Good afternoon. My name is Christine, and I will be your conference operator today. At this time, I would like to welcome everyone to the KLA Corporation Second Quarter Fiscal Year 2019 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question and answer session.
Thank you. Ed Lockwood with KLA Corporation Investor Relations, You may begin your conference.
Thank you, Christine. Good afternoon, everyone, and welcome to our conference call. Joining me on our call today are Rick Wallace, our President and Executive Officer and Brent Higgins, our Chief Financial Officer. We're here today to discuss quarterly results for the period ended December 31, 2018. We released these results this afternoon at 1:15 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 posted on the KLA Investor Relations website. There, you'll also find a calendar of future investor events, presentations and conferences, as well as links to KLA's SEC filings, including our Annual Report on Form 10 ks for the year ended June 30, 2018. In those filings, you will also 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 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.
KLA reported excellent results for the December quarter with shipments, revenue and earnings per share each closing above the range of guidance in the period. The December quarter caps the 3rd consecutive year of mid teens revenue growth for KLA. The consistent strong financial performance we are delivering is a result of our continued customer collaboration, product innovation and outstanding operational excellence. Our performance also highlights the strength and resilience of the KLA business model and the company's ability to consistently deliver long term growth while delivering top tier financial performance and strong cash returns to stockholders. Consistent with this vision and with an eye to the future, on January 10, we unveiled the new name and logo for KLA Corporation.
Our new, more contemporary brand honors the legacy of KLA's past and reflects our vision of the future for employees and for partners. Now for some perspective on today's market dynamics. In terms of our view of the current WFE demand climate, we are aligned with the consensus expectations for a down year for the equipment investment in 2019, largely driven by meaningful declines in memory spend in both segments, which is expected to be partially offset by growth in advanced foundry and logic. However, notwithstanding the near term market headwinds currently impacting WFE investment, the long term growth dynamics for the industry remains strong, fueled by larger and more diversified semiconductor device end demand and disciplined market driven capacity planning. The reduction in memory capacity investment we are seeing today is a result of weaker mobile demand and a pullback in data center.
However, we expect supply and demand to rebalance over time given a more rational and disciplined capacity investment posture by our customers. In contrast to memory, leading edge foundry and logic investments have begun to ramp and momentum is expected to continue in 2019 reasonably balanced through the year with customers investing to support transitions to advanced nodes and the insertion of EUV lithography. For KLA, we have already seen our mix of business shifting to logic and foundry, and investment from these customers is expected to remain strong in 2019. Now for some highlights of our market leadership and product differentiation strategies. KLA continues to experience significant growth in demand for our wafer and mask inspection products, driven by tighter wafer cleanliness and geometry specifications in the bare wafer market and the introduction of both EUV and non EUV projects at the 7 nanometer node in the mask shops.
We're also seeing strong customer acceptance of recently released new products, including the revolutionary new Voyager laser scanning pattern inspection and the SP7 bare wafer inspection platforms. Both products are being adopted in volume at multiple customer sites, demonstrating that our long term R and D investments and product strategies are meeting market requirements and enabling customers to progress their advanced technology roadmaps. KLA's service business also continues to deliver excellent revenue growth performance while generating strong cash flow. Service is expected to exceed $1,000,000,000 in calendar 2019 and deliver long term annual revenue growth rates in the 9% to 11% range. Growth in services is tied to a number factors, including expansion of the installed base and more end demand for legacy applications, driving higher utilization of capacity and extension of useful life.
These are just a couple of examples of how our strategies for technology and market leadership are delivering results. As we move ahead in the New Year, we remain focused on advancing our long term strategies, positioning the company for success and continuing to deliver strong financial performance and long term stockholder value. To conclude, before handing the call over to Bren, I'd like to give a quick update on the status of the Orbotech transaction. KLA and Orbotech are continuing to work cooperatively on approval of our transaction with the Chinese antitrust authority, the State Administration for Market Regulation, and we are finally we are finalizing discussions with them. We expect to receive China regulatory approval this quarter.
Given the timeliness and sensitivity of these discussions, we will forego any further discussions and will not answer additional questions regarding the transaction until we have new developments to discuss. This concludes my comments for today. Now I'll turn the call over to Bren. Bren?
Thanks, Rick, and good afternoon, everyone. As Rick highlighted in his opening remarks, the December quarter delivered excellent financial results for the company. Shipments, revenue, GAAP, non GAAP diluted earnings per share each came in above the range of guidance in the quarter. Revenue was 1,120,000,000 dollars GAAP diluted earnings per share was $2.42 and non GAAP diluted earnings per share was $2.44 in the December quarter. 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 December demand environment in terms of shipments. Total shipments were a record $1,090,000,000 above the range of guidance for the quarter. The upside to our shipping guidance was a result of pull ins of approximately $65,000,000 of deliveries originally scheduled for the March quarter. As a result of these pull ins, the shipment results for the second half of calendar twenty eighteen were essentially flat with the first half.
Our outlook for March quarter shipments is in the range of 8 $60,000,000 to $940,000,000 with the quarterly sequential decline in shipments a function of these pull ins into the December quarter, as well as a shift in delivery dates from 2 memory customers that occurred very late in December. Though visibility in the industry today is challenging and customer plans remain fluid, particularly in memory, our current view is for the second half twenty nineteen shipments to be greater than the first half, a result of the factors I just discussed and our latest customer delivery expectations for 2019. Memory was 61% of semiconductor shipments in December. DRAM accounted for 38% of system shipments. We expect memory to be approximately 40% of shipments in the March quarter.
Foundry was 24% of shipments in the December quarter and is forecasted to be about 50% of the total in March. Logic shipments were 15% and the current outlook is for Logic to be approximately 10% of shipments in March. The approximate distribution of shipments by product group was wafer inspection was 48% of shipments, patterning was 28%, Patterning includes shipments for reticle inspection. Service was 21% and non semi and component inspection was approximately 3%. I'll turn now to the income statement.
Revenue was a record $1,120,000,000 in December $50,000,000 above the midpoint of guidance. We expect March revenue to be in the range of $880,000,000 to $960,000,000 March revenue levels are lower than we expected back in October. As highlighted in our recent earnings reports, the adoption of ASC 606 for revenue recognition means that quarterly revenue levels are now more closely tied to quarterly shipments. Due to this dynamic, the shipment pull ins we experienced in December led to meaningful revenue upside in the quarter, but at the expense of the March quarter. This, coupled with the memory shipment delays I mentioned earlier, are lowering our revenue expectations for March.
Due to our record shipment backlog and expectations for system shipment scheduling for the remainder of the year, we anticipate that the March quarter will be the low point and anticipate sequential revenue growth to resume in the June quarter and continue for the remainder of calendar year 2019. Gross margin was 63.6% in December, 40 basis points lower than the midpoint of guidance as a modest improvement in product mix was offset by slightly higher manufacturing and service costs. In March, we expect gross margin to be in the range of 61% to 62%, principally due to volume as manufacturing costs are spread across a lower revenue base. Product mix expectations are roughly consistent with the December quarter. Total operating expenses were $275,000,000 in December and at the midpoint of our guidance.
Operating margin was 39.1%. For the March quarter, we expect operating expenses to be approximately 2 $8,000,000 at the midpoint, with variability around this level driven principally by the timing of program development costs. Looking forward, our customers' technology roadmaps represent an opportunity for served market expansion for process control and market share opportunities for KLA. Our operating expense investment levels for 2019 are geared to meet the needs of this expanding market for our products and technology. We are making significant investments to support EUV adoption, increasing metrology and inspection challenges in memory and data analytics and design based capabilities to ensure customers are able to get increasing value from our products.
We are optimistic about these growth prospects and plan to invest accordingly. The effective tax rate was 11.4%. Given the new corporate tax structure in the U. S. And our expectations for the geographic distribution of profit, we are adjusting our long term planning rate down 1% to 14%.
At this point, we expect this rate to remain at 14%, inclusive of Orbotech after close of the transaction. Finally, net income for the quarter was 372,000,000 dollars and we had 152,600,000 fully diluted weighted shares outstanding. Now for some highlights of the balance sheet and cash flow statement. Cash and investments were $2,700,000,000 cash from operations was $282,000,000 and free cash flow was 256,000,000 dollars Capital expenditures for 2018 were higher than our historical run rate of around $50,000,000 to $60,000,000 per year due to the expansion of production facilities to support future growth as well as investments to support our new R and D focused facility in Ann Arbor, Michigan. I would expect CapEx levels to remain elevated in calendar 2019 as we continue to make investments in these areas.
For calendar year 2018, free cash flow as a percent of revenue was 30%. In the December quarter, we paid an aggregate of $115,000,000 in regular quarterly dividends and dividend equivalents upon the vesting of restricted stock units and repurchased $250,000,000 of common stock pursuant to our share repurchase program. We are currently repurchasing shares under an existing $1,000,000,000 buyback authorization with consistent with the previously consistent with the previously articulated approach and subject to market conditions. We have authorization for an additional $1,000,000,000 share repurchase upon completion of the Orbotech acquisition. In conclusion, the results demonstrated by KLA in the December quarter reflect the company's technology leadership, the critical nature of process control in our customers' growth strategies and the value generated by our industry leading business model.
Given these factors and coupled with the new opportunities for market expansion represented by the anticipated Orbotech acquisition, we believe KLA is uniquely positioned to continue to deliver long term value to stockholders. After 3 strong years of memory investment, 2019 will be a year of digestion for this segment of the industry. Customers continue to press their technology roadmaps, but their capacity planning remains fluid. For KLA, we expect that given our technology leadership, coupled with expected growth in the foundry and logic segments and along with our exposure to broader opportunities in the wafer and reticle markets, we are well positioned to outperform the industry in 2019. With that, to summarize, guidance for the March quarter is shipments in the range of $860,000,000 to $940,000,000 revenue between $880,000,000 $960,000,000 and GAAP diluted EPS of $1.35 to $1.67 per share as well as non GAAP diluted EPS of $1.39 to $1.71 per share.
We plan to update guidance inclusive of the Orbotech acquisition shortly after completion of the transaction later this quarter. Before turning the call over for your questions, I'd like to notify investors that we have decided to shift our 2019 New York Investor Day from the original planned date in March to later in the calendar year. We will update you on the new timing at a later date. With that, I'll now turn the call back over to Ed to begin the Q and A. Okay.
Thank you, Bren. At this point, we'll open up
the call for your questions. We request that 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 for additional questions
and we'll do our best
to give everyone a chance for follow ups as time permits. All right, Christine, we're ready for the first question.
Your first question comes from the line of Timothy Arcuri from UBS. You may go ahead, sir.
Thanks a lot. So Bren, I'm trying to sort of noodle through the pull in and noodle through the impact of that. So if I adjust for the pull in, the shipments were like 2.15 in the back half of 2018. And then if I adjust for that pull in, the shipments would be like 9.65 roughly at the midpoint for March. You said before that the first half shipments would be up versus the back half.
So for it to even be flat, that would imply that June shipments would have to be like 1.18 or something like that. So they have to be up a lot versus March. So I'm just wondering, have those 2 memory push outs, did they push out beyond June such that the June shipments would not be 1.18 so that it would be what you said it was before?
Yes, Tim. So I think on your math, look, we had $65,000,000 of shipment pull ins into the December quarter. So based on that guidance, yes, just that effect alone would move the number from $900,000,000 to 965, The push outs are pretty significant in terms of 2 major projects. So, I would say one pushed out further than the first half of the year. The other one, we'll see.
I think that there are a number of projects that timing might be in the middle of the year. So we'll have to see where it ultimately lands. But clearly, it had an effect on our view. First half now, I would expect to be down versus the second half of twenty eighteen. And then we would see a recovery in the second half of 2019.
So down somewhere in and around 10% plus or minus is how I'm modeling it today, but we'll see how it plays out.
Okay, got it. And then if I look back at the revenue, if I just take the midpoint of the revenue guidance, something like 920 and I look back at what you did when you were at 920 in the past, margin was about 200 basis points higher than what you're guiding it. So can you maybe give a little information why is margin so low? Is it just mix? And do you get that back in June and throughout the rest of the year?
Thanks.
So, Tim, I mean, we were obviously sizing the company. And as you can see, our output from December in the 1.1% to 1.2% range. So the decline in the second half of the year and then that carrying forward here through the Q1 is that we're taking basically a factory that size to ship a much higher level and spreading those costs across a smaller revenue base. So the volume impact of that is pushing gross margins down and that's really the only change from a quarter to quarter basis as you look at the different moving parts within margin. So I would expect as we start to see revenue pick up given the guidance we said of sequential revenue growth through the rest of the calendar year, we'll start to see some incremental gross margin improvement there.
And based on the guidance that we were given in terms of outperform relative to the industry based on where consensus WFP estimates likely are, we probably see gross margin somewhere in and around, I would say, 60 3% plus or minus 50 basis points as a model in the year. And we'll have to see how some of the mix dynamics play through. But obviously, we're at a much lower revenue level today and with the industry contracting than what we saw in calendar 2018 and that will have effect on our gross margins in the near term.
Thanks, Brent.
Your next question comes from the line of John Pitzer from Credit Suisse. Your line is you may go ahead, sir.
Hi, this is Ada for John. Can you discuss if you're seeing any changes in domestic China at this point?
Well, so domestic China is a little weaker versus the last call, where we were thinking that shipments looked about flat for the indigenous projects year to year. As we look at that today, it's probably somewhere in the 10% to 15% lower. We'll see obviously visibility in the second half is not so great at this point. But if I look at the shipment profile of what we shipped in 2018, what we expect to ship in 2019, it's about 10% to 15% lower. Most of it around memory.
Got it. And can you talk about the implementation of EV in DRAM and logicfoundry? And if you're seeing any changes to the adoption cadence given kind of the slow adoption of leading edge nodes that's being discussed right now?
No real change. This is Rick. In terms of the rate of adoption, we see continued piloting in early development with an intent to ramp and we're participating in that through some of the development work we do and also in the mass shop. Some of our demand has been driven by that, but no real change in the cadence of what we've seen in the past.
Thank you.
Your next question comes from the line of Krish Sankar. Your line is open. From Cowen, your line is open.
Hi, this is Steve calling on behalf of Krish. Thanks for taking my questions. First one I wanted to ask about was on your bare wafer inspection tool business. Just given how strong that business has been performing for a while now and just given some of the moderation in wafer starts in the semi industry, how should we think about the trajectory of that business across the rest of this year?
Yes. So this is Brent. So that business continues to show very strong momentum. You have to keep in mind that there are a number of things that are happening there. First of all, there was a long period of time without any investment really at all.
So there's a change in the capacity requirements there that customers have been investing in. That coupled with spec changes have driven not just the inspection tools, but also need for the metrology tools. So we've seen that business perform very well through 2018 and would expect as we look at 2019 not much change from that business. So, I would expect to see it carry forward. And based on communication so far with customers, I don't have any reason to change that assessment.
Okay. Got it. And as for my follow-up, I wanted to ask about the relative trend or profile of foundry and logic demand across this year, is that going to be more first half weighted and followed by a moderation in the back half when I assume memory picks up the demand profile? Or do you also see foundry and light relatively steady across the year? Thanks.
In some of the prepared remarks, we talked about it being reasonably balanced across the halves. So I think second half could be a little bit larger, but generally pretty reasonably balanced for both logic and foundries, you add the 2 segments together.
Perfect. Thank you.
Your next question comes from the line of C. J. Muse from Evercore. You may go ahead, sir. J.
Muse:] Good afternoon. Thank you for taking the question. I guess first question on the deferred revenue side, it was a nice uptick for September, but looks like very modest impact here in December. So I guess first question, do you think that the volatility associated with deferred revenues is now behind us?
Yes, C. J, I think it is. It wasn't that big of an issue for us, but certainly we're seeing revenue much closer to shipments you saw from the results in the December quarter and the guidance for March. And if you look in the 10 Q filing, you see the reconciliation between 6 056, effectively the same results quarter to quarter. So there was these timing issues that had that played out.
But at the end of the day, I don't I think the right way to think about the business and model it given that these are really timing dynamics is pretty much the shipment number will be the revenue number with some variation related to new products. Now we do ship more new products maybe than some of the peers. And so that can be have an effect or certain regions where you may have to go all the way to customer acceptance. But generally, the numbers are going to be pretty close together.
Okay. That's very helpful. And I guess as my follow-up, as you think about the progression of EUV and thinking specifically to foundry, can you speak to what's driving the demand here, 7 nanometer versus 5 nanometer? And how you see the revenue kind of progression through calendar 2019 and into calendar 2020?
I'm sorry, C. J, what's driving the demand from the device standpoint or for us?
I'm trying to understand your demand side, both from a more modest pilot line 7 nanometer plus activity this year, ramping more aggressively to 5 next year?
Yes, sure. It's pretty straightforward actually. Most of the demand early in the 7 nanometer comes out of the MAF shop because that's where people are calling new mask sets and driving a lot of utilization of new capability in the mask shop and also in the development phases of trying to get those devices to work. And then it will shift toward production and it will drive more in line kind of applications, both inspection and also some of the metrology needs as we ramp. So but right now, what we're experiencing is mainly in the mash up and the development.
Very helpful. Thank you.
Your next question comes from the line of Patrick Ho from Stifel. Please go ahead, sir.
Thank you very much. Maybe Rick, a follow-up to CJ's EUV question. From your delivery perspective, has everything generally remained on track? Or are you seeing any potential pull ins or push outs in terms of the timing of delivery of your reticle inspection tools?
Nothing has delayed. If anything, throughout calendar 2018, we saw accelerated demand in support of a larger number of starts than we would have forecast for a year ago in terms of advanced design. So far more tape outs of advanced designs, both for EUV, but also just advanced 7 nanometer without EUV. So we're seeing the demand on both of those. We don't have an EUV specific tool in the market.
We have tools that can cover both. So we're pretty well situated to support it either way. But that's been strong and particularly in the foundry logic area. Great.
That's helpful. And maybe as a follow-up question in the DRAM market, we've seen how, I think in the past, you talked about an increase in metrology usage with 3 d NAND. As the DRAM industry goes to 1Y and eventually to 1Z and with increases in patterning steps, how do you see a mix of an increase in process control intensity? Is it going to be more biased towards your inspection tools because of the patterning steps? Or are you also seeing more metrology applications come online as the DRAM industry migrates down these next few nodes?
Yes, some of us, but for sure the DRAM will push inspection, high level inspection sensitivity because they're more sensitive than, say, a NAND flash would be towards advanced inspection capability for smaller defects. So definitely DRAM is going to push it in terms of things like our Gen 5. Metrology, both of them. Metrology, more so, I think the flatness and cleanliness on wafers for NAND has been a driver we've talked about in the past. So it then moves when you go to DRAM back to overlay constraints.
So it really depends. Fortunately for us, there are different problems that kind of push different parts of
the portfolio depending on where they are in the cycle.
Great. Thank you.
Your next question comes from the line of Harlan Sur from JPMorgan. You may go ahead, sir.
Good afternoon. Thanks for taking my question. Maybe focusing on products, on your flagship Gen 5 TWI inspection system, can you guys just true us up here? I know the team was anticipating 17 to 18 systems in the field exiting last year. Did you guys hit that target?
And more importantly, sort of given the ramp of EUV, the early work on 5 and 7 nanometer logic, one alpha nodes for DRAM. What are your thoughts around growth of Gen 5 this calendar year?
Yes, Harlan, it's Brent. So thanks for the question. So again, we did hit our target. Expectations were very consistent our results were consistent with expectations for that product. And as we move into next year, we're still seeing a steady cadence of investment here.
Most of the tools are development focused. We're introducing the 2nd iteration of the product line that provides more better custom ownership for customers slightly better throughput and also has some new features with data analytics, computational capabilities, design based capabilities and so on. So it is moving along pretty well, should be deployed. We'll start to see a crossover. I don't know exactly what the crossover percent will look like in 2019, but as you start to think about 5 nanometer ramps, you'll start to see more Gen 5 deployed in production.
Yes. Okay. Good to see the momentum there. And then can you guys just give us an update on your multi column e beam inspector system for sub-seven nanometer mask inspection? Last time you gave us an update, which was about a year ago, I think the team was on track to introduce systems this calendar year, calendar year 2019.
Can we get an update and any early metrics on performance, throughput or customer feedback?
The customer interest remains high. We are now in a phase of this program where because we're engaged in developments with specific customers, we're not talking publicly about progress. But I can tell you the there's a lot of interest, a lot of demand out there for capability as you've seen the increase in an EUV capability and implementation. But we're not in a position right now to go through the specifics of where we're going based on the collaborations we have.
Yes, great. Thank you very much.
There are no further questions at this time. I turn the call back over to the presenters.
Thank you, Christine, and thank you all for joining us today. This concludes our conference call.