Good afternoon. My name is Chantelle, and I'll be your conference operator today. At this time, I would like to welcome everyone to the KLA-Tencor first quarter fiscal year 2019 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer session. If you would like to ask a question during this time, simply press star, then the number 1 on your telephone keypad. If you would like to withdraw your question, press the pound key. Thank you. Ed Lockwood with KLA-Tencor Investor Relations, you may begin your conference.
Thank you, Chantelle. 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 today to discuss quarterly results for the period ended September 30th, 2018. 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. 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 30th, 2018.
In those filings, you'll 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 the 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.
Thank you, Ed, and thank you all for joining us today. KLA-Tencor delivered another outstanding result in the September quarter, driven by the company's technology and market leadership and the compelling value of our diversified product and service portfolio in enabling customer success. The September quarter results also show the company is benefiting from our strategies for market leadership and revenue diversification. Furthermore, they demonstrate the critical nature of process control in enabling technology inflections in the semiconductor industry, including growth markets such as vertical NAND, EUV adoption, and the China semiconductor industry. With the expected closing this quarter of the Orbotech acquisition, KLA-Tencor will further extend its market reach in the electronics value chain, enhancing the company's product and services portfolio beyond our core and WFE to address new growth markets where technological complexity is rising and where KLA can extend its core competencies into exciting new opportunities.
Now for some perspective on the current industry demand environment. First, notwithstanding the recent adjustments in capacity investment from memory customers and delays in logic spend from the second half of 2018 into 2019, we believe the long-term factors underpinning demand in the wafer fab equipment industry remain sound. This is a result of several key elements, including more diversified end markets for semiconductor, the ongoing commitment of customers to driving innovation and leading-edge technology roadmaps, disciplined market-driven capacity planning, and the high levels of investment required to address increased design complexity and advanced device architectures. We expect these industry drivers will persist in delivering long-term growth and value creation opportunities for the company, the industry, and for all our stakeholders. Moving now to the recent highlights that demonstrate successful execution of the company's strategic focus on technology and market leadership.
First, as the market leader in process control, KLA-Tencor is helping to enable growth of the semiconductor industry in China. Memory and foundry manufacturers in this region are investing at a high level to accelerate process development and yield learning. We expect momentum in China to continue in 2019 and beyond, with customers progressing their technology roadmaps and ramping new production capacity in the initial phase of a multi-year investment cycle. Additionally, over the past several quarters, we've seen exceptional demand for bare wafer and mask inspection products. Growth in our mask inspection business is consistent with planned increases in CapEx from the leading foundries as these customers ramp seven-nanometer capacity to support a high number of customer tape-outs at this node and begin aggressive development of five nanometer, including EUV development.
In bare wafer, KLA's market-leading inspection metrology tools are key enablers of the growth in wafer supply to address capacity expansion and memory. These products are also essential in helping customers in all segments meet more stringent design specification for wafer flatness and cleanliness. Finally, KLA-Tencor service business continues to be a highlight. Going forward, it is on a trajectory to deliver high single digit to low double digit annual revenue growth with low business volatility consistent with historical trends. Long-term growth in services is tied to expansion of the installed base, as well as from the increasing uptime requirements from current node production and at the trailing edge. Trailing edge fabs are currently running at near full utilization, creating new opportunities for product enhancements and upgrades.
In summary, before I turn the call over to Bren, KLA-Tencor delivered another outstanding performance in the September quarter, driven by the company's strong execution and market leadership. Given our momentum in the marketplace, diversified growth markets, and the critical role the company's products and services play in enabling customer success, we are positioned for a strong finish in 2018. I'd now like to turn the call over to Bren for his review of the financial results. Bren?
Thanks, Rick. Good afternoon, everyone. As Rick highlighted in his opening remarks, the September quarter delivered excellent financial results for the company. Shipments, revenue, gross margin, GAAP and non-GAAP diluted earnings per share all came in at the upper end of the range of guidance in the quarter. Revenue was $1.09 billion, GAAP diluted earnings per share were $2.54, and non-GAAP diluted earnings per share were $2.46. The primary difference between GAAP and non-GAAP earnings was the discrete tax benefit taken in the quarter related to new guidance affecting our adoption of the new tax law in the U.S. As a reminder, since this is the first quarter of our new fiscal year 2019, our results reflect the adoption of ASC 606 for revenue recognition. We have adopted the new standard using the modified retrospective approach.
All revenue commentary on our results and guidance exclusively reflect our adoption of the new standard, and we do not plan to provide any color related to the financial results under the previous standard. In today's press release, you'll find a reconciliation of GAAP to non-GAAP diluted earnings per share. As a reminder, unless I explicitly refer to GAAP results, my commentary will be solely focused on the non-GAAP results, which exclude the adjustments covered in the press release. Now, for highlights of the September demand environment in terms of shipments. Total shipments were $1.007 billion, above the $975 million midpoint, and at the top end of guidance for the quarter, driven by strength in memory and an expected sequential increase in shipments to foundry customers.
Looking forward, we are modeling December quarter shipments to be in a range of $985 million-$1.065 billion, consistent with the update we provided in early September. Our current outlook is for shipments in the first half of calendar 2019 to be modestly higher compared with the second half of 2018. The shipment profile in the first half of 2019 is expected to show accelerating momentum from foundry customers, driven by seven-nanometer design starts and five-nanometer development activity, consistent investment from logic customers, and a balanced mix in memory. Memory was 57% of shipments in September. DRAM accounted for 26% of total system shipments in the period. We expect memory to be strong again this quarter in approximately 64% of total shipments. Foundry was 38% of shipments in the September quarter, and is forecasted to be about 22% of the total in December.
Logic shipments were 5% of the total in Q3, and the current outlook is for logic to be 14% in December. The approximate distribution of shipments by product group was: wafer inspection was 48% of shipments, patterning was 27%, patterning includes shipments for reticle inspection, service was 22%, and non-semi and component inspection was approximately 3%. I'll turn now to the income statement. Revenue was $1.09 billion in September, and finishing at the top end of the range of guidance. We expect December revenue to be in the range of $1.03 billion-$1.11 billion for the quarter. Gross margin was 65.2%, and also at the top end of guidance for the quarter. The factors driving the strong gross margin performance in September were consistent with recent margin trends, with the upside largely driven by product mix.
In December, we expect gross margin to be in the range of 63.5%-64.5%, as a slightly weaker product mix is offset by higher service and manufacturing efficiencies. Total operating expenses were $263 million in September, as non-headcount engineering program investments were lower than expected in the quarter due to timing issues related to prototype materials. We expect to incur those expenses in the December quarter, as we are modeling operating expenses to be approximately $275 million at the midpoint, with variability around this operating expense level driven principally by the timing of these types of program development costs. Looking forward for the next several quarters, we are modeling quarterly operating expenses in the $270 million-$275 million range based on planned product development requirements and our current top-line expectations. Operating margin in September was 41.1%.
The effective tax rate was 11.3% in the quarter, and below the 15% long-term tax planning rate, as business mix and further implementation of provisions of the Tax Cuts and Jobs Act legislation in the U.S. impacted our rate. We will provide an update to the planning rate for the company, inclusive of the Orbotech acquisition, when we report results for the December quarter. Finally, net income for the quarter was $384 million, and we ended the quarter with 156.1 million fully diluted shares outstanding. For the December quarter, you should model share count at approximately 153 million. I'll turn now to highlights of the balance sheet and cash flow statement. Cash and investments were $2.8 billion. Cash from operations was $381 million, and free cash flow was $359 million.
In September, we paid an aggregate of $123 million in regular quarterly dividends and dividend equivalents for fully vested restricted stock units, and repurchased $300 million of common stock pursuant to our share repurchase program. We are currently repurchasing shares under an existing $1 billion buyback authorization, and expect to complete this program over the next few quarters, consistent with the previously articulated approach, and subject to market conditions. We have authorization for an additional $1 billion share repurchase upon completion of the Orbotech acquisition. Finally, in regards to the adoption of ASC 606, please refer to our 10-Q filing for a detailed reconciliation of differences in revenue recognition under the new and legacy standards. These differences are largely driven by timing of revenue recognition, principally due to when control of the products transfers to the customer.
Under ASC 606, we see a reduction in the time period between shipment and revenue recognition compared to the previous standard. Based on the product and customer mix in our current shipment and revenue forecast, we expect reported revenue under the new standard to be favorable for calendar 2018, and in the range of 2.5%, ±50 basis points. The difference in revenue recognition between ASC 606 and the legacy standard could fluctuate from quarter to quarter, but will narrow over a multiple quarter time horizon. In conclusion, the results demonstrated by KLA-Tencor in the September quarter reflect the company's technology leadership, the critical nature of process control on our customers' growth strategies, and the value generated by our industry-leading business model.
As the market leader in process control, coupled with the new opportunities for market expansion represented by the pending Orbotech acquisition, we believe KLA-Tencor is uniquely positioned to deliver long-term value to stockholders. With that, the summarized guidance for the December quarter is shipments in the range of $985 million to $1.065 billion, revenue between $1.03 billion and $1.11 billion, and GAAP diluted EPS of $1.88 to $2.20 per share, as well as non-GAAP diluted EPS of $2.02 to $2.34 per share. Before turning the call over for your questions, I'd like to announce we have scheduled an investor day for March 6th, 2019 in New York City. Please circle that date on your calendars and keep an eye out for further details and a formal invite in the coming weeks. We look forward to seeing you all in New York.
With that, I'll now turn the call back over to Ed to begin the Q&A.
Okay. Thank you, Bren. At this point, we'd like to open the call up to your questions. We once again request you limit yourself to one question and one follow-up, given the limited time we have for today's call. Please feel free to re-queue, and we'll do our best to give everyone a chance to rejoin today's call as time permits. All right, Chantelle, we're ready for the first question.
At this time, I would like to remind everyone, in order to ask a question, press star, then number one on your telephone keypad. We'll pause for just a moment to compile the Q&A roster. Your first question comes from Timothy Arcuri with UBS. Your line is open.
Thank you much. Hi, guys. I had two. First of all, I'm sure you saw the news today about the export restrictions to Jinhua, which is one of the three big memory fabs, of course, being built that you're shipping to this year. My first question is, does this sort of change how you think about your business next year? It seems to be a little more surgical than likely to spread to be a big, broad export restriction, but I'm curious your thoughts. Thanks.
Hey, Tim. This is Rick, and then Bren will follow. It does not change our view for the rest of 2018 or what we're looking at in 2019 based on the expectation we had from that customer. To your point, it was a strategical export control. Obviously, other things would change if that were broadened, but as it stands today, it does not change our view. Yeah, Tim, I think as we look at this year, we feel pretty good about the tools that we've shipped there and closing out on that business. There's some de minimis levels of business in our ship plans over the next several quarters and into our forecast for next year for that site. I don't think it changes in a material way, anyway, of how we're really thinking about the business going forward.
Okay, awesome. Thank you. Then, Bren, service was up a lot. It was up 26% year-over-year, a big inflection. I guess my question is, are you doing something different in service that caused the big inflection? Can service grow that much year-over-year in December and then as you get into the first half of next year? Thank you.
Tim, that's a result of our adoption of 606 and what is happening there. I provided some color in the last call on this topic to provide a little bit of clarity. There will be more in our SEC disclosures that we'll file in the next couple of days. What we're doing here is that given the experience of our customers around our obligations in the first-year warranty is very similar to second and third-year contracts, is we're having to carve out of the tool purchase and defer the revenue associated with that first-year obligation.
Historically, it was a cost accrual. What's happened is we've reversed the cost accrual. Then for the tools under warranty, we've added the deferred revenue, which we will take over the next 12 months, effectively, for all tools that were under warranty effective the transition date to 606 on June 30th. It's a unique dynamic that you saw with a pretty big inflection. I think the dynamics around our service business are consistent. Rick talked about it in terms of our views of growth rate going forward. You will see this step-up that will happen here. We'll see it probably play out over the next couple of quarters. Then it will level back out, something consistent with what we saw historically.
No changes in cash flow or business operations, but given the experience is fundamentally consistent with second and third-year contracts, the literature guides us this direction in terms of how we treat those obligations.
Awesome, guys. Thank you so much.
Thank you.
Your next question comes from John Pitzer with Credit Suisse. Your line is open.
Good afternoon, guys. Thanks for letting me ask a question. Congratulations on the solid results. Bren, maybe to follow up just on Tim's question there. Relative to your view that first half of 2019 should be higher than second half of 2018, if you could elaborate a little bit about what's driving that view is? How much of a benefit is 606? Is the expectation that the memory adjustments are now behind you, or are you still seeing memory uncertainty, but logic and foundry is really giving you that confidence? Any color there would be helpful.
Hey, John, it's Bren. Those were shipment statements, not revenue, and I think it's an important distinction here, because as we go through this transition, one anchor of continuity is the shipment metric, which is why we're continuing to provide not only actual results and context, but also guidance. To be consistent with what we had said previously and to be consistent with this metric that is unchanging, our commentary reflects that. As we move into this first half, I think the way the second half of this year has played out is very similar to the way we described in an update that we did back in September, where the September quarter came in a little bit stronger, December quarter sequential growth weaker and consistent with that guidance.
As we look at the first half of next year, we see an increase in foundry and logic investment, and we see memory in a relatively balanced profile as we move into the first half of the year. I would say that it is modest growth in terms of our expectations. We look at the bill plan. I'm not going to comment at this point of whether, given where we are, whether it's March or June. As we look at the first half, given the timing and our conversations with customers, that's how we're seeing the first half play out, at least at this point in terms of shipments.
That's helpful. Maybe as my follow-ups, just relative to all the consternation and concern about memory, it was interesting to hear you say that you believe memory shipments as a percent of overall shipments will grow sequentially in the December quarter. Rick, I'm wondering if you could just talk to what extent that's rising sort of intensity of what you do in the memory market versus just timing of projects. Any help on sort of the rising intensity would be helpful.
The intensity has stepped up, but it's more consistent with what we've seen over the last year. Remember, we have other products that contribute to that too, such as the bare wafer inspection products, which are leveraged to the memory overall wafer shipment. Those products have been extremely strong as the wafer demand around the world continues to get stretched. Because of flatness requirements, we've seen an uptick in our business for flatness measurement. I think it's more related to those functions, and that really has been playing out throughout this memory cycle, where intensity has grown partly because of the strength of the wafer houses themselves.
Perfect. Thanks, guys.
Your next question comes from Krish Sankar with Cowen. Your line is open.
Yeah. Hi. Thanks for taking my question. I have two of them. First one, just to follow up on China. It looks like you guys are not worried too much about the export control impacting your customer or at least your shipments to China, that's kind of good to know. Is there a way to quantify either, I think you said in the past how indigenous China bookings are in the $600 million range for this year, or as a percentage of sales, like 25% of system sales with China. Is there a way to quantify what it was for September quarter? Then I had a follow-up.
Krish, let me take the first part and then let Bren answer. We're not concerned about this particular movement in the market, this one was a very strategic export control. Let's just be clear on that.
Krish. 27% of shipments in the September quarter were China. I would say that most of that is indigenous China. There wasn't a lot of activity with the multinationals there. Probably a little bit, but not a lot. Consistently, as we've looked at that indigenous business into this year and into next year, the range you talked about is about how we're seeing it in terms of shipment or revenue levels, $500 million-$600 million. It's more foundry-centric, a little bit more foundry-centric and material-centric in 2018, and it looks to be that way in 2019 as well, at least from an order perspective. Generally, we expect a continuation of momentum from those customers. To the earlier point, I think we feel okay, strategically, that this situation around export controls seems to be confined to that one particular situation.
As we said earlier, don't think it has much effect on how we're running the business or planning for it into next year.
Got it. Thank you very much. That's very helpful. Just as a follow-up, your commentary on first half shipments and the fact that next year would be more weighted towards foundry and logic. Is it fair to assume that, without any guidance, calendar 2019 revenue should grow over calendar 2018? Given it's more weighted to foundry logic, the margin profile or EPS should be better than sales. Is that a fair enough assumption?
I'll make a couple comments around 2019. The first is we do expect foundry logic to be up in 2019 versus 2018, and that we expect the first half to be modestly up from a shipment perspective versus the second half of 2018. We'll have more to say as we get to the end of this quarter and report results for the December quarter on the total year view. But at least that's how we see it right now. You're right, those segments are good segments for KLA in terms of process control intensity. Our margins are very consistent across our customer base. I don't think it affects the margin profile or expectations from that business. Certainly that's business we're more exposed to, in terms of the process control intensity of those wafer fab dollars. We're encouraged by that.
We'll see how the broader industry plays out. I'll have more to say about that as we move into December and in the first part of next year.
Thanks, Bren. Thanks, Rick.
Your next question comes from Harlan Sur with J.P. Morgan. Your line is open.
Good afternoon. Great job on the quarterly execution, guys, and strong free cash flow. ASML talked about shipping 30 EUV systems next year. That's up from about 18 this year. The EUV adoption curve is here, and it looks like it's a pretty aggressive ramp. You guys are supporting that with your mask inspection, blank inspection, CD overlay, Gen 5 print check portfolio. Outside of ASML, you guys are probably one of the bigger beneficiaries as EUV ramps. Given that ramp adoption next year, can you guys just quantify your EUV-related opportunity next year? Does this help the team sort of sustain that sort of 64%, 65% gross margin profile maybe into next year?
Hey, Harlan, it's Rick. I'll take the first part, and then Bren will follow up. We don't break out our business by EUV in particular. To your point, there are a lot of drivers about EUV that are frankly good for KLA-Tencor and for helping our customers solve the related problems that they have with it. As you mentioned, we're seeing good business, as we mentioned in the prepared remarks, in our mask business due to the number of advanced starts that are going through fabs. There's also support for print check, as you mentioned, with Gen 5, and also the overlay challenges that our customers face. It is a catalyst and a driver for us as we go forward, but we don't break it out in particular.
We're a little bit agnostic into how many tools there are per se next year. Our demand won't really change if it's the 30 tools they talked about or 20 tools. It's really the driving of the new capability nodes that are driving our business. Bren, you can break out the second part.
On gross margins, Harlan, I think, as we look at next year, in my comments in the script, we see things operating generally around this level. Product mix will drive us directionally here and there from quarter to quarter. In and around this 64-ish% plus or minus 50 basis points, looks like that's how things are trending right now. Obviously, if we see expansion in the business, we should get leverage, and that would work probably both directions if it turns out that the revenue were to come down. In terms of the fundamental structural dynamics around margins, that's generally the right place to be.
On your Gen 5 patterned wafer inspection system, I think you guys had said, anticipated 17, 18 systems in the field by the end of this year. Did you guys hit that target? How do you guys see the momentum of Gen 5 going into next year, just given the sharp ramp of EUV, the start of five-nanometer EUV foundry, and seven-nanometer EUV logic development activities?
Yes, Harlan, we did hit our target. We're consistent with the numbers that we provided earlier. We would expect an increase into next year. I would expect revenue from Gen 5 into next year, given the drivers that you mentioned, that Rick elaborated on. We would expect an increase in Gen 5 revenue in 2019 versus what we saw in 2018.
In terms of momentum, it's playing out very much the same as prior generations when we've got the new generations of inspection products where you'll have a couple of early adopters, maybe one big early adopter that'll drive it. You have customers that are maybe more evaluative of it, and they'll spend a lot of time trying to figure it out. The momentum gets going when the customers who have not adopted realize the advantage that the leaders are having. We see it kind of flow out. When we model those, it's not just the number of systems, it's where they're located and the use cases. We have some that are being utilized in the early stages of manufacturing support where others are in development. We like the momentum of the product. We're finding unique capabilities.
It is true that EUV creates more opportunities for that product to differentiate and for customers to rely on it. We're feeling very good about how we're positioned as we go forward in 2019.
Great. Thank you.
Your next question comes from Vivek Arya with Bank of America Merrill Lynch. Your line is open.
Thanks for taking my question. For the first one, you mentioned the potential for first half 2019 orders to slightly grow half-over-half. How sensitive is that to assumption of where memory prices will trend?
My statement was around shipments, not about orders. I think right now the plans our customers have put in front of us, given what we're seeing, it doesn't seem to necessarily be pricing dependent. Obviously, that does influence how they think about overall supply. We've seen a number of adjustments already and how those have played out through 2018 and those pushes into 2019. Based on what we know today, our expectation is to see some balanced investment into the first half of 2019 from a shipment perspective. As I said, modestly up versus the second half of 2018.
Got it. For my follow-up, just a question on inventories. They are higher than what we have seen historically. Can you give us some sense of what the range should be for whether it's days or dollars or what have you over the next several quarters? Thank you.
You're right. It's a good question. They are higher. We have seen some increases related to some of our long lead time products that are in the queue, namely the reticle inspection products. We talked about some of the incremental demand that we're seeing for that tool, those are long lead times, so we have to get in the queue to buy those materials early. We have a number of new products that are coming out, we're spinning up supply chain to support that. In some cases, we're working with newer suppliers, we're buying early to qualify parts to support a ramp. We have a new product launch in laser scanning, in E-beam. We talked about Gen 5 and the increments for Gen 5 into next year. All those things are driving the inventory levels higher.
I would expect based on what we're seeing in terms of output expectations into next year, that we'll see that number flatten out, as we start to put that material into tools and ship those tools out. We are committing earlier in those cases to make sure we've got the products in position so we can ramp them, that's where we see it in our financials is in the inventory build.
Thank you.
Your next question comes from C.J. Muse with Evercore. Your line is open.
Yeah, good afternoon. Thank you for taking my question. I guess first question, back on deferred revenues. It looks like that ticked up from June to September by $300 million-plus. Is that the kind of number we should be thinking about in terms of an increase for deferred in fiscal 2019 versus fiscal 2018? As a second part to that, should we be thinking about deferred being isolated to certain long lead time or newer products? Are there certain gross margins associated with those products vis-a-vis the rest of your mix?
Yeah, C.J., maybe this is something we need to reconcile with you, deferred revenue backlog should come down. One thing about 606 is, given the timing issues and given our implementation of 605, which was rules based, as a result, took us longer to meet the conditions of transfer and customer acceptance. Under 606, we get there much faster. From the time we ship a tool to the time we revenue it should only be about a month. We should see deferred revenue related to that to come down. I talked a little bit about the warranty dynamic earlier, which will play out over the next few quarters. There isn't anything in particular that's special or unique about certain products.
It's more really based on if you ship a new product it's first of a kind, matching requirements, things like that we have to go all the way to an acceptance on. Under 606, you go to that acceptance level in a much faster way, then all the follow-on tools are generally, you see revenue at shipment. The installation acceptance process becomes or is considered more perfunctory from an accounting perspective. That's what's happening. I would expect the deferred revenues to come down over time given those dynamics.
Very helpful. As a follow-up, as you think about this Jinhua ruling from the Department of Commerce, how are you thinking, if at all, that could impact MOFCOM and their willingness to sign off on your acquisition of Orbotech?
We've had dialogue and discussions, we're proceeding along the path that we had modeled where we were in terms of regulatory in China. We feel very good about the exchange that we're having, and we believe we're on track to close that out this calendar year. As we had said this quarter. We feel good about that. We have seen no indication of any change in their posture based on any of the other things that are going on relative to trade.
Good to hear. Thank you.
Your next question comes from Toshiya Hari with Goldman Sachs. Your line is open.
Great. Thank you very much for taking my questions. Rick, you called out foundry five nanometer as one of the potential drivers heading into first half of 2019. I realize it's really early, but how do you think about that node in terms of contribution to your business over the next couple of years?
Well, I think it'll be a continuation of the expansion we've seen in terms of the newer products that we have are going to be targeted at five nanometer. We see the process control intensity challenges are very significant for our customers because that's the node in which EUV is going to be adopted in a greater percentage. Some people are looking at some level of EUV at seven, but five is really where it increases in adoption. That'll drive a lot of use. We're well positioned for that.
We're working closely with the customers that are pushing their technology. This is part of the Gen 5 discussion that we've had in the past, where Gen 5 was really more of a development tool if you go back a year ago, and now it's becoming more of a pilot tool in early production, and five nanometer becomes more biased toward production. We feel great about where we are with that tool, but also the supporting metrology tools as well. In the first part of next year, we'll see the seven-nanometer tapeouts that the customer's currently talking about. We'll see that drive up some activity. We're seeing it in the mask shop. We'll see it in the wafer fab as well. We'll start to see more of the N5 investments in early development as we move towards the second half of the year.
As Rick said, it's a challenging node. It's a bigger node for EUV. We've got a number of products that are targeted for it. I think it'll be interesting and intriguing business for us as we move into the second half of the year.
Great. As a quick follow-up, on bare wafer inspection, I think this is another segment or product group, rather, that you guys have called out over the past couple, if not several quarters. I realize it's a high-margin business for you guys. I think some of your customers or all your customers remain pretty constructive into 2018, I'm sorry, 2019 in terms of their outlook in terms of pricing. Some of them have toned it down a little bit just given the weakness in memory and certain parts of logic. How sustainable do you think this business is for you? I ask because, in the past, I think it's been pretty volatile for you guys. Thank you.
We're certainly in a period where there's kind of three things working at once in favor of this business, which is there's capacity expansion, there's technological challenges associated with defectivity, and there's increased flatness requirements. It is true that has stepped up the level of business. What we're modeling as we go forward is we don't see that level of growth going forward again, where we've essentially, over the last few years, that business has grown quite a bit. The sustainability of the current levels is what we're modeling in terms of when we talk with our customers as they continue to bring on capability, and remember, the % of their wafers that are going to leading edge right now is relatively small, over time, they have to convert more of that to leading edge.
We'll be feathering in our products in support of that. We feel pretty good about the current level of business that we have in the bare wafer and its sustainability. We don't see another leg up, though, as we saw in the last few years as we went to this node. Thanks so much.
Your next question comes from Patrick Ho with BMO. Your line is open.
Thank you very much. Maybe just as a follow-up to your comments on the memory market, at least in the near term, when you're discussing about a balanced memory market, does that include the combination of DRAM and NAND, or are you seeing one or the other potentially driving the first half of 2019 outlook that you detailed?
That's a statement on our expectations for shipments into the first half, that it's a relatively balanced shipment profile across the two segments. I don't really have much more to say than that. I think we feel pretty good. You have to remember one thing about KLA is that we tend to be more about enabling technology and less about just raw capacity expansion. As long as our customers are continuing to push their roadmaps, and they are in DRAM, and they are pursuing incremental layers in NAND, that we see and expect to see a continued level of business from those customers, irrespective of the capacity adjustments that could happen. Yeah, we don't disagree with the industry perspective that DRAM investment in 2019 will be coming down.
We do see foundry up, as Bren said, that's not as much of a driver for us as the other factors you mentioned.
Great. That's helpful. Maybe, Rick, as a follow-up in terms of China and the indigenous market, particularly on the trailing edge foundry logic segment, that's been a surprising strength for the entire industry in 2018. From a process control intensity standpoint, do you believe the local semiconductor manufacturers on the foundry logic side are seeing the value, this will then continue as they continue to migrate down nodes in the future? I guess I'm a little surprised that there's been so much strength coming out of there, given that they can reuse tools or buy used tools in the marketplace.
There's a number of process challenges I think that they're facing, even though they have, as you say, they have the options that some of the bigger players might have tried to leverage. It's harder when you're relatively new and your scale isn't as big to be able to do the reuse and some of the things that you've seen in the other places. They're also tackling a number of technology challenges at once. We have excellent relationships there, and we feel very good about the sustainability of that business. On a relative basis, too, when you look at those fabs in terms of scale, they're significantly smaller, as I said, than what you'd see elsewhere. I think it continues to be strong. I do think there's even potential for more in the way of things like mask shops, where you'll continue to see strength.
Ultimately, they'd like to have wafer manufacturing, but I think that's several years away before that'll be a significant piece of that. They also are challenged to get used equipment. It's a pretty tight market out there, and we will sell, at times, used KLA equipment. We don't really have any of that in inventory. What we've done is we've restarted older product lines to support some of that business. You're seeing current revs of products that are deconfigured to meet these trailing-edge needs that certainly have the ability to be upgraded over time from those customers. They're investing that way, and to Rick's point, there are markets to ship into, and eventually they'll be able to get to a place where they can do that.
Great. Thank you.
Your next question comes from Atif Malik with Citigroup. Your line is open.
Hi. Thanks for taking my questions. Rick, I want to get your thoughts on the use of EUV for DRAM, when you think it gets implemented on DRAM, and how you guys could benefit from that.
Well, I think that you're going to start seeing some adoption of it. It very much depends on the economics, I think, and that's going to be the big challenge. I think we're going to see some in 2019, beyond what we've seen in pilot in 2018. It's really a similar story, though, to what we see in logic, where EUV presents opportunities both in terms of the mask shop. Obviously, with DRAM, you don't have the number of starts, but you do have very significant concerns about lifetime and contamination and EUV cleanliness overall. I think it's much more about the scalability and scaling of the design rule in DRAM and also some of the challenges they're trying to get around in terms of overlay control. It's a driver, but not as much as it is, of course, in logic.
Okay. On China, in a nuclear winter scenario where, let's say, there are broad restrictions put on equipment suppliers to ship equipment to China, do you think this spending will just get absorbed elsewhere in Korea or Taiwan or in other fabs, infrastructure there to take the demand?
Boy, it's hard to speculate on that. I would think there's clearly a case that China's investing for strategic reasons, and therefore, it's more additive in some ways than if they were to not be allowed to invest. I think you'd probably see some impact. We rate that probability as low, and maybe also because of the action that was taken was very targeted and for specific reasons. We're not modeling that as one of the outcomes. Yes, I think that that would have an overall impact on WFE, for sure.
Operator, we're ready for the next question.
If you would like to ask a question, press star, then number one on your telephone keypad. Your next question comes from Sidney Ho with Deutsche Bank. Your line is open.
Thanks for taking my question. Just to follow up on the service revenue. I want to make sure that you talked about it takes a few quarters for the revenue recognition to normalize. Should we think about by the end of this fiscal year, you will get back to the longer-term trend of up, say, 9%-10% year-over-year?
Yes. That's a good way to think about it, because you're going to have to work through the deferred revenue associated with all the tools that were under warranty at the time of conversion. There are some tools that shipped right at the end of that quarter, so it'll take a year for that to completely roll off, although it's likely a little bit heavier in the front end than it is in the back half of the fiscal year. That's a good way to think about it.
Okay, great. My second question is that in the past year, you have talked about trailing edge is now close to 40% of your revenues. Some foundries have talked about overcapacity of 28 nanometers wafers and utilization may come down. Do you expect that to be a short-term phenomenon, and do you expect next year you'll see trailing edge going back to 40% of your revenues?
It looks pretty stable to us as we look at next year around, and it's more trailing edge, that's more of a foundry statement than overall. Given the diversity of end markets around semis, if you look at those customers that are investing, the activity we're seeing, I see it being fairly stable. We'll have to watch those markets and see, but at least at this point, that's how it looks to us.
Part of what drives that is we have created options for those customers to upgrade their capability, and so part of the business that we have for them, even in a market where maybe they're not investing in new capacity, is upgrade their existing so they can get more efficient. We're seeing big demand for that. That was an initiative started a couple of years ago to be able to extend the value of the tools that are already in the installed base, where we obviously have a home court advantage.
Great. Thank you very much.
There are no further questions at this time. I will now turn the call back over to Ed Lockwood.
Thank you, Chantelle. No further commentary from us today. Thank you all for joining. This concludes our conference call.
This concludes today's conference call. You may now disconnect.