Good afternoon, ladies and gentlemen. My name is Jerome, and I will be your conference operator today. At this time, I would like to welcome everyone to the KLA Corporation Second Quarter 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 Thank you.
Now it's my pleasure to hand the call over to your host, Mr. Ed Lockwood with KLE Corporation Investor Relations. The floor is yours.
Thank you, Jerome. 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 Brent Higgins, our Chief Financial Officer. We're here today to discuss quarterly results for the period ended June 30, 2019. 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'll 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.
Thank you, Ed. Good afternoon, everyone, and thank you for joining us for today's call. Q2 was another solid quarter for KLA with results finishing above the midpoint of guidance, demonstrating the company is benefiting from our strategies for growth and market leadership, while delivering strong relative performance and a challenging year for the industry. I'd like to provide some insights into today's equipment demand environment. Even with the signs of stabilization in NAND pricing, DRAM continues to be weak and the business environment in memory is soft.
This has resulted in broad based low levels of investment as customers have idled existing capacity and delayed new capacity plans as they focus on rebalancing supply and demand. The weakness in memory is being offset by rising demand from foundry and logic, which are traditionally strong markets for KLA. The business environment in Foundry and Logic is expected to continue to be strong through the second half of twenty nineteen and into 2020, driven by next generation technology development, capacity additions at the leading edge, increasing competitive dynamics and investment in EUV infrastructure. Altogether, our outlook for WFE investment in 2019 remains consistent with the initial view we held in January, with demand expected to decline by approximately 20% in the year and with a significant shift in product mix to foundry and logic. Now I'd like to update you on some recent product highlights from our semiconductor process control business.
KLA's market leadership is enabled by successful execution of a portfolio strategy focused on differentiation to address our customers' most critical challenges. We're very pleased with our product positioning and the strong customer acceptance we're experiencing across our portfolio. For example, we are currently seeing accelerated adoption of our flagship Gen5 optical inspection platform, which is now in its 2nd iteration since first being introduced in 2016. We expect Gen5 shipments to double in 2019 compared to the previous year. Customers are leveraging the combination of sensitivity and throughput in this platform to enable unique detection of yield limiting defects at significantly lower cost of ownership compared to the alternatives.
The strong customer adoption of Gen 5 and the continued success of the Gen 4 platform, now in its 5th iteration, are further confirmation of the success of our multi generation platform strategy for innovation and market leadership in optical inspection. Further, the latest generation of our laser scattering optical inspection platform known as Voyager is also enjoying strong adoption in the marketplace. Leading memory and foundry customers are deploying Voyager for in line monitoring application in high volume manufacturing. In mask inspection, the strong momentum which we have experienced over the past several quarters continues and is positioned to extend through 2020. We are seeing upside from leading foundries for our latest generation mass inspection platform and expect demand to broaden as customers move ahead with their EUV deployment strategies.
In metrology, as WFE is transitioning more toward logic and foundry, we're seeing strong adoption of the new film and CD platforms released last year as our customers ramp complex technology architectures like FinFET, new materials and new metal interconnects. And with the recent acquisition of Orbotech, we are further diversifying our business, broadening our product portfolio and growth opportunities and serving a larger market. Integration and synergy activities are now well underway, and we're very excited about the growth opportunities in combination with Orbotech. We look forward to further discussions of this in our upcoming Investor Day in September. In summary, despite uncertainty in the current industry demand environment, momentum is building for KLA, driven by strength in our semiconductor process control business and contributions from the recent acquisition of Orbotech.
As a result, we are on a path for strong relative performance in 2019, while we continue to drive innovation and introduce differentiated products and solutions to serve the market when growth reaccelerates. With that, I'll turn the call over to Bren for his commentary on the Q2 financial results. Bren?
Thanks, Rick, and good afternoon, everyone. Total revenue in Q2 was $1,258,000,000 and above the midpoint of the range of guidance. GAAP earnings per share was 1.35 dollars and non GAAP earnings per share was $1.78 each finishing at the upper end of the range of guidance. Total shipments were $1,354,000,000 approximately $79,000,000 over the midpoint and exceeding the high end of the range of guidance for the quarter. Semiconductor process control shipments were approximately 1.0 $80,000,000,000 We are pleased with the results we have achieved in the June quarter despite significant noise and uncertainty in the global electronics market.
As we continue to focus on executing our business across all markets and move forward with our integration and synergy plans from the Orbotech acquisition. Beginning this quarter, we will report our results under the new segment reporting structure that we adopted subsequent to the completion of the Orbotech acquisition, and you will see this reflected in our Form 10 ks when it is filed. Under this new structure, we will report the KLA Process Control Business in the Semiconductor Process Control segment and will separate the former Orbotech businesses into 2 segments, Specialty Semiconductor Process and PCB Display and Component Inspection. The latter segment now includes the former IQOS component inspection business of KLA. We believe this new segment reporting structure best reflects how our business is organized and the unique characteristics of each segment in terms of channel, markets and technology.
Results from the applicable services components will also be included within each segment. In addition, the June quarter will be the last quarter we report shipments in our earnings call, and we will no longer provide shipment guidance going forward. As explained in detail in the earnings call last May, under ASC 606 for revenue recognition, the overall timing of revenue shifts forward and as a result, the difference between shipments and revenue is immaterial and doesn't warrant the resource commitment to maintain dual reporting. Subsequently, investors can assume a close approximation of shipments to reported revenue in any given quarter. Now for the June quarter results.
As I mentioned, total revenue in the second quarter were $1,258,000,000 We expect total revenue to grow about 7% at the midpoint and be in a range of $1,310,000,000 to $1,390,000,000 in the September quarter. And for the second half revenue levels to be higher than the first half with continued sequential growth expected in the December quarter across all our business segments. I'll now turn to some detail on commentary regarding segment revenue trends in the June quarter. For the Semiconductor Process Control segment, which as stated represents all legacy KLA except our component inspection business, revenue was $1,003,000,000 in the quarter. Component inspection revenue was just over $28,000,000 As Rick discussed in his opening remarks, our view of the WFE demand environment for 2019 remains mostly consistent with our original view from January, with KLA benefiting from stronger foundry and logic demand.
I would note that on the margin over the past 6 months, although a review of the overall demand environment in 2019 is unchanged, the near term outlook for foundry logic investment has improved, offset by declines in memory. In fact, over the course of the June quarter, we have seen our overall second half expectations improve modestly. Our current view for the semiconductor process control business is for the second half revenue to be up in the low double digits versus first half of the calendar year, as we now expect revenue from foundry and logic customers to be up over 35% versus the first half. Memory investment remains weak and directed towards technology migration mostly only. Memory was approximately 51% of semiconductor process control system shipments in June, and we expect memory to be approximately 42% of system revenue in the September quarter.
Foundry was 35% of shipments and is forecasted to be about 44% of system revenue in Q3. Shipments from logic customers were 14% and the current outlook is for logic revenue to be approximately flat in September. Turning now to the Specialty Semiconductor Process segment, the former SVTS division of Orbotech. SVTS is a leader in PVD and Edge Solutions and fast growing specialty semiconductor applications like MEMS, sensors, power and RF devices as well as in advanced packaging markets. Revenue for SPTS was 67,000,000 dollars June quarter results for this business were impacted meaningfully by the U.
S. Department of Commerce ban on shipments of RF and MEMS semiconductors to Huawei as customers with Huawei market share delayed planned capacity investments. As a leader in etch and deposition tools for these markets, SBTS saw a delay in a portion of its expected business due to this ban. Though the longer term implications of this action are not clear, notwithstanding this issue, SVCS is still expected to deliver year over year pro form a revenue growth in calendar year 2019. Revenue for the PCB, Display and Component Inspection segment was $185,000,000 This segment includes the former PCB and display businesses of Orbotech and KLA's IQOS component inspection business.
Results for this segment were in line with our expectations for the quarter and are on track with our plans for this year. Now I'll discuss the distribution of revenue by major product category in Q2. Wafer inspection was 32%. Patterning, which includes reticle inspection, was 23%. Wafer inspection and patterning are part of the Semiconductor Process Control segment.
PCB displaying component inspection revenue was 10% and specialty semiconductor process was 4%. Other, which includes solar, instruments and the KLA Pro mature product enhancements business was 4%. Service was 27% of revenue in the June quarter. In terms of the regional split of revenue, China was 32%, Taiwan was 25%, the U. S.
Was 15%, Japan was 10%, Korea was 8%, Europe was 6% and the rest of Asia was 4%. Now for more detail on the results and the P and L. Gross margin was 58.9% in June, at the top end of the guided range for the quarter of 58% to 59%, as a higher level of semi process control revenue offset the Huawei effect on our specialty semiconductor business. We expect gross margin in the September quarter to be in the range of 60% to 61% as a more favorable product mix in our semi process control business and higher expected service margins drive gross margin improvement in the quarter. Looking ahead, we believe there are many opportunities for us to improve the Orbotech gross margin profile across the businesses by leveraging our global supply chain, service infrastructure and global footprint.
We will discuss these initiatives in more detail over the coming quarters as we get a firm picture on the timing and financial impact of these actions. Total operating expenses were $370,000,000 in June, below the guided $375,000,000 target due to lower than expected expenses across the business and some synergy benefit from Orbotech. Operating margin was 29.5%. We expect quarterly operating expenses to be in the range of $370,000,000 to $375,000,000 for the remainder of calendar 2019, consistent with the timing of our planned product development investments and the realization of initial synergy activities. Other income and expense in the June quarter was $38,000,000 and we expect OIE to be approximately 36,000,000 dollars this quarter.
The effective tax rate was 13.7 percent. And going forward, investors should continue to model our tax planning rate at the 14% level given the new corporate tax structure in the U. S. And our expectations for the geographic distribution of profit. Net income was $289,000,000 and we had $162,000,000 diluted weighted average shares outstanding.
Now for some highlights on the balance sheet and cash flow statement. Cash and investments were $1,700,000,000 and total debt was 3,400,000,000 dollars Cash from operations was $325,000,000 and free cash flow was $270,000,000 We are making infrastructure investments to support our future growth, including the construction of a new building at our Milpitas headquarters site and a new facility in Ann Arbor, Michigan. We expect annual capital expenditures to exceed for the next few years due to these projects and other infrastructure investments necessary to sustain our future growth expectations. In the June quarter, we paid an aggregate of $121,000,000 in regular quarterly dividends and dividend equivalents upon the vesting restricted stock units and repurchased $345,000,000 of common stock at an average share price of just below $112 per share pursuant to our share program. We have approximately $900,000,000 available under our current share repurchase authorization.
For September, we expect a fully diluted share count of between 159,000,000 and 160,000,000 shares. In conclusion, the June quarter results demonstrated strong operating performance. With our diversified end markets, continued technology leadership across a broad product portfolio and operational discipline, KLA is positioned for strong relative performance in 2019, and we are encouraged by the momentum we are seeing in our With that, to summarize, guidance for the Q3 is revenue between $1,310,000,000 $1,390,000,000 dollars GAAP diluted EPS of $1.75 to $2.05 per share and non GAAP diluted EPS of $2.04 a share to $2.34 per share. Before turning the call over for your questions, I'd like to remind investors that we have scheduled our 2019 Investor Day for Tuesday, September 17, in Midtown, New York. We look forward to seeing you there.
I'll now turn the call back over to Ed to begin the Q and A.
Thank you, Bren. As we begin the Q and A, we request you limit yourself to one question and one follow-up. Please feel free to re queue if you have any additional questions, which we will accommodate as time permits. Jerome, we're ready for the first question.
Your first question comes from the line of John Pfitzer with Credit
Congratulations on the solid results. Rick, it's good to see foundrylogic performing strongly in the calendar second half with expectation that that continues into 2020. I'd be kind of curious as you look at the memory market and differentiate between NAND, DRAM and maybe process control and bare wafer. How do you think that market plays out in the back half of the year? Which quarter do you think it bottoms in?
And how do you think about the recovery potential in 2020?
I'll give some thoughts and then let Bren weigh in. Right now, we don't see as we said, we don't see a lot of momentum in DRAM. I think what we've got now is some strengthening, I think we think in the foundry and logic as we said, but not a lot other than technology migration and not a lot of capacity. So you think about when the recovery might come for NAND, probably first half of twenty twenty and DRAM, what our customers are saying now is more mid-twenty 20 timeframe before we'd see any meaningful change.
Yes, John, I would say that I characterize the market is what we're mostly seeing is technology migration investment only. And one thing about KLA is since we do help our customers navigate their roadmap transitions, we are seeing some level of business from some of these customers. There's also some activity in China. We saw some last quarter influenced our shipments and we expect to see some more in the second half of the year. But to Rick's point, I think as we look at the overall market, I wouldn't expect to see any meaningful capacity as until we get into 2020.
And given that customers have been disciplined in pushing out capacity, they've been idling capacity. How quickly that comes back is a little early to tell from this point. You mentioned bare wafer on the bare wafer side. We see our business with bare wafer being roughly flat into the second half of twenty nineteen. Now, 2019 overall for that business is lower than it was in 2018.
We had a huge inflection in 2018. We've seen it come off a bit in 2019, probably comes off a little bit in 2020. I think we're operating at a more sustainable or higher level for that business moving forward given the dynamics around memory, around specifications both for inspection, but also for metrology. So, and the number that we've provided in the commentary, I think that's been part of our view in terms of expectations moving forward. So, I would say that much has changed there and it's something certainly we've been pretty open about.
That's helpful guys. And then maybe as my follow-up, Rick, I'd love to get your comments on just inspection and process control intensity in foundry logic as you move to 7 and then to 5. And I guess it's kind of a complex equation. How does EUV benefit you guys in the business going forward?
Sure, John. I think there are a couple of things. 1, we mentioned the strength in Gen 5 and a lot of that is driven of course logic is going to drive that harder and we're seeing a transition from Gen 4 to Gen 5 in terms of the bulk of our system. So the design will shrink. You're going to drive smaller defectivity requirements driving us toward the Gen 5.
The other thing that's happening is overlay is a big driver for us in terms of the additional pressure put on our customers as they drive advanced design roles. You mentioned EUV, we're seeing that in a couple of ways. 1, we're seeing it in the mask shop with a number of starts pre EUV, but also the anticipated large number of EUV, but also the print down checks, because I think what's really going to happen for a while is people are going to want to verify the designs. So another use for Gen 5. So overall, we think there's going to be an increase in process control intensity as we introduce EUV.
I think that that's more in the development phase. Longer term, I think it levels out a bit as we get into high volume production later. But right now, definitely the mix is favorable to us in terms of what we're seeing. We also mentioned increased competition in foundry and that's also been a driver I think to the mix shift overall.
Your next question comes from the line of Harlan Sur with JPMorgan. You are now live.
Good afternoon, guys. Nice job on the quarterly execution and strong outlook. In terms of the strong results and outlook, specifically within your mask or reticle inspection business, EUV system shipments looks like they're going to grow about 70% this year. If I look into next year, the installed EUV base is still growing about 50% to 60%. So given your guys' very high market share at the mass shops, how do you see your mass shop inspection business directionally this year?
And do you guys already have visibility into the directionality of this segment next year, just given the long lead times and continued growth of the installed base?
Yes, Harlan, it's Brandon, and I'll go first here. But if you look at the reticle inspection business, a couple of things are driving it. 1st, significant tape outs in the foundry at 7 nanometer. And so that's driving significant purchasing of the product. You have to remember that reticle inspection in a mash shop behaves similar to process where you're inspecting every reticle before you ship it to the fab.
So it has some unique dynamics in terms of how customers buy relative to the design starts and they move together. That's one dynamic and that's driving the business. The other obviously is the EUV development activity that's also driving the Terron system. So, you have both effects. Frankly, the biggest driver today is more around the design starts at 7, and it's driving that business to have nice solid growth in a year, obviously, where WFE is down.
So we're seeing growth in that. And as Rick said in the prepared remarks, we would expect that to continue into 2020. Timing of the EUV deployment, how we see that plays out next year will potentially influence some of the upgrades to the existing installed base out there. But there's some sustainability in the business and we're seeing a nice recovery in it. And then we'll see about next generation products as they come out as we move into the second half of next year to support EUV directly.
So there's a lot of exciting things happening in that space and we're seeing the numbers flow through in terms of P and L impact.
I think just to build on one aspect of it, I think the fact that we've extended the Tayron platform to be able to handle these EUV layers, we benefit whether or not depending on the number of EUV layers, we still benefit because we've got an optical platform that can handle either the mass for EUV or for traditional lithography. So I think that's a part of why we're benefiting more depending on the starts and just the intensity at the advanced nodes than necessarily just on the EUV because it's still not clear how many layers and at what nodes they're going to be adopted, but we're seeing strength in reticle regardless of which way that goes.
Great. Thanks for the insights there. And then you guys were thinking 90 days ago that there was an upward bias for the Orbotech business moving into the second half of the year, but just given all of the China trade overhang, given that Orbotech has a number of large China customers, Do you guys still see the second half of this year will be better for the Orbotech team? And if so, maybe a bit of color on what segments are improving in the second half? I mean, I would assume that specialty semi is doing well just given the strong focus on RF and Power, but what about FPD and PCB?
Yes. Our growth expectations for specialty semi have come down a bit for this year directly related to the Huawei effect. It's an indirect effect, but you do have customers in the RF space that have market share with Huawei phones. And so they've gotten more cautious in some of their plans for capacity and that's impacted that business. So that business is still going to grow year over year, but probably not to the degree that we expected 90 days ago before the ban came out.
I would say PCB and flat panel are in line with our expectations of PCB flattish, flat panels down this year, but most of the growth for the business is going to come from specialty semi. So there's still some growth there year to year, but a little bit less given the Huawei effect. Yes, but just to put it in
great respect to Partland, we're still within a few percentage of what we'd originally modeled in terms of profitability and contribution to KLA for the business. So it still looks good, as Brent said, some kind of shifting dynamics. So not really that different from what we thought earlier in the year.
Your next question comes from the line of Timothy Arcuri with UBS. You are now live.
Thanks a lot. I guess the first question, Rick, is that there have been some other companies in your broader sector that the past couple of weeks have talked about, some pull ins from China that are sort of helping the back half of the year. And I know you talked last quarter about a big project that was out of the second half and now it's sort of back in the second half. But what are you seeing generally in China? I guess, is it your view that the trade stuff only increases the pace of these projects as you kind of look into the back half of the year and into next year?
We have definitely seen some puts and takes in China, Tim, to the point, but we're seeing what others are seeing where some maybe increased urgency in terms of the second half to get those projects fully up. And as you know, there's just a lot of noise in the system in terms of what effects might come in. The only substantial thing we've seen is a very small part of our business as Bren mentioned. But overall, pretty much where we thought in terms of the second half having some strength in it.
Yes, I think the DRAM project that pulled in, I mean it's interesting, we started the beginning of the year, we thought was completely out. Now it looks like we'll see it ship in the second half of the year. We're seeing, to Rick's point, some puts and takes related to some of the wafer plans in China. So overall, I would say our expectations for China business this year versus where we thought are probably on the margin slightly higher than where we were before, but not a lot of change there overall.
Okay, Brent. Thanks. And then, I guess as a second question, I'm wondering if you can quantify in the spec semis segment how much the sort of indirect Huawei ban is? Is it something like $10,000,000 to $20,000,000 a quarter? Is that what it's costing you sort of into the back half of the year?
I'm just sort of trying to baseline what the business would look like if this ban had not or is not in effect?
Yes. So Tim, I think in the immediate quarter and you'll see some adjustments to plan in the immediate quarter, the impact was between $20,000,000 25,000,000 and certainly some of the strength in other parts of our business help us achieve our results for the quarter. That number probably goes up to the $35,000,000 ish plus or minus as we move into the second half of the year in terms of our expectations. So probably in total, so probably somewhere around $35,000,000 $40,000,000 impact on calendar 2019. In the long run, it's interesting as those as other providers that are non U.
S. Providers start to ramp their capacity, that creates an opportunity specialty semiconductor business there. So in the long run and they're in inferior position. So in the long run, there potentially is a big opportunity out there in terms of how the designing around the supply chain works. But in terms of the current year, the impact is probably somewhere between $35,000,000 $40,000,000 in total.
Okay, guys. Awesome. Thank you so much.
Jerome? Next question?
Your next question comes from the line of Krish Sankar with Cowen. You are now live.
Hi. Thanks for taking my question. First one for Rick or Bren. I know you guys have not given out your guidance, but if I look at some of the commentary made in terms of strength of foundry lasting into first half of twenty twenty and NAND in first half and maybe DRAM in the second of 2020 recovering. Is it fair to assume that your legacy KLA business is going to be up in calendar '20 versus calendar 'nineteen?
And if so, what is the risk to that guesstimate? And then I had a follow-up.
Yes. So let me take the first part and then give it to Bren. So we're not going to call it legacy. It's a process control business now that we have other businesses. And the trajectory is good.
We're going to get into more discussion of the outlook at our Analyst Day next month. But definitely, we feel like things are coming our way in terms of the right kind of market momentum, the advanced design rule work that's going on. In addition, some of the competitive dynamics, we talked about Gen 5 strengthening and some new projects, new products hitting the market. So we feel very good about overall position and Brent can talk in broader terms.
Yes, I think we feel pretty good about logicfoundry and sustainability of spend levels into 2020. So, I think if you look across those end markets and you look at the activity there, we would expect to see continued investment. We talked about competitive dynamics. The strength of the 7 nanometer node out there is also limiting how much reuse customers can do. And so that's certainly having an effect as well.
You'll see automotive and industrial hopefully start to come back next year. And so as you think about the broader demand across all of logicfoundry, I think there are a number of drivers that give us some confidence moving into next year about those segments.
Got it. Okay. And then as a follow-up, you guys introduced a new e beam wafer defect review product recently. And I'm kind of curious, how do we think about the coexistence of Genphi and e beam down the road for your product portfolio? And is this e beam kind of just targeted towards specialized applications?
So just kind of curious on how to think about the lay of the land for your products? Thank you.
Well, I think that what we said all along is we think there's a complementary role for optical and e beam and this continues that. I think that what we have in our latest technology is a very capable e beam tool that when our customers utilize with our advanced optical, they really get the best of both in terms of capabilities for the market. But I don't think there'll ever be a day where there's not a complementary e beam solution with optical. Optical keeps getting better, e beam has to get better too. But I think the general mix between e beam and optical will remain about the same in terms of the way customers spend their dollars.
We're very excited about what we've seen in the market and we think the synergy of having our optical tool coupled with our e beam is really great for our customers trying to solve some of their very challenging problems.
Thanks, Rick.
Your next question comes from the line of C. J. Muse with Evercore ISI. You are now live.
Great. Thank you. Good afternoon. Thanks for taking the question. I guess wanted to follow-up on that last question regarding your expectations for sustainability of foundry strength to continue through 2020.
I guess within that, could you speak to, I guess, both your positioning within Gen 5 EUV, e beam, perhaps new products that you haven't announced yet that you just highlighted? And then also from an end market perspective, in terms of rising competition, as you look at Samsung coming in? Would love to hear, I guess, in more detail your thoughts on that front.
Yes. So this is Rick. I'll talk more sentiment than actual numbers in terms of 2020 because we really don't know. But you can always tell how your customer is behaving, what the mood is in the market. And right now, we're actually in a situation where we see a lot of energy around our customers pushing for new capability, pushing for getting their advanced designs out.
You see a lot of tape outs. The mask business has been good. So definitely feel strong. The other thing and not to be missed what Bren mentioned is we don't see a lot of reuse happening because of some of the challenges of the new technology. So that was something that we were trying to really map out to see what it was going to look like.
And the combination of new capability on our side, new challenges on our customer side make us feel like it looks very strong in terms of the momentum. How long into 2020? We don't really have great visibility into that. It's just now we have a case where you've got multiple players really concerned about bringing out new technology and ramping new devices. And at the same time, we're hitting with some products that are new to the market and very exciting for us.
Very helpful. Thank you. As my follow-up, could you, I guess, speak a little bit to your expectations for growth in the service bucket, both for process control as well as for overall Orbotech?
Yes, C. J. So, in process control, for those process control customers, we believe we have a long term trajectory somewhere in that 9% to 10% CAGR opportunity over time. We're adding tools to the installed base at a much faster rate than they're coming off. So that creates opportunities for us.
75% of that revenue stream is contract based because of customers' desire to keep those tools up and how they buy process control. Also just the general complexity of what we sell. So that's good for that business. We've seen it slow a little bit in the near term related to just some of the idling of capacity that's well understood in the market. But over the long run, we've seen it grow at that rate and we expect it to continue to grow like at that rate over time.
The PCB business for Orbotech has a strong service profile, say 95% of the tools are under contract. So of the PCB revenue we report about 40% of it is service stream. So because of the imaging technology and the need for that tool is enabling for circuit boards, that's a positive trend for that business. I think on the flat panel side, there's very little service activity in terms of some consumable parts that are attractive, but there's some opportunity there for us certainly. And on specialty semiconductors, as we think about how we try to leverage our position in working with customers to offer better solutions over time, there might be an opportunity for us to help customers that way on the specialty side.
Smaller companies always have a harder time with service, just the broader footprint. So maybe what we end up doing is enabling a better cost position for both flat panel and for specialty semi, but a lot of opportunity for us moving forward, I think, in terms of driving that stream for the company.
Thanks, Brent.
Your next question comes from the line of Vivek Arya with Bank of America Merrill Lynch. You are now live.
Thanks for taking my questions. I had 2 as well. First on gross margins. So you're guiding gross margins up 160 basis points or so, 60%, 61%. What's driving that?
And should we expect margins continue to expand as your sales potentially grow again in December?
Well, as I said last quarter, I thought there were some unique effects affecting the June quarter from an overall mix perspective in our semi process control business. Not all our products carry the same margin. And under 606, whatever you ship is ultimately what you revenue. So, some of that was a bit dilutive to our margins, drove the margins down
almost just short of
59%. Moving forward, obviously, we have some growth in revenue and that's helpful. We're seeing a reversion sort of back to a normalized mix on the process control side. And I'm expecting to see stronger and higher utilization rates out of the service business and some higher margins in the service overall. So all those are driving us into the 60% to 61% range and I would expect to see that as we move into next quarter as well.
So a normalized in effect that I telegraphed last quarter off of the June number and seems like that's where we're expected to see the overall as we move into the next 6 months or so.
Got it. And for my follow-up, Rick, I'm curious how resilient has your core process control services business been in this cyclical downturn versus what you assume, what went well, what did not go as well. Every time we get into a downturn, we always hope for the resilience of that business. But I'm just curious as you look back how resilient it actually was over the last several quarters?
Yes, sure. It was pretty resilient. I think that as Brent mentioned, there was a little bit of softening we saw, but overall we still see healthy growth rate. It was a little bit under what's been modeled for the long term, but we actually think we'll catch back up with that long term modeling for a lot of reasons. I mean, I think that the utilization on some of the fabs has obviously been decreased, but the service base is so large now and there's a lot of value in keeping those tools up and running.
So we feel pretty good about it. Still, and I think the slowest quarter was still in low upper single digits. So pretty good about 8%.
Yes, back in the worst downturn we've ever had. I mean, it's always held up pretty well, right. And it's I think the other thing about that business for us is it's bigger now, right, because it's growing faster than the systems business. So bigger as a percent of the total. So a solid anchor with we believe an earnings stream that's accretive to the overall.
So, I think the dynamics are intact. It goes to the points earlier about how customers buy service, that they need the tools up, they need matching performance, there's general complexity that's hard to deal with. And for all those reasons, they tend to rely on us and want a contract stream to ensure the uptime of those products. And even in difficult environment, they still tend to run the tools and there's a a certain amount of business that's there for us.
Thank you.
Your next question comes from the line of Joe Quatrochi with Wells Fargo. You are now live.
Yes. Thanks for taking the question. I was wondering if you could talk about some of the gross margin puts and takes for some of the new products that you launched last month. Can you just help us remind us how we should think about those gross margins ramping over time?
Yes. Joe, it's something I've been talking about. I mean, anytime and it really goes back to how we introduce products at KLA. Typically, when we're bringing products out into the market, our focus is on use case validation and driving applications and adoption. And so we usually come out of the product.
We're trying to prove it out. And the margins typically are a little bit lower than what I'd say the mature iteration of the previous platform. Then the engineering team starts to design for costs, we start to look at ways to second source. And as we introduce new subsequent iterations to the products that the margin profile improves. So anytime we have a new one come out, it's a little bit lower and then over time, it catches back up.
So it did have an effect on the margin profile, as I mentioned in the prior quarters. And I think we'll see that play out as we move over the rest of this year and into next year. And with a big portfolio like we have, we tend to see some products where there are different stages of that maturity cycle, so they tend to offset each other. But generally, part of what we do at KLA is ensure the value of what we deliver to customers in terms of how we price and discipline around that. So we ensure that what we are able to deliver product by product is pretty consistent and usually over time, we're able to drive more and more value out of it.
And I would say that we're not any different today with the latest round of products.
Okay, that's helpful. And then on the E Beam side, I was just curious if you could share any kind of early customer feedback that you've gotten so far. Maybe how should we think about the initial ramp for adoption of that solution?
The initial feedback and we're still we're out in a number of sites and we're getting feedback and we're doing demos. Feedback is good. We're not ready to start modeling it into the numbers yet because it does take a while to get the adoption of these platforms going. But we feel pretty good about the technical capability and the production worthiness. It does, as I say, take a little while for customers to adopt enough to contribute meaningfully when we're at a $5,000,000,000 run rate.
Yes. I would say the portfolio approach that we have, these products fit with the portfolio. You've got common capabilities across the tools, common algorithms, common other options that help drive how incremental performance out of the inspectors. So with the review or even baseline ground truth reference tools, it helps sort of enable the broader franchise. So that's the approach we've taken to KLA.
It matters more than ever today with the challenges in the production process, the size of defects, the noise that happens on the wafer. So across all of that, that having those capabilities that independently are tough because sometimes markets aren't always all that big, but collectively across the portfolio, create a lot of value for our customers.
Your next question comes from the line of Quinn Bolton with Needham. You are now live.
Thank you for taking my question and congratulations on the nice results and outlook. I'm just wondering, you mentioned the strength in the Gen 5 tool. You guys introduced the 5th iteration of Gen 4 last month. Just wondering what demand you're seeing for the older Gen 4 systems as Gen 5 ramps?
Well, it's think of it like a lithography mix and match. So what you get is you end up with customers deploying the most cost effective solution they can that has the capabilities that they need. And that really cascades starting with e beam then getting to 39XX then 29XX and then the new Voyager platform. So it's really the easier layers are harder than they used to be on the advanced nodes. So customers will deploy where they can the Gen 4 and then they'll put Gen 5 up against the problems when that's the only way to really solve them.
Does that answer your question?
That's helpful. Thank you. And then just a follow-up on the China question. You referenced some puts and takes, but generally perhaps a strengthening in that market versus 90 days ago. Do you have any sense as the demand strengthening you're seeing more of a timing shift where projects are getting pulled in?
Or do you think that this is just an acceleration in the roadmap for some of those indigenous Chinese fabs? Thanks.
I don't think it says much about I think what happens is there was uncertainty maybe about their own plans and their ability to procure tools. So that maybe pushed it out. And then when they realized they could do it, pulled it back in. I don't want to speak for them. But I think it's more that the project is getting solidified.
And I think 90 days ago, maybe that was more on pause to see if they could even get the tool sets. So that's kind of where we are. It's not so much about end demand, I don't think as them staying on some of their plans. And by the way, there were a lot more programs there that we already derated. If you go back a couple of years ago and had listened to what customers would have said, we're getting closer and closer to what we anticipated for 2019 and a going run rate for 2020.
Thank you.
Your next question comes from the line of Sidney Ho with Deutsche Bank. You are now live.
Great. Thank you. If you look at the capacity build for the upcoming 5 nanometers,
how do
you think the rate at which the capacity is being built as compared to previous nodes, say, to 7 nanometers or 10 nanometers? We've heard that the pilot line for 5 nanometers could be a little bit bigger than in the past, but just want to hear from your perspective of what is driving that kind of changes?
Yes. I think that and I'll go first here. I mean, we are seeing a little bit stronger adoption level. And to the point earlier, you're seeing less migration of other tools from previous nodes and so that's driving a certain amount of activity. I would expect we'll probably be somewhere between 80 ks 90 ks wafer starts in for 5 nanometers we get into the sort of through the 1st part of 2020 or maybe that's toward the end of 2020.
So I would say that because of some of those other dynamics related to 7, we're seeing perhaps more activity for us on the 5 nanometer node.
Okay. Maybe another my follow-up question is on the China strength that you guys expect in the second half. It seems that you guys talk about DRAM project being pulled in. But my understanding is that is that true that a lot of that revenue you have already it because it seems like they have gone most of those customers have gone past initial yield improvement stage. And from here on out, it's more on a production level type of run rate?
Well, like I said, I mean, there's some puts and takes in the overall level of business in China. I think it's slightly better than what we thought before. But there is some rationalization of wafer capacity that's happening likely as well. So while you do have some strength around this particular DRAM project, you do have some other moving parts. I think the way to think about this business is more about proving out technology roadmaps and then moving on to the next node.
So there's some amount of capacity that gets added, but then there's a lot of effort to progress down the technology roadmap. And because of that, we're seeing more engagement than you otherwise might because, yes, yields are slightly improving on the trailing node that they're rapid as they move to the next node, then they're challenged again and need to upgrade certain parts of the tool set. So that's driving a more continuous level of business, not just with this customer, but with other customers. And you might see when you're at some node and then go ramp it to significant volume production as you'd see in one of the leading edge memory fabs. It's a little different behavior, smaller fabs and more of a focus on trying to move down the technology curve than just ramping a lot of capacity.
Great. That's helpful. Thanks.
Your next question comes from the line of Patrick Ho with Stifel. Your line is now live.
Good afternoon. This is Brian Chin on for Patrick. Thanks for letting us ask a few questions. Maybe a few questions on the PCB and flat panel markets. PCB first, the overlay of Huawei might also cloud things a little bit here, but of the major smartphone ecosystems, it sounds like China has been the laggard in terms of adoption of tighter line in space, SLP and MSAP manufacturing.
So have you begun to see the China leader or leaders begin to adopt the Orbotech or now KLA imaging products this year? Or are we still earlier on this adoption curve for them as we and maybe you'll see that more as we move into next year?
Yes, still not yet. I think we do expect that to see that and the current expectation is, as you say, it's probably next year, probably the 3rd guys to do that.
Okay. That's helpful. And maybe pivoting to the slot panel, from an early planning perspective, obviously a weak spending year environment this year, but do you see any lead indicators, early indicators for your product lines like the AOI tool that suggests we could see a meaningful pickup in the spending environment come next year? And if you do, does this increase the urgency to pull in some of the cost synergies relative to that 12 to 24 month horizon?
We don't it's too early for us right now to see 2020 picking up. I do think we had some marginal improvement off of a bottom, but I would say that it's probably later than that. And to your point, we are actively working some of the synergy programs there.
All right. Thank you.
We have a follow-up question from Harlan Sur with JPMorgan.
On the strong adoption of the Gen 5 wafer inspection platform, this I think it was originally targeted for sub-seven nanometer nodes. However, we keep hearing that customers are adopting Gen 5 for yield improvement even at some of the older nodes. And we also hear that Gen 5 is being adopted earlier by the memory guys and then you also have EUV print check as another use case. So how much of these types of buys are driving the strength in shipments this year versus the real leading edge development activities?
We haven't thought about it in those terms. I'd probably say half and half though. I mean, if I thought about it, it's broad use in development. I think what happens and especially since we make improvements to it and drive the productivity of the tool up, then it starts to be competitive in terms of cost of ownership with some applications for Gen 4. But a lot of this, as you might imagine, the discovery aspect of a new product is you're not really sure what it's going to find and what value it's going to create.
So now what we're seeing is significant value, as you say, even in some maybe more traditional places. And frankly, what we originally expected was in some places people might have tried to deploy e beam inspection. They get away from that by leveraging the much higher throughput of the optical platform. So we kind of see it broadening and feel very good. It took us a little while, but we feel very good about the progress there.
I think as customers are seeing more and more demand, more and more activity at these other nodes too that that's driving more yield challenges. And so now the tool is faster and so they're debugging challenges they're having even at prior nodes now using the Gen 5 capability. To Rick's point, you have a whole bunch a whole lot of headroom add that enables customers to use that tool for full wafer coverage type yield analysis that didn't exist without the Gen 5 product line out there. So given the demand there and how much activity is happening across new designs at those nodes, you're seeing more debugging that's happening there as well.
So just one last dynamic. I think you may know, but what a lot of customers do is it takes them a while to prove out the capability of a tool before they release it even internally for broad use. And so what we've seen in the last couple of quarters is we've kind of broken through at some critical places where they have broader ability now to deploy outside of the first people who are just evaluating. And so that really opens up a number of use cases and hence the significant progress in Gen 5.
Yes. Thanks for the insights.
Thank you, Arlen. That's all the time we have for today's call. Jerome, if you would conclude the call with the final commentary.
Thank you for joining KLA Corporation's 2nd quarter 2019 earnings conference call. You may now disconnect.