KLA-Tencor Corporation’s (KLAC) fourth quarter earnings beat the Zacks Consensus by 13 cents, or 9.6%. Revenue was also better than expected, beating the consensus by 2.3%.
The 0.5% decline in share prices was the response to the guidance and would have been more significant if investors were not already expecting a correction.
Revenue
KLA reported revenue of $892.4 million, which was up 7.0% sequentially, 59.5% year over year and within the guided range of $840-900 million. The technical complexity of manufacturing semiconductors and increasingly challenging yield issues remain secular revenue drivers for the leading manufacturer of process control equipment.
Additionally, delays in EUV adoption are likely to increase yield issues and the demand for better yields, which will be a positive for KLA.
Products generated 83% of total revenue, an increase of 7.6% sequentially and 72.8% year over year. Services revenue comprised the remaining 17%, up 4.2% sequentially and 15.2% year over year. Services are likely to grow in importance, as the company strives to maintain its large installed base.
We are unable to comment on the revenue breakdown by product line and geography since relevant information will not be available until the company files the Form 10Q.
Orders
KLA’s orders were flat sequentially, coming in at $853 million. This represented a year-over-year decline of 10.8%.
KLA’s fortunes are tied to the foundry segment, first because the company is more exposed to this market and second, because its process control equipment is in higher demand at foundries that are always looking to improve efficiencies in order to drive down costs.
As a result, the segment continued to generate the largest chunk of revenue (43%) in the last quarter, despite the 25.9% sequential and 6.4% year-over-year declines. Foundries have been softening for a while now, so the decline was more or less expected. Moreover, the softness was a market phenomenon and KLA’s products remain extremely well positioned in the segment
The memory segment (30% of total orders) was up 11.1% and 27.5%, respectively from the previous and year-ago quarters. The NAND side remains the major driver of growth in memory, although management stated that there were signs of caution for the September quarter. DRAM remains sluggish, consistent with industry-wide trends.
Logic brought in the remaining 27% of orders, with very strong sequential growth, although down from last year. Although KLA’s tone was decidedly cautious, we note that Intel Corp (INTC) raised its capex expectations for the year, which should be a positive for KLA.
There is considerable lumpiness in KLA’s semiconductor business, since individual units are of high value. Consequently, the wafer inspection product line saw orders declining 12.5% on a sequential basis and 21.9% year over year.
Reticle Inspection jumped 70.0% and sequentially, while declining 20.2% from a year ago. Metrology was down 5.3% sequentially and up 14.7% from last year Solar, storage, HB LED and other products were flat sequentially and down 10.8% from last year.
Orders strengthened in the U.S., Japan and Korea, while they dropped significantly in Europe and other Asian countries. Taiwan softened yet again, as may be expected, given the weakness at foundries.
Overall, the order contribution by geography was as follows—The U.S. 33%, Europe 8%, Japan 22%, Taiwan 20%, Korea 13% and Other Asia/Pacific 4%. The relatively higher concentration in Asia is due to the presence of a larger number of foundries and memory manufacturers in the region.
The six-month backlog at quarter-end was $1.4 billion, flat sequentially and up 4.5% year over year.
Margins
The pro forma gross margin for the quarter was 60.7%, down 62 basis points (bps) from the previous quarter’s 61.3% and up 44 bps from 60.3% in the year-ago quarter. Incremental gross margins dropped a good bit lower than the long term target of 60-70%. KLAC stated that the gross margin decline was attributable to higher parts costs related to the services business.
Operating expenses of $184.2 million were down 2.9% from the previous quarter’s $189.7 million. The operating margin was 40.1%, up 148 bps sequentially and 942 bps year over year. The weaker margin was the result of higher cost of sales, as both E,R&D and SG&A declined as a percentage of sales.
Excluding the impact of acquisition-related expenses, restructuring costs and restatement-related charges on a tax-adjusted basis, the pro forma net income came in at $254.4 million, or 28.5% of sales, compared to $224.8 million, or 26.9% in the previous quarter and $119.9 million, or 21.4% of sales in the year-ago quarter.
Including the special items, the GAAP net income was $245.0 million ($1.43 per share) compared to income of $209.8 million ($1.22 per share) in the March 2011 quarter and $113.1 million ($0.66 per share) in the June quarter of last year.
Balance Sheet
Inventories were up 3.4%, with inventory turns going up slightly from 2.3X to 2.4X. Days sales outstanding (DSOs) went from 63 to around 60. KLA ended with cash and short-term investments of $2.04 billion, up $199.0 million during the quarter.
The company generated $289.8 million of cash from operations, spending $14.6 million on capital expenses, $58.0 million on share repurchases and $41.9 million on dividend during the quarter.
Guidance
For the third quarter of fiscal 2011, KLA expects orders to be down 35% (+/- 10%) sequentially to 469-640 million, revenue of between $770 million and $820 million, gross margin of around 60% (implying incremental gross margin at the low end of the long-term target of 60-70%), opex to increase slightly to $197 million, other income/expense to be a net expense of $10 million, tax rate 26%, resulting in a non-GAAP EPS of between $1.10-1.24.
In Summary
KLA reported a strong quarter, although guidance for the next quarter was weak. We think longer term drivers remain intact, mainly the increasing demand for yield improvements due to manufacturing complexities and a slower transition to the next generation platform.
In the near term, we think there could be some softness of a temporary nature due to slowdown at foundries, caution at NAND makers (although KLA continues to record wins) and a sluggish DRAM market. However, logic should hold up.
KLA’s leadership position in the process control segment and geographic diversity will help the company through these trying times. This is evident from the strong pickup in orders across the U.S., Japan and Korea, which offset the continued weakness at Taiwanese customers. Additionally, the non-semi business serves as a buffer, providing some protection against downward pressures in the semi business.
KLA shares currently carry a Zacks #3 Rank, implying a short-term Hold recommendation. We have a similar rank on other equipment providers, such as Novellus Systems (NVLS) and Applied Materials (AMAT).
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