科磊 (KLAC) 2018 Q4 法說會逐字稿

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.

(Operator Instructions)

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're 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'll 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'll 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'll turn the call over to Rick.

Thanks, Ed.

We're 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, while setting all-time records in quarterly shipments, revenue, GAAP and non-GAAP diluted earnings per share.

I'm also pleased to report that we ended the June quarter with a positive book-to-bill and with record total backlog of almost $2 billion.

Also, we are pleased to note our continued progress on our time line 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 the bare wafer market to address capacity growth in memory; and 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 tapeouts.

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've seen exceptional growth in demand for bare wafer inspection and metrology solutions driven by the expansion of bare wafer supply associated with the strong memory market as well as more stringent cleanliness and flatness requirements for bare wafers.

In addition, IC memory and logic customers are also experienced -- 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 at a high level to accelerate early process development and yield learning.

With our broad portfolio of advanced process control solutions and our demonstrated ability to meet aggressive ramp schedules, KLA-Tencor's business in China is operating at a high level, and we expect it to remain strong for the foreseeable future.

And finally, KLA-Tencor service business continues to be a highlight.

Service is approaching $1 billion in annual revenue today and is expected to continue to deliver consistent, high single-digit annual revenue growth over the next several years.

I'll note that greater than 75% of service revenue is from service contracts to enable needed uptime 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 in trailing edge fabs, which are running at full utilization and 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 in 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'll 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 a 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'll 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 at the top end of the guided 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 to $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 pushouts and slowing logic investment.

Our shipment mix in the second half features continued strong customer pull from our memory customers, including those in China, ramping bare wafer products and an expected pick up 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 at the midpoint and be in the range of $1.030 billion 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 the 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, with the upside 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 e-beam, EUV and advanced memory applications, to name 3 important examples.

For the September quarter, we expect operating expenses to be approximately $270 million, with variability around this operating expense level driven principally by the timing of nonheadcount 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 of 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 an aggregate of $117 million 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 billion 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 and expect a 12- to 18-month time frame, subject to market conditions.

We have an additional $1 billion share repurchase authorized upon completion of the Orbotech acquisition.

Finally, I'll 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're 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 standard 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 2 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 recognize 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 transferred control of the product to a customer.

The determination of satisfaction of 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 similar 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 the 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, a detailed reconciliation of the differences in revenue recognition between the old and new standards will be provided on a quarterly basis, beginning with the reporting of the results of 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 in our Form 10-Q.

Although there are future factors in terms of shipment timing and customer acceptance of products that could impact 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 in the June quarter reflect the company's technology leadership, the critical nature of process control in our customers' 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 path of 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 and the traditional computing and mobility markets.

As the market leader in process control and with our revenue diversification within the wafer fab equipment market, coupled with the new opportunities for growth and market expansion presented by the pending Orbotech acquisition, we believe the company's uniquely positioned to benefit from this industry growth and we continue 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 with 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 of $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 like to open up the call for questions.

(Operator Instructions) All right.

Lance, we're ready for the first question.

(Operator Instructions) The first question comes from the line of Mr. Timothy Arcuri from UBS.

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 was this all memory, and the inevitable question is going to be why should everyone trust that September quarter is going to be the bottom?

What is -- what do you see to basically catalyze Q4 being better?

And then I had a follow-up.

Yes, Tim.

So it's been pretty well chronicled about some of the push-outs that we've 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 was 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're pretty confident about it.

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

Awesome.

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, [9 50 to 9 60], in annualized earnings.

So the stock would be trading at roughly 10.5x to 11x earnings.

So I would think that you're chomping at the bit to basically buy back 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're able to do that?

So we authorized $1 billion, which -- so 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 time frame for execution, over the next 12 to 18 months.

So we weren't 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, focused in terms of how we think about the execution of this and the principles that ultimately drive 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'll increase it even further after we close the Orbotech acquisition.

The next question comes from the line of Harlan Sur from JPMorgan.

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 and 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's a couple of factors.

One, we do have a more diversified set of customers as opposed to being pure play, and so we've 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 tapeouts for EUV, you talked about Gen 5, there's 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.

And the other thing that you guys have talked about, and I'm 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, right, that you guys just recently introduced for post-litho development inspection.

You also introduced your Surfscan SP7 tool.

I hear 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've always been a product company, Harlan.

So we do need this innovation.

And it does 2 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 new addressable markets in addition to the ones that you've mentioned, with Voyager and SP7, there are 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're 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 it helps to offset some of the impact of [reuse].

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's 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's an economic motive as well.

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

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

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, et cetera.

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

Yes, no.

It's a good question, C.J. I think around the 6-month backlog in terms of orders to shipment, you'll 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'll have more shipments effectively becoming revenue sooner.

So where we will have -- with a 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 principal changes in the prepared remarks.

But in terms of how we manage lead times to -- 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 adds, you guys outperform.

And so as we look at your second half outperformance per the guide, is that indicative of capacity adds that we should start to see layering in, starting say, 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?

Any way to, sort of, help us understand the moving parts there?

Yes.

So there are a lot of moving parts.

I mean, you're 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.

It would seems -- like, over the course of this year, we've had a project a quarter pretty much.

So we'll see how that plays out as you move into the next phases there.

We're seeing foundry and logic 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 a bigger contribution from those segments.

So I hate to -- I wish I could give you more, but it is a bit of an all-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.

Your next question comes from the line of Krish Sankar from Cowen and Co.

I just had a question, looks like your memory numbers in calendar Q3 are in line with your peers.

You're 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're seeing in memory, is it driven by DRAM or NAND?

And I just have a follow-up after that.

So on the foundry side it's -- I mean, we're seeing foundry and logic both come back.

And so you've got multiple customers investing there, but certainly on the foundry side, one customer is investing more than others.

On the -- I'm 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?

We don't really quantify it 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's development work that's going on.

That will scale.

We do think the process control intensity around the EUV is similar to what the 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 is definitely a consistent trend.

And Krish, what was the second part of your question?

The sustainability of the bare wafer inspection business?

Oh, so to Rick's comments in the prepared remarks, I mean, we're seeing significant investment there, both being driven by the strong memory environment.

You've got increasing flatness specs, you've 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're 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's significant investment in memory, from a WFE perspective, we're going to continue to see that business participate pretty strongly.

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

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

Well, we always had a through-cycle mentality looking at the businesses that Orbotech was in, that hasn't changed.

And we're 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've done so far with that team.

We're very excited about putting the 2 together.

And obviously, we'll have a lot more to say once we finish 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 product front.

Can you elaborate on that point and talk to sustainability in service margins?

Sure.

I mean, there were minor changes there.

I mean, one of the good things we're seeing in service now is that we've 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're geographically pretty dispersed.

So between the field resources but also infrastructure to support all that activity, we've been investing pretty significantly over the last 12 to 18 months.

We're now slowly completing that, and so we're starting to see the incremental margins flow through on service.

So I would expect -- one good thing about the consolidated customer base is we're able to get -- to leverage service infrastructure, certainly in certain places like in China or -- well, we made the investments in China, but in Korea or in Taiwan, we're able to try to leverage those resources.

So it's a good story, and I would expect to see service continue to do 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 the business is certainly strong and accretive to the overall company.

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

Just looking at your shipment by geography, Korea was really strong this past fiscal year.

I'm just trying to better understand, would you be able to qualitatively help me understand the mix, maybe perhaps between memory and bare wafer?

Oh, most 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'm trying to assess how I should think about your new product 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 scaled, especially for 3D NAND and 2 of these new fabs are for 90-plus layer 3D NAND manufacturing, and would that give you opportunity to see a material increase in memory, especially NAND?

Well, so we've been pretty pleased with the process control intensity improvement that we've seen in flash.

And so it's been a good sign.

I would expect that the new products, if we can continue to solve customer problems, we'll continue to see some momentum there.

It's still about half that of what we see in foundry logic.

So the intensity for lots of reasons is lower, but we are seeing incremental improvement.

We've seen more metrology.

We have new metrology products specifically targeted to that space which should help with that.

So as we move forward, with the increasing foundry logic mix we would expect into next year -- really at kind of an all-time low this year, we would also expect that to influence the overall process control intensity as a percent of wafer fab.

But we're encouraged about what we're seeing in 3D NAND.

If we can continue to execute, hopefully, there's 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 a 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'll see continued success with those initial penetrations.

And that will be the basis for driving additional percent of WFE out of memory.

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.

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

Two questions on China, Rick, my understanding is that the 3 key domestic Chinese product lines are almost done this year and the emphasis is to improve the yield.

Given your position in the 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, any 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 greenfield facilities.

And as you might imagine, there's a lot of interest in our expertise and capability there.

So we're partnered very closely and we've had a lot of executive exchanges as well as others.

So we feel very good about our ability to support their new fabs and their ramp.

I won't get into specific of the yields, but they are making progress.

We are seeing the promise of additional investment based on the initial success that they're seeing.

And we feel very good about our position in enabling that as they go forward.

And of course, it's -- 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're 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 -- and 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're building new facilities, but we've seen remarkable stability, if you just go back over the last couple of years and even as we look forward of the business levels we're seeing in China.

So this year, we should book somewhere in the neighborhood, and I've 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'll see as we start getting -- we're a little ways away from what things will look like as we move into '19, but all indications at this point give me confidence that we're going to continue to see this level of investment from these players as we move forward.

Your next question comes from the line of Mr. John Pitzer from Crédit Suisse.

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, in kind of our data set, at least.

I'm kind of curious, as you think about the December recovery, is logic kind of helping bolster that view of a recovery December?

Or is it still just mostly memory?

Hi, John, Bren's here, too.

I'll let him answer that one.

Yes.

So John, you're 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 this shifting profile of 40-ish percent-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.

And it looks like there's 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 that you guys are still significantly outgrowing WFE.

I'm curious, to what extent do you think that's just better leverage 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 the -- I think the part that's maybe a little misunderstood and we need to do a better job of explaining it, is things like the wafer manufacturers, there is high capital intensity of inspection and metrology for those, and they're 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're seeing a lot of benefit in the demands that are placed on wafers as they move to new technologies in memory because of the cleanliness and also the flatness.

So that's actually been a boost.

And then as you point out, John, the EUV factor is still there.

And then lastly, we'd say the process control intensity in China has been supportive of the overall business environment for us as we have great positions there 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.

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

First question, on the foundry side.

You mentioned that there's improvement on foundry shipment 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 (inaudible) 5-nanometer?

And then just kind of tied to 5-nanometer, should we expect a much higher level of Gen 5 adoption of 5-nanometer versus 7?

Can you kind of talk about the Gen 5 progress there?

I think there's a couple of ways to think about it.

It's early for 5 but EUV activity drives a lot of the business in the mask shop.

And so we're seeing a benefit from that in terms of our business in mask is doing quite well.

Also, wafer manufacturers are very supportive of bringing in new capability, so we're 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.

And I think the other thing that's happening, is you are seeing an increase in 7-nanometer tapeouts moving through the foundries.

And so, a, that's driving certain reticle capabilities, not just writers, but then inspectors from us, but we would expect some follow-on capacity additions to support that business.

As we move into '19 and you start to see some of that investment around 5-nanometer development.

Certainly Gen 5 plays a bigger role on 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 kind of 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're going to grow quite a bit and sounds like you guys are upbeat on, at least, in the first half of '19.

Do you think you can maintain OpEx at this level or just grow OpEx modestly, can you talk about that?

Yes, we think the OpEx is going to trend in line with the model that we published.

So we're operating about 50 to 100 basis points above that model for these revenue levels given the commentary we provided around next year sort of fits within that.

So I would see the OpEx scaling a little bit in line with the models we've published.

We try to drive incremental margins, certainly greater than 40%, target 40% to 50% on our incremental margins.

So there's a number of new programs we're investing in, new platforms supporting EUV, supporting X-ray metrology, so -- and in addition there's a couple of things that we just recently announced and there's follow-on activity around those.

So I would expect us to continue to invest.

We're going to deliver to the model we've been public with, and we're going to continue to try to drive leverage through.

But given the level of business we're seeing, I feel pretty good about the sustainability of our investment profile.

(Operator Instructions) Your next question comes from the line of Mr. Patrick Ho from Stifel.

Rick, I appreciate the color you've given on some of the increasing capital intensity trend 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 industry moves to 1Y and you see a lot more of these multi-patterning steps and even some of the process change to where they become, I guess, more logic-like, is that also helping to increase the process control intensity given that they're more logic-like, and obviously, those -- that's been your key bread-and-butter for years?

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

And that wasn't necessarily originally anticipated, the degree with which we've 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've displaced some interest that people had, had at e-beam for those applications with Gen 5. So we feel very good about that, and we're definitely getting indications that there's 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're seeing in memory as well.

So Patrick, we're encouraged.

Right now -- we're trying to be a little more conservative in terms of how we model it, just given the historic behavior from these customers, but we deliver -- believe that we can deliver any capability here around some of these problems that, that's an opportunity for us.

Most of the context they provide around performance and intensity levels is based on little improvement there.

So if we can drive improvement and process control intensity, then that's an opportunity for us to deliver incremental upside to, sort of, the base model about how we're running the business over the next few years.

Great.

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 contracts to date.

But unlike process tools, which, in many cases, can eat 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 enhancements that process control can offer and how that can grow?

Well, I mean, certainly, the contract profile -- you've got it pretty well, where there's a limited number of these tools.

They're very important to keep them up, and customers want a 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're continuing to look for opportunities to sell incremental enhancements to the installed base.

As you know, there's a lot of trailing-edge activity that's happening to support automotive and IoT.

They're running those older fabs in the installed base much hotter.

So there's 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're going to add incremental capability to the existing tool, whether it's speed or increased sensitivity.

So we're pursuing and looking at those opportunities and given 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're 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 it's designed, and that's really a big part of the value proposition.

So they are different businesses.

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

Your logic foundry customer in Taiwan talked about improving manufacturing efficiencies.

From your experience with them, do they -- their CapEx cost impacting all the equipment 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 the spending on 7-nanometers and EUV?

Well, I think there's 2 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 to 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've clearly got to show is continued improvement in 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 enable that and we also try to support it by driving new capabilities.

Okay, great.

My follow-up question is related to China.

You talked about your shipment strength in China this quarter, this June quarter.

About a year ago, you talked about China as a region has a potential SAM for process control for about $5 billion between 2017 and 2020.

Given your comment that Chinese manufacturer seems to have higher process control intensity, do you think that estimate is higher, lower, or is just about the same?

I think it's too early to say.

I mean, we've seen, in the same time, we've seen some softening in the forecast for the total wafer outs in China, so I don't know that we could speculate on that.

We are pleased with the production, the support and the business that we've got in China, but I would say if they meet their published goals, then we'll exceed that target.

However, I think there's some definite challenges that they've got in terms of scaling those factories over time in the next couple of years.

Your next question comes from the line of Vivek Arya from Bank of America Merrill Lynch.

One more on China.

So shipments there were 32% of total versus 19%, 18% kind of levels.

Were there any one-offs?

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 ships and revenues may deviate a bit, although we've 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 shipped to.

This quarter, there's 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 asked in a different way, if we assume that WFE is conceptually flat next year, can you still grow your services business at a double-digit pace?

I mean, the way the service business generally works is you have book and ship in the same quarter.

There's 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 PO 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 fabs being utilized 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 would be flat, by the way.

Even if WFE is flat, we're going to grow this year.

So we think there's still a lot of energy left in the sustainability of the growth in services.

(Operator Instructions) Your next question comes from the line of Harlan Sur from JPMorgan.

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 multicolumn e-beam EUV reticle inspection platform, is that still on track for introduction next year?

Boy, those are 2 very different questions, Harlan.

So in terms of the indigenous China projects, we have not seen demand yet for Gen 5 for those projects.

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 it their need we can satisfy with a 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 close engagements with our customers on that.

And there's clearly a lot of customer interest, but I won't go beyond that at this point.

There are no further questions.

Presenters, I'll turn the call over back to you.

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

Enjoy the rest of your day.

This concludes this conference.

You may now disconnect.