Table of Contents

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q


(Mark one)
T
QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2013
or
£
TRANSITION REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from              to             
Commission File Number 000-09992
KLA-Tencor Corporation
(Exact name of registrant as specified in its charter)
  
Delaware
 
04-2564110
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification No.)
 
 
 
One Technology Drive, Milpitas, California
 
95035
(Address of Principal Executive Offices)
 
(Zip Code)
(408) 875-3000
(Registrant’s telephone number, including area code)
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  £
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  £
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer x
 
Accelerated filer £
 
Non-accelerated filer £
 
Smaller reporting company £
 
 
 
 
(Do not check if a smaller reporting company)
 
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes £    No  x
As of October 11, 2013, there were 166,649,418 shares of the registrant’s Common Stock, $0.001 par value, outstanding.


Table of Contents

INDEX
 
 
 
Page
Number
 
 
 
PART I
FINANCIAL INFORMATION
 
Item 1
 
 
 
 
 
 
Item 2
Item 3
Item 4
 
 
 
PART II
OTHER INFORMATION
 
Item 1
Item 1A
Item 2
Item 3
Item 4
Item 5
Item 6
 
 
 
 
 
 


 

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PART I. FINANCIAL INFORMATION

ITEM 1.
FINANCIAL STATEMENTS
KLA-TENCOR CORPORATION
Condensed Consolidated Balance Sheets
(Unaudited)
 
(In thousands)
September 30,
2013
 
June 30,
2013
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
904,949

 
$
985,390

Marketable securities
2,046,926

 
1,933,491

Accounts receivable, net
440,674

 
524,610

Inventories
660,276

 
634,448

Deferred income taxes
191,449

 
198,525

Other current assets
110,464

 
75,039

Total current assets
4,354,738

 
4,351,503

Land, property and equipment, net
319,837

 
305,281

Goodwill
326,556

 
326,635

Purchased intangibles, net
30,022

 
34,515

Other non-current assets
252,399

 
269,423

Total assets
$
5,283,552

 
$
5,287,357

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
114,716

 
$
115,680

Deferred system profit
165,931

 
157,965

Unearned revenue
54,363

 
60,838

Other current liabilities
500,100

 
527,049

Total current liabilities
835,110

 
861,532

Non-current liabilities:
 
 
 
Long-term debt
747,511

 
747,376

Pension liabilities
59,578

 
57,959

Income tax payable
58,995

 
59,494

Unearned revenue
54,918

 
42,228

Other non-current liabilities
36,277

 
36,616

Total liabilities
1,792,389

 
1,805,205

Commitments and contingencies (Note 11 and Note 12)

 

Stockholders’ equity:
 
 
 
Common stock and capital in excess of par value
1,178,784

 
1,159,565

Retained earnings
2,344,270

 
2,359,233

Accumulated other comprehensive income (loss)
(31,891
)
 
(36,646
)
Total stockholders’ equity
3,491,163

 
3,482,152

Total liabilities and stockholders’ equity
$
5,283,552

 
$
5,287,357

 
See accompanying notes to condensed consolidated financial statements (unaudited).

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KLA-TENCOR CORPORATION
Condensed Consolidated Statements of Operations
(Unaudited)
 
 
Three months ended
 
September 30,
(In thousands, except per share data)
2013
 
2012
Revenues:
 
 
 
Product
$
501,740

 
$
574,078

Service
156,597

 
146,631

Total revenues
658,337

 
720,709

Costs and operating expenses:
 
 
 
Costs of revenues
277,657

 
317,225

Engineering, research and development
132,273

 
119,742

Selling, general and administrative
98,496

 
97,185

Total costs and operating expenses
508,426

 
534,152

Income from operations
149,911

 
186,557

Interest income and other, net
3,615

 
3,488

Interest expense
13,662

 
13,503

Income before income taxes
139,864

 
176,542

Provision for income taxes
28,667

 
41,175

Net income
$
111,197

 
$
135,367

Net income per share:
 
 
 
Basic
$
0.67

 
$
0.81

Diluted
$
0.66

 
$
0.80

Cash dividends declared per share
$
0.45

 
$
0.40

Weighted average number of shares:
 
 
 
Basic
165,886

 
166,531

Diluted
168,734

 
169,824

 
See accompanying notes to condensed consolidated financial statements (unaudited).

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KLA-TENCOR CORPORATION
Condensed Consolidated Statements of Comprehensive Income
(Unaudited)

 
Three months ended
 
September 30,
(In thousands)
2013
 
2012
Net income
$
111,197

 
$
135,367

Other comprehensive income:
 
 
 
Currency translation adjustments:
 
 
 
Change in currency translation adjustments
5,110

 
6,622

Change in income tax benefit or expense
(1,315
)
 
(1,677
)
Net change related to currency translation adjustments
3,795

 
4,945

Cash flow hedges:
 
 
 
Change in net unrealized gains or losses
(291
)
 
(241
)
Reclassification adjustments for gains or losses included in net income
(2,516
)
 
1,092

Change in income tax benefit or expense
1,005

 
(303
)
Net change related to cash flow hedges
(1,802
)
 
548

Net change related to unrecognized losses and transition obligations in connection with defined benefit plans
199

 
157

Available-for-sale investments:
 
 
 
Change in net unrealized gains or losses
4,139

 
3,917

Reclassification adjustments for gains or losses included in net income
(234
)
 
(309
)
Change in income tax benefit or expense
(1,342
)
 
(1,226
)
Net change related to available-for-sale securities
2,563

 
2,382

Other comprehensive income
4,755

 
8,032

Total comprehensive income
$
115,952

 
$
143,399


See accompanying notes to condensed consolidated financial statements (unaudited).

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KLA-TENCOR CORPORATION
Condensed Consolidated Statements of Cash Flows
(Unaudited)
 
Three months ended
September 30,
(In thousands)
2013
 
2012
Cash flows from operating activities:
 
 
 
Net income
$
111,197

 
$
135,367

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation and amortization
20,637

 
24,016

Asset impairment charges

 
1,327

Non-cash stock-based compensation expense
19,219

 
18,984

Excess tax benefit from equity awards
(18,605
)
 
(7,026
)
Net gain on sale of marketable securities and other investments
(234
)
 
(309
)
Changes in assets and liabilities:
 
 
 
Decrease in accounts receivable, net
85,771

 
166,855

Increase in inventories
(29,805
)
 
(39,289
)
Decrease (increase) in other assets
(9,425
)
 
19,676

Decrease in accounts payable
(1,058
)
 
(23,104
)
Increase (decrease) in deferred system profit
7,966

 
(5,292
)
Decrease in other liabilities
(8,415
)
 
(45,812
)
Net cash provided by operating activities
177,248

 
245,393

Cash flows from investing activities:
 
 
 
Capital expenditures, net
(21,751
)
 
(20,272
)
Purchase of available-for-sale securities
(348,031
)
 
(448,149
)
Proceeds from sale of available-for-sale securities
203,541

 
227,568

Proceeds from maturity of available-for-sale securities
32,058

 
75,578

Purchase of trading securities
(20,851
)
 
(11,168
)
Proceeds from sale of trading securities
18,366

 
9,322

Net cash used in investing activities
(136,668
)
 
(167,121
)
Cash flows from financing activities:
 
 
 
Issuance of common stock
41,047

 
23,250

Tax withholding payments related to vested and released restricted stock units
(48,264
)
 
(18,961
)
Common stock repurchases
(60,504
)
 
(68,317
)
Payment of dividends to stockholders
(74,617
)
 
(66,629
)
Excess tax benefit from equity awards
18,605

 
7,026

Net cash used in financing activities
(123,733
)
 
(123,631
)
Effect of exchange rate changes on cash and cash equivalents
2,712

 
4,007

Net decrease in cash and cash equivalents
(80,441
)
 
(41,352
)
Cash and cash equivalents at beginning of period
985,390

 
751,294

Cash and cash equivalents at end of period
$
904,949

 
$
709,942

Supplemental cash flow disclosures:
 
 
 
Income taxes paid, net
$
19,052

 
$
27,909

Interest paid
$
217

 
$
233

Non-cash investing activities
 
 
 
Purchase of land, property and equipment
$
1,798

 
$

 
See accompanying notes to condensed consolidated financial statements (unaudited).

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KLA-TENCOR CORPORATION
Notes to Condensed Consolidated Financial Statements
(Unaudited)

NOTE 1 – BASIS OF PRESENTATION
Basis of Presentation. The condensed consolidated financial statements have been prepared by KLA-Tencor Corporation (“KLA-Tencor” or the “Company”) pursuant to the rules and regulations of the U.S. Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations. In the opinion of management, the unaudited interim financial statements reflect all adjustments (consisting only of normal, recurring adjustments) necessary for a fair statement of the financial position, results of operations and cash flows for the periods indicated. These financial statements and notes, however, should be read in conjunction with Item 8, “Financial Statements and Supplementary Data” included in the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2013, filed with the SEC on August 8, 2013.
The condensed consolidated financial statements include the accounts of KLA-Tencor and its majority-owned subsidiaries. All significant intercompany balances and transactions have been eliminated.
The results of operations for the three months ended September 30, 2013 are not necessarily indicative of the results that may be expected for any other interim period or for the full fiscal year ending June 30, 2014.
Certain reclassifications have been made to the prior year’s Condensed Consolidated Balance Sheet and notes to conform to the current year presentation. The reclassifications had no effect on the Condensed Consolidated Statements of Operations or Cash Flows.
Management Estimates. The preparation of the condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions in applying the Company's accounting policies that affect the reported amounts of assets and liabilities (and related disclosure of contingent assets and liabilities) at the date of the condensed consolidated financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates.
Revenue Recognition. KLA-Tencor recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the selling price is fixed or determinable, and collectibility is reasonably assured. The Company derives revenue from three sources—sales of systems, spare parts and services. In general, the Company recognizes revenue for systems when the system has been installed, is operating according to predetermined specifications and is accepted by the customer. When a customer delays installation for delivered products for which the Company has demonstrated a history of successful installation and acceptance, the Company recognizes revenue upon customer acceptance. Under certain circumstances, however, the Company recognizes revenue upon shipment, prior to acceptance from the customer, as follows:
When the customer fab has previously accepted the same tool, with the same specifications, and when the Company can objectively demonstrate that the tool meets all of the required acceptance criteria.
When system sales to independent distributors have no installation requirement, contain no acceptance agreement, and 100% payment is due based upon shipment.
When the installation of the system is deemed perfunctory.
When the customer withholds acceptance due to issues unrelated to product performance, in which case revenue is recognized when the system is performing as intended and meets predetermined specifications.
In circumstances in which we recognize revenue prior to installation, the portion of revenue associated with installation is deferred based on estimated fair value, and that revenue is recognized upon completion of the installation.

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In many instances, products are sold in stand-alone arrangements. Services are sold separately through renewals of annual maintenance contracts. The Company also allows for multiple element revenue arrangements in cases where certain elements of a sales arrangement are not delivered and accepted in one reporting period. To determine the relative fair value of each element in a revenue arrangement, the Company allocates arrangement consideration based on the selling price hierarchy. For substantially all of the arrangements with multiple deliverables pertaining to products and services, the Company uses vendor-specific objective evidence (“VSOE”) or third-party evidence (“TPE”) to allocate the selling price to each deliverable. The Company determines TPE based on historical prices charged for products and services when sold on a stand-alone basis. When the Company is unable to establish relative selling price using VSOE or TPE, the Company uses estimated selling price (“ESP”) in its allocation of arrangement consideration. The objective of ESP is to determine the price at which the Company would transact a sale if the product or service were sold on a stand-alone basis. ESP could potentially be used for new or customized products. The Company regularly reviews relative selling prices and maintains internal controls over the establishment and updates of these estimates. In a multiple element revenue arrangement, the Company defers revenue recognition associated with the relative fair value of the undelivered elements until that element is delivered to the customer. To be considered a separate element, the product or service in question must represent a separate unit of accounting, which means that such product or service must fulfill the following criteria: (a) the delivered item(s) has value to the customer on a stand-alone basis; and (b) if the arrangement includes a general right of return relative to the delivered item(s), delivery or performance of the undelivered item(s) is considered probable and substantially in the control of the Company. If the arrangement does not meet all the above criteria, the entire amount of the sales contract is deferred until all elements are accepted by the customer.
Trade-in rights are occasionally granted to customers to trade in tools in connection with subsequent purchases. The Company estimates the value of the trade-in right and reduces the revenue recognized on the initial sale. This amount is recognized at the earlier of the exercise of the trade-in right or the expiration of the trade-in right.
 Spare parts revenue is recognized when the product has been shipped, risk of loss has passed to the customer and collection of the resulting receivable is probable.
Service and maintenance contract revenue is recognized ratably over the term of the maintenance contract. Revenue from services performed in the absence of a maintenance contract, including consulting and training revenue, is recognized when the related services are performed and collectibility is reasonably assured.
The Company sells stand-alone software that is subject to the software revenue recognition guidance. The Company periodically reviews selling prices to determine whether VSOE exists, and in some situations where the Company is unable to establish VSOE for undelivered elements such as post-contract service, revenue is recognized ratably over the term of the service contract.
The Company also defers the fair value of non-standard warranty bundled with equipment sales as unearned revenue. Non-standard warranty includes services incremental to the standard 40-hour per week coverage for twelve months. Non-standard warranty is recognized ratably as revenue when the applicable warranty term period commences.
The deferred system profit balance equals the amount of deferred system revenue that was invoiced and due on shipment, less applicable product and warranty costs. Deferred system revenue represents the value of products that have been shipped and billed to customers which have not met the Company's revenue recognition criteria. Deferred system profit does not include the profit associated with product shipments to customers in Japan, to whom title does not transfer until customer acceptance. Shipments to customers in Japan are classified as inventory at cost until the time of acceptance.

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Recent Accounting Pronouncements. In June 2011, the Financial Accounting Standards Board (“FASB”) issued an accounting standard update requiring an increase in the prominence of items reported in other comprehensive income. The amendment eliminated the option to present components of other comprehensive income as part of the statement of changes in stockholders' equity and required that total comprehensive income, the components of net income, and the components of other comprehensive income be presented in a single continuous statement of comprehensive income or in two separate but consecutive statements. The amendment became effective for the Company's interim period ended September 30, 2012. In February 2013, the FASB issued an accounting standard update on the reporting of reclassifications out of accumulated other comprehensive income of various components, which was originally deferred by the FASB in December 2011. The February 2013 update does not change the current requirements for reporting net income or other comprehensive income in financial statements. However, this update requires an entity to present parenthetically (on the face of the financial statements, in the notes, or in some cases, cross-referenced to related footnote disclosures) significant amounts reclassified from each component of accumulated other comprehensive income and the income statement line items affected by the reclassification. The amendment reflected in the February 2013 update became effective prospectively for the Company's interim period ended September 30, 2013. Early adoption was permitted. The amendment reflected in the February 2013 update did not have an impact on the Company's financial position, results of operations or cash flows as it is disclosure-only in nature.
In December 2011, the FASB issued an accounting standard update requiring enhanced disclosure about certain financial instruments and derivative instruments that are offset in the balance sheet or subject to an enforceable master netting arrangement or similar agreement. The disclosure requirement became effective retrospectively for the Company's interim period ended September 30, 2013. The disclosure requirement did not have an impact on the Company's financial position, results of operations or cash flows as it is disclosure-only in nature.
In July 2013, the FASB issued an accounting standard update that provides explicit guidance on the financial statement presentation of an unrecognized tax benefit when a net operating loss carryforward or a tax credit carryforward exists. Under the new standard update, the Company’s unrecognized tax benefit, or a portion of an unrecognized tax benefit, should be presented in the financial statements as a reduction to a deferred tax asset for a net operating loss carryforward or a tax credit carryforward. This accounting standard update will be effective for the Company's interim period ending September 30, 2014 and applied prospectively with early adoption permitted. The Company is currently evaluating the impact of this accounting standard update on its consolidated financial statements.
NOTE 2 – FAIR VALUE MEASUREMENTS
The Company’s financial assets and liabilities are measured and recorded at fair value, except for equity investments in privately-held companies. These equity investments are generally accounted for under the cost method of accounting and are periodically assessed for other-than-temporary impairment when an event or circumstance indicates that an other-than-temporary decline in value may have occurred. The Company’s non-financial assets, such as goodwill, intangible assets, and land, property and equipment, are recorded at cost and are assessed for impairment when an event or circumstance indicates that an other-than-temporary decline in value may have occurred.
Fair Value of Financial Instruments. KLA-Tencor has evaluated the estimated fair value of financial instruments using available market information and valuations as provided by third-party sources. The use of different market assumptions and/or estimation methodologies could have a significant effect on the estimated fair value amounts. The fair value of the Company's cash equivalents, accounts receivable, accounts payable and other current liabilities approximate their carrying amounts due to the relatively short maturity of these items.
Fair Value Hierarchy. The authoritative guidance for fair value measurements establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy are described below:
Level 1
  
Valuations based on quoted prices in active markets for identical assets or liabilities that the entity has the ability to access.
 
 
 
Level 2
  
Valuations based on quoted prices for similar assets or liabilities, quoted prices in markets that are not active, or other inputs that are observable or can be corroborated by observable data for substantially the full term of the assets or liabilities.
 
 
 
Level 3
  
Valuations based on inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.

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A financial instrument’s level within the fair value hierarchy is based on the lowest level of any input that is significant to the fair value measurement.
All of the Company’s financial instruments were classified within Level 1 or Level 2 of the fair value hierarchy as of September 30, 2013, because they were valued using quoted market prices, broker/dealer quotes or alternative pricing sources with reasonable levels of price transparency. As of September 30, 2013, the types of instruments valued based on quoted market prices in active markets included money market funds, U.S. Treasury securities, equity securities and certain U.S. Government agency securities and sovereign securities. Such instruments are generally classified within Level 1 of the fair value hierarchy.
As of September 30, 2013, the types of instruments valued based on other observable inputs included corporate debt securities, municipal securities and certain U.S. Government agency securities and sovereign securities. The market inputs used to value these instruments generally consist of market yields, reported trades and broker/dealer quotes. Such instruments are generally classified within Level 2 of the fair value hierarchy.
The principal market in which the Company executes its foreign currency contracts is the institutional market in an over-the-counter environment with a relatively high level of price transparency. The market participants usually are large commercial banks. The Company’s foreign currency contracts’ valuation inputs are based on quoted prices and quoted pricing intervals from public data sources and do not involve management judgment. These contracts are typically classified within Level 2 of the fair value hierarchy.
Financial assets (excluding cash held in operating accounts and time deposits) and liabilities measured at fair value on a recurring basis as of the date indicated below were presented on the Company’s Condensed Consolidated Balance Sheet as follows:
As of September 30, 2013 (In thousands)
Total
 
Quoted Prices in
Active Markets
for Identical
Assets (Level 1)
 
Significant Other
Observable Inputs
(Level 2)
Assets
 
 
 
 
 
Cash equivalents:
 
 
 
 
 
Corporate debt securities
$
27,600

 
$

 
$
27,600

Money market and other
685,074

 
685,074

 

Marketable securities:
 
 
 
 
 
U.S. Treasury securities
147,236

 
147,236

 

U.S. Government agency securities
684,749

 
672,502

 
12,247

Municipal securities
104,533

 

 
104,533

Corporate debt securities
1,070,336

 

 
1,070,336

Sovereign securities
33,202

 
8,498

 
24,704

Equity securities
2,128

 
2,128

 

Total cash equivalents and marketable securities(1)
2,754,858

 
1,515,438

 
1,239,420

Other current assets:
 
 
 
 
 
Derivative assets
1,185

 

 
1,185

Other non-current assets:
 
 
 
 
 
Executive Deferred Savings Plan
147,926

 
102,112

 
45,814

Total financial assets(1)
$
2,903,969

 
$
1,617,550

 
$
1,286,419

Liabilities
 
 
 
 
 
Other current liabilities:
 
 
 
 
 
Derivative liabilities
$
(1,445
)
 
$

 
$
(1,445
)
Executive Deferred Savings Plan
(148,282
)
 
(102,280
)
 
(46,002
)
Total financial liabilities
$
(149,727
)
 
$
(102,280
)
 
$
(47,447
)
________________
(1) Excludes cash of $176.3 million held in operating accounts and time deposits of $20.7 million as of September 30, 2013.


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Financial assets (excluding cash held in operating accounts and time deposits) and liabilities measured at fair value on a recurring basis as of the date indicated below were presented on the Company’s Condensed Consolidated Balance Sheet as follows:  
As of June 30, 2013 (In thousands)
Total
 
Quoted Prices in
Active Markets
for Identical
Assets (Level 1)
 
Significant Other
Observable Inputs
(Level 2)
Assets
 
 
 
 
 
Cash equivalents:
 
 
 
 
 
Corporate debt securities
$
3,800

 
$

 
$
3,800

Money market and other
817,608

 
817,608

 

Marketable securities:
 
 
 
 
 
U.S. Treasury securities
93,787

 
93,787

 

U.S. Government agency securities
598,031

 
598,031

 

Municipal securities
103,455

 

 
103,455

Corporate debt securities
1,099,525

 

 
1,099,525

Sovereign securities
33,805

 
13,559

 
20,246

Total cash equivalents and marketable securities(1)
2,750,011

 
1,522,985

 
1,227,026

Other current assets:
 
 
 
 
 
Derivative assets
4,016

 

 
4,016

Other non-current assets:
 
 
 
 
 
Executive Deferred Savings Plan
136,461

 
96,180

 
40,281

Total financial assets(1)
$
2,890,488

 
$
1,619,165

 
$
1,271,323

Liabilities
 
 
 
 
 
Other current liabilities:
 
 
 
 
 
Derivative liabilities
$
(2,173
)
 
$

 
$
(2,173
)
Executive Deferred Savings Plan
(137,849
)
 
(97,570
)
 
(40,279
)
Total financial liabilities
$
(140,022
)
 
$
(97,570
)
 
$
(42,452
)
________________
(1) Excludes cash of $125.5 million held in operating accounts and time deposits of $43.4 million as of June 30, 2013.
There were no transfers in and out of Level 1 and Level 2 fair value measurements during the three months ended September 30, 2013. The Company did not have any assets or liabilities measured at fair value on a recurring basis within Level 3 fair value measurements as of September 30, 2013 or June 30, 2013.



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NOTE 3 – FINANCIAL STATEMENT COMPONENTS
Balance Sheet Components
(In thousands)
As of
September 30, 2013
 
As of
June 30, 2013
Accounts receivable, net:
 
 
 
Accounts receivable, gross
$
462,766

 
$
546,745

Allowance for doubtful accounts
(22,092
)
 
(22,135
)
 
$
440,674

 
$
524,610

Inventories:
 
 
 
Customer service parts
$
182,560

 
$
180,749

Raw materials
254,902

 
229,233

Work-in-process
170,104

 
176,704

Finished goods
52,710

 
47,762

 
$
660,276

 
$
634,448

Other current assets:
 
 
 
Prepaid expenses
$
37,146

 
$
31,997

Prepaid income taxes
57,764

 
25,825

Other current assets
15,554

 
17,217

 
$
110,464

 
$
75,039

Land, property and equipment, net:
 
 
 
Land
$
41,834

 
$
41,850

Buildings and leasehold improvements
276,893

 
272,920

Machinery and equipment
487,874

 
476,747

Office furniture and fixtures
20,837

 
20,701

Construction-in-process
19,324

 
16,604

 
846,762

 
828,822

Less: accumulated depreciation and amortization
(526,925
)
 
(523,541
)
 
$
319,837

 
$
305,281

Other non-current assets:
 
 
 
Executive Deferred Savings Plan(1)
$
147,926

 
$
136,461

Deferred tax assets – long-term
87,573

 
114,833

Other
16,900

 
18,129

 
$
252,399

 
$
269,423

Other current liabilities:
 
 
 
Warranty
$
37,314

 
$
42,603

Executive Deferred Savings Plan(1)
148,282

 
137,849

Compensation and benefits
156,418

 
195,793

Income taxes payable
14,141

 
11,076

Interest payable
21,706

 
8,769

Other accrued expenses
122,239

 
130,959

 
$
500,100

 
$
527,049


12

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________________
(1)
KLA-Tencor has a non-qualified deferred compensation plan whereby certain executives and non-employee directors may defer a portion of their compensation. Participants are credited with returns based on their allocation of their account balances among measurement funds. The Company controls the investment of these funds, and the participants remain general creditors of KLA-Tencor. Distributions from the plan commence the quarter following a participant’s retirement or termination of employment, except in cases where such distributions are required to be delayed in order to avoid a prohibited distribution under Internal Revenue Code Section 409A. As of September 30, 2013, the Company had a deferred compensation plan related asset and liability included as a component of other non-current assets and other current liabilities on the Condensed Consolidated Balance Sheet.
Accumulated Other Comprehensive Income (Loss)
The components of accumulated other comprehensive income (loss) (“AOCI”) as of the dates indicated below were as follows:
(In thousands)
Currency Translation Adjustments
 
Unrealized Gains (Losses) on Available-for-Sale Investments
 
Unrealized Gains (Losses) on Cash Flow Hedges
 
Unrealized Gains (Losses) on Defined Benefit Plans
 
Total
Balance as of June 30, 2013
$
(22,467
)
 
$
(602
)
 
$
1,594

 
$
(15,171
)
 
$
(36,646
)
Other comprehensive income (loss) before reclassifications
5,110

 
4,139

 
(291
)
 
313

 
9,271

Amounts reclassified from AOCI

 
(234
)
 
(2,516
)
 

 
(2,750
)
Taxes (benefits)
(1,315
)
 
(1,342
)
 
1,005

 
(114
)
 
(1,766
)
Other comprehensive income (loss)
3,795

 
2,563

 
(1,802
)
 
199

 
4,755

Balance as of September 30, 2013
$
(18,672
)
 
$
1,961

 
$
(208
)
 
$
(14,972
)
 
$
(31,891
)
The effects on net income of amounts reclassified from AOCI for the three months ended September 30, 2013 were as follows (in thousands):
AOCI Components
 
Location
 
Amounts Reclassified from AOCI to the Consolidated Statement of Operations
Gains on cash flow hedges from foreign exchange contracts
 
Revenues
 
$
2,450

 
 
Costs of revenues
 
66

 
 
Total before tax
 
2,516

Unrealized gains on available-for-sale investments
 
Interest income and other, net
 
234

Total amount reclassified from AOCI
 
 
 
$
2,750

NOTE 4 – MARKETABLE SECURITIES
The amortized cost and fair value of marketable securities as of the dates indicated below were as follows:
As of September 30, 2013 (In thousands)
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
U.S. Treasury securities
$
147,198

 
$
100

 
$
(62
)
 
$
147,236

U.S. Government agency securities
684,400

 
754

 
(405
)
 
684,749

Municipal securities
104,743

 
60

 
(270
)
 
104,533

Corporate debt securities
1,095,912

 
2,919

 
(895
)
 
1,097,936

Money market and other
685,074

 

 

 
685,074

Sovereign securities
33,198

 
18

 
(14
)
 
33,202

Equity securities
1,360

 
768

 

 
2,128

Subtotal
2,751,885

 
4,619

 
(1,646
)
 
2,754,858

Add: Time deposits(1)
20,713

 

 

 
20,713

Less: Cash equivalents
728,645

 

 

 
728,645

Marketable securities
$
2,043,953

 
$
4,619

 
$
(1,646
)
 
$
2,046,926


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Table of Contents

As of June 30, 2013 (In thousands)
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
U.S. Treasury securities
$
93,940

 
$
53

 
$
(206
)
 
$
93,787

U.S. Government agency securities
598,471

 
569

 
(1,009
)
 
598,031

Municipal securities
103,686

 
71

 
(302
)
 
103,455

Corporate debt securities
1,103,438

 
2,353

 
(2,466
)
 
1,103,325

Money market and other
817,608

 

 

 
817,608

Sovereign securities
33,799

 
25

 
(19
)
 
33,805

Subtotal
2,750,942

 
3,071

 
(4,002
)
 
2,750,011

Add: Time deposits(1)
43,413

 

 

 
43,413

Less: Cash equivalents
859,933

 

 

 
859,933

Marketable securities
$
1,934,422

 
$
3,071

 
$
(4,002
)
 
$
1,933,491

________________
(1)
Time deposits excluded from fair value measurements.
KLA-Tencor’s investment portfolio consists of both corporate and government securities that have a maximum maturity of three years. The longer the duration of these securities, the more susceptible they are to changes in market interest rates and bond yields. As yields increase, those securities with a lower yield-at-cost show a mark-to-market unrealized loss. All unrealized losses are due to changes in market interest rates, bond yields and/or credit ratings. The Company has the ability to realize the full value of all of these investments upon maturity. The following table summarizes the fair value and gross unrealized losses of the Company’s investments that were in an unrealized loss position as of the date indicated below:
 
As of September 30, 2013 (In thousands)
Fair Value
 
Gross
Unrealized
Losses(1)
U.S. Treasury securities
$
30,627

 
$
(62
)
U.S. Government agency securities
248,191

 
(405
)
Municipal securities
61,180

 
(270
)
Corporate debt securities
367,513

 
(895
)
Sovereign securities
21,127

 
(14
)
Total
$
728,638

 
$
(1,646
)
__________________ 
(1)
Of the total gross unrealized losses, the amount of total gross unrealized losses related to investments that had been in a continuous loss position for 12 months or more was immaterial.

The contractual maturities of securities classified as available-for-sale, regardless of their classification on the Company's Condensed Consolidated Balance Sheet, as of the date indicated below were as follows:
As of September 30, 2013 (In thousands)
Amortized Cost
 
Fair Value
Due within one year
$
478,400

 
$
480,079

Due after one year through three years
1,565,553

 
1,566,847

 
$
2,043,953

 
$
2,046,926

Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Realized gains on available-for-sale securities for the three months ended September 30, 2013 and September 30, 2012 were each $0.3 million. Realized losses on available-for-sale securities for the three months ended September 30, 2013 and September 30, 2012 were immaterial.

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NOTE 5 – GOODWILL AND PURCHASED INTANGIBLE ASSETS
Goodwill
The following table presents goodwill balances as of the dates indicated below:
(In thousands)
As of
September 30, 2013
 
As of
June 30, 2013
Gross goodwill balance
$
604,126

 
$
604,205

Accumulated impairment losses
(277,570
)
 
(277,570
)
Net goodwill balance
$
326,556

 
$
326,635

The changes in the gross goodwill balance since June 30, 2013 resulted from foreign currency translation adjustments.
Goodwill represents the excess of the purchase price over the fair value of the net tangible and identifiable intangible assets acquired in each business combination.
The Company has four reporting units: Defect Inspection, Metrology, Service, and Software and Other. As of September 30, 2013, substantially all of the goodwill balance resided in the Defect Inspection reporting unit.
The Company performed a qualitative assessment of the goodwill by reporting unit as of November 30, 2012 during the three months ended December 31, 2012 and concluded that it was more likely than not that the fair value of each of the reporting units exceeded its carrying amount. As of December 31, 2012, the Company's assessment indicated that goodwill in the reporting units was not impaired. There have been no significant events or circumstances affecting the valuation of goodwill subsequent to the qualitative assessment performed in the second quarter of the fiscal year ended June 30, 2013. The next annual assessment of the goodwill by reporting unit will be performed in the second quarter of the fiscal year ending June 30, 2014.
Purchased Intangible Assets
The components of purchased intangible assets as of the dates indicated below were as follows:
(In thousands)
 
 
As of
September 30, 2013
 
As of
June 30, 2013
Category
Range of
Useful Lives
 
Gross
Carrying
Amount
 
Accumulated
Amortization
and
Impairment
 
Net
Amount
 
Gross
Carrying
Amount
 
Accumulated
Amortization
and
Impairment
 
Net
Amount
Existing technology
4-7 years
 
$
133,659

 
$
120,977

 
$
12,682

 
$
133,659

 
$
119,106

 
$
14,553

Patents
6-13 years
 
57,648

 
51,904

 
5,744

 
57,648

 
51,068

 
6,580

Trade name/Trademark
4-10 years
 
19,893

 
16,303

 
3,590

 
19,893

 
15,928

 
3,965

Customer relationships
6-7 years
 
54,680

 
46,674

 
8,006

 
54,680

 
45,263

 
9,417

Other
0-1 year
 
16,200

 
16,200

 

 
16,200

 
16,200

 

Total
 
 
$
282,080

 
$
252,058

 
$
30,022

 
$
282,080

 
$
247,565

 
$
34,515

Intangible assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset or asset group may not be recoverable.

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Table of Contents

For the three months ended September 30, 2013 and 2012, amortization expense for other intangible assets was $4.5 million and $7.2 million, respectively. Based on the intangible assets recorded as of September 30, 2013, and assuming no subsequent additions to, or impairment of, the underlying assets, the remaining estimated amortization expense is expected to be as follows:
Fiscal year ending June 30:
Amortization
(In thousands)
2014 (remaining 9 months)
$
10,875

2015
12,752

2016
5,564

2017
806

2018
25

Total
$
30,022


NOTE 6 – LONG-TERM DEBT
In April 2008, the Company issued $750 million aggregate principal amount of 6.90% senior, unsecured long-term debt due in 2018 with an effective interest rate of 7.00%. The discount on the debt amounted to $5.4 million and is being amortized over the life of the debt using the straight-line method as opposed to the interest method due to immateriality. Interest is payable semi-annually on November 1 and May 1. The debt indenture includes covenants that limit the Company’s ability to grant liens on its facilities and to enter into sale and leaseback transactions, subject to significant allowances under which certain sale and leaseback transactions are not restricted. The Company was in compliance with all of its covenants as of September 30, 2013.
In certain circumstances involving a change of control followed by a downgrade of the rating of the Company’s senior notes, the Company will be required to make an offer to repurchase the senior notes at a purchase price equal to 101% of the aggregate principal amount of the notes, plus accrued and unpaid interest. The Company’s ability to repurchase the senior notes in such event may be limited by law, by the indenture associated with the senior notes, by the Company’s then-available financial resources or by the terms of other agreements to which the Company may be party at such time. If the Company fails to repurchase the senior notes as required by the indenture, it would constitute an event of default under the indenture governing the senior notes which, in turn, may also constitute an event of default under other obligations.
Based on the trading prices of the debt on the applicable dates, the fair value of the debt as of September 30, 2013 and June 30, 2013 was $879.2 million and $872.3 million , respectively. While the debt is recorded at cost, the fair value of the long-term debt was determined based on quoted prices in markets that are not active; accordingly, the long-term debt is categorized as Level 2 for purposes of the fair value measurement hierarchy.
NOTE 7 – EQUITY AND LONG-TERM INCENTIVE COMPENSATION PLANS
Equity Incentive Program
Under the Company’s current equity incentive program, the Company issues equity awards from its 2004 Equity Incentive Plan (the “2004 Plan”), which provides for the grant of options to purchase shares of its common stock, stock appreciation rights, restricted stock units, performance shares, performance units and deferred stock units to its employees, consultants and members of its Board of Directors. The 2004 Plan currently permits the issuance of up to 32.0 million shares of common stock. Any 2004 Plan awards of restricted stock units, performance shares, performance units or deferred stock units with a per share or unit purchase price lower than 100% of fair market value on the grant date are currently counted against the total number of shares issuable under the 2004 Plan as 1.8 shares for every one share subject thereto.

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Table of Contents

The following table summarizes the combined activity under the Company's equity incentive plans for the indicated period:
(In thousands)
Available
For Grant
Balances as of June 30, 2013(1)
6,696

Restricted stock units granted(2)(3)
(1,224
)
Restricted stock units canceled(2)
36

Options canceled/expired/forfeited
27

Plan shares expired(4)
(18
)
Balances as of September 30, 2013(1)
5,517

__________________ 
(1)
Includes shares available for issuance under the 2004 Plan, as well as under the Company’s 1998 Outside Director Option Plan (the “Outside Director Plan”), which only permits the issuance of stock options to the Company’s non-employee members of the Board of Directors. As of September 30, 2013, 1.7 million shares were available for grant under the Outside Director Plan.
(2)
The number of restricted stock units provided in this row reflects the application of the 1.8x multiple described above.
(3)
Includes 0.3 million (reflected as 0.6 million shares in this table due to the application of the 1.8x multiple described above) restricted stock units granted to senior management during the three months ended September 30, 2013 with performance-based vesting criteria (in addition to service-based vesting criteria for any of such restricted stock units that are deemed to have been earned). As of September 30, 2013, it had not yet been determined the extent to which (if at all) the performance-based vesting criteria of such restricted stock units had been satisfied. Therefore, this line item includes all such performance-based restricted stock units, granted during such fiscal period, reported at the maximum possible number of shares that may ultimately be issuable under such restricted stock units if all applicable performance-based criteria are achieved at their maximum and all applicable service-based criteria are fully satisfied.
(4)
Represents the portion of shares listed as “Options canceled/expired/forfeited” above that were issued under the Company’s equity incentive plans other than the 2004 Plan or the Outside Director Plan. Because the Company is only currently authorized to issue equity awards under the 2004 Plan and the Outside Director Plan, any equity awards that are canceled, expire or are forfeited under any other Company equity incentive plans do not result in additional shares being available to the Company for future grant.
Except for stock options granted to non-employee Board members as part of their regular compensation package for service through the end of the first quarter of fiscal year 2008, the Company has granted only restricted stock units under its equity incentive program since September 2006. For the preceding several years until September 30, 2006, stock options were granted at the market price of the Company’s common stock on the date of grant (except for the previously disclosed retroactively priced options which were granted primarily prior to the fiscal year ended June 30, 2002), generally with a vesting period of five years and an exercise period not to exceed seven years (ten years for options granted prior to July 1, 2005) from the date of issuance. Restricted stock units may be granted with varying criteria such as service-based and/or performance-based vesting.
The fair value of stock-based awards is measured at the grant date and is recognized as an expense over the employee’s requisite service period. The fair value is determined using a Black-Scholes valuation model for purchase rights under the Company’s Employee Stock Purchase Plan and using the closing price of the Company’s common stock on the grant date for restricted stock units, adjusted to exclude the present value of dividends which are not accrued on the restricted stock units.
The following table shows pre-tax stock-based compensation expense for the indicated periods: 
 
Three months ended
September 30,
(In thousands)
2013
 
2012
Stock-based compensation expense by:
 
 
 
Costs of revenues
$
3,177

 
$
3,275

Engineering, research and development
5,408

 
5,463

Selling, general and administrative
10,634

 
10,246

Total stock-based compensation expense
$
19,219

 
$
18,984


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Table of Contents

The following table shows stock-based compensation capitalized as inventory as of the dates indicated below: 
(In thousands)
As of
September 30, 2013
 
As of
June 30, 2013
Inventory
$
8,382

 
$
8,098

Stock Options
The following table summarizes the activity and weighted-average exercise price for stock options under all plans during the three months ended September 30, 2013: 
Stock Options
Shares
(In thousands)
 
Weighted-Average
Exercise Price
Outstanding stock options as of June 30, 2013
1,663

 
$
48.97

Granted

 
$

Exercised
(820
)
 
$
49.98

Canceled/expired/forfeited
(27
)
 
$
50.42

Outstanding stock options as of September 30, 2013 (all outstanding and all vested and exercisable)
816

 
$
47.92

The Company has not issued any stock options since November 1, 2007. The weighted-average remaining contractual terms for total options outstanding under all plans, and for total options vested and exercisable under all plans, as of September 30, 2013 were each 0.7 years. The aggregate intrinsic values for total options outstanding under all plans, and for total options vested and exercisable under all plans, as of September 30, 2013 were each $10.6 million.
The authoritative guidance on stock-based compensation permits companies to select the option-pricing model used to estimate the fair value of their stock-based compensation awards. The Black-Scholes option-pricing model requires the input of assumptions, including the option’s expected term and the expected price volatility of the underlying stock. For purposes of the fair value estimates presented in this report, the Company has based its expected stock price volatility assumption on the market-based implied volatility from traded options of the Company’s common stock. As of September 30, 2013, the Company had no unrecognized stock-based compensation balance related to stock options.
The following table shows the total intrinsic value of options exercised, total cash received from employees and non-employee Board members as a result of stock option exercises and tax benefits realized by the Company in connection with these stock option exercises for the indicated periods: 
 
Three months ended
September 30,
(In thousands)
2013
 
2012
Total intrinsic value of options exercised
$
7,883

 
$
3,927

Total cash received from employees and non-employee Board members as a result of stock option exercises
$
41,047

 
$
23,250

Tax benefits realized by the Company in connection with these exercises
$
2,617

 
$
1,294

The Company generally settles employee stock option exercises with newly issued common shares, except in certain tax jurisdictions where settling such exercises with treasury shares provides the Company or one of its subsidiaries with a tax benefit.

18

Table of Contents

Restricted Stock Units
The following table shows the applicable number of restricted stock units and weighted-average grant date fair value for restricted stock units granted, vested and released, withheld for taxes, and forfeited during the three months ended September 30, 2013 and restricted stock units outstanding as of September 30, 2013 and June 30, 2013: 
Restricted Stock Units
Shares
(In thousands) (1)
 
Weighted-Average
Grant Date
Fair Value
Outstanding restricted stock units as of June 30, 2013
5,374

 
$
34.39

Granted(2)
680

 
$
53.02

Vested and released
(1,457
)
 
$
32.46

Withheld for taxes
(814
)
 
$
32.46

Forfeited
(20
)
 
$
33.56

Outstanding restricted stock units as of September 30, 2013(2)
3,763

 
$
38.93

__________________ 
(1)
Share numbers reflect actual shares subject to awarded restricted stock units. Under the terms of the 2004 Plan, each of the share numbers presented in this column is multiplied by 1.8 to calculate the impact on the share reserve under the 2004 Plan.
(2)
Includes 0.3 million restricted stock units granted to senior management during the three months ended September 30, 2013 with performance-based vesting criteria (in addition to service-based vesting criteria for any of such restricted stock units that are deemed to have been earned). As of September 30, 2013, it had not yet been determined the extent to which (if at all) the performance-based vesting criteria of such restricted stock units had been satisfied. Therefore, this line item includes all such performance-based restricted stock units, reported at the maximum possible number of shares that may ultimately be issuable under such restricted stock units if all applicable performance-based criteria are achieved at their maximum and all applicable service-based criteria are fully satisfied.
The restricted stock units granted by the Company since the beginning of the fiscal year ended June 30, 2013 generally vest (a) with respect to awards with only service-based vesting criteria, in four equal installments on the first, second, third and fourth anniversaries of the grant date and (b) with respect to awards with both performance-based and service-based vesting criteria, in two equal installments on the third and fourth anniversaries of the grant date, in each case subject to the recipient remaining employed by the Company as of the applicable vesting date. The restricted stock units granted by the Company from the beginning of the fiscal year ended June 30, 2007 through the fiscal year ended June 30, 2012 generally vest in two equal installments on the second and fourth anniversaries of the grant date, subject to the recipient remaining employed by the Company as of the applicable vesting date. The fair value is determined using the closing price of the Company’s common stock on the grant date for restricted stock units, adjusted to exclude the present value of dividends which are not accrued on the restricted stock units. The restricted stock units have been awarded under the 2004 Plan, and each unit will entitle the recipient to one share of common stock when the applicable vesting requirements for that unit are satisfied. However, for each share actually issued under the awarded restricted stock units, the share reserve under the 2004 Plan will be reduced by 1.8 shares, as provided under the terms of the 2004 Plan.
The following table shows the weighted-average grant date fair value per unit for the restricted stock units granted and tax benefits realized by the Company in connection with vested and released restricted stock units for the indicated periods: 
(In thousands, except for weighted-average grant date fair value)
Three months ended
September 30,
2013
 
2012
Weighted-average grant date fair value per unit
$
53.02

 
$
51.65

Tax benefits realized by the Company in connection with vested and released restricted stock units
$
40,606

 
$
17,871

As of September 30, 2013, the unrecognized stock-based compensation expense balance related to restricted stock units was $116.8 million, excluding the impact of estimated forfeitures, and will be recognized over a weighted-average remaining contractual term and an estimated weighted-average amortization period of 1.8 years. The intrinsic value of outstanding restricted stock units as of September 30, 2013 was $229.0 million.

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Table of Contents

Cash-Based Long-Term Incentive Compensation
Starting in fiscal year 2013, the Company adopted a cash-based long-term incentive program for many of its employees as part of the Company's employee compensation program. During the three months ended September 30, 2013, the Company approved cash-based long-term incentive (“Cash LTI”) awards of $1.8 million under the Company's Cash Long-Term Incentive Plan (“Cash LTI Plan”). Cash LTI awards issued to employees under the Cash LTI Plan will vest in four equal installments, with 25% of the aggregate amount of the Cash LTI award vesting on each yearly anniversary of the grant date over a four-year period. In order to receive payments under a Cash LTI award, participants must remain employed by the Company as of the applicable award vesting date. Executives and non-employee Board members are not participating in this program. During the three months ended September 30, 2013, the Company recognized $4.1 million in compensation expense under the Cash LTI Plan. As of September 30, 2013, the unrecognized compensation balance related to the Cash LTI Plan was $47.8 million, excluding the impact of estimated forfeitures.
Employee Stock Purchase Plan
KLA-Tencor’s Employee Stock Purchase Plan (“ESPP”) provides that eligible employees may contribute up to 10% of their eligible earnings toward the semi-annual purchase of KLA-Tencor’s common stock. The ESPP is qualified under Section 423 of the Internal Revenue Code. The employee’s purchase price is derived from a formula based on the closing price of the common stock on the first day of the offering period versus the closing price on the date of purchase (or, if not a trading day, on the immediately preceding trading day).
Effective January 1, 2010, the offering period (or length of the look-back period) under the ESPP has a duration of six months, and the purchase price with respect to each offering period beginning on or after such date is, until otherwise amended, equal to 85% of the lesser of (i) the fair market value of the Company’s common stock at the commencement of the applicable six-month offering period or (ii) the fair market value of the Company’s common stock on the purchase date.
The Company estimates the fair value of purchase rights under the ESPP using a Black-Scholes valuation model. The fair value of each purchase right under the ESPP was estimated on the date of grant using the Black-Scholes option valuation model and the straight-line attribution approach with the following weighted-average assumptions: 
 
Three months ended
September 30,
 
2013
 
2012
Stock purchase plan:
 
 
 
Expected stock price volatility
29.1
%
 
30.2
%
Risk-free interest rate
0.1
%
 
0.1
%
Dividend yield
2.9
%
 
3.3
%
Expected life of options (in years)
0.5

 
0.5

 No shares were purchased under the ESPP during the three months ended September 30, 2013 or 2012. The following table shows the tax benefits realized by the Company in connection with the disqualifying dispositions of shares purchased under the ESPP and the weighted-average fair value per share for the indicated periods: 
(In thousands, except for weighted-average fair value per share)
Three months ended
September 30,
2013
 
2012
Tax benefits realized by the Company in connection with the disqualifying dispositions of shares purchased under the ESPP
$
786

 
$
606

Weighted-average fair value per share based on Black-Scholes model
$
11.80

 
$
10.54

The ESPP shares are replenished annually on the first day of each fiscal year by virtue of an evergreen provision. The provision allows for share replenishment equal to the lesser of 2.0 million shares or the number of shares which KLA-Tencor estimates will be required to be issued under the ESPP during the forthcoming fiscal year. As of September 30, 2013, a total of 1.7 million shares were reserved and available for issuance under the ESPP. As of the date of this report, no additional shares have been added to the ESPP with respect to the fiscal year ending June 30, 2014.

20

Table of Contents


NOTE 8 – STOCK REPURCHASE PROGRAM
Since July 1997, the Board of Directors has authorized the Company to systematically repurchase in the open market up to 80.8 million shares of its common stock under a repurchase program, including 8.0 million shares authorized in November 2012. The intent of this program is to offset the dilution from KLA-Tencor’s equity incentive plans and employee stock purchase plan, as well as to return excess cash to the Company’s stockholders. Subject to market conditions, applicable legal requirements and other factors, the repurchases will be made from time to time in the open market in compliance with applicable securities laws, including the Securities Exchange Act of 1934 and the rules promulgated thereunder, such as Rule 10b-18. As of September 30, 2013, 4.8 million shares were available for repurchase under the Company’s repurchase program.
Share repurchases for the indicated periods (based on the settlement date of the applicable repurchase) were as follows:
 
Three months ended
September 30,
(In thousands)
2013
 
2012
Number of shares of common stock repurchased
1,038

 
1,361

Total cost of repurchases
$
60,504

 
$
68,317


NOTE 9 – NET INCOME PER SHARE
Basic net income per share is calculated by dividing net income available to common stockholders by the weighted-average number of common shares outstanding during the period. Diluted net income per share is calculated by using the weighted-average number of common shares outstanding during the period, increased to include the number of additional shares of common stock that would have been outstanding if the shares of common stock underlying the Company’s outstanding dilutive stock options and restricted stock units had been issued. The dilutive effect of outstanding options and restricted stock units is reflected in diluted net income per share by application of the treasury stock method. Under the treasury stock method, the amount the employee must pay for exercising stock options, the amount of compensation cost for future service that the Company has not yet recognized, and the amount of tax benefits that is to be recorded in additional paid-in capital when the award becomes deductible are assumed to be used to repurchase shares. The following table sets forth the computation of basic and diluted net income per share:
(In thousands, except per share amounts)
Three months ended
September 30,
2013
 
2012
Numerator:
 
 
 
Net income
$
111,197

 
$
135,367

Denominator:
 
 
 
Weighted-average shares-basic, excluding unvested restricted stock units
165,886

 
166,531

Effect of dilutive options and restricted stock units
2,848

 
3,293

Weighted-average shares-diluted
168,734

 
169,824

Basic net income per share
$
0.67

 
$
0.81

Diluted net income per share
$
0.66

 
$
0.80

Anti-dilutive securities excluded from the computation of diluted net income per share
30

 
1,717

The total amount of dividends paid during the three months ended September 30, 2013 and 2012 was $74.6 million and $66.6 million, respectively. On July 9, 2013, the Company announced that its Board of Directors had authorized an increase in the level of the Company's quarterly dividend from $0.40 to $0.45 per share. The increase in the amount of dividends paid during the three months ended September 30, 2013 reflects that increase in the level of the Company's quarterly dividend.

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NOTE 10 – INCOME TAXES
The following table provides details of income taxes:
(Dollar amounts in thousands)
Three months ended September 30,
 
2013
 
2012
Income before income taxes
$
139,864

 
$
176,542

Provision for income taxes
$
28,667

 
$
41,175

Effective tax rate
20.5
%
 
23.3
%
The Company’s estimated annual effective tax rate for the fiscal year ending June 30, 2014 is approximately 22.9%.
The difference between the actual effective tax rate of 20.5% during the quarter and the estimated annual effective tax rate of 22.9% is primarily due to a decrease in tax expense of $2.0 million related to deductions for employee stock activity and a decrease in tax expense of $2.7 million related to a non-taxable increase in the assets held within the Company's Executive Deferred Savings Plan.
Tax expense was lower as a percentage of income during the three months ended September 30, 2013 compared to the three months ended September 30, 2012 primarily due to the impact of the following items:
Tax expense was decreased by $2.3 million during the three months ended September 30, 2013 due to an increase in the proportion of the Company's earnings generated in jurisdictions with tax rates lower than the U.S. statutory tax rate; and
Tax expense was decreased by $1.2 million during the three months ended September 30, 2013 related to the U.S. federal research credit. The research credit was not available during the three months ended September 30, 2012, because the credit expired on December 31, 2011. On January 2, 2013, the American Taxpayer Relief Act of 2012 reinstated the research credit and extended the credit through December 31, 2013.
In the normal course of business, the Company is subject to examination by tax authorities throughout the world. The Company is subject to U.S. federal income tax examination for all years beginning from the fiscal year ended June 30, 2010.  The Company is subject to state income tax examinations for all years beginning from the fiscal year ended June 30, 2009. The Company is also subject to examinations in other major foreign jurisdictions, including Singapore, for all years beginning from the fiscal year ended June 30, 2009. It is possible that certain examinations may be concluded in the next twelve months. The Company believes it is possible that it may recognize up to $7.2 million of its existing unrecognized tax benefits within the next twelve months as a result of the lapse of statutes of limitations and the resolution of examinations with various tax authorities.
NOTE 11 – LITIGATION AND OTHER LEGAL MATTERS
The Company is named from time to time as a party to lawsuits and other types of legal proceedings and claims in the normal course of its business. Actions filed against the Company include commercial, intellectual property, customer, and labor and employment related claims, including complaints of alleged wrongful termination and potential class action lawsuits regarding alleged violations of federal and state wage and hour and other laws. In general, legal proceedings and claims regardless of their merit, and associated internal investigations (especially those relating to intellectual property or confidential information disputes) are often expensive to prosecute, defend or conduct and may divert management's attention and other company resources. Moreover, the results of legal proceedings are difficult to predict, and the costs incurred in litigation can be substantial, regardless of outcome. The Company believes the amounts provided in its condensed consolidated financial statements are adequate in light of the probable and estimated liabilities. However, because such matters are subject to many uncertainties, the ultimate outcomes are not predictable, and there can be no assurances that the actual amounts required to satisfy alleged liabilities from the matters described above will not exceed the amounts reflected in the Company's condensed consolidated financial statements or will not have a material adverse effect on its results of operations, financial condition or cash flows.

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NOTE 12 – COMMITMENTS AND CONTINGENCIES
Factoring. KLA-Tencor has agreements (referred to as “factoring agreements”) with financial institutions to sell certain of its trade receivables and promissory notes from customers without recourse. The Company does not believe it is at risk for any material losses as a result of these agreements. In addition, the Company periodically sells certain letters of credit (“LCs”), without recourse, received from customers in payment for goods.
The following table shows total receivables sold under factoring agreements for the indicated periods:
 
Three months ended September 30,
(In thousands)
2013
 
2012
Receivables sold under factoring agreements
$
45,882

 
$
48,534

Factoring fees for the sale of certain trade receivables were recorded in interest income and other, net and were not material for the periods presented.

Facilities. KLA-Tencor leases certain of its facilities under arrangements that are accounted for as operating leases. Rent expense was $2.1 million and $2.2 million for the three months ended September 30, 2013 and 2012, respectively.
The following is a schedule of expected operating lease payments:
Fiscal year ending June 30,
Amount
(In thousands)
2014 (remaining 9 months)
$
5,977

2015
6,330

2016
4,906

2017
3,762

2018
2,545

2019 and thereafter
1,181

Total minimum lease payments
$
24,701

Purchase Commitments. KLA-Tencor maintains certain open inventory purchase commitments with its suppliers to ensure a smooth and continuous supply for key components. The Company’s liability under these purchase commitments is generally restricted to a forecasted time-horizon as mutually agreed upon between the parties. This forecasted time-horizon can vary among different suppliers. The Company’s open inventory purchase commitments were approximately $303.4 million as of September 30, 2013 and are primarily due within the next 12 months. Actual expenditures will vary based upon the volume of the transactions and length of contractual service provided. In addition, the amounts paid under these arrangements may be less in the event that the arrangements are renegotiated or canceled. Certain agreements provide for potential cancellation penalties.
Cash Long-Term Incentive Plan. As of September 30, 2013, the Company had committed $62.9 million to future payment obligations under its Cash LTI Plan. The calculation of compensation expense related to the Cash LTI Plan includes estimated forfeiture rate assumptions. Cash LTI awards issued to employees under the Cash LTI Plan vest in four equal installments, with 25% of the aggregate amount of the Cash LTI award vesting on each yearly anniversary of the grant date over a four-year period. In order to receive payments under a Cash LTI award, participants must remain employed by the Company as of the applicable award vesting date.
Warranties, Guarantees and Contingencies. KLA-Tencor provides standard warranty coverage on its systems for 40 hours per week for 12 months, providing labor and parts necessary to repair the systems during the warranty period. The Company accounts for the estimated warranty cost as a charge to costs of revenues when revenue is recognized. The estimated warranty cost is based on historical product performance and field expenses. Utilizing actual service records, the Company calculates the average service hours and parts expense per system and applies the actual labor and overhead rates to determine the estimated warranty charge. The Company updates these estimated charges on a quarterly basis. The actual product performance and/or field expense profiles may differ, and in those cases the Company adjusts its warranty accruals accordingly.

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The following table provides the changes in the product warranty accrual for the indicated periods:
 
Three months ended September 30,
(In thousands)
2013
 
2012
Beginning balance
$
42,603

 
$
46,496

Accruals for warranties issued during the period
9,308

 
10,646

Changes in liability related to pre-existing warranties
(3,384
)
 
2,352

Settlements made during the period
(11,213
)
 
(13,303
)
Ending balance
$
37,314

 
$
46,191

The Company maintains guarantee arrangements available through various financial institutions for up to $26.0 million, of which $24.1 million had been issued as of September 30, 2013, primarily to fund guarantees to customs authorities for value-added tax (“VAT”) and other operating requirements of the Company’s subsidiaries in Europe and Asia.
KLA-Tencor is a party to a variety of agreements pursuant to which it may be obligated to indemnify the other party with respect to certain matters. Typically, these obligations arise in connection with contracts and license agreements or the sale of assets, under which the Company customarily agrees to hold the other party harmless against losses arising from, or provides customers with other remedies to protect against, bodily injury or damage to personal property caused by the Company's products, non-compliance with the Company's product performance specifications, infringement by the Company's products of third-party intellectual property rights and a breach of warranties, representations and covenants related to matters such as title to assets sold, validity of certain intellectual property rights, non-infringement of third-party rights, and certain income tax-related matters. In each of these circumstances, payment by the Company is typically subject to the other party making a claim to and cooperating with the Company pursuant to the procedures specified in the particular contract. This usually allows the Company to challenge the other party's claims or, in case of breach of intellectual property representations or covenants, to control the defense or settlement of any third-party claims brought against the other party. Further, the Company's obligations under these agreements may be limited in terms of amounts, activity (typically at the Company's option to replace or correct the products or terminate the agreement with a refund to the other party), and duration. In some instances, the Company may have recourse against third parties and/or insurance covering certain payments made by the Company.
Subject to certain limitations, the Company is obligated to indemnify its current and former directors, officers and employees with respect to certain litigation matters and investigations that arise in connection with their service to the Company. These obligations arise under the terms of the Company's certificate of incorporation, its bylaws, applicable contracts, and Delaware and California law. The obligation to indemnify generally means that the Company is required to pay or reimburse the individuals' reasonable legal expenses and possibly damages and other liabilities incurred in connection with these matters.
In addition, the Company may in limited circumstances enter into agreements that contain customer-specific pricing, discount, rebate or credit commitments offered by the Company. Furthermore, the Company may give these customers limited audit or inspection rights to enable them to confirm that the Company is complying with these commitments. If a customer elects to exercise its audit or inspection rights, the Company may be required to expend significant resources to support the audit or inspection, as well as to defend or settle any dispute with a customer that could potentially arise out of such audit or inspection. To date, the Company has made no accruals in its condensed consolidated financial statements for this contingency. While the Company has not in the past incurred significant expenses for resolving disputes regarding these types of commitments, the Company cannot make any assurance that it will not incur any such liabilities in the future.
It is not possible to predict the maximum potential amount of future payments under these or similar agreements due to the conditional nature of the Company's obligations and the unique facts and circumstances involved in each particular agreement. Historically, payments made by the Company under these agreements have not had a material effect on its business, financial condition, results of operations or cash flows.
NOTE 13 – DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
The authoritative guidance requires companies to recognize all derivative instruments and hedging activities, including foreign currency exchange contracts, as either assets or liabilities at fair value on the balance sheet. Changes in the fair value of derivatives that do not qualify for hedge treatment, as well as the ineffective portion of any hedges, are reflected in the Condensed Consolidated Statement of Operations. In accordance with the guidance, the Company designates foreign currency forward exchange and option contracts as cash flow hedges of certain forecasted foreign currency denominated sales and purchase transactions.

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Table of Contents

KLA-Tencor’s foreign subsidiaries operate and sell KLA-Tencor’s products in various global markets. As a result, KLA-Tencor is exposed to risks relating to changes in foreign currency exchange rates. KLA-Tencor utilizes foreign currency forward exchange contracts and option contracts to hedge against future movements in foreign exchange rates that affect certain existing and forecasted foreign currency denominated sales and purchase transactions, such as the Japanese yen, the euro and the Israeli new shekel. The Company routinely hedges its exposures to certain foreign currencies with various financial institutions in an effort to minimize the impact of certain currency exchange rate fluctuations. These currency forward exchange contracts and options, designated as cash flow hedges, generally have maturities of less than 18 months. Cash flow hedges are evaluated for effectiveness monthly, based on changes in total fair value of the derivatives. If a financial counterparty to any of the Company’s hedging arrangements experiences financial difficulties or is otherwise unable to honor the terms of the foreign currency hedge, the Company may experience material losses.
For derivative instruments that are designated and qualify as cash flow hedges, the effective portion of the gains or losses on the derivative is reported as a component of accumulated other comprehensive income (loss) (“OCI”) and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. Changes in the fair value of currency forward exchange and option contracts due to changes in time value are excluded from the assessment of effectiveness. Gains and losses on the derivative representing either hedge ineffectiveness or hedge components excluded from the assessment of effectiveness are recognized in current earnings.
For derivative instruments that are not designated as accounting hedges, gains and losses are recognized in interest income and other, net. The Company uses foreign currency forward contracts to hedge certain foreign currency denominated assets or liabilities. The gains and losses on these derivatives are largely offset by the changes in the fair value of the assets or liabilities being hedged.
Derivatives in Cash Flow Hedging Relationships: Foreign Exchange Contracts
The locations and amounts of designated and non-designated derivative instruments’ gains and losses reported in the condensed consolidated financial statements for the indicated periods were as follows:
 
 
Three months ended
September 30,
(In thousands)
Location in Financial Statements
2013
 
2012
Derivatives Designated as Hedging Instruments
 
 
 
 
Gains in accumulated OCI on derivatives (effective portion)
Accumulated OCI
$
(291
)
 
$
(241
)
Gains (losses) reclassified from accumulated OCI into income (effective portion):
Revenues
$
2,450

 
$
(491
)
 
Costs of revenues
66

 
(601
)
 
Total gains (losses) reclassified from accumulated OCI into income (effective portion)
$
2,516

 
$
(1,092
)
Gains recognized in income on derivatives (ineffectiveness portion and amount excluded from effectiveness testing)
Interest income and other, net
$
(18
)
 
$
51

Derivatives Not Designated as Hedging Instruments
 
 
 
 
Gains (losses) recognized in income
Interest income and other, net
$
2,626

 
$
673

The U.S. dollar equivalent of all outstanding notional amounts of hedge contracts, with maximum maturity of 13 months, as of the dates indicated below was as follows: 
(In thousands)
As of
September 30, 2013
 
As of
June 30, 2013
Cash flow hedge contracts
 
 
 
Purchase
$
9,000

 
$
14,641

Sell
$
60,234

 
$
35,178

Other foreign currency hedge contracts
 
 
 
Purchase
$
111,360

 
$
99,175

Sell
$
68,419

 
$
97,901


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Table of Contents

The locations and fair value amounts of the Company’s derivative instruments reported in its Condensed Consolidated Balance Sheets as of the dates indicated below were as follows: 
 
Asset Derivatives
 
Liability Derivatives
 
Balance Sheet Location
 
As of
September 30, 2013
 
As of
June 30, 2013
 
Balance Sheet Location
 
As of
September 30, 2013
 
As of
June 30, 2013
(In thousands)
 
Fair Value
 
 
 
Fair Value
Derivatives designated as hedging instruments
 
 
 
 
 
 
 
 
 
 
 
Foreign exchange contracts
Other current assets
 
$
282

 
$
362

 
Other current liabilities
 
$
505

 
$
384

Total derivatives designated as hedging instruments
 
 
$
282

 
$
362

 
 
 
$
505

 
$
384

Derivatives not designated as hedging instruments
 
 
 
 
 
 
 
 
 
 
 
Foreign exchange contracts
Other current assets
 
$
903

 
$
3,654

 
Other current liabilities
 
$
940

 
$
1,789

Total derivatives not designated as hedging instruments
 
 
$
903

 
$
3,654

 
 
 
$
940

 
$
1,789

Total derivatives
 
 
$
1,185

 
$
4,016

 
 
 
$
1,445

 
$
2,173

The following table provides the balances and changes in accumulated other comprehensive income (loss), before taxes, related to derivative instruments for the indicated periods:
 
Three months ended
September 30,
(In thousands)
2013
 
2012
Beginning balance
$
2,484

 
$
(962
)
Amount reclassified to income
(2,516
)
 
1,092

Net change
(291
)
 
(241
)
Ending balance
$
(323
)
 
$
(111
)
Offsetting of Derivative Assets and Liabilities
KLA-Tencor presents derivatives at gross fair values in the Condensed Consolidated Balance Sheet. The Company has entered into arrangements with each of its counterparties, which reduce credit risk by permitting net settlement of transactions with the same counterparty under certain conditions. As of September 30, 2013 and June 30, 2013, information related to the offsetting arrangements was as follows (in thousands):
As of September 30, 2013
 
 
 
 
 
Gross Amounts Not Offset in the Consolidated Balance Sheet
 
 
Description
 
Gross Amounts of Recognized Assets
 
Gross Amounts Offset in the Consolidated Balance Sheets
 
Net Amount Presented in the Consolidated Balance Sheets
 
Financial Instruments
 
Cash Collateral Received
 
Net Amount
Derivatives - Assets
 
$
1,185

 
$

 
$
1,185

 
$
(1,139
)
 
$

 
$
46

Derivatives - Liabilities
 
$
(1,445
)
 
$

 
$
(1,445
)
 
$
1,139

 
$

 
$
(306
)
As of June 30, 2013
 
 
 
 
 
Gross Amounts Not Offset in the Consolidated Balance Sheet
 
 
Description
 
Gross Amounts of Recognized Assets
 
Gross Amounts Offset in the Consolidated Balance Sheets
 
Net Amount Presented in the Consolidated Balance Sheets
 
Financial Instruments
 
Cash Collateral Received
 
Net Amount
Derivatives - Assets
 
$
4,016

 
$

 
$
4,016

 
$
(1,520
)
 
$

 
$
2,496

Derivatives - Liabilities
 
$
(2,173
)
 
$

 
$
(2,173
)
 
$
1,520

 
$

 
$
(653
)

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Table of Contents


NOTE 14 – RELATED PARTY TRANSACTIONS
During the three months ended September 30, 2013 and 2012, the Company purchased from, or sold to, several entities, where one or more executive officers of the Company or members of the Company’s Board of Directors, or their immediate family members, also serves as an executive officer or board member, including Cisco Systems, Inc., Freescale Semiconductor, Inc., Avago Technologies Ltd. and SAP AG. The following table provides the transactions with these parties for the indicated periods (for the portion of such period that they were considered related):
 
Three months ended
September 30,
(In thousands)
2013
 
2012
Total revenues
$
385

 
$
2,872

Total purchases
$
456

 
$
2,384

The Company had a receivable balance from these parties of $0.1 million and $0.9 million as of September 30, 2013 and June 30, 2013, respectively. Management believes that such transactions are at arm’s length and on similar terms as would have been obtained from unaffiliated third parties.
NOTE 15 – SEGMENT REPORTING AND GEOGRAPHIC INFORMATION
KLA-Tencor reports one reportable segment in accordance with the provisions of the authoritative guidance for segment reporting. Operating segments are defined as components of an enterprise about which separate financial information is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. KLA-Tencor’s chief operating decision maker is the Chief Executive Officer.
The Company is engaged primarily in designing, manufacturing, and marketing process control and yield management solutions for the semiconductor and related nanoelectronics industries. All operating segments have been aggregated due to their inter-dependencies, commonality of long-term economic characteristics, products and services, the production processes, class of customer and distribution processes. The Company’s service products are an extension of the system product portfolio and provide customers with spare parts and fab management services (including system preventive maintenance and optimization services) to improve yield, increase production uptime and throughput, and lower the cost of ownership. Since the Company operates in one reportable segment, all financial segment information required by the authoritative guidance can be found in the condensed consolidated financial statements.
The Company’s significant operations outside the United States include manufacturing facilities in Singapore, Israel, Belgium, Germany and China and sales, marketing and service offices in Western Europe, Japan and the Asia Pacific regions. For geographical revenue reporting, revenues are attributed to the geographic location in which the customer is located. Long-lived assets consist primarily of net property and equipment and are attributed to the geographic region in which they are located.
The following is a summary of revenues by geographic region, based on ship-to location, for the indicated periods (as a percentage of total revenues):
  
Three months ended September 30,
(Dollar amounts in thousands)
2013
 
2012
Revenues:
 
 
 
 
 
 
 
North America
$
179,395

 
28
%
 
$
149,988

 
21
%
Taiwan
117,291

 
18
%
 
276,299

 
38
%
Japan
81,412

 
12
%
 
88,715

 
12
%
Europe & Israel
121,487

 
18
%
 
59,160

 
8
%
Korea
77,278

 
12
%
 
70,247

 
10
%
Rest of Asia
81,474

 
12
%
 
76,300

 
11
%
Total
$
658,337

 
100
%
 
$
720,709

 
100
%

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Table of Contents

The following is a summary of revenues by major products for the indicated periods (as a percentage of total revenues):
  
Three months ended September 30,
(Dollar amounts in thousands)
2013
 
2012
Revenues:
 
 
 
 
 
 
 
Defect inspection
$
343,163

 
52
%
 
$
388,488

 
54
%
Metrology
132,982

 
20
%
 
142,482

 
20
%
Service
156,597

 
24
%
 
146,631

 
20
%
Other
25,595

 
4
%
 
43,108

 
6
%
Total
$
658,337

 
100
%
 
$
720,709

 
100
%
Two customers each accounted for greater than 10% of total revenues for the three months ended September 30, 2013. Four customers each accounted for greater than 10% of total revenues for the three months ended September 30, 2012. Four customers each accounted for greater than 10% of net accounts receivable as of September 30, 2013. Two customers each accounted for greater than 10% of net accounts receivable as of June 30, 2013.
Long-lived assets by geographic region as of the dates indicated below were as follows: 
(In thousands)
As of
September 30, 2013
 
As of
June 30, 2013
Long-lived assets:
 
 
 
United States
$
224,488

 
$
215,136

Europe
46,689

 
49,556

Israel
30,575

 
28,374

Singapore
44,848

 
44,957

Rest of Asia
11,155

 
9,736

Total
$
357,755

 
$
347,759


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Table of Contents


ITEM 2.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
This report contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. All statements other than statements of historical fact may be forward-looking statements. You can identify these and other forward-looking statements by the use of words such as “may,” “will,” “could,” “would,” “should,” “expects,” “plans,” “anticipates,” “relies,” “believes,” “estimates,” “predicts,” “intends,” “potential,” “continue,” “thinks,” “seeks,” or the negative of such terms, or other comparable terminology. Forward-looking statements also include the assumptions underlying or relating to any of the foregoing statements. Such forward-looking statements include, among others, forecasts of the future results of our operations; orders for our products and capital equipment generally; sales of semiconductors; the allocation of capital spending by our customers (and, in particular, the percentage of spending that our customers allocate to process control); growth of revenue in the semiconductor industry, the semiconductor capital equipment industry and our business; technological trends in the semiconductor industry; future developments or trends in the global capital and financial markets; our future product offerings and product features; the success and market acceptance of new products; timing of shipment of backlog; the future of our product shipments and our product and service revenues; our future gross margins; our future research and development expenses and selling, general and administrative expenses; our ability to successfully maintain cost discipline; international sales and operations; our ability to maintain or improve our existing competitive position; success of our product offerings; creation and funding of programs for research and development; attraction and retention of employees; results of our investment in leading edge technologies; the effects of hedging transactions; the effect of the sale of trade receivables and promissory notes from customers; our future income tax rate; future payments of dividends to our stockholders; the completion of any acquisitions of third parties, or the technology or assets thereof; benefits received from any acquisitions and development of acquired technologies; sufficiency of our existing cash balance, investments and cash generated from operations to meet our operating and working capital requirements; and the adoption of new accounting pronouncements.
Our actual results may differ significantly from those projected in the forward-looking statements in this report. Factors that might cause or contribute to such differences include, but are not limited to, those discussed in Part II, Item 1A, “Risk Factors” in this report as well as in Item 1, “Business” and Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the year ended June 30, 2013, filed with the Securities and Exchange Commission on August 8, 2013. You should carefully review these risks and also review the risks described in other documents we file from time to time with the Securities and Exchange Commission. You are cautioned not to place undue reliance on these forward-looking statements, and we expressly assume no obligation and do not intend to update the forward-looking statements in this report after the date hereof.
EXECUTIVE SUMMARY
KLA-Tencor Corporation is a leading supplier of process control and yield management solutions for the semiconductor and related nanoelectronics industries. Our broad portfolio of defect inspection and metrology products and related service, software and other offerings primarily supports integrated circuit (“IC” or “chip”) manufacturers throughout the entire semiconductor fabrication process, from research and development to final volume production. We provide leading-edge equipment, software and support that enable IC manufacturers to identify, resolve and manage significant advanced technology manufacturing process challenges and obtain higher finished product yields at lower overall cost. In addition to serving the semiconductor industry, we also provide a range of technology solutions to a number of other high technology industries, including the light emitting diode (“LED”) and data storage industries, as well as general materials research.
Our products and services are used by the vast majority of bare wafer, IC, lithography reticle (“reticle” or “mask”) and disk manufacturers around the world. Our products, services and expertise are used by our customers to measure and control nanometric-level manufacturing processes, and to detect, analyze and resolve critical product defects that arise in that environment. Our revenues are driven largely by our customers' spending on capital equipment and related maintenance services necessary to support key transitions in their underlying product technologies, or to increase their production volumes in response to market demand. Our semiconductor customers generally operate in one or more of the three major semiconductor markets - memory, foundry and logic. All three of these markets are characterized by rapid technological changes and sudden shifts in end-user demand, which influence the level and pattern of our customers' spending on our products and services. Although capital spending in all three semiconductor markets has historically been very cyclical, the demand for more advanced and lower cost chips used in a growing number of consumer electronics, communications, data processing, and industrial and automotive products has resulted over the long term in a favorable demand environment for our process control and yield management solutions.

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Table of Contents

As a supplier to the global semiconductor and semiconductor-related industries, we are subject to the cyclical capital spending that characterizes these industries. The timing, length, intensity and volatility of the capacity-oriented capital spending cycles of our customers are unpredictable. In addition, our customer base continues to become more highly concentrated over time, thereby increasing the potential impact of a sudden change in capital spending by a major customer on our revenues and profitability. As our customer base becomes increasingly more concentrated, large orders from a relatively limited number of customers account for a substantial portion of our sales, which potentially exposes us to more volatility for revenues and earnings.
However, in addition to these trends of cyclicality and consolidation, the semiconductor industry has also been significantly impacted by constant technological innovation. The growing use of increasingly sophisticated semiconductor devices has caused many of our customers to invest in additional semiconductor manufacturing capabilities and capacity. These investments have included process control and yield management equipment and services and have had a significant favorable impact on our revenues over the long term.
Our revenues during the three months ended September 30, 2013 declined compared to the three months ended June 30, 2013 and September 30, 2012 primarily due to lower levels of shipment during the period resulting from lower shipment backlog at the beginning of the period, relative to the three months ended June 30, 2013 and September 30, 2012. However, at the same time, we experienced a very strong level of new orders for process control and yield management equipment spanning all of our three primary markets -- memory, foundry and logic - during the three months ended September 30, 2013, and we expect to fulfill and recognize revenue for those equipment sales in future periods. We believe that, over the long term, our customers will continue to invest in advanced technologies and new materials to enable smaller design rules and higher density application, as well as to reduce cost. We expect that this in turn will drive long-term increased adoption of process control equipment and services that reduce semiconductor defectivity and improve manufacturing yields, reinforcing the longer-term growth drivers in our industry.
The following table sets forth some of our key quarterly unaudited financial information that we use to manage our business: 
(In thousands, except net income per share)
Three months ended
September 30,
2013
 
June 30,
2013
 
March 31,
2013
 
December 31,
2012
 
September 30,
2012
Total revenues
$
658,337

 
$
720,032

 
$
729,029

 
$
673,011

 
$
720,709

Total costs and operating expenses
$
508,426

 
$
532,397

 
$
526,783

 
$
519,764

 
$
534,152

Gross margin
$
380,680

 
$
413,228

 
$
419,521

 
$
369,096

 
$
403,484

Income from operations
$
149,911

 
$
187,635

 
$
202,246

 
$
153,247

 
$
186,557

Net income
$
111,197

 
$
134,770

 
$
166,382

 
$
106,630

 
$
135,367

Net income per share:
 
 
 
 
 
 
 
 
 
Basic (1)
$
0.67

 
$
0.81

 
$
1.00

 
$
0.64

 
$
0.81

Diluted (1)
$
0.66

 
$
0.80

 
$
0.98

 
$
0.63

 
$
0.80

__________________ 
(1)
Basic and diluted earnings per share are computed independently for each of the quarters presented based on the weighted-average basic and fully diluted shares outstanding for each quarter. Therefore, the sum of quarterly basic and diluted per share information may not equal annual (or other multiple-quarter calculations of) basic and diluted earnings per share.
CRITICAL ACCOUNTING ESTIMATES AND POLICIES
The preparation of our Condensed Consolidated Financial Statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions in applying our accounting policies that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. Note 1 to the Consolidated Financial Statements in our Annual Report on Form 10-K for the fiscal year ended June 30, 2013 describes the significant accounting policies and methods used in preparation of the Consolidated Financial Statements. We base these estimates and assumptions on historical experience, and evaluate them on an on-going basis to ensure that they remain reasonable under current conditions. Actual results could differ from those estimates. We discuss the development and selection of the critical accounting estimates with the Audit Committee of our Board of Directors on a quarterly basis, and the Audit Committee has reviewed our related disclosure in this Quarterly Report on Form 10-Q. The accounting policies that reflect our more significant estimates, judgments and assumptions and which we believe are the most critical to aid in fully understanding and evaluating our reported financial results include the following:

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Revenue Recognition
Inventories
Warranty
Allowance for Doubtful Accounts
Equity and Long-Term Incentive Compensation Plans
Contingencies and Litigation
Goodwill and Intangible Assets
Income Taxes
There were no significant changes in our critical accounting estimates and policies during the three months ended September 30, 2013. Please refer to Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in Part II, Item 7 of our Annual Report on Form 10-K for our fiscal year ended June 30, 2013 for a more complete discussion of our critical accounting policies and estimates.
Valuation of Goodwill and Intangible Assets
We performed a qualitative assessment of the goodwill by reporting unit as of November 30, 2012 during the three months ended December 31, 2012 and concluded that there was no impairment. We assess goodwill for impairment annually as well as whenever events or changes in circumstances indicate that the carrying amount of goodwill in any reporting unit may not be recoverable. Long-lived assets are tested for recoverability whenever events or changes in circumstances indicate that the assets' carrying amount may not be recoverable.
Our next annual assessment of the goodwill by reporting unit will be performed during the three months ending December 31, 2013. If we were to encounter challenging economic conditions, such as a decline in our operating results, an unfavorable industry or macroeconomic environment, a substantial decline in our stock price, or any other adverse change in market conditions, we may be required to perform the two-step quantitative goodwill impairment analysis. In addition, if such conditions have the effect of changing one of the critical assumptions or estimates we use to calculate the value of our goodwill or intangible assets, we may be required to record goodwill and/or intangible asset impairment charges in future periods, whether in connection with our next annual impairment assessment in the second quarter of fiscal year 2014 or prior to that, if any triggering event occurs outside of the quarter during which the annual goodwill impairment assessment is performed. It is not possible at this time to determine if any such future impairment charge would result or, if it does, whether such charge would be material to our results of operations.
Revenue Recognition
We recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the selling price is fixed or determinable, and collectibility is reasonably assured. We derives revenue from three sources—sales of systems, spare parts and services. In general, we recognize revenue for systems when the system has been installed, is operating according to predetermined specifications and is accepted by the customer. When a customer delays installation for delivered products for which we have demonstrated a history of successful installation and acceptance, we recognize revenue upon customer acceptance. Under certain circumstances, however, we recognize revenue upon shipment, prior to acceptance from the customer, as follows:
When the customer fab has previously accepted the same tool, with the same specifications, and when we can objectively demonstrate that the tool meets all of the required acceptance criteria.
When system sales to independent distributors have no installation requirement, contain no acceptance agreement, and 100% payment is due based upon shipment.
When the installation of the system is deemed perfunctory.
When the customer withholds acceptance due to issues unrelated to product performance, in which case revenue is recognized when the system is performing as intended and meets predetermined specifications.
In circumstances in which we recognize revenue prior to installation, the portion of revenue associated with installation is deferred based on estimated fair value, and that revenue is recognized upon completion of the installation.

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In many instances, products are sold in stand-alone arrangements. Services are sold separately through renewals of annual maintenance contracts. We also allow for multiple element revenue arrangements in cases where certain elements of a sales arrangement are not delivered and accepted in one reporting period. To determine the relative fair value of each element in a revenue arrangement, we allocate arrangement consideration based on the selling price hierarchy. For substantially all of the arrangements with multiple deliverables pertaining to products and services, we use vendor-specific objective evidence (“VSOE”) or third-party evidence (“TPE”) to allocate the selling price to each deliverable. We determine TPE based on historical prices charged for products and services when sold on a stand-alone basis. When we are unable to establish relative selling price using VSOE or TPE, we use estimated selling price (“ESP”) in our allocation of arrangement consideration. The objective of ESP is to determine the price at which we would transact a sale if the product or service were sold on a stand-alone basis. ESP could potentially be used for new or customized products. We regularly review relative selling prices and maintain internal controls over the establishment and updates of these estimates. In a multiple element revenue arrangement, we defer revenue recognition associated with the relative fair value of the undelivered elements until that element is delivered to the customer. To be considered a separate element, the product or service in question must represent a separate unit of accounting, which means that such product or service must fulfill the following criteria: (a) the delivered item(s) has value to the customer on a stand-alone basis; and (b) if the arrangement includes a general right of return relative to the delivered item(s), delivery or performance of the undelivered item(s) is considered probable and substantially in our control. If the arrangement does not meet all the above criteria, the entire amount of the sales contract is deferred until all elements are accepted by the customer.
Trade-in rights are occasionally granted to customers to trade in tools in connection with subsequent purchases. We estimate the value of the trade-in right and reduce the revenue recognized on the initial sale. This amount is recognized at the earlier of the exercise of the trade-in right or the expiration of the trade-in right.
 Spare parts revenue is recognized when the product has been shipped, risk of loss has passed to the customer and collection of the resulting receivable is probable.
Service and maintenance contract revenue is recognized ratably over the term of the maintenance contract. Revenue from services performed in the absence of a maintenance contract, including consulting and training revenue, is recognized when the related services are performed and collectibility is reasonably assured.
We sell stand-alone software that is subject to the software revenue recognition guidance. We periodically review selling prices to determine whether VSOE exists, and in some situations where we are unable to establish VSOE for undelivered elements such as post-contract service, revenue is recognized ratably over the term of the service contract.
We also defer the fair value of non-standard warranty bundled with equipment sales as unearned revenue. Non-standard warranty includes services incremental to the standard 40-hour per week coverage for twelve months. Non-standard warranty is recognized ratably as revenue when the applicable warranty term period commences.
The deferred system profit balance equals the amount of deferred system revenue that was invoiced and due on shipment, less applicable product and warranty costs. Deferred system revenue represents the value of products that have been shipped and billed to customers which have not met our revenue recognition criteria. Deferred system profit does not include the profit associated with product shipments to customers in Japan, to whom title does not transfer until customer acceptance. Shipments to customers in Japan are classified as inventory at cost until the time of acceptance.
We enter into sales arrangements that may consist of multiple deliverables of our products and services where certain elements of the sales arrangement are not delivered and accepted in one reporting period. Judgment is required to properly identify the accounting units of the multiple deliverable transactions and to determine the manner in which revenue should be allocated among the accounting units.  Additionally, judgment is required to interpret various commercial terms and determine when all criteria of revenue recognition have been met in order for revenue recognition to occur in the appropriate accounting period. While changes in the allocation of the estimated selling price between the accounting units will not affect the amount of total revenue recognized for a particular arrangement, any material changes in these allocations could impact the timing of revenue recognition, which could have a material effect on our financial position and results of operations. 

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Recent Accounting Pronouncements
In June 2011, the Financial Accounting Standards Board (“FASB”) issued an accounting standard update requiring an increase in the prominence of items reported in other comprehensive income. The amendment eliminated the option to present components of other comprehensive income as part of the statement of changes in stockholders' equity and required that total comprehensive income, the components of net income, and the components of other comprehensive income be presented in a single continuous statement of comprehensive income or in two separate but consecutive statements. The amendment became effective for our interim period ended September 30, 2012. In February 2013, the FASB issued an accounting standard update on the reporting of reclassifications out of accumulated other comprehensive income of various components, which was originally deferred by the FASB in December 2011. The February 2013 update does not change the current requirements for reporting net income or other comprehensive income in financial statements. However, this update requires an entity to present parenthetically (on the face of the financial statements, in the notes, or in some cases, cross-referenced to related footnote disclosures) significant amounts reclassified from each component of accumulated other comprehensive income and the income statement line items affected by the reclassification. The amendment reflected in the February 2013 update became effective prospectively for our interim period ended September 30, 2013. Early adoption was permitted. The amendment reflected in the February 2013 update did not have an impact on our financial position, results of operations or cash flows as it is disclosure-only in nature.
In December 2011, the FASB issued an accounting standard update requiring enhanced disclosure about certain financial instruments and derivative instruments that are offset in the balance sheet or subject to an enforceable master netting arrangement or similar agreement. The disclosure requirement became effective retrospectively for our interim period ended September 30, 2013. The disclosure requirement did not have an impact on our financial position, results of operations or cash flows as it is disclosure-only in nature.
In July 2013, the FASB issued an accounting standard update that provides explicit guidance on the financial statement presentation of an unrecognized tax benefit when a net operating loss carryforward or a tax credit carryforward exists. Under the new standard update, our unrecognized tax benefit, or a portion of an unrecognized tax benefit, should be presented in the financial statements as a reduction to a deferred tax asset for a net operating loss carryforward or a tax credit carryforward. This accounting standard update will be effective for our interim period ending September 30, 2014 and applied prospectively with early adoption permitted. We are currently evaluating the impact of this accounting standard update on our consolidated financial statements.
RESULTS OF OPERATIONS
Revenues and Gross Margin
 
Three months ended
 
 
 
 
(Dollar amounts in thousands)
September 30,
2013
 
June 30,
2013
 
September 30,
2012
 
Q1 FY14 vs.
Q4 FY13
 
Q1 FY14 vs.
Q1 FY13
Revenues:
 
 
 
 
 
 
 
 
 
 
 
Product
$
501,740

 
$
570,300

 
$
574,078

 
$
(68,560
)
 
(12
)%
 
$
(72,338
)
 
(13
)%
Service
156,597

 
149,732

 
146,631

 
6,865

 
5
 %
 
9,966