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KLA-Tencor Corporation’s (KLAC - Analyst Report) first quarter earnings missed the Zacks Consensus Estimate by 3 cents, as increased caution at customers impacted all areas of its business.

Revenue

KLA reported revenue of $720.7 million, which was down 19.2% sequentially and 9.5% from the year-ago quarter. This was below the mid-point of the guidance range and was short of the consensus estimate of $740.0 million.

KLA was impacted by the same macro concerns that have hurt the entire technology sector. However, being an equipment supplier in a weak demand environment is probably the worst spot to be in. Customers are making the most of existing inventory, and maintaining low utilization rates.

Additionally, since each system is high-valued, there is a natural customer concentration, which results in great fluctuations in revenue/orders in times of weak demand. All these factors were evident from KLA’s first quarter results.

Products generated 80% of total revenue, a 23.0% sequential and 11.7% year-over-year decline. Services revenue comprised the remaining 20%, more or less consistent with both the previous and year-ago quarters.

Both defect inspection and metrology products declined double-digits from the previous and year-ago quarters. Specifically, defect inspection declined 30.3% sequentially and 10.5% year over year. Metrology revenue dropped 22.3% sequentially and 26.4% from the year-ago quarter.

The U.S., Japan and Other Asia regions grew revenue 14.4%, 13.8% and 10.8% on a sequential basis, while Korea and Europe & Israel declined 74.1% and 18.4%, respectively. All except Taiwan and Other Asia declined double-digits from the year-ago quarter.

Orders

The caution at customers also led to a 38.8% sequential decline in orders to $506 million. Despite the weaker sales, the decline in orders also resulted pulled down the backlog.

The decline in orders was broad-based across customers, although foundries were the worst impacted (as may be expected), dropping 56.9% from the June 2012 quarter. Memory was down 44.6%, while logic declined 22.2%. However foundry and logic revenue increased 10.1% and 58.5% from last year, compared to an 11.4% decline in memory revenue.

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.

Memory customers reined in purchases because of uncertain PC demand, both with respect to the onslaught of tablets on the core computing market and the adoption of new ultra-thin and ultra-light computing systems.

Despite the significant decline in the last quarter, foundries remain KLA’s most important customers, accounting for 54% of its quarterly revenue. Logic brought in another 30% with the balance coming from memory.

KLA’s strength in the logic segment is tied to its relationship with Intel (INTC), which is en route to ramping its 14nm production.

The wafer inspection product line saw orders drop 35.0% on a sequential basis, while growing 89.6% year over year. Reticle Inspection was down 93.2% sequentially and 94.2% from a year ago. Metrology was down 58.3% sequentially and up 11.6% from last year. Solar, storage, HB LED and other products were down 18.4% sequentially and 53.7% from last year.

The decline in orders was on account of a Taiwanese customer, with orders increasing across all other geographies. Overall, the order contribution by geography was as follows: The U.S. 43%, Europe 13%, Japan 13%, Korea 20%, Taiwan 7% 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 $1.03 billion, down 16.9% sequentially and 6.7% from the year-ago quarter.

Margins

KLA’s gross margin shrunk 337 bps sequentially and 143 bps year over year to 56.6%, due to lower volume. The incremental gross margin stayed above the targeted 60-70%.

Operating expenses of $211.5 million were up 0.6% from the previous quarter’s $210.1 million. The operating margin was 27.3%, down 917 bps sequentially and 593 bps year over year. All expenses were significantly higher as a percentage of sales from both the previous and year-ago quarters because of weak revenue in the quarter.

Excluding the impact of acquisition-related expenses and restructuring charges on a tax-adjusted basis, the pro forma net income came in at $142.4 million, 19.8% of sales, compared to $254.8 million, or 28.6% in the previous quarter and $198.1 million, or 24.9% of sales in the year-ago quarter.

Including special items, the GAAP net income was $135.4 million ($0.80 per share) compared to income of $247.9 million ($1.46 per share) in the June 2012 quarter and $191.9 million ($1.13 per share) in September of last year.

Balance Sheet

Inventories grew 6% during the quarter, with inventory turns down to 1.8X. Days sales outstanding (DSOs) went from 72 to around 68. KLA ended with cash and short term investments of $2.64 billion, up $103.6 million during the quarter. The company generated $245.4 million of cash from operations, spending $20.3 million on capital expenses, $68.3 million on share repurchases and $66.6 million on dividends during the quarter.

Guidance

For the second quarter of fiscal 2013, KLA expects orders to be $550 to $750 million, revenue of between $600 million and $660 million and non-GAAP EPS of between $0.45 and $0.65, well below the Zacks Consensus Estimate of $0.93.

In Summary

The technical complexity of manufacturing semiconductors and increasingly challenging yield issues are long-term revenue drivers for the leading manufacturer of process control equipment.

However, KLA’s first quarter results and second quarter guidance indicate slowing end markets and caution at customers that could continue for a couple of quarters at least.

The non-semi business also weakened in the last quarter and solar market issues are also impacting the company. Of course, the segment still generates a very small percentage of its orders, so the impact is relatively small.

Estimates for 2013 have moved down over the last 30 days, although they are trending up for 2014. Therefore, there could be some weakness in the next few quarters, with demand picking up thereafter.

KLA shares currently carry a Zacks Rank of #3, implying a short-term Hold recommendation. Market conditions are clearly telling on other equipment makers as well, as seen from the Zacks Ranks of #3 and #4 (Sell), respectively on equipment makers Lam Research (LRCX - Snapshot Report) and Applied Materials (AMAT - Analyst Report).

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