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KLA-Tencor Corporation’s (KLAC - Analyst Report) third quarter earnings beat the Zacks Consensus by 7 cents, or 5.6%. Revenue was also better than expected, beating by 3.4%. Investors treated the news positively, as reflected in the 1.22% increase in prices. Revenue growth, positive mix and cost control combined to generate the results.

Revenue

KLA reported revenue of $834.1 million, which was up 8.8% sequentially, 74.4% year over year and exceeding the high end of the guided range of $780-830 million. As we had expected, technology purchases at leading edge foundries were the primary divers in the last quarter, offsetting the softness at the trailing edge (primarily Asia).

These purchases are likely to continue over the next few quarters, according to KLA. The technical complexity of manufacturing semiconductors and increasingly challenging yield issues remain secular revenue drivers for the leading manufacturer of process control equipment.

Products generated 83% of total revenue, an increase of 10.1% sequentially and 97.6% year over year. Services revenue comprised the remaining 17%, up 3.1% sequentially and 11.1% 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 bounced up in the last quarter, coming in at $853 million. This represented sequential and year-over-year increases of 17.7% and 31.4%, respectively. KLA stated that the previous four quarter average was a 14% growth from the prior peak levels back in 2006-2007.

 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 accounted for 58% of revenue in the last quarter. KLA indicated that foundries spent mainly on technology and capacity expansion was limited in the last quarter. It is apparent that the softness in Asia resulted in the 5.2% sequential decline in quarterly orders, which were however up 52.5% from last year. Since underlying demand drivers remain in tact, the softness may be expected to be temporary.

The memory segment (27% of total orders) jumped 58.8% sequentially, while dropping 4.1% from last year. KLA stated that the NAND side of the business drove the strength in the last quarter, accounting for 73% of memory orders in the last quarter.

Logic brought in the remaining 15% of orders, with phenomenal growth in the last quarter. Segment orders increased 120.6% sequentially and 51.7% from last year. KLA mentioned that that 22nm buildouts - most likely at Intel Corp (INTC - Analyst Report) – would continue to drive order strength through 2011 and 2012.

There is considerable lumpiness in KLA’s semiconductor business, since individual units are of high value. Consequently, the wafer inspection product line saw orders soaring 88.2% on a sequential basis and 31.4% year over year.

Metrology also had an extremely strong quarter, increasing 11.8% sequentially and 149.7% from last year. Reticle inspection was soft, declining 54.7% and 12.4%, respectively from the previous and year-ago quarters. Solar, storage, HB LED and other products were up 5.3% sequentially and down 1.4% from last year.

The strength in orders was driven by the U.S. and Europe and we expect this to be sustained. Japan was also strong (driven by NAND and this strength may be expected to soften). Korea and Taiwan were the softest markets in the last quarter, while other Asian countries strengthened, most likely driven by China.

Overall, the order contribution by geography was as follows: The U.S. 25%, Europe 16%, Japan 17%, Korea 9%, Taiwan 23% and Other Asia/Pacific 10%. The relatively higher concentration in Asia is due to the presence of a larger number of foundries and chip manufacturing companies in the region.

The six-month backlog at quarter-end was $1.4 billion, flat sequentially but up 49.1% year over year.

Margins

The pro forma gross margin for the quarter was 61.3%, up 123 basis points (bps) from the previous quarter’s 60.1% and up 367 bps from 57.7% in the year-ago quarter. Incremental gross margins were better than the long term target of 60-70%.

KLAC stated that the gross margin expansion was attributable to higher volumes systems mix. However, lower-cost manufacturing at Singapore and Israel remain offsetting factors.

Operating expenses of $189.7 million were up 3.4% from the previous quarter’s $183.5 million. The operating margin was 38.6%, up 243 bps sequentially and 1,585 bps year over year.

Roughly half the operating margin expansion was attributable to the higher gross margin and most of the remainder was on account of lower R&D (as apercentage of sales). However, SG&A also declined as a percentage of sales.

Excluding the impact of acquisition-related expenses and restatement-related charges on a tax-adjusted basis, as well as certain discrete tax items, the pro forma net income came in at $224.8 million, or 26.9% of sales, compared to $187.2 million, or 24.4% in the previous quarter and $71.3 million, or 14.9% of sales in the year-ago quarter.

Including the special items, the GAAP net income was $209.8 million ($1.22 per share) compared to income of $185.5 million ($1.09 per share) in the December 2010 quarter and $57.0 million ($0.33 per share) in the March quarter of last year.

Balance Sheet

Inventories were up 10.3%, with inventory turns going down slightly from 2.4X to 2.3X. Days sales outstanding (DSOs) went from 63 to around 62. KLA ended with cash and short term investments of $1.84 billion, up $203.2 million during the quarter. The company generated $243.9 million of cash from operations, spending $13.8 million on capital expenses, $57.7 million on share repurchases and $41.9 million on dividend payouts during the quarter.

 

Guidance

For the third quarter of fiscal 2011, KLA expects orders to be down 0-20% sequentially to 680-855 million, revenue of between $840 million and $900 million, incremental gross margin to be within the long-term target of 60-70%, opex to increase slightly, tax rate 30%, other income/expense of -$11 million and non-GAAP EPS of between $1.28-1.44 based on 169 million shares outstanding.

 

In Summary

KLA reported a strong quarter, with orders, revenue, margins and earnings increasing nicely. We think end market drivers remain strong for the leading provider of process control equipment.

In the near term, we think there could be some softness of a temporary nature due to uncertainties related to Japan. However, 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., Europe and possibly China, which offset the weakness at the Taiwanese and Korean customers.

Subsequent to the earnings announcement, KLA also provided an update on the situation in Northern Japan. The company stated that all its facilities in Japan were operational, although power outages and transportation delays were causing temporary setbacks. Moreover, KLA employees and their families are safe.

KLA shares currently carry a Zacks #2 Rank, implying a short-term Hold recommendation. We have a similar rank on other equipment providers, such as Novellus Systems and Teradyne Inc (TER - Analyst Report) that reported  earlier this week.

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