Hosseini - SIG Atif Malik - Citigroup John Pitzer - Credit Suisse Edwin Mok - Needham Patrick Ho - Stifel Sidney Ho - Deutsche Bank Vivek Arya - Bank of America/Merrill Lynch.

Good afternoon. My name is Lance and I will be your conference operator today. At this time, I would like to welcome everyone to the KLA-Tencor Corporation Fourth Quarter Fiscal Year 2018 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session.

[Operator Instructions] Thank you. Mr. Ed Lockwood of KLA-Tencor Investor Relations, you may begin your conference..

Thank you, Lance. Good afternoon, everyone and welcome to our conference call. Joining me on our call today are Rick Wallace, our President and Chief Executive Officer and Bren Higgins, our Chief Financial Officer. We are here today to discuss quarterly results for the period ended June 30, 2018.

We released these results this afternoon at 1:15 Pacific Time. If you haven’t seen the release, you can find it on our website. Today’s discussion of our financial results will be presented on our non-GAAP financial basis unless otherwise specified.

A detailed reconciliation of GAAP to non-GAAP results can be found in today’s earnings press release and in the Investor Relation presentation on KLA-Tencor’s Investor Relations website.

There you will also find a calendar of future investor events, presentations and conferences as well as links to KLA-Tencor’s SEC filings, including our annual report on Form 10-K for the year ended June 30, 2017. In those filings, you will also find descriptions of risk factors that could impact our future results.

As you know, our future results are subject to risks. Any forward-looking statements, including those we make on the call today, are subject to those risks and KLA-Tencor cannot guarantee those forward-looking statements will come true. Our actual results may differ significantly from those projected in our forward-looking statements.

With that, I will turn the call over to Rick..

Thanks, Ed. We are very pleased to report another strong quarter for KLA-Tencor with shipments revenue and non-GAAP diluted earnings per share each finishing at the upper end of guidance.

KLA-Tencor delivered the second highest quarterly booking results in our history in the June quarter offsetting all-time records in quarterly shipments, revenue GAAP, and non-GAAP diluted earnings per share. I am also pleased to report that we ended the June quarter with a positive book-to-bill with record total backlog of almost $2 million.

Also we are pleased to note our continued progress our timeline for closing the Orbotech acquisition in the fourth quarter of this calendar year. On July 12, the Orbotech shareholders approved the merger and to-date we have received all the necessary regulatory approvals with the exception of Korea and China, which we expect to obtain in due course.

The record results and strong momentum KLA-Tencor is delivering today demonstrates the value of our market leadership and the critical nature of process control.

They also highlight our market diversification and the benefits of our exposure to growth markets, such as EUV lithography, the early ramp of 7-nanometer devices in foundry, growth in bare wafer market to address capacity growth in memory in China to highlight a few.

The overall, WFE industry environment continues to perform at a high level and we are excited about the prospects for continued strength in industry demand as we begin the second half of 2018 and look ahead to 2019.

Our view is for WFE levels to grow in the mid single-digit range in 2018 aligned with the current consensus growth forecast for the year. Against this industry backdrop, our view for KLA-Tencor revenue growth is in the low double-digits for the calendar year.

Now, let’s discuss some of the unique dynamics that are fueling our market leadership and diversified growth.

First, we are experiencing near record levels of demand in mask inspection and registration fueled by customers’ investments in EUV lithography and by continued strength in multi-patterning optical lithography supporting 10 and 7-nanometer design tape-out.

KLA-Tencor is working with each of our major customers to accelerate EUV mask development and yield learning providing a complete portfolio of advanced mask inspection solutions.

EUV promises to be a positive catalyst for future growth for process control as it continues to enable linear scaling and presents market opportunities that we believe KLA-Tencor is uniquely positioned to address as the market leader in mask and wafer inspection as well as in films, CD and overlay metrology.

Another example is in how over the past several quarters we have seen exceptional growth in demand for bare wafer inspection and metrology solutions driven by the expansion of bare wafer supply associated with a strong memory market as well as more stringent cleanliness and flatness requirements for bare wafers.

In addition, IC, memory and logic customers are also experience – increased their investment in process tool qualification to limit yield excursions and to meet aggressive yield and capacity ramp goals. A third example of how KLA-Tencor is benefiting from our market diversification and technology leadership is seen in our strong results in China.

Investment in China is the next major market inflection of WFE and as the market leader in process control, KLA-Tencor is helping to enable development and growth of the China semiconductor industry.

Our customers in China are investing with us in a high level to accelerate early process development and yield learning with our product portfolio as advanced process control solutions and our demonstrated ability to meet aggressive ramp schedules, KLA-Tencor business in China is operating at a high level and we expect it to remain strong for the foreseeable future.

And finally, KLA-Tencor’s service business continues to be a highlight. Service is approaching $1 billion in annual revenue today and is expected to continue deliver consistent high single-digit annual revenue growth over the next several years.

I will note that greater than 75% of service revenue is from service contracts to enable needed up-time of our systems demonstrating the value of the insight and technology these systems provide to enable customer success.

Long-term growth in services is tied to growth in the installed base as well as from expanding investment and trailing edge fabs, which are running at full utilization in creating new opportunities for product enhancements and upgrades.

To sum up today’s results before I turn the call over to Bren June was another record-setting quarter for KLA-Tencor demonstrating the company’s strong execution and fast growing industry environment.

Given our market diversification and the record levels of demand we are experiencing in the marketplace, 2018 is shaping up to be an outstanding year for KLA-Tencor and we are encouraged by the early signs of continuing momentum we are seeing for 2019. I will now turn the call over to Bren for his comments.

Bren?.

Thanks, Rick and good afternoon everyone. As Rick highlighted in his opening remarks, the June quarter delivered excellent financial results for the company.

Shipments, revenue, GAAP and non-GAAP diluted earnings per share all came in at the upper end of the range of guidance in the quarter, with revenue, shipments and earnings per share once again achieving record levels.

These results were driven by strong demand across our major product markets as well as the solid execution of our strategic objectives. Revenue was $1.070 billion in the June quarter. GAAP and non-GAAP diluted earnings per share were both $2.22. In our press release, you will find a reconciliation of GAAP to non-GAAP diluted earnings per share.

As a reminder unless I explicitly refer to GAAP results, my commentary will be solely focused on the non-GAAP results, which exclude the adjustments covered in the press release. Now, turning to highlights of the June demand environment in terms of shipments.

Total shipments were $1.07 billion, about $20 million above the midpoint of guidance and finishing into top end of the guidance range for the quarter driven by strength in memory. Looking forward, we are modeling September quarter shipments to be down almost 10% at the midpoint and be in the range of $935 million or $1.015 billion.

Our current expectation is for shipment growth in the second half of calendar ‘18 to be flat to up low single-digits compared with the first half with sequential quarterly growth resuming in the December quarter.

While second half shipments will be stronger than the first half, this half to half growth expectation is modestly lower than our expectations from 3 months ago given the widely reported memory push-outs in slowing logic investment.

Our shipment mix in the second half of the year has continued strong customer pull from our memory customers, including those in China, ramping bare wafer products and expected pickup in foundry logic shipments in the second half of the year. Memory was 69% of shipments and in line with our original forecast for the quarter.

DRAM accounted for 28% of total system shipments in the period. For September, we expect memory shipments to be approximately 59% of the total. Foundry was 22% of shipments in the June quarter and foundry is forecasted to be about 36% of shipments in Q3 driven by increases in EUV investment and 7-nanometer design starts.

Logic was 9% of shipments and our current outlook is for logic to be approximately 5% of total system shipments this quarter.

In terms of the approximate distribution of shipments by product group, wafer inspection was 47% of shipments, patterning was 29%, patterning includes shipments for our metrology businesses and for reticle inspection; service was 21%; and non-semi was approximately 3%.

Revenue was a record $1.070 billion in June, finishing at the upper end of the range of guidance. We expect September revenue to be flat into midpoint and be in the range of $1.030 to $1.110 billion for the quarter.

Revenue in the second half of calendar ‘18 is expected to grow in the mid single-digits compared with first half, aligned with our current outlook for revenue growth in the low double-digits in the calendar year. Gross margins were 64.8% at the upper end of guidance for the quarter.

The factors driving our strong gross margin performance in June were consistent with recent margin trends for the efforts largely driven by product mix. Looking forward to September, we expect gross margins to again be in the range of 64% to 65% as improving service margins offset slightly weaker product system mix.

Total operating expenses were $265 million in June and operating margin was 40%. We continue to see many opportunities for top line growth in our core business and plan to maintain our investment posture with new programs, including those supporting EUV and advanced memory applications to name three important examples.

For the September quarter, we expect operating expenses to be approximately $270 million with variability around its operating expense level driven principally by the timing of non-headcount engineering program development costs.

For the full year in calendar ‘18, we expect operating margins to be in the 39% range, solidly above the targeted 38% plus margin level in our published business model for these revenue levels and demonstrating KLA-Tencor’s leading market position and business execution.

Free cash flow margin is currently forecasted to be in the upper 20th percentile in 2018, ranking KLA-Tencor among the top tier companies in our industry. The effective tax rate was 15% in the quarter in line with our guidance and our long-term tax planning rate.

Finally, net income for the June quarter was a record $348 million and we had 156.8 million fully diluted shares outstanding. Turning briefly to highlights of the June quarter balance sheet and cash flow statement. Cash and investments ended the quarter at almost $2.9 billion.

Cash from operations was strong at $374 million and free cash flow was $351 million.

In the quarter, we retired $225 million of outstanding debt on our revolving credit facility, paid in aggregate of $117 in regular quarterly dividends and dividend equivalents for fully vested restricted stock units and repurchased $38 million of common stock pursuant to our share repurchase program.

At the end of the June quarter, we had just under $1 million authorized under our share repurchase program.

Legal restrictions related to the timing of shareholder approval of the Orbotech transaction limited our repurchase activity in Q2, but we plan to resume repurchases in the September quarter targeting quarterly repurchase volumes consistent with our previously articulated approach, an expected 12 to 18 month timeframe subject to market conditions.

We have an additional $1 billion share repurchase authorized upon completion of the Orbotech acquisition. Finally, I will note that we will adopt a new revenue recognition standard, ASC 606, starting in the September quarter, to coincide with the start of our 2019 fiscal year.

We are adopting ASC 606 using the modified retrospective method in which we will report financial results prospectively under the new standard, but will not restate historical results.

Also throughout FY ‘19 which ends on June 30, 2019, we will provide a quarterly reconciliation of reported revenue as well as what revenue would have been under the old reporting standards in order to help investors quantify the impact of differences in revenue recognition under the old and new standards.

We do not foresee any impact to cash flows or business operations from the adoption of ASC 606. However, adoption of ASC 606 will impact reported revenue. Here is the summary of two primary changes to revenue recognition resulting from the adoption of ASC 606.

First, instead of accruing the cost of 1-year warranties for systems that we sell to our customers, we will allocate revenue to the warranty element of each transaction and recognized the revenue over the warranty period since we will provide preventative maintenance as well as repair services during the warranty period in a manner consistent with our normal service contracts.

Second, we will continue to recognize systems revenue at the point of time where we have satisfied our performance obligations and transfer control of the product to a customer.

The determination of satisfaction and performance obligations is based on several factors, including the transfer of title, physical possession of the tool by the customer, customer acceptance of the product and whether customer acceptance is considered a formality based on history of acceptance of consumer products.

We expect that the new standard will generally allow for earlier timing of revenue recognition and circumstances were to deem that sufficient performance indicators have been satisfied to conclude that control has been transferred to the customer. We are still assessing the overall impact to revenue from adoption of the new standard.

As I mentioned in the detailed reconciliation of differences in revenue recognition between the old and new standards will be provided on a quarterly basis, beginning with the reporting of the results for the September quarter.

Going forward, quarterly guidance including the guidance for the September quarter will only be provided based on the new rules. We will report actual revenue under both sets of rules for every quarter in fiscal ‘19 and our Form 10-Q.

Although there are future factors in terms of shipment, timing and customer acceptance of products, including packed results under both standards, based on current shipment and revenue forecast, we expect the difference in reported revenue under the new standard to be favorable in calendar ‘18 and in the range of 1% plus or minus 50 basis points higher when compared with the old standard.

In conclusion, the results demonstrated by KLA-Tencor’s June quarter reflects the company’s technology leadership, the critical nature of process control in our customer’s growth strategies and the value of our industry leading business model.

The semiconductor and semi-equipment industry environment today is strong, healthy and performing at a high level with multiple growth fueled by demand from exciting new applications such as artificial intelligence, big data, increasing semiconductor automotive content and the Internet of Things layered on top of investment in China in the traditional computing and mobility markets.

As the market leader in process control and with our revenue diversification within the labor fab equipment market, coupled with the new opportunities for growth in market expansion presented by the pending Orbotech acquisition, we believe the company is uniquely positioned to benefit from this industry growth and it continues to deliver long-term value to our shareholders.

Looking forward to the second half of 2018 and beyond fueled by record total backlog at the end of the June quarter and growth in revenue in the second half of the year, we are positioned for another year of solid growth in 2018 and look forward to more of the same in 2019.

With that, our guidance for the September quarter is shipments in the range of $935 million to $1.015 billion, revenue between $1.030 billion and $1.110 billion and GAAP diluted EPS $2 to 2.32 per share as well as non-GAAP diluted EPS of $2.04 to $2.36 per share. With that, I will now turn the call back over to Ed to begin the Q&A..

Okay. Thank you, Bren. At this point, we would like to open up the call for questions. We request that you limit yourself to one question with one follow-up given the limited time we have for today’s call.

Please feel free to re-queue for any additional questions you may have and we will do our best to give everyone a chance for follow-ups in today’s call as time permits. Alright, Lance, we are ready for the first question..

[Operator Instructions] The first question comes from the line of Timothy Arcuri from UBS. Your line is now open..

Thanks very much. Bren, I guess the first question is it looks like you lost maybe $50 million in shipments for the entirety of the second half, almost all of which was in the third calendar quarter.

So I guess my question is with this all memory and the inevitable question is going to be why should everyone trust that September quarter is going to be the bottom of what is – what you see to basically catalyze Q4 being better? And then I had a follow-up. Thanks..

Yes, Tim. So, it’s pretty well chronicled about some of the push-outs that we have seen over the last month or so, and that’s an industry statement. Yes, it was mostly memory. There was some impact in some other segments as well, but most of it is memory.

Based on what we see in our build plans, we see a pretty strong snapback into the December quarter and all indications here at this point given our conversations with customers with all customers is that that’s the case. So, we are pretty confident about it.

I think it’s our customers behaving rationally in terms of how they are managing capacity and we would expect it to come back in Q4..

Awesome, thanks. And then just as my follow-up question, you guys almost always are at or above the high-end of the earnings range. So, if I assume that, that’s going to happen again in the third quarter that would put you at basically $950 million to $960 million in annualized earnings, so the stock will be trading at roughly 10.5x to 11x earnings.

So I would think that you are chomping at the bit to basically buyback your stock at these levels. So, can you talk a little bit about what the plan is for repo and what the cadence might be once you are able to do that? Thanks..

So, we authorized $1 billion, which I covered this in the prepared remarks, we authorized $1 billion and then another $1 billion contingent on the closing of the Orbotech acquisition and a timeframe for execution over the next 12 to 18 months.

So, we were able to do that for legal reasons in the June quarter and we would expect that we plan to begin doing that in a much more aggressive way beginning this quarter.

So, we tend to be very principled focus in terms of how we think about the execution of this in the principle that ultimately drives how we think about deploying the cash flows of the company.

So we plan to do that in a systematic way, although we do have flexibility to be opportunistic as we move over the next 12 months, but we expect to step up our posture and we will increase it even further after we close the Orbotech acquisition..

Awesome, Bren. Thanks so much..

The next question comes from the line of the Harlan Sur from JPMorgan. Your line is now open..

Good afternoon and solid job on the quarterly execution guys.

On the significantly better sustainability of your business relative to others in the equipment market, you guys have always talked about your business as being more tied to the rate of new technology migration versus capacity addition, I think your EUV mask inspection platform is a good example of that, Gen-5 is a good example of that.

And it seems that technology migration cadence continues to be strong across all segments of the market, is that at a high level how we should think about the sustainability of your business here in the second half relative to what your peers are seeing out there that are probably more a little bit more capacity focused?.

Hey, Harlan, it’s Rick. I think that’s right, there is a couple factors.

One, we do have a more diversified set of customers as opposed to being pure-play and so we have got a number of elements if you think about mask manufacturing, but also wafer manufacturing has been an important segment for us and that has capacity and technology built into it as customers push the sensitivity requirements and flatness requirements of our wafer manufacturers that drives the business cycle there, reticles for new tape-outs for EUV, you talked about Gen-5, there is also – it’s also true in metrology products.

So, it’s a broad base of customers all advancing technologies both memory and logic and we also have of course the activities that are going on in China, so pretty broad and we feel good about the diversification of the customer base at this point..

Thanks for the insights there. And the other thing that you guys have talked about and I am wondering again how much does this add to a pretty strong second half demand profile is that you guys have talked about strong new product pipeline right, which in some cases is expanding your SAM opportunity like the Voyager platform.

Did you guys just recently introduced for pulsatile developed inspection. You also introduced your Surfscan SP7 tool.

Here you guys got 90% market share like how is the new product cadence and in some cases the SAM expansion helping the momentum here in the second half and into next year?.

Well, we have always been a product company, Harlan. So we do need this innovation and does two things. One, it enables our customers to move their technology forward. It also makes it very challenging from a competitive standpoint for people to keep up with us given the rate of introduction and investment in new capability.

And as you point out, we are bringing out new platforms that will have the new addressable markets in addition to the ones that you mentioned with Voyager and SP7, their other products in the pipeline.

So, it gives us a lot of confidence as we finish off calendar ‘18 and go into ‘19 and beyond that we are well-positioned not just to continue to perform across all sectors, but also drive additional growth through the additional expansion of our available markets..

Hey, Harlan, it’s Bren. The other thing I would add is that it helps to offset some of the impact that bringing us, when you bring new capability to market, customers want to try to use that capability and so there is – that becomes pretty attractive to them. It also brings favorable economics with each generation.

So even if they don’t need the capability, there is a cost of ownership improvement that comes with new generations of products. So, even if they don’t need the capability, they tend to – there is an economic motive as well.

So to Rick’s point, it’s important for our competitive positioning to maintain the cadence that’s far ahead of what our competitors are doing, but it also provides an opportunity for customers to leverage the capability and for us to offset the impact of some of those kinds of things..

Great. Thank you..

Your next question comes from the line of C.J. Muse from Evercore. Your line is now open..

Yes, good afternoon. Thank you for taking my question. I guess first question with the adoption of ASC 606, can you still manage your business to a 6-month backlog that’s always been a core part of offering great visibility etcetera.

So, curious what the ramifications are of this change in accounting standard?.

Yes, I know it’s a good question, C.J. I think around the 6-month backlog in terms of orders to shipment, you will see us continue to manage within that window. I’d ideally like to have that down closer to 5 versus 6.

Where we will see the impact of 606 is that you will see revenue come to the P&L sooner, the standards around qualifying for revenue from a shipment perspective, you will have more shipments effectively becoming revenue sooner.

So, where we will have with the consolidated customer base you have more – potentially more volatility in the revenue number. We increased the range a little bit as a result of potentially that factor, because it does reduce the daylight between shipments and revenue.

But for our business, it should stay relatively consistent I talked to some of the principle changes in the prepared remarks, but in terms of how we manage lead times from order to shipment that part of our business won’t change..

Very helpful.

And I guess as a follow-up typically I guess in terms of new capacity as you guys outperformed and so as we look at your second half outperformance for the guide, is that indicative of capacity adds that we should start to see layering it and starting Q4, Q1, Q2, is that a majority of it or is it more leverage to mask and wafer inspection where the full industry won’t benefit from that, anyway to sort of help us understand the moving parts there?.

Yes. So, there are a lot of moving parts, meaning you are right, I mean, reticle and wafer will have those businesses are ramping and so that will have an impact into the first part of the year. The shipments into China, I don’t expect that to abate.

That’s been fairly consistent obviously big projects which seems like over the course of this year we have had our project to quarter pretty much. So we will see how that plays out as you move into the next phases there.

We are seeing foundry logics start to come back in the second half profile and that – and if you look at the order mix that I think is a pretty good harbinger for what we expect to see into the first part of next year in terms of the bigger contribution from those segments.

So I think that I wish I can give you more, but it is a bit of an all of the above answer, but clearly, there are aspects to Rick’s point earlier of the ramp around wafer and mask that is a bit unique to K-T..

Very helpful. Thank you..

Your next question comes from the line of Krish Sankar from Cowen & Co. Your line is now open..

Hi, thanks for taking my question and Bren, thanks for the color on the September shipments. I just had a question it looks like your memory numbers in calendar Q3 are in line with your peers you are seeing a nice snapback in foundry.

Can you just tell us, give us some color on what’s driving those foundry shipments, is it one customer or is it across multiple customers and along the same path in December, the snapback you are seeing in memory is it driven by DRAM or NAND? And I just had a follow-up after that..

So on the foundry side, it’s – I mean we are seeing foundry logic both come back and so you got multiple customers investing there, but certainly on the foundry side of one customer is investing more than others. On the – I am just taking a quick look here, so in September we would expect it to be slightly weighted to DRAM of the memory mix..

Got it. And then as a follow-up question, I just wanted to find out is there a way – can you guys say how much of your total sales is exposed to EUV at this point, is there a way to quantify that and also the bare wafer inspection business has been pretty strong for a couple of quarters, how sustainable do you think this is? Thank you..

We don’t really quantified around the EUV participation, but I would say it’s on the order of 5% to 10% depending on how you look at it. And certainly there is development work that’s going on, that will scale.

We do think the process control intensity around EUV is similar to what process control intensity is for non-EUV which means as EUV costs go up for scanners the process control will scale with that, so that it is definitely consistent trend..

And Chris what was the second part of your question?.

The sustainability of the bare wafer inspection business?.

To the Rick’s comments in the prepared remarks, I mean we are seeing significant investment there both being driven by the strong memory environment. You have got increasing flatness specs. You have got cleanliness specs that are driving investments from the IC manufacturers. To support all that you have the wafer manufacturers also investing.

So they have to deliver wafers. They have under invested for a number of years and so you are seeing new investment there against new specs. So I would expect those numbers to continue to be strong as we move certainly through this year and through next year as well.

And as long as there is significant investment in memory from a WFE perspective, we are going to see that business participate pretty strongly..

Thanks Rick. Thanks Bren..

Thank you..

Your next question comes from the line of Toshiya Hari from Goldman Sachs. Your line is now open..

Yes, great. Thank you so much.

Fundamentals in the flat panel display industry have certainly deteriorated since you announced the Orbotech deal, so Rick I wanted to ask if your view on that part of the industry has changed long-term?.

Well, we always said it’s through cycle mentality looking at the businesses that Orbotech was in, that hasn’t changed. And we are not really in a position to talk about their business yet, but in terms of the strategic nature of that deal we feel very good about the original thesis and all the subsequent work we have done so far with that team.

We are very excited about putting the two together and obviously we will have a lot more to say once we finished the regulatory process..

Understood. And then secondly Bren you talked a little bit about service margins improving in the September quarter and that to some extent offsetting the decline in margins on the products side, can you elaborate on that point and talk to sustainability and service margins? Thank you..

Sure. I mean there were minor changes there. I mean one of the good things we are seeing in China in-service now that we have invested pretty significantly in China to add resources to support all of that business both to be able to ramp those fabs and then support them over time. And as you know they are geographically pretty dispersed.

So between the field resources, but also infrastructure to support all that activity we have been investing pretty significantly over the last 12 months to 18 months. We are now slowly completing that and so we are starting to see the incremental margins flow through on service.

So I would expect one good thing about the consolidated customer base is we are able to get to leverage service infrastructures certainly in certain places like in China or not well maybe the investments in China, but in Korea or in Taiwan we are able to try to leverage those resources.

So it’s a good story and I would expect to see service continued to be well. Obviously, it’s dilutive to our overall gross margins but the incremental offsets some of that ongoing dilution. But we believe the operating margin profile of business is certainly strong and accretive to the overall company..

Thanks so much..

Your next question comes from the line of Mehdi Hosseini from SIG. Your line is now open..

Yes. Thanks for taking my question.

Just looking at your shipment by geography, Korea was really strong this past fiscal year, I am just trying to better understand, would you be able to quantitatively help me understand the mix maybe perhaps between memory and bare wafer?.

Almost of it is memory in Korea. I mean there is a little bare wafer, but most of it is memory..

Okay, helpful.

And then looking forward there are a couple of new fabs coming online Greenfield fabs and I am trying to assess how I should think about your new product and a scaling should we expect your revenue to or a percentage of your system revenue as a percentage of WFE finally to hit 10% plus as your design wins are scale especially for 3D NAND and two of these new fabs for 90 plus layer 3D NAND manufacturing and would that give you the opportunity to see a material increase in memory especially NAND?.

So we have been pretty pleased with the process control intensity improvement that we have seen in flash and so it’s been a good sign. I would expect that the new products if we can continue so our customer problems will continue to see some momentum there. It’s still about half of that what we see in foundry logic.

So the intensity for lots of reasons is lower, but we are seeing incremental improvement. We have seen more metrology. We have new metrology products specifically targeted let’s say should help with that. So as we move forward with the increase in foundry logic mix, we would expect into next year really having an all time low this year.

We would also expect that to influence the overall process control in terms of the percent of wafer, but we are encouraged by what we are seeing in 3D NAND and if we can continue to execute hopefully there is more there for us..

So Mehdi just to build on that, the challenge has not been available problems to solve, the challenge has been solutions which solve those problems and it’s not a competitive challenge for us, it’s just the feasibility, so it’s taken some time to work and collaborate with those customers to get new technologies to market really to address the verticalization of NAND.

And we have very strong products in the pipeline addressing that. So we think calendar ‘19 we will see continued success with those initial penetrations and that will be the basis for driving additional percent of WFE out of memory..

Okay.

So one way or another it should move higher, right now it’s like 7% to 8% of WFE, it should move higher as…?.

Correct..

Got it. Thank you..

Your next question comes from the line of Atif Malik from Citigroup. Your line is now open..

Hi. Thanks for taking my question and good job on the guiding in tough environment.

Two questions on China, Rick my understanding is that the three key domestic Chinese product lines are almost done this year and the emphasis is to improve the yield, given your position in inspection market, can you just update us where the yield stand with those domestic projects and then what your expectations are for the volume business to come from those projects.

And then as a follow-up, if you can also talk about tariffs and implications from tariffs on your supply chain or your business?.

Sure. The exciting thing is we have great partnerships with our customers in China looking at ramping retail facilities. And as you might imagine there is a lot of interest in our expertise and capability there, so we are partnered very closely and we have had a lot of executive exchanges as well as others.

So we feel very good about our ability to support their new fabs in their ramp. I won’t get into the specific of the yields, but they are making progress. We are seeing the promise of additional investment based on the initial success that they are seeing and we feel very good about our position and enabling that as they go forward.

And of course in this case it’s really across the product portfolio. In terms of the implications of tariffs, our supply chain isn’t based in China, so from a standpoint of our key components we are not really subject to that, obviously we have an eye out for other changes that could be coming.

But as of this point, it does not have any impact on our business..

And then Atif just in terms of the investment profile. I mean as we – just thinking about from an order perspective and there is a little bit more lead time to these orders because in a lot of cases, they are building new facilities. But we have seen remarkable stability.

If you just go back in the last couple of years and even as we look forward of the business levels we are seeing in China.

So this year we should book somewhere in the neighborhood and I said this before somewhere in the neighborhood of about $600 million or so from indigenous China and I would expect that level of investment to continue and we will see as start gating out, little ways of away from what things will look like as we move into ‘19 but all indications at this point give me confidence that we are going to continue to see this level of investment for these players as we move forward..

Thank you..

Your next question comes from the line of Mr. John Pitzer from Credit Suisse. Your line is now open..

Good afternoon, Rick. Thanks for letting me asking questions. Congratulations on solid results. I think you guys talked about in your prepared comments the September shipments from logic being down around 5%, which I think is the second lowest and kind of our dataset at least.

I am kind of curious as you think about the December recovery, is logic kind of helping bolster that view of a recovery in December, is it still just mostly memory?.

Hi, John. Bren here too. Yes, John, you are right I mean September is fairly weak, so we do see some bounce back in that segment. We also see bounce back in foundry. So, we do see the shifting profile of 40%ish or so of the shipment mix going to foundry logic into the second half of the year.

So, yes, it looks like it’s going to bounce back, it looks like there is some sustainability to it into the first part of next year..

That’s helpful. And then Rick it’s nice to see that despite the fact that WFE is mixing slightly more towards memory this year than last year, but you guys are still significantly outgrowing WFE.

I am curious to what extent do you think that’s just better leveraged to memory versus kind of EUV playing out this year and you talked about kind of the process intensity of NAND, how should we think about 1Y and 1Z on the DRAM front?.

So, I think the part that’s maybe a little misunderstood and we need to do a better job explaining it is things like the wafer manufacturer is there is high capital intensity of inspection and metrology for those and they are really feeding the memory guys.

So, it’s probably the case that our intensity around memory is higher than the way it’s traditionally thought of. So, we are seeing a lot of benefit in the demands that are placed on wafers as they moved to new technologies in memory, because of the cleanliness and also the flatness. So that’s actually been a boost.

And as you point out on the EUV factor is still there and then lastly we would say the process control intensity in China has been supportive of the overall business environment for us as we have great positions there and in their early stages of trying to ramp new facilities.

So I think all of those factors have come together to give us a very nice 2018 and what looks like a very strong 2019..

Perfect. Thank you very much..

Your next question comes from the line of Mr. Edwin Mok from Needham. Your line is now open..

Hi, great job guys. Thanks for taking my questions.

First question on the foundry side, you mentioned that there is improvement on foundry shipments from September to December, if I calculate correctly second half is actually really strong versus first half, is it all driven by 7-nanometer or are you seeing that demand year-over-year and then just kind of tied to [indiscernible], should we expect a much higher level of Gen-5 adoption in 5-nanometer versus 7, can you kind of talk about the Gen-5 progress?.

I think there is couple of ways to think about it. It’s early for 5, but EUV activity drives a lot of the business in the mouse shop. And so we are seeing the benefit from that in terms of our business in mask is doing quite well. Also wafer manufacturers are very supportive of bringing in new capabilities. So we are seeing that as a driver.

And then you do see Gen-5 and you see actually some of the metrology tools too in support of the new nodes, so I think it’s really a combination of those factors that gives us the diversification of reach across to the customers and is really driving the general outperform..

Yes, I think the other thing that’s happening is as you are seeing an increase in 7-nanometer tape-outs moving through the foundries and so a) that’s driving certain reticle capability, not just writers, but then inspectors from us, but we would expect to follow-on capacity additions to support that business.

As we move into ‘19 you start to see some of that investment around 5-nanometer development. Certainly, Gen-5 plays a bigger role in that. I would expect that business to grow next year versus this year just driven by some of these dynamics..

Great. That was extremely helpful.

And then just a question on the OpEx and maybe I guess operating leverage on the model, Bren, do you think you can sustain OpEx at this level, it seems like December you can grow quite a bit and it sounds like you guys upbeat at least in the first half of ‘19, do you think you can maintain OpEx at this level or just grow OpEx, can you talk about that?.

Yes. I would think the OpEx is going to trend in line with the model that we published. So we are operating about 50 to 100 basis points above that model for these revenue levels given the commentary we provided around next year, it sort of fits within that. So I would see the OpEx scaling a little bit in line with the models we have published.

We try to drive incremental margins, certainly greater than 40% target, 40% to 50% on our incremental margins. So there is a number of new programs we are investing in, new platforms supporting EUV, supporting extra metrology. So, in addition to a couple of things that we just recently announced and there is follow-on activity around those.

So I would expect us to continue to invest. We are going to deliver to the model we have been public with and we are going to continue to try to drive leverage through. But given the level of business we are seeing, I feel pretty good about the sustainability of our investment profile..

Great. Thank you..

Thank you..

[Operator Instructions] Your next question comes from the line of Patrick Ho from Stifel. Your line is now open..

Thank you very much. And Rick, I appreciate the color you have given on some of the increasing capital intensity trends on the memory side. Maybe as a follow-up to John’s question earlier about DRAM and the 1X and 1Y, you talked about the cleanliness and some of the issues there.

As the DRAM ministry moves to 1Y and you see a lot more of these multi-patterning steps and even some of the process change where they could come, I guess more logic like, is that also helping to increase the process control intensity given that they are more logic like and obviously those – that that’s been your key bread-and-butter for the years?.

Well, certainly, we are seeing interest and some adoption of Gen-5 in the DRAM guys as they look at 1Y. So absolutely we are seeing that.

And that wasn’t necessarily originally anticipated the degree with which we have seen that strength, but it just – it kind of goes to the point of the desire to get more capability in there and the fact that the coverage matters quite a bit. So we have just placed some interest that people have had at e-beam for those applications with Gen-5.

So we feel very good about that. And we are definitely getting indications that there is more to come there. It’s not just that, it’s also registration, so if you think about DRAM and the challenges it has for registration we see more adoption there as well. So we feel very good about the trends that we are seeing in memory as well..

So Patrick we are encouraged – we are trying to be a little more conservative in terms of how we model it just given the historic behavior from these customers what we deliver, believe we can deliver any capability here around some of these problems as that’s an opportunity for us.

Most of the context that provide around performance and intensity levels is based on little improvement there, so if we can drive improvement in process control intensity that’s an opportunity for us to deliver incremental upside sort of the base model about how we are running the business over the next few years..

Right. And Bren, maybe as my follow-up question in terms of services, you talked about 75% of your revenues are coming from I guess the service contract today, but unlike process tools which in many cases can eke themselves up and it just becomes a kind of recurring revenue stream of replacing parts.

Can you give a little color of the type of value-added solution or some of the product enhancement that process control can offer and how that can grow?.

Well, I mean certainly the contract profile that you got it pretty well, where there is a limited number of these tools, they are very important to keep them up and customers want to contract structure to ensure that the uptime and availability is there.

And so the 75% certain level of contract as a percent of the total has been fairly consistent at that level. So, we feel very good about the sustainability of that over time as they stretch the installed base. We are continuing to look for opportunities to sell incremental enhancements to the installed base.

As you know that there is a lot of trailing edge activity that’s happening to support automotive and IoT, they are running those older fabs and the installed base much harder.

So, there is incremental demand for those customers to not only drive higher uptime for their tools, which is driving the business, but also to buy enhancements to the current installed base and those fabs are full, so it’s not like in some cases you can move in extra tools, you are going to add incremental capability to the existing school, whether it’s speed or increased sensitivity.

So, we are pursuing and looking at those opportunities and given that the stratification of demand for semi, it creates an interesting opportunity for us going forward..

And maybe a very significant difference between process control, service business and process business, is the availability of alternative suppliers for consumables.

So if you are in a process company, you have that threat of outside sources providing consumables, process control, we have a very strong position to enable and make this equipment continue to perform as is designed and that’s really a big part of the value proposition. So they are different businesses..

Thank you..

Thank you..

Your next question comes from the line of Sidney Ho from Deutsche Bank. Your line is now open..

Thanks for taking my questions. Your largest foundry customer in Taiwan talked about improving manufacturing efficiencies. From your experience with them, do their CapEx cut impacting all the equivalent types equally or do you think that will impact you guys less because process control is more front-end loaded.

And clearly your guidance for September quarter is very good do you think it is more than offset by their spending on 7 nanometers in EUV?.

Well, I think there is two sides of it. One, we like to believe we enable better capital efficiency by helping customers get more value out of the rest of their tools. On the other hand, of course, every customer is trying to manage all their costs and work across the products to extend and reuse.

And as Bren said, one of the keys to our success is to continually bring out new products and new capabilities as a counter. What you have clearly got to show is continued improvement and cost of ownership performance, which means more capability. So, I think the answer is kind of both.

I think you definitely see a push from all of our customers to enhance their sustainability of their investment and by doing that drive efficiency and we enabled that and we also try to support it by driving new capabilities..

Okay, great. My follow-up question is related to China, can you talk about your shipment strength in China this quarter, this June quarter.

About a year ago, you talked about China as the region has the potential of SAM for process control for about $5 billion between 2017 and 2020, given your comment that Chinese manufacturers seems to have high process control intensity, do you think that estimate is higher, lower is just about the same?.

I think it’s too early to say. I mean we have seen in the same time we have seen some softening in the forecast for the sort of wafer outs in China. So I don’t know that we could speculate on that.

We are pleased with the production that the support in the business that we have got in China, but I would say if they meet their published goals, then we will exceed that target. However, I think there are some definite challenges that they have got in terms of scaling those factories over time in the next couple of years..

Alright, thank you..

Your next question comes from the line of Vivek Arya from Bank of America/Merrill Lynch. Your line is now open..

Thanks for taking my question. One more on China, so shipments there were 32% of total versus 18% kind of level, were there anyone off and I think somewhere during the prepared remarks, you mentioned that you expect China to stay around the $600 million contribution level next year, so kind of flat.

I just wanted to confirm I heard that right?.

You did. I mean, that’s an order level. And so what actually – how much actually shifts and revenues may deviate a bit, although we have been – things have been pretty consistent in and around that level. So that’s a reasonable number to use as you think moving forward.

And if you look last quarter there was significant vertical NAND project that we ship to this quarter, there is a significant DRAM project, it’s not all the business, but certainly a big part of it..

Got it.

And then on the services side, is there a backlog number we should keep in mind or I guess often a different way, if we assume that WFE is conceptually flat next year, can you still grow your services business at a double-digit base?.

I mean, the way the service business generally works is you have booking shipments in the same quarter. There is some extended warranty backlog, but it’s pretty minor. So there isn’t a backlog number, but it’s continuous in terms of the contracts that we signed and then we get the POs that are consistent with those contracts.

But the other thing that contributes to it, if you think about the installed base and how long it lasts, one of the things driving, if you will, IoT or automotive is found to be utilizing longer, customers wanting more capability, wanting both enhancements and also those tools to run longer.

So, the decay rate of what we would have originally modeled of tools coming off contract is slower and that’s how you can drive growth even in a flat systems shipment business, which we don’t think ours will be flat by the way even if WFE is flat, we are going to grow this year.

So, we think there is still lot of energy left in the sustainability of the growth in services..

Thank you..

Thank you..

[Operator Instructions] Your next question comes from the line of the Harlan Sur from JPMorgan. Your line is now open..

Yes, thanks for the follow-up.

Given how far behind China is in terms of mainstream technology adoption, given that they do have a track record of higher process control intensity, have you guys seen any Gen-5 pull-ins from China, which may help them to accelerate the yield learning? And then just a quick follow-up in terms of keeping the product pipeline healthy, can you just give us an update on the multi-column e-beam EUV reticle inspection platform, is that still on track for introduction next year?.

Boy, those are our two very different questions, Harlan. So, in terms of the indigenous China projects, we have not seen demand yet for Gen-5 for those projects that we think that’s down the road for the guys that are doing memory, that’s something that certainly we could envision down the road once as you say.

Right now, that’s not really their focus nor at this point is that their need we can satisfy with the number of the products that we already have.

In terms of the multi-beam product, we continue to make investment, we continue to work through some of the technical hurdles and we have a lot of closed engagements with our customers on that and there is clearly a lot of customer interest, but I won’t go beyond that at this point..

Great. Thank you..

There are no further questions. Presenters, I turn the call over back to you..

Thank you, Lance and thank you all for joining us today and your ongoing interest in the ownership of KLA-Tencor. Enjoy the rest of your day..

This concludes today’s conference. You may now disconnect..