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KLA-Tencor Corporation’s (KLAC - Analyst Report) second-quarter earnings beat the Zacks Consensus Estimate by 7 cents helped by improving trends across segments. The backlog growth and better-than-expected guidance drove share prices up 2.4%.

Revenue

KLA reported revenue of $673.0 million, which was down 6.6% sequentially and up 4.8% from the year-ago quarter. This was much better than the mid-point of the guidance range and also exceeded our expectations of around $635 million.

KLA remains an equipment supplier in a weak demand environment, which 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 second-quarter results.

Products generated 78% of total revenue, an 8.9% sequential decline and 4.5% year-over-year increase. Services revenue comprised the remaining 22%, up 2.3% sequentially and 5.8% year over year.

The two main product lines declined sequentially. Defect inspection declined 7.4% sequentially and grew 7.1% year over year. Metrology was down 13.0% and 11.5% from the previous and year-ago quarters, respectively.

The U.S., Japan, and Europe & Israel regions grew revenue 13.1%, 4.7% and 1.0% on a sequential basis, while Taiwan, Korea and Other Asia declined 19.1% and 18.5% and 8.2%, respectively. All except the U.S. and Taiwan declined from the year-ago quarter.

Orders

The last quarter was a good one for KLA in terms of orders, as strong demand for tablets and other mobile devices kept the pressure on foundries, which in turn increased their orders with KLA.

The 50.2% sequential increase in orders was mainly because of the foundry segment, which grew 114.2% to 67% of total new system orders. Memory customers grew 83.4% for a 17% share, with logic declining 7.9% to a 16% share. Foundry, memory and logic customers saw order declines of 12.8%, 21.1% and 56.0%, respectively from the year-ago quarter. Non-semi and service orders also increased sequentially.

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

The wafer inspection product line saw orders jump 41.4% on a sequential basis, while declining 20.0% year over year. Reticle Inspection grew 1,401.9% sequentially and dropped 38.5% from a year ago. Metrology was up 90.3% sequentially and down 30.9% from last year. Solar, storage, HB LED and other products were up 12.6% sequentially and down 20.0% from last year.

Taiwan and the U.S. drove most of the increase in orders. Overall, the order contribution by geography was as follows—U.S. 33%, Europe 1%, Japan 7%, Korea 13%, Taiwan 39% and Other Asia/Pacific 7%. 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 $1.09 billion, up 6.3% sequentially and down 22.1% from the year-ago quarter.

Margins

KLA’s gross margin shrunk 149 bps sequentially and 322 bps year over year to 55.1%, due to inventory reserves and adjustments related to product transitions at customers. The incremental gross margin stayed above the targeted 60-70%.

Operating expenses of $213.5 million were up 1.0% from the previous quarter’s $211.5 million. The operating margin was 23.4%, down 387 bps sequentially and 280 bps year over year. The sequential decline in the operating margin was mainly because of a weaker gross margin and higher R&D (as a percentage of sales) although SG&A also increased. The decline from last year was entirely on account of the weaker gross margin.

Excluding the impact of acquisition-related expenses on a tax-adjusted basis and discrete tax items, the pro forma net income came in at $106.0 million, or 15.7% of sales, compared to $142.4 million, or 19.8% in the previous quarter and $121.9 million, or 19.0% of sales in the year-ago quarter.

Including the special items, the GAAP net income was $106.6 million ($0.63 per share) compared to income of $135.4 million ($0.80 per share) in the Sep 2012 quarter and $110.8 million ($0.66 per share) in the Dec quarter of last year.

Balance Sheet

Inventories were down 3.9% during the quarter, with inventory turns flat at 1.8X. Days sales outstanding (DSOs) went from 68 to around 82. KLA ended with cash and short term investments balance of $2.58 billion, down $59.8 million during the quarter. The company generated $77.4 million of cash from operations, spending $17.1 million on capital expenses, $68.3 million on share repurchases and $66.5 million on dividends during the quarter.

Guidance   

For the second quarter of fiscal 2013, KLA expects orders to be $700 to $850 million, revenue of between $690 million and $750 million and non-GAAP EPS of between $0.76 and $0.96, well above the Zacks Consensus Estimate of $0.73.

In Summary

KLA’s second quarter results and third quarter guidance indicate stronger demand although the guidance range appears wide. The backlog growth was encouraging however, as it followed three quarters of decline. The fact that it was driven by growth across all segments (semi, non-semi and services) is particularly encouraging.

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

KLA shares currently carry a Zacks Rank #3, similar to peer Lam Research (LRCX - Snapshot Report) but better than Applied Materials (AMAT - Analyst Report), which has a Zacks Rank #4.

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