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Edited Transcript of KLAC earnings conference call or presentation 27-Apr-17 10:00pm GMT

Thomson Reuters StreetEvents

Q3 2017 KLA-Tencor Corp Earnings Call

MILPITAS May 1, 2017 (Thomson StreetEvents) -- Edited Transcript of KLA-Tencor Corp earnings conference call or presentation Thursday, April 27, 2017 at 10:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Bren D. Higgins

KLA-Tencor Corporation - CFO and EVP

* Richard P. Wallace

KLA-Tencor Corporation - CEO, President and Executive Director

* Theodore J. Lockwood

KLA-Tencor Corporation - Senior Director of IR

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Conference Call Participants

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* Atif Malik

Citigroup Inc, Research Division - VP and Semiconductor Capital Equipment and Specialty Semiconductor Analyst

* Christopher James Muse

Evercore ISI, Research Division - Senior MD, Senior Equity Research Analyst and Fundamental Research Analyst

* Farhan Ahmad

Crédit Suisse AG, Research Division - VP and Senior Analyst for Semiconductor Capital Equipment sector

* Harlan Sur

JP Morgan Chase & Co, Research Division - Senior Analyst

* Jagadish Kalyanam Iyer

Summit Redstone Partners, L.L.C - MD and Senior Analyst

* Patrick J. Ho

Stifel, Nicolaus & Company, Incorporated, Research Division - Director

* Romit Jitendra Shah

Nomura Securities Co. Ltd., Research Division - Executive Director

* Stephen Chin

UBS Investment Bank, Research Division - MD in the Technology Group and Research Analyst

* Timothy Michael Arcuri

Cowen and Company, LLC, Research Division - MD and Senior Analyst

* Toshiya Hari

Goldman Sachs Group Inc., Research Division - MD

* Yeuk-Fai Mok

Needham & Company, LLC, Research Division - Senior Analyst of Semiconductor Capital Equipment

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Presentation

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Operator [1]

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Good afternoon. My name is Christine, and I'll be your conference operator today. At this time, I would like to welcome everyone to the KLA-Tencor March 2017 Quarterly Earnings Conference Call. (Operator Instructions) Thank you. Mr. Ed Lockwood, with KLA-Tencor Investor Relations, you may begin your conference.

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Theodore J. Lockwood, KLA-Tencor Corporation - Senior Director of IR [2]

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Thank you, Christine. 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 to discuss quarterly results for the period ended March 31, 2017. We released these results this afternoon at 1:15 p.m. Pacific Time. If you haven't seen the release, you can find it on our website at www.klatencor.com. A simulcast of this call will be accessible on demand following its completion on the Investor Relations section of our website.

Today's discussion of our financial results will be presented on a 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 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, 2016. 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 this 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.

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Richard P. Wallace, KLA-Tencor Corporation - CEO, President and Executive Director [3]

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Thanks, Ed, and thank you all for joining us today for our March 2017 earnings call. I plan to briefly cover 3 things with you in my prepared remarks today before handing off to Bren. First, a quick look at KLA-Tencor's outstanding performance in March, followed by a look at highlights of the very strong market share performance delivered by the company in 2016, and then concluding with an updated outlook for industry growth for KLA-Tencor in 2017.

Let's begin with the March quarter. KLA-Tencor delivered excellent results in March, thanks to another outstanding performance by our employees in executing the company's growth strategies in what is a very exciting and dynamic period for the company and for the semiconductor industry as a whole. March shipments, revenue and diluted GAAP and non-GAAP earnings per share all came in above the midpoint of our range of guidance, with shipments finishing at a record $909 million in the quarter.

During the quarter, we experienced strength across our inspection and metrology portfolio, with growth in market leadership metrics for the March quarter continuing the momentum we achieved in calendar year 2016 and highlighting by the quarter record for our unpatterned wafer inspection products. Working in close collaboration with leading global semiconductor device manufacturers, KLA-Tencor's strategies are focused on ensuring our customers success. This effort is helping to address the most complex manufacturing challenges for inspection and measurement in the marketplace today, in both development and capacity monitoring applications.

These challenges include patterning and process window issues associated with EUV and multi-patterning lithography, and as the industry moves to smaller dimensions and three-dimensional structures to address cost, power and device performance improvements. Our successful execution of these strategies continues to bear fruit in terms of market leadership and relative outperformance of KLA-Tencor.

In fact, the recent market share numbers from Gartner show the overall process control segment grew 11% in 2016, or roughly in line with WFE industry growth in the year. In that period, total revenue for KLA-Tencor grew 14% and systems revenue grew 18%. The 2016 share data also shows KLA-Tencor increased our market leadership in process control by about 300 basis points in the year, reflecting our focus on market and technology innovation and most critical applications and inspection and metrology as well as the breadth of our product and services portfolio.

We saw particular strength in 2016 from optical wafer inspection. Recent successful new product introductions in this flagship market for KLA-Tencor including the launch of the new Gen 5 broadband plasma platform, plus strong customer acceptance of the Gen 4 platform for a leading edge capacity monitoring and successful new offerings in laser scanning patterned wafer inspection as well as unpatterned wafer inspection, together, contributed to expansion of the total available market for process control and growth in KLA-Tencor's share of the process control market in 2016.

The story for metrology in 2016 was highlighted by the growth in optical CD metrology, which is the preferred technology for an increasing number of CD metrology applications. Optical CD is playing an enabling role in the proliferation of advanced 3D device architectures and leading edge memory and logic, measuring not only line widths but also profile features on the chip. The robust market share and relative growth delivered by KLA-Tencor in 2016 are the result of continued successful execution of product and service strategies that address the most complex inspection and measurement challenges in today's marketplace. And through that, KLA-Tencor is helping to drive growth and innovation in a period of solid, sustained performance for the semiconductor industry.

Turning to the overall industry environment for calendar 2017. As March results have indicated across the board, the investment landscape in each of the major customer end markets today is solid and broadly based, supporting a growth outlook for the overall WFE industry that's expected to be in the mid-single-digits or higher in 2017.

Given the momentum in demand demonstrated in the March quarter results, and with upside to the original industry growth estimates for the year coming from a broadening of the competitive landscape in 10- and 7-nanometer foundry, we now see WFE growth favoring the upper end of the initial range of our estimates for 2017. And our preliminary review of the 2018 industry landscape points to a continuation of these investment trends.

Given a business model that consistently delivers superior operating leverage and ranks KLA-Tencor in the top tier of leading semiconductor companies, and coupled with leadership position in each of the most critical process control markets, the March quarter results show that the stage is set to build on the momentum of calendar 2016 and deliver what we plan to be a year of double-digit revenue growth in 2017 for KLA-Tencor.

Now turning to guidance for the June quarter. Shipments are expected to be in a range of $890 million to $970 million; revenue for the quarter expected to be in the range of $885 million to $945 million; with non-GAAP diluted earnings in the range of $1.46 per share to $1.66 per share.

And I will now turn the call over to Bren Higgins for his comments. Bren?

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Bren D. Higgins, KLA-Tencor Corporation - CFO and EVP [4]

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Thanks, Rick, and good afternoon, everyone. As Rick highlighted in his opening remarks, the March quarter represented another outstanding period of financial performance and operational execution for KLA-Tencor. Shipments, revenue, and GAAP and non-GAAP diluted earnings per share each finished above the midpoint of the range of guidance in the quarter. This result was driven by strong demand across our product portfolio as well as solid execution and cost management in our manufacturing and service operations.

Revenue was $914 million in the March quarter, GAAP diluted earnings per share was $1.61 in the quarter and non-GAAP diluted earnings per share was $1.62. In our press release, you'll find a reconciliation of GAAP to non-GAAP diluted earnings per share. With the exception of when I explicitly refer to GAAP results, my commentary will be focused on the non-GAAP results, which exclude the adjustments covered in the press release.

Now turning to highlights of the March quarter demand environment. Although we are no longer guiding quarterly orders, for the time being, we will continue to share our perspective on the current end market demand picture to give investors insight into industry trends in KLA-Tencor's performance. Upon completion of an upgrade of our internal analysis systems, our plan is to begin providing an end market mix detail for shipment results and guidance beginning in the September quarter.

At that time, all end market customer mix, business segment and regional breakdowns will be provided on a shipment basis and we will discontinue all formal order commentary including disclosure of the quarterly results. But for now, for the March quarter, new orders were $990 million. Foundry was 54% of new system orders in March, driven by an anticipated broadening of the customer base for investment in 10-nanometer production and 7-nanometer development and by continued investment in legacy technology nodes.

We are currently modeling foundry orders to be approximately 50% of the total in the June quarter. Memory was 42% of new orders, with investment evenly split between DRAM and NAND. We are currently modeling memory orders to be about 40% of the total in the June quarter, with NAND representing about 60% of the memory mix. Logic was 4% of new system orders and is currently forecasted to be approximately 10% of the June quarter total.

In terms of the approximate distribution of orders by product group for the first quarter of calendar '17: wafer inspection was 56% of new orders; patterning was 21%, patterning includes orders from our reticle inspection business; non-semi was approximately 3%; and service was 20% total orders.

Total shipments were a record $909 million in the quarter, finishing above the $890 million midpoint of guidance for March. Looking forward, we are modeling June quarter shipments to be a new record at the midpoint of guidance and be in a range of $890 million to $970 million. Current build plans are supporting quarterly shipment levels in excess of $900 million and we expect this trend to extend at least through the second half of the calendar year. This outlook has strengthened since the earnings call back in January. Current expectations are for second half of 2017 shipments to be up mid-single digits versus the first half of the calendar year.

Turning now to the income statement. Revenue was $914 million in March, finishing above the midpoint of the range of guidance. We expect revenue to be in the range of $885 million to $945 million in the June quarter. Non-GAAP gross margin was 62.5%, in line with expectations for the quarter. The strong gross margin performance in March is consistent with recent margin trends in terms of mix of product business and operating leverage in our manufacturing and service operations. Compared to the December quarter, the benefit of the incremental sequential revenue was offset by a less favorable product mix in the period.

Looking forward to the June quarter, we expect gross margin to be in the range of 62.5% and 63.5%, up about 50 basis points at the midpoint versus the March quarter, due principally to the mix of products we plan to revenue in the quarter.

As we highlighted last quarter, going forward, we expect to deliver gross margin results, a couple hundred basis points above our 2015 published business model targets due to a number of factors including customer reception of new product offerings, more efficient new product introduction execution and improved variable cost management in service and manufacturing operations.

Total non-GAAP operating expenses were $224 million in March, up about $3 million compared with December and non-GAAP operating margin was 38%. We are modeling operating expense levels of between $234 million and $238 million in the June quarter due to higher compensation expenses and prototype materials expenses for current programs.

For calendar '17, we are modeling operating expenses to be around $950 million due to incremental investments and product road maps supporting 3D NAND and EUV inspection and metrology opportunities as well as higher variable compensation expense. Given our gross margin expectations, we expect to continue to deliver operating margins solidly above our published model for the foreseeable future.

Our non-GAAP effective tax rate was 20.7% in the quarter, just below our previously guided long-term planning rate of 22%, reflecting a higher mix of revenue from products developed or manufactured offshore and other discrete items impacting the tax rate. You should assume a 22% tax rate going forward for modeling purposes.

Finally, net income -- non-GAAP net income for the March quarter was $256 million and we ended the quarter with 158 million fully diluted shares outstanding.

I'll now turn briefly to highlights in the balance sheet and our cash flow statement. Cash and investments ended the quarter at $2.7 billion, an increase of approximately $111 million compared with the December quarter. Cash from operations was $225 million in the quarter and free cash flow was $215 million.

In March, we paid an aggregate of $86 million of regular quarterly dividends and dividend equivalents for fully vested restricted stock units and made a supplemental payment of $25 million towards our outstanding term loan. We expect to continue executing our delevering commitments over the remainder of the calendar year, consistent with our leverage targets.

In conclusion, KLA-Tencor's results in March reflect our market leadership, the critical nature of process control in our customers' growth strategies at the leading edge and in legacy design rules and our industry-leading business model. This, fueled by record total backlog of $1.7 billion at the end of the March quarter, position the company for another year of greater-than-market growth and an overall WFE industry environment that is currently forecasted to grow mid-single digits or higher in calendar year '17. This performance demonstrates the company's market leadership, the strong customer acceptance of the portfolio of solutions addressing the most critical yield requirements of leading edge and our operational core competencies.

With that, to summarize, our guidance for the June quarter is: shipments in the range of $890 million to $970 million; revenue between $885 million and $945 million; and GAAP diluted EPS from $1.44 to $1.64 per share as well as non-GAAP diluted EPS of $1.46 to $1.66 per share.

This concludes our remarks on the quarter. I'll now turn the call back over to Ed to begin the Q&A. Ed?

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Theodore J. Lockwood, KLA-Tencor Corporation - Senior Director of IR [5]

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Okay. Thank you, Bren. At this point, I'd like to open up the call up to Q&A.

(Operator Instructions)

All right, Christine, we're ready for your first question.

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Questions and Answers

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Operator [1]

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Your first question comes from the line of Timothy Arcuri from Cowen.

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Timothy Michael Arcuri, Cowen and Company, LLC, Research Division - MD and Senior Analyst [2]

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Bren, I just wanted to ask you about maybe as you think about updating your model. Everyone else is coming out with these financial models that are tied to WFE. And it looks pretty obvious that this year, WFE -- you guys aren't quite as high but if you look at the other guys, they're thinking like high, high 30s, maybe $39 billion. So it seems like $40 billion is now sort of like the new norm, almost. So I'm wondering can you give us a sense of what the EPS would be in a new model at a $40 billion WFE? And then I have a follow-up.

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Bren D. Higgins, KLA-Tencor Corporation - CFO and EVP [3]

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Well Tim, we haven't published a new model so it's a little bit difficult for me to answer that in terms of different WFE levels. I mean, I think the way you have to work through that is as I've said around the revenue performance, from an operating margin perspective, I think we're operating a couple hundred basis points better than what we had published before. But the easiest way to model that is if you're talking about in nearer term, and I think it's an important assumption that we're talking now or a year from now and so on, but if you're just thinking near term a $40 billion environment, you'd have to think about process control intensity on that. And I think in calendar '16, process control intensity was below 13 percentile. So sometime between -- somewhere between 13% and 14%. The mix of business would be a factor in that. Market share, what Gartner just reported 51%. We've got internal objectives to gain share at least 1 point a share a year over the next few years, so that's certainly a factor there. And then our service business, which is currently -- will be somewhere around $800 million into calendar '17. So if you put all that together with the operating margin I suggested, I think you can probably work your way to an EPS result.

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Timothy Michael Arcuri, Cowen and Company, LLC, Research Division - MD and Senior Analyst [4]

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Awesome. And then I guess, Rick, a question for you. So there's a lot of concerns, I've actually gotten a lot of questions recently about some perceptions that there's a lot of reuse between 10 and 7-nanometer. I guess it sort of ignores all the investments that still has to be made at 10. But can you talk about that? I guess it comes down to how much backfill there is on 10-nanometer. But can you just talk about that from like a high level?

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Richard P. Wallace, KLA-Tencor Corporation - CEO, President and Executive Director [5]

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Absolutely, Tim. I think that the biggest issue associated with 10 and 7 is the number of design starts that there are that are ultimately going to land at 7. And 7's a much more significant node than what we saw with 20 going to 16. So therefore, we don't see reuse as being as significant, mainly because there's going to be such an expansion in the overall capacity. So we think that'll drive our intensity. And it will be more like what we saw with the 28 node when you combine 10 and 7 to look more like that. So we feel pretty good about how that is playing out. Not only that, you have multiple players in the 10 and 7 race, so you've got broad industry support, a number of foundries all competing for that as there are increased starts.

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Operator [6]

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Your next question comes from the line of Farhan Ahmad from Crédit Suisse.

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Farhan Ahmad, Crédit Suisse AG, Research Division - VP and Senior Analyst for Semiconductor Capital Equipment sector [7]

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My question is regarding the OpEx increase second half of the year. Can you just talk about what exactly are you investing in? And you touch a little bit upon the EUV opportunity, and I just want to understand like is there something new that you are doing in that area or just accelerating some of the programs that you have there?

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Bren D. Higgins, KLA-Tencor Corporation - CFO and EVP [8]

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Yes, Farhan. Thanks. It's a good question. So there is some acceleration, I will call it incremental investment. We think there are opportunities for us on the inspection side, well, frankly metrology side as well, for driving more process control into 3D NAND. And so there are number of efforts in the company that are focused on that. There's also work we're doing to enable EUV development activities. And so there's work there. Finally, the industry has strengthened, certainly the company performance has strengthened. So there's some variable comp dynamics that are part of that. And so when you add it all up, it looks like it's about $20 million higher for the year than what I was suggesting back in January. But our outlook has strengthened as well. So I think if you look back January versus today, we're probably in excess of $200 million of incremental revenues to where we see things today. And so if you follow our traditional drop-through model of operating margin, it's an incremental $20 million or so in costs. So it fits our model, and we see it as an opportunity to invest in some of these big opportunities. We think that will help drive process control intensity into '18 and '19.

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Farhan Ahmad, Crédit Suisse AG, Research Division - VP and Senior Analyst for Semiconductor Capital Equipment sector [9]

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And then, Rick, you talked about 2018 outlook looking positive at this stage. Can you maybe touch on some of the product drivers that you -- that give you confidence of some growth in 2018?

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Richard P. Wallace, KLA-Tencor Corporation - CEO, President and Executive Director [10]

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Sure. I think that as you look out into '18, what you see is that the investment time frame that will include work on the 5-nanometer, so as you get to later in the year, and then continued expansion in addition to additional capacity being brought on by the guys who aren't in the lead in the 10 and 7. So that's really from the foundry standpoint. Memory, you have continued investment going on kind of across the board. And our process control intensity is strengthening in memory so we see continued drive from that. And of course, we've all talked about the investment that's going on in China. So right now, it looks pretty good and our customers are certainly excited about their prospects as we go forward.

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Operator [11]

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

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Christopher James Muse, Evercore ISI, Research Division - Senior MD, Senior Equity Research Analyst and Fundamental Research Analyst [12]

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I guess first question, I imagine you have a pretty good view today in terms of the capital intensity as we migrate down to 7-nanometer, and would love to hear your thoughts on what that intensity looks like from process control vis-à-vis 10 or 14, whichever's easier as a compare for you.

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Bren D. Higgins, KLA-Tencor Corporation - CFO and EVP [13]

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Well, so C.J., it's Bren. I mean, as we look to calendar -- or we look at 7-nanometer, I mean, 7-nanometer has a full shrink. You're shrinking in the front end. You also have -- you're shrinking in backend in transistor wiring. So we think that, that, coupled with the multi-patterning schemes, the process integration structures the customers are dealing with, those new materials in the backend, will create a number of process window challenges we think will be good for our business. As we move into 7-nanometer, we have a number of new products that will come out that customers will be able to try to address some of these technology challenges but also drive cost of ownership. So I think process control intensity per wafer goes up somewhere in that 20-ish percent range or so. Obviously the number of wafer starts ultimately over time, and design starts, will be a factor in that because lots of designs change how customers invest. But how we're looking at it now is, I think that to Rick's earlier comments, I mean, reuse will be limited. And I think the new product introductions, plus the technology road map, will be a good driver for our business.

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Christopher James Muse, Evercore ISI, Research Division - Senior MD, Senior Equity Research Analyst and Fundamental Research Analyst [14]

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That's very helpful. And I guess as my follow-up, if you make the assumption that your revenues, market growth in calendar '18, will the OpEx uptick we just saw be temporary or will that continue? Will you continue to invest given the heightened revenues? And this is just investments not including the increase in variable comp.

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Bren D. Higgins, KLA-Tencor Corporation - CFO and EVP [15]

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Well, the variable comp will adjust, right? So that's one factor that will play out as you move into '18. I think the easiest way for you to think about modeling the company is back to the model that we had put out, we're targeting an operating margin level based on certain revenue targets. And we're exceeding the published model because of the strengths in gross margin, which we believe are sustainable. And so that's what's driving the outperformance. So as revenue grows, we will invest. And I think that as I outlined earlier, I think there's a lot of opportunities out there and so we'll invest in those. But we're committed to the operating model and that's how you've got to think about it.

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Operator [16]

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

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Harlan Sur, JP Morgan Chase & Co, Research Division - Senior Analyst [17]

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Last call you guys talked about the potential for shipments to be slightly down second half versus first half, now you're expecting second half to be up by mid-single-digit percentage points. So maybe you can just help us understand what's driving the better second half view. Is it foundry, logic, 10, 7, or is it memory, is it legacy China, is it a combination of all of the above?

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Bren D. Higgins, KLA-Tencor Corporation - CFO and EVP [18]

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Yes, Harlan, it's Bren, and thank you for the comment. It really is more of an all of the above statement. Certainly, logic foundry into the second half of the year has strengthened in terms of the shipment profile, so, and we certainly saw that versus where we were in January. So now looks like it's up a little bit, and it's been really filling out in the December quarter. So we feel pretty good about that. I think in China, we continue to be surprised by the pull, customer pull that we see from those customers. So that's a factor in it as well. So -- but I think all segments right now are investing and are putting a lot of pressure on us in terms of quick delivery. So I think the good thing about the upside we're seeing is its quick orders and quick deliveries, which will enable us to drive some revenue performance in the second half. But that's basically what's driving it. And I think finally, the only other thing is that the order profile -- so you look at the backlog that we're bring into the year, the order result in March, what we expect to be a book-to-bill greater than 1 in June. So we've got a fair amount of sort of backlog or runway in terms of what we see coming and how to scale and plan the factory through the second half of the year.

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Richard P. Wallace, KLA-Tencor Corporation - CEO, President and Executive Director [19]

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I'd just add to that, Harlan, I think one of the things that changed in the last 3 months is we were anticipating but not convinced that there was going to be this broad support for the 10, 7 across multiple customers. And we see a lot more evidence of that now so that really has strengthened the foundry side of the equation to Bren's point, driving all those things. So it was a good quarter from that regard.

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Harlan Sur, JP Morgan Chase & Co, Research Division - Senior Analyst [20]

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Great insights. Recently on the memory side, we were talking to the CTOs of one of your large 3D NAND memory customers and when we asked him about his equipment spending intensity going from 2D to 3D, he's saying that most of his buys are 3 areas: number one, the position; number two, edge; number three, in metrology. And this was for 32-layer 3D. They're transitioning to 64-layer now and still saying that metrology tool buys are a very high priority. So I know that you guys have been wanting to collect more data on this. But it seems that on the metrology side, whether it's overlay, film thickness measurement, CD, whatever, that your metrology intensity for 3D is increasing pretty dramatically over 2D. So first of all, are you seeing this sort of higher metrology intensity on 3D versus your prior assumptions? And is there any way to kind of quantify that?

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Richard P. Wallace, KLA-Tencor Corporation - CEO, President and Executive Director [21]

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Yes, Harlan, yes. I mean, the metrology side has been pretty healthy. The concern we have was actually on the other side, in the defectivity side being lower intensity and we're seeing that strengthen and that's relatively early just due to the offerings that we have. But I think that was the area where we think there's more upside because of all the work that people have to do to do destructive tests. And as the complexity increases, there's more opportunity. So we do think the intensity goes up. And I think that if you look at planar -- overall process control intensity for planar versus 3D, they're actually pretty comparable now and likely more upside to that as we go forward.

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Operator [22]

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

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Toshiya Hari, Goldman Sachs Group Inc., Research Division - MD [23]

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My first one is on gross margins. You're guiding Q2 gross margins to 62.5 to 63.5, which continue to be a pretty strong level, above levels we had seen 2, 3 years ago. Is this kind of the new normal for the company, and we should expect this to be a sustainable gross margin number? Or going forward should we expect kind of reversion to the 59% to 60% range?

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Bren D. Higgins, KLA-Tencor Corporation - CFO and EVP [24]

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Yes, it's a good question. And really, we're seeing benefit in a lot of places. I mean, we're seeing improving margin profiles in service. We're seeing improving margin profile across products. New product introduction execution has been very strong in terms of how you manage from transitioning from one product to another. So -- and at these revenue levels, I think that the scaling of our factory and the leverage that exists in that has all been good. So I don't envision a drop-off like you described. I mean, certainly at these revenue levels I think as I guided, I thought calendar '17 was 62 plus or minus 50 basis points. I think we're probably at the higher end of that guidance range now as we look into next year. And I don't see anything on the horizon that suggests that this profile will change going forward. So we feel pretty good about it. And as I said earlier, I think what's driving how we're looking at our operating model and performance at various revenue levels is not so much about what we're spending but how much more gross margin we think we're going to generate from our revenue.

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Toshiya Hari, Goldman Sachs Group Inc., Research Division - MD [25]

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Great. And then I had a follow-up on the wafer side of things. I think it's been about a decade since the Shin-Etsus and the SUMCOs and the Filtronics have expanded capacity in a meaningful way. And we hear more and more about very tight wafer supply these days. Just curious have you had preliminary talks with your customer about potentially expanding capacity? Or are they still very disciplined and still at 12 to 18 months out before they make a meaningful change in their capacity plans?

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Richard P. Wallace, KLA-Tencor Corporation - CEO, President and Executive Director [26]

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Well, we have ongoing conversations with them as they are -- we're critical suppliers to them. And there has been levels of investment for technology capability on a routine basis. But we have seen expansion recently. And 2017 looks like it's going to be a very good year overall relative to capacity in support of increased capacity demand. So that business is part of the strength that we're seeing.

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Bren D. Higgins, KLA-Tencor Corporation - CFO and EVP [27]

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So Toshiya, the only thing I'll add to that is that in our unpatterned inspection business, we had a record year in FY '16 and we just had a record quarter in that business in the March quarter from a quarter perspective. Now some of that is 3D NAND because 3D NAND is driving unpatterned inspection. They basically use these tools to monitor the deposition equipment to ensure cleanliness and so on. But also, the wafer activity is a part of that. And I think that's starting and we expect to see that growing a little bit over time here and it will be a nice tailwind as we progress through this year.

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Operator [28]

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Your next question comes from the line of Romit Shah from Nomura.

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Romit Jitendra Shah, Nomura Securities Co. Ltd., Research Division - Executive Director [29]

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I think there's been this perception, or there was at least, that as memory spending grew as a percentage of WFE, KLA's revenue growth would underperform. That's kind of the trend that we saw in 2014 and '15. But more recently, the revenue performance has been substantially better in spite of pretty healthy memory spending. And I can't say I appreciate what's the difference this cycle. And if you could talk maybe a little bit about if DRAM continues to grow as a percentage of WFE, how does KLA do in that environment?

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Richard P. Wallace, KLA-Tencor Corporation - CEO, President and Executive Director [30]

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Well, there's really 2 things. One, what we saw in the period you referred to where it was underperforming, where we underperformed, I think the other thing that happened in addition to the mix shifting quite fast towards memory, you also had a lot of reuse happening. So it's kind of a combination of factors that played against us. What we have now is expansion of capacity continuing in foundry. Foundry continues to be reasonably strong, less reuse, more players, and our memory process control intensity going up over time. And then some other factors like the last conversation we just had like the OEMs and where the wafer manufacturer is investing. So really a broad customer base. On top of all that, we have China, where the process control intensity tends to be higher overall because these are smaller projects. So we have a lot of factors working in our favor that are supportive of our revenue growth performance.

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Romit Jitendra Shah, Nomura Securities Co. Ltd., Research Division - Executive Director [31]

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So is it fair, Rick, to say that you're sort of agnostic to the mix of WFE?

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Richard P. Wallace, KLA-Tencor Corporation - CEO, President and Executive Director [32]

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Not agnostic. We have a much higher percentage of adoption in foundry than we do in memory. But unless there's a major shift in terms of the relative performance, we believe we'll continue to perform in line or better than the industry as we go forward.

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Operator [33]

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

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Yeuk-Fai Mok, Needham & Company, LLC, Research Division - Senior Analyst of Semiconductor Capital Equipment [34]

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So recently one of your customer, and I think we've heard from other people as well that there's talk about shrinking from 28 to 22-nanometer rather than moving down to 14 and then 10, 7, right? And how would that benefit or affect your business? Do you expect that shrink to drive increased process improvement?

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Richard P. Wallace, KLA-Tencor Corporation - CEO, President and Executive Director [35]

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I'm sorry, from 28 to 22, is that what you said?

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Yeuk-Fai Mok, Needham & Company, LLC, Research Division - Senior Analyst of Semiconductor Capital Equipment [36]

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Yes.

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Richard P. Wallace, KLA-Tencor Corporation - CEO, President and Executive Director [37]

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Yes. Sure, I mean, any time there's any kind of shrink going on that there tends to be increased demand for -- especially on the wafer side, wafer inspection side for finding smaller defects so that will drive it. But you're talking about a relatively small part of our overall market so you wouldn't see as big a change as you would in a node shift down to 7-nanometer, for example, if that make sense. But sure, any of those trends are good and especially when the fabs -- from our standpoint, if it's the smaller fab doing it, the relative process control intensity is higher just because of where they are on the yield curve and on the volume curve, if that makes sense.

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Yeuk-Fai Mok, Needham & Company, LLC, Research Division - Senior Analyst of Semiconductor Capital Equipment [38]

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Actually, that's helpful color there. And then on your guidance outlook, I think you talked about from a logic order picking up this quarter. Is this kind of a renewed resumption of spending by the logic guys or is it just a kind of one quarter timing of things?

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Bren D. Higgins, KLA-Tencor Corporation - CFO and EVP [39]

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Yes, I think when you look at the -- across the year, our view on logic spending in '17 versus '16 is relatively flat, so I think it's a quarterly dynamic more than anything. So yes, I think it's just -- we got orders that are going to get placed and the numbers will be higher next quarter.

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Operator [40]

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Your next question comes from the line of Stephen Chin from UBS.

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Stephen Chin, UBS Investment Bank, Research Division - MD in the Technology Group and Research Analyst [41]

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I just had a follow-up question on WFE spend from China. In China, we are continuing to see satellite pictures of some of these big domestic China fabs making pretty good progress constructing their shelves. How impactful do you think domestic China WFE will be this year for pilot line equipment?

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Bren D. Higgins, KLA-Tencor Corporation - CFO and EVP [42]

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Well, when you look at our order profile, I mean, it was -- so what we saw in '16 and what we expect to see in '17 for the most part is foundry-centric. And so it was roughly 15% of foundry orders in '16 and maybe 25% of foundry orders in '17. I think what's interesting is while the memory investment from a shipment perspective is more of an '18 and beyond dynamic, we are starting to see memory orders show up on the funnel. And so as we look, I'm not sure exactly when we'll see those orders booked, whether we'll see them book in June, or whether we'll see them book in September. But they are for shipments in early '18. And so your question about progress on the facilities is a good one. And so far as we monitor that and we begin to staff up in anticipation of supporting these ramps, these are factors we watch pretty closely. But right now, there's a lot of activity there, and we're chasing -- trying to hire people and ramp up to be able to support those customers in a pretty diverse fab footprint overall across the country.

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Stephen Chin, UBS Investment Bank, Research Division - MD in the Technology Group and Research Analyst [43]

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And a follow-up question on the market share gains that KLA saw last year. Do you get the sense that customers were waiting for KLA's new products last year, and the strong gains we saw last year should continue into this year as well?

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Richard P. Wallace, KLA-Tencor Corporation - CEO, President and Executive Director [44]

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I certainly think we create more momentum with new products in general than in the industry cycle so a new product cycle is very good for us. And I think that in this case, there are 2 things. One, there is a large scale adoption of, in this case, our Gen 4, but not just that we brought out the GEN 5 but also in metrology we have products that were meeting the need. So I'd say that our market share position continues to be very strong. We are investing very heavily in new capability to bring it on. But the other thing we've done in response to the demand in China, we've actually restarted some of our product lines that are suited, well-suited for that market, because we believe market share in China is critical going forward. The other thing that's going on there, and you may be well familiar is one of the big challenges a lot of our customers have there is talent and engineering talent. So one of the other ways we can help us with the worldwide apps presence and the ability to support them as they ramp, not only do they benefit but we benefit from strong share as well.

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Operator [45]

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Your next question comes from the line of Jagadish Iyer from Summit Redstone.

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Jagadish Kalyanam Iyer, Summit Redstone Partners, L.L.C - MD and Senior Analyst [46]

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Two questions, Rick. First, on the 10-nanometer and the 7-nanometer, I was just wondering how should we think of growth between the wafer inspection and metrology? We have new materials being added and new dimensions with the FinFETs and things like that. So I just wanted to get your perspective on the growth between wafer inspection and metrology. Then I have a follow-up.

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Richard P. Wallace, KLA-Tencor Corporation - CEO, President and Executive Director [47]

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Sure. Yes, I think the way I think about it is the wafer inspection is really driving more capability in terms of -- if you think about smaller defects and the actual scaling is happening going to 7. So not only do they need more capable tools but they have to run them at higher resolutions, which drives the utilization in a way that they need more capacity. Metrology, there are more layers, especially with multi-patterning. So what you end up with is more capacity buys in addition to increased technology. So on a percentage basis, both are growing, slightly different drivers between the 2, though.

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Jagadish Kalyanam Iyer, Summit Redstone Partners, L.L.C - MD and Senior Analyst [48]

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Okay. Fair enough. I just wanted a second question as a follow-up is I wanted to understand your momentum on your Gen 5 tool. And how should we think about the ramp in calendar '17 versus calendar '16? And is there a possibility of seeding Gen 5 into memory at some point?

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Richard P. Wallace, KLA-Tencor Corporation - CEO, President and Executive Director [49]

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Yes. Gen 5 is pretty much doing what we thought it would do. And like any new product introduction, not necessarily exactly in the places because it's kind of had different adoption in different locations. But we broadened our penetration. And Gen 5 is now at both memory and foundry and logic facilities. And we're seeing we've got multiple orders now in both foundry but also what we're seeing in memory. So we feel pretty good about our penetration. We're on the plan that we laid out when we introduced the product in terms of our 2016 objectives. Bren can talk to the details of that. And then we hope to be entering, through 2017, entering 2018 with a lot of momentum.

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Bren D. Higgins, KLA-Tencor Corporation - CFO and EVP [50]

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Yes, I think as Rick said, it's going pretty much according to plan. We revenued 4 tools in 2016, and our plan is to revenue 8 to 10 tools in 2017. To Rick's point, they're seeded all over, in multiple customers, so across all the segments. The other dynamic is driving Gen 5 besides the discovery opportunities, where we compete more directly with [EV] capabilities is that you're also seeing it deployed in EUV development situations too. Because it's used as a tool for radical verification when you print wafers and use the wafer results to calibrate pattern fidelity on the wafer -- or on the reticle. So there's an additional use case there that we're encouraged by, and we're in line with our plans. And I think by the end of calendar year '17, we should have somewhere between, I don't know, 15 and 18 tools or so in the field fully installed. So we'll see how many we actually end up with revenue beyond the plan I told you but there's -- they're out there and getting deployed and demonstrating value.

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Operator [51]

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

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Atif Malik, Citigroup Inc, Research Division - VP and Semiconductor Capital Equipment and Specialty Semiconductor Analyst [52]

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Rick, in your prepared remarks, you talked about gaining share and seeing strength in unpatterned wafer inspection last year. What drove that strength in terms of end markets? Was it just the volume of wafers being kind of cranked out in 3D NAND? Or which end market that drove that strength? And then I have a follow-up.

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Richard P. Wallace, KLA-Tencor Corporation - CEO, President and Executive Director [53]

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Well, unpatterned really does benefit from 3D NAND. So we definitely see demand coming from 3D NAND. And we also see it just in general multi-pattern and there are more layers. And customers have long realized that monitor wafers can be a very efficient way to clean and maintain and come up from downtime on tools to reverify their processes. So that's really it. Plus, we saw, as Bren said, we think the momentum continues based on some of the work we're seeing in the wafer manufacturers which are part of what was driving our March results. So we think that continues to be strong for us.

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Atif Malik, Citigroup Inc, Research Division - VP and Semiconductor Capital Equipment and Specialty Semiconductor Analyst [54]

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Okay. And then on China, the investors community is still kind of skeptical on the Chinese projects. There obviously are 10-plus of these and then 5 or 6 more active ones. But overall when you look at these projects, do you think China has the expertise or the engineering talent to build and run these fabs? Or are we going to be seeing -- are we going to build these fabs and just kind of learn through experience and then kind of stumble or [go towards] low-end products? I just want to get your sense of how ready China is to build fabs and then run them.

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Richard P. Wallace, KLA-Tencor Corporation - CEO, President and Executive Director [55]

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It's a great question. I -- let's start with there's certainly a significant investment and I've been in this industry a long time, and I would say I've heard this before out of China but we're seeing a lot more evidence now of actual commitment. There's also leadership has been put in place from other areas, so you have experienced leaders now running a lot of these companies that have demonstrated their ability to run successful organizations in other parts of the world. So I think you have that. The biggest gap probably ends up being the engineering workforce to be able to execute. And I think in that case, what we're seeing is a lot of these ambitious projects are also coming with the requests for support from equipment companies, and so we're definitely feeling that and are participating. We are relatively cautious, too, and if you take our plans, we don't bake in everything that we hear that's said in China in terms of how we run the business. But we're also positioned to be able to support it, should it ramp. And I think the most significant part of that expansion to WFE is not in 2017 or 2018. It's actually toward the end of '18, '19. And so I think it's still early. Right now, we feel very good about the prospects for '17 and the early 2018 numbers look very doable from our standpoint.

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Operator [56]

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

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Patrick J. Ho, Stifel, Nicolaus & Company, Incorporated, Research Division - Director [57]

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You answered this a little bit when you talked about the Gen 5 product and some of the applications that you're getting adoption for that product. But given the continued success of the GEN 4, is that slowing any of the, I guess, the product momentum for Gen 5 and that adoption given that the GEN 4 is still I guess a workhorse tool for even these next-generation nodes?

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Richard P. Wallace, KLA-Tencor Corporation - CEO, President and Executive Director [58]

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Not really. I mean I think that, that goes to 2 things. One is our customers have always sought the lowest-cost solution for the solving the inspection problems. So if we had not expanded the GEN 4, then maybe that would be the case. But the Gen 5 in its development isn't yet at a point where it could have offloaded those inspections. Whenever we do introduce a new -- a whole new technology platform, we almost are forced to reduce the functionality of it on introduction, which is the case here. So it has capability but it doesn't have the same breadth of capability that a GEN 4 will have. That will happen over time and as that does, the Gen 5 will take more and more of the layers as we go forward.

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Patrick J. Ho, Stifel, Nicolaus & Company, Incorporated, Research Division - Director [59]

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Great. And as a follow-up question, given your strong exposure to the foundry segment, today we're seeing the second-tier foundries building out there 28-nanometer capabilities. How much of, I guess, your expertise in that node given that you've helped the other leading players ramp-up on that years ago, how much are you helping out those second-tier players, and how is that helping provide potential incremental business or even services opportunities with these second-tier foundries that are trying to get ramped up?

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Richard P. Wallace, KLA-Tencor Corporation - CEO, President and Executive Director [60]

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Well, we definitely have a close partnership with many players across the board on, say, 28. And I do think we support them as best we can. We don't really make money on services from that. What we do is we support them with tool sales. Our market share tends to be pretty good. And we're committed to doing what -- helping them with best practices in terms of ramping their facilities. These are very capable people but they do often appreciate the support. The other thing I'd mention is in some cases, we actually restarted some of the older products to be able to support them with exactly the capabilities that they need. So we're not selling the latest generation in general into those facilities. We'll sell a mix, some new and some of the, maybe, GEN 3 kind of product line.

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Bren D. Higgins, KLA-Tencor Corporation - CFO and EVP [61]

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Market share, just the only thing I'll add is, market share tends to be stronger with those customers. And so what comes with that is, to Rick's point, the need for some additional support as we work through it. So we have applications, engineers and fabs all around the world, and they get deployed in these opportunities. We think we benefit pretty well from the market position we have on the tools, and these folks help the customers get value out of the tools.

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Operator [62]

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There are no further questions at this time. Mr. Ed Lockwood, I'll turn the call back over to you.

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Theodore J. Lockwood, KLA-Tencor Corporation - Senior Director of IR [63]

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Okay. Thank you, Christine. And thank you all for joining us here on our call today. Just a reminder, an audio replay of today's call will be available on our website later on this afternoon. And once again, we appreciate your interest in KLA-Tencor. Thank you.

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Operator [64]

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Thank you. This concludes today's conference call. You may now disconnect.