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KLA-Tencor Corporation (KLAC - Analyst Report) reported second-quarter 2014 earnings of 85 cents a share, beating the Zacks Consensus Estimate by 6 cents, or 7.6%.

Revenues

KLA reported revenues of $705.1 million, up 7.1% sequentially, 4.8% from the year-ago quarter, within the guided range of $670-730 million and more or less in line with our estimate.

Products generated 77% of total revenue, up 8.5% sequentially and 4.0% year over year. Defect inspection, metrology and other product lines grew 15.0%, -2.2% and -23.9%, respectively on a sequential basis. They grew 7.3%, 11.5% and -49.7% from a year ago.

Services revenues comprised the remaining 23%, up 2.8% sequentially and 7.3% year over year.

North America, Japan and Europe & Israel declined 17.4%, 21.1% and 42.1%, respectively on a sequential basis, while Taiwan, Korea and Other Asia grew strong double-digits. Revenue from North America, Taiwan and Japan remained below year-ago levels, while other regions grew. Overall, North America, Taiwan, Japan, Europe & Israel, Korea and Other Asia/Pacific generated 21%, 21%, 9%, 10%, 22% and 17% of quarterly revenue, respectively.

Orders

New orders in the second quarter were $728 million, down 7.8% sequentially and 4.2% year over year. Management said that the significant weakness versus expectations were on account of the pushback of a large order for reticle inspection products.

On the other hand, shipments were up strongly from both quarters. Backlog increased 2.3% sequentially and 12.5% from last year. Backlog excluding the value shipped but not recognized as revenue declined13.6% sequentially and 2.3% year over year.

Overall, the order contribution by segment was as follows: foundry customers 47%, memory 46%, and logic 7%.

Wafer inspection products had a particularly bad quarter, with revenue declining 23.8% and 14.2% from the previous and year-ago quarters, respectively. Reticle inspection products grew 26.7% and 5.4%, respectively. Other product orders increased 84.3% sequentially but remained below year-ago levels. from both the previous and year-ago quarters, while service orders grew from both periods. Products were 78% of total orders with services accounting for the balance.

Europe, Korea and Other Asia/Pacific declined. Overall, the order contribution by geography was as follows: North America 26%, Europe 1%, Japan 12%, Korea 18%, Taiwan 30% and Other Asia/Pacific 13%. The relatively higher concentration in Asia is due to the presence of a larger number of foundries and memory manufacturers in the region.

Margins

KLA’s gross margin was up 159 basis points (bps) sequentially and 468 bps year over year to 59.8%. The expansion in gross margin was due to a favorable product mix, better-than-expected manufacturing efficiencies and stronger volumes during the quarter.

Operating expenses of $228.1 million were flattish sequentially and up 6.8% from a year ago. The operating margin shrank 386 bps sequentially and 405 bps from last year. All expenses dropped sequentially as a percentage of sales and only R&D increased from last year.

The pro forma net income was $143.1 million, or 20.3% of sales compared to $114.9 million, or 17.5% in the Sep 2013 quarter and $106.0 million, or 15.7% in the Dec quarter of last year. Including one-time items such as restructuring and acquisition-related charges on a tax-adjusted basis, the GAAP net income was $139.2 million ($0.83 a share) compared to $111.2 million ($0.66 a share) in the previous quarter and $106.6 million ($0.63 a share) in the year-ago quarter. 

Balance Sheet

KLA ended with cash and short-term investments balance of $2.95 billion, consistent with the previous quarter. The company generated $115.3 million of cash from operations, spending $14.5 million on capital expenses, $60.3 million on share repurchases and $75.0 million on dividends during the quarter.

Guidance

For the third quarter of fiscal 2014, KLA expects orders of $700-900 million and shipments of $720-780 million. Quarterly revenues are expected to be between $790 million and $850 million, gross margin of 58.59%, opex in a range of $225-230 million and other income/expense of $10-11 million. The tax rate is expected to be 23%, yielding non-GAAP EPS in the range of $1.00 - $1.20, better than the Zacks Consensus Estimate of $1.06.

In Summary

KLA’s second quarter results and third quarter guidance indicate stronger growth in 2014. Particularly, KLA should see accelerated growth in the memory business, especially from the NAND segment. Foundry and logic could also pick up given key customer Intel’s (INTC - Analyst Report) ambitious plans for the year. Earlier this year, Intel cancelled plans to equip its 14nm fab in Arizona, but this could come back later.

KLA-Tencoris an equipment supplier in gradually strengthening demand environment. So while customers continue to make the most of existing inventory, strengthening end markets could drive demand for new equipment. At the same time, since each system is high-valued, customer concentration is obviated, which results in great fluctuations in revenue/orders in times of weak demand.

The underlying drivers (process node transition and strong demand for smartphones and mobile computing devices) should increase capex spending as we move through the year.

The technical complexity of manufacturing semiconductors and increasingly challenging yield issues remain revenue drivers for this leading manufacturer of process control equipment.

KLA shares currently have a Zacks Rank #3 (Hold), similar to equipment makers Lam Research (LRCX - Snapshot Report) and Applied Materials (AMAT - Analyst Report).

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