Table of Contents

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

FORM 10-Q


(Mark one)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2016
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 10, 2016, there were 156,318,732 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,
2016
 
June 30,
2016
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
966,325

 
$
1,108,488

Marketable securities
1,528,296

 
1,382,806

Accounts receivable, net
654,699

 
613,233

Inventories
703,262

 
698,635

Other current assets
76,580

 
64,870

Total current assets
3,929,162

 
3,868,032

Land, property and equipment, net
272,351

 
278,014

Goodwill
335,198

 
335,177

Deferred income taxes
267,793

 
302,219

Purchased intangibles, net
3,065

 
4,331

Other non-current assets
188,529

 
174,659

Total assets
$
4,996,098

 
$
4,962,432

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
105,066

 
$
106,517

Deferred system profit
185,640

 
174,551

Unearned revenue
54,841

 
59,147

Other current liabilities
629,194

 
662,208

Total current liabilities
974,741

 
1,002,423

Non-current liabilities:
 
 
 
Long-term debt
3,018,567

 
3,057,936

Unearned revenue
60,279

 
56,336

Other non-current liabilities
161,002

 
156,623

Total liabilities
4,214,589

 
4,273,318

Commitments and contingencies (Note 11 and Note 12)

 

Stockholders’ equity:
 
 
 
Common stock and capital in excess of par value
447,018

 
452,974

Retained earnings
381,124

 
284,825

Accumulated other comprehensive income (loss)
(46,633
)
 
(48,685
)
Total stockholders’ equity
781,509

 
689,114

Total liabilities and stockholders’ equity
$
4,996,098

 
$
4,962,432

 
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 amounts)
2016
 
2015
Revenues:
 
 
 
Product
$
561,753

 
$
460,739

Service
188,920

 
181,905

Total revenues
750,673

 
642,644

Costs and expenses:
 
 
 
Costs of revenues
277,836

 
270,244

Research and development
129,233

 
119,943

Selling, general and administrative
94,388

 
91,663

Interest expense
30,732

 
30,564

Other expense (income), net
(3,736
)
 
(4,069
)
Income before income taxes
222,220

 
134,299

Provision for income taxes
44,119

 
29,402

Net income
$
178,101

 
$
104,897

Net income per share:
 
 
 
Basic
$
1.14

 
$
0.67

Diluted
$
1.13

 
$
0.66

Cash dividends declared per share
$
0.52

 
$
0.52

Weighted-average number of shares:
 
 
 
Basic
156,129

 
156,820

Diluted
157,021

 
157,984


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)
2016
 
2015
Net income
$
178,101

 
$
104,897

Other comprehensive income (loss):
 
 
 
Currency translation adjustments:
 
 
 
Change in currency translation adjustments
3,924

 
(6,124
)
Change in income tax benefit or expense
782

 
1,384

Net change related to currency translation adjustments
4,706

 
(4,740
)
Cash flow hedges:
 
 
 
Change in net unrealized gains or losses
(1,838
)
 
(1,861
)
Reclassification adjustments for net gains or losses included in net income
1,379

 
(402
)
Change in income tax benefit or expense
165

 
814

Net change related to cash flow hedges
(294
)
 
(1,449
)
Net change related to unrecognized losses and transition obligations in connection with defined benefit plans
245

 
230

Available-for-sale securities:
 
 
 
Change in net unrealized gains or losses
(2,877
)
 
481

Reclassification adjustments for net gains or losses included in net income
(204
)
 
(17
)
Change in income tax benefit or expense
476

 
(69
)
Net change related to available-for-sale securities
(2,605
)
 
395

Other comprehensive income (loss)
2,052

 
(5,564
)
Total comprehensive income
$
180,153

 
$
99,333


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)
2016
 
2015
Cash flows from operating activities:
 
 
 
Net income
$
178,101

 
$
104,897

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation and amortization
14,422

 
19,735

Asset impairment charges
358

 

Non-cash stock-based compensation expense
11,478

 
12,248

Excess tax benefit from equity awards

 
(10,159
)
Net gain on sales of marketable securities and other investments
(204
)
 
(1,233
)
Changes in assets and liabilities:
 
 
 
Decrease (increase) in accounts receivable, net
(38,241
)
 
124,925

Decrease (increase) in inventories
1,187

 
(31,243
)
Decrease in other assets
19,477

 
34,381

Increase (decrease) in accounts payable
(1,547
)
 
4,158

Increase (decrease) in deferred system profit
11,089

 
(14,504
)
Decrease in other liabilities
(26,343
)
 
(49,423
)
Net cash provided by operating activities
169,777

 
193,782

Cash flows from investing activities:
 
 
 
Acquisition of non-marketable securities
(1,470
)
 

Capital expenditures, net
(9,883
)
 
(7,341
)
Purchases of available-for-sale securities
(457,512
)
 
(343,358
)
Proceeds from sale of available-for-sale securities
111,106

 
200,353

Proceeds from maturity of available-for-sale securities
197,100

 
184,973

Purchases of trading securities
(52,465
)
 
(18,267
)
Proceeds from sale of trading securities
45,301

 
15,540

Net cash provided by (used in) investing activities
(167,823
)
 
31,900

Cash flows from financing activities:
 
 
 
Repayment of debt
(40,000
)
 
(40,000
)
Tax withholding payments related to vested and released restricted stock units
(17,376
)
 
(21,526
)
Common stock repurchases

 
(142,592
)
Payment of dividends to stockholders
(89,313
)
 
(101,674
)
Excess tax benefit from equity awards

 
10,159

Net cash used in financing activities
(146,689
)
 
(295,633
)
Effect of exchange rate changes on cash and cash equivalents
2,572

 
(4,377
)
Net decrease in cash and cash equivalents
(142,163
)
 
(74,328
)
Cash and cash equivalents at beginning of period
1,108,488

 
838,025

Cash and cash equivalents at end of period
$
966,325

 
$
763,697

Supplemental cash flow disclosures:
 
 
 
Income taxes paid, net
$
39,411

 
$
7,844

Interest paid
$
3,243

 
$
3,149

Non-cash activities:
 
 
 
Purchase of land, property and equipment - investing activities
$
1,974

 
$
1,490

Unsettled common stock repurchase - financing activities
$

 
$
9,610

Dividends payable - financing activities
$
12,045

 
$
20,892

 
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 – DESCRIPTION OF BUSINESS AND BASIS OF PRESENTATION
Description of Business. KLA-Tencor Corporation (“KLA-Tencor” or the “Company”) is a leading supplier of process control and yield management solutions for the semiconductor and related nanoelectronics industries. KLA-Tencor’s broad portfolio of inspection and metrology products, and related service, software and other offerings primarily supports integrated circuit, which is referred to as an “IC” or “chip,” manufacturers throughout the entire semiconductor fabrication process, from research and development to final volume production. KLA-Tencor provides 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, KLA-Tencor also provides a range of technology solutions to a number of other high technology industries, including the LED and data storage industries, as well as general materials research. Headquartered in Milpitas, California, KLA-Tencor has subsidiaries both in the United States and in key markets throughout the world.
Merger Agreement. On October 20, 2015, the Company entered into an Agreement and Plan of Merger and Reorganization (the “Merger Agreement” or “Merger”) with Lam Research Corporation (“Lam Research”) which was subject to regulatory approvals. On October 5, 2016, the parties mutually agreed to terminate the Merger Agreement. See Note 17, “Subsequent Events” for additional details.
Basis of Presentation. The condensed consolidated financial statements have been prepared by the Company pursuant to the rules and regulations of the 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, comprehensive income, 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, 2016, filed with the SEC on August 5, 2016.
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, 2016 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, 2017.
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 prior year’s Condensed Consolidated Statements of Operations, Comprehensive Income and 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. The Company 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 the Company has demonstrated a history of successful installation and acceptance, the Company recognizes revenue upon delivery and customer acceptance. Under certain circumstances, however, the Company recognizes revenue 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% of the payment is due based upon shipment.
When the installation of the system is deemed perfunctory.

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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 the Company recognizes 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.
In many instances, products are sold in stand-alone arrangements. Services are sold separately through renewals of annual maintenance contracts. The Company has 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 each undelivered element 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 software revenue recognition guidance. The Company periodically reviews selling prices to determine whether VSOE exists, and in 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 12 months. Non-standard warranty is recognized ratably as revenue when the applicable warranty term period commences.
The deferred system profit balance equals the value of products that have been shipped and billed to customers which have not met the Company’s revenue recognition criteria, less applicable product and warranty costs. Deferred system profit does not include the profit associated with product shipments to certain customers in Japan, to whom title does not transfer until customer acceptance. Shipments to such customers in Japan are classified as inventory at cost until the time of acceptance.

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Recent Accounting Pronouncements.
Recently Adopted
In April 2015, the Financial Accounting Standards Board (“FASB”) issued an accounting standard update for customer’s cloud based fees. The guidance changes what a customer must consider in determining whether a cloud computing arrangement contains a software license. If the arrangement contains a software license, the customer would account for the fees related to the software license element in accordance with guidance related to internal use software; if the arrangement does not contain a software license, the customer would account for the arrangement as a service contract. The Company adopted this update beginning in the first quarter of its fiscal year ending June 30, 2017 on a prospective basis and there was no impact of adoption on its condensed consolidated financial statements.
In March 2016, the FASB issued an accounting standard update to simplify certain aspects of share-based payment awards to employees, including the accounting for income taxes, an option to recognize gross stock-based compensation expense with actual forfeitures recognized as they occur and statutory tax withholding requirements, as well as certain classifications in the statement of cash flows. The update is effective for the Company beginning in the first quarter of its fiscal year ending June 30, 2018, with early adoption permitted and all of the guidance must be adopted in the same period. However, the Company elected to early-adopt this standard update beginning in the first quarter of its fiscal year ending June 30, 2017.
Impact to Condensed Consolidated Statements of Operations
The primary impact of adopting the standard update is a change in the recording of the excess tax benefits or deficiencies from share-based payments. Before adoption, the Company recognized the excess tax benefits or deficiencies related to stock-based compensation as a credit or charge to additional paid-in capital (“APIC”) in the Company’s Condensed Consolidated Balance Sheets. Under the standard update, these excess tax benefits or deficiencies are recognized as a discrete tax benefit or discrete tax expense in the income tax provision in the Company’s Condensed Consolidated Statement of Operations. For the three months ended September 30, 2016, the Company recognized a discrete tax benefit of $5.7 million related to net excess tax benefits mainly from stock-based compensation and dividend equivalents. The standard update requires companies to adopt the amendment related to accounting for excess tax benefits or deficiencies on a prospective basis only and as a result, prior periods were not retrospectively adjusted.
Impact to Condensed Consolidated Statements of Cash Flows
In addition to the income tax consequence as described above, the standard update for share-based payment requires that cash flows from excess tax benefits related to share-based payments be reported as operating activities in the Condensed Consolidated Statements of Cash Flows. Previously, cash flows from excess tax benefit related to share-based payments were reported as financing activities. The standard update allows for two methods of adoption which are prospective or retrospective application. The Company elected to adopt this amendment on a prospective basis and as a result, prior periods were not retrospectively adjusted.
Updates Not Yet Effective
In May 2014, the FASB issued an accounting standard update regarding revenue from customer contracts to transfer goods and services or non-financial assets unless the contracts are covered by other standards (for example, insurance or lease contracts). Under the new guidance, an entity should recognize revenue in connection with the transfer of promised goods or services to customers in an amount that reflects the consideration that the entity expects to be entitled to receive in exchange for those goods or services. In addition, the new standard requires that reporting companies disclose the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. In August 2015, the FASB issued an amendment to defer the effective date of the update by one year, with early adoption on the original effective date permitted. With this amendment, the updates are effective for the Company beginning in the first quarter of the fiscal year ending June 30, 2019, with early adoption permitted beginning in the first quarter of the fiscal year ending June 30, 2018. Subsequent to this amendment, the FASB has issued additional clarifying implementation guidance. The new revenue standard may be applied retrospectively to each prior period presented or retrospectively with the cumulative effect recognized as of the date of adoption. The Company is currently evaluating the impact of this accounting standard update on its condensed consolidated financial statements.

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In July 2015, the FASB issued an accounting standard update for the subsequent measurement of inventory. The amended guidance requires entities to measure inventory at the lower of cost or net realizable value. Net realizable value is the estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal and transportation. The requirement would replace the current lower of cost or market evaluation and the accounting guidance is unchanged for inventory measured using last-in, first-out (“LIFO”) or the retail inventory method. The update is effective for the Company beginning in the first quarter of the Company’s fiscal year ending June 30, 2018 and should be applied prospectively with early adoption permitted as of the beginning of an interim or annual reporting period. The Company is currently evaluating the impact of this accounting standard update on its condensed consolidated financial statements.
In January 2016, the FASB issued an accounting standard update that changes the accounting for financial instruments primarily related to equity investments (other than those accounted for under the equity method of accounting or those that result in consolidation of the investee), financial liabilities under the fair value option, and the presentation and disclosure requirements for financial instruments. The accounting standard update is effective for the Company beginning in the first quarter of its fiscal year ending 2019, and early adoption is permitted. The Company is currently evaluating the impact of this accounting standard update on its condensed consolidated financial statements.
In February 2016, the FASB issued an accounting standard update which amends the existing accounting standards for leases. Consistent with current guidance, the recognition, measurement, and presentation of expenses and cash flows arising from a lease by a lessee primarily will depend on its classification. Under the new guidance, a lessee will be required to recognize assets and liabilities for all leases with lease terms of more than 12 months. The update is effective for the Company beginning in the first quarter of its fiscal year ending June 30, 2020 using a modified retrospective transition method. Early adoption is permitted. The Company is currently evaluating the impact of this accounting standard update on its condensed consolidated financial statements.
In June 2016, the FASB issued an accounting standard update that changes the accounting for recognizing impairments of financial assets. Under the update, credit losses for certain types of financial instruments will be estimated based on expected losses. The update also modifies the impairment models for available-for-sale debt securities and for purchased financial assets with credit deterioration since their origination. The update is effective for the Company beginning in the first quarter of its fiscal year ending June 30, 2021, with early adoption permitted starting in the first quarter of fiscal year ending 2020. The Company is currently evaluating the impact of this accounting standard update on its condensed consolidated financial statements.
NOTE 2 – FAIR VALUE MEASUREMENTS
The Company’s financial assets and liabilities are measured and recorded at fair value, except for certain 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.
The Company’s financial instruments were classified within Level 1 or Level 2 of the fair value hierarchy as of September 30, 2016, 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, 2016, the types of instruments valued based on quoted market prices in active markets included money market funds, U.S. Treasury securities, certain U.S. Government agency securities and certain sovereign securities. Such instruments are generally classified within Level 1 of the fair value hierarchy.
As of September 30, 2016, the types of instruments valued based on other observable inputs included corporate debt securities, certain U.S. Government agency securities, municipal securities, and certain 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 generally are large financial institutions. 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, 2016 (In thousands)
Total
 
Quoted Prices in
Active Markets
for Identical
Assets (Level 1)
 
Significant Other
Observable Inputs
(Level 2)
Assets
 
 
 
 
 
Cash equivalents:
 
 
 
 
 
U.S. Treasury securities
$
12,699

 
$
12,699

 
$

Corporate debt securities
28,748

 

 
28,748

Money market and other
581,240

 
581,240

 

Marketable securities:
 
 
 
 
 
U.S. Treasury securities
259,269

 
259,269

 

U.S. Government agency securities
424,018

 
404,022

 
19,996

Municipal securities
3,009

 

 
3,009

Corporate debt securities
812,577

 

 
812,577

Sovereign securities
21,971

 
1,004

 
20,967

Total cash equivalents and marketable securities(1)
2,143,531

 
1,258,234

 
885,297

Other current assets:
 
 
 
 
 
Derivative assets
692

 

 
692

Other non-current assets:
 
 
 
 
 
Executive Deferred Savings Plan
174,752

 
133,380

 
41,372

Total financial assets(1)
$
2,318,975

 
$
1,391,614

 
$
927,361

Liabilities
 
 
 
 
 
Other current liabilities:
 
 
 
 
 
Derivative liabilities
$
(7,637
)
 
$

 
$
(7,637
)
Total financial liabilities
$
(7,637
)
 
$

 
$
(7,637
)
________________
(1) Excludes cash of $320.5 million held in operating accounts and time deposits of $30.5 million as of September 30, 2016.


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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, 2016 (In thousands)
Total
 
Quoted Prices in
Active Markets
for Identical
Assets (Level 1)
 
Significant Other
Observable Inputs
(Level 2)
Assets
 
 
 
 
 
Cash equivalents:
 
 
 
 
 
U.S. Treasury securities
$
68,748

 
$
68,748

 
$

Corporate debt securities
20,569

 

 
20,569

Money market and other
626,156

 
626,156

 

Marketable securities:
 
 
 
 
 
U.S. Treasury securities
258,754

 
258,754

 

U.S. Government agency securities
405,705

 
385,731

 
19,974

Municipal securities
5,016

 

 
5,016

Corporate debt securities
657,905

 

 
657,905

Sovereign securities
41,257

 
6,426

 
34,831

Total cash equivalents and marketable securities(1)
2,084,110

 
1,345,815

 
738,295

Other current assets:
 
 
 
 
 
Derivative assets
1,095

 

 
1,095

Other non-current assets:
 
 
 
 
 
Executive Deferred Savings Plan
162,160

 
106,149

 
56,011

Total financial assets(1)
$
2,247,365

 
$
1,451,964

 
$
795,401

Liabilities
 
 
 
 
 
Other current liabilities:
 
 
 
 
 
Derivative liabilities
$
(11,647
)
 
$

 
$
(11,647
)
Total financial liabilities
$
(11,647
)
 
$

 
$
(11,647
)
________________
(1) Excludes cash of $330.1 million held in operating accounts and time deposits of $77.1 million as of June 30, 2016.
There were no transfers between Level 1 and Level 2 fair value measurements during the three months ended September 30, 2016. 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, 2016 or June 30, 2016.



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NOTE 3 – FINANCIAL STATEMENT COMPONENTS
Balance Sheet Components
(In thousands)
As of
September 30, 2016
 
As of
June 30, 2016
Accounts receivable, net:
 
 
 
Accounts receivable, gross
$
676,366

 
$
634,905

Allowance for doubtful accounts
(21,667
)
 
(21,672
)
 
$
654,699

 
$
613,233

Inventories:
 
 
 
Customer service parts
$
245,105

 
$
234,712

Raw materials
207,080

 
208,689

Work-in-process
188,909

 
187,733

Finished goods
62,168

 
67,501

 
$
703,262

 
$
698,635

Other current assets:
 
 
 
Prepaid expenses
$
38,111

 
$
37,127

Income tax related receivables
29,753

 
18,190

Other current assets
8,716

 
9,553

 
$
76,580

 
$
64,870

Land, property and equipment, net:
 
 
 
Land
$
40,606

 
$
40,603

Buildings and leasehold improvements
314,649

 
313,239

Machinery and equipment
510,763

 
507,378

Office furniture and fixtures
21,287

 
21,737

Construction-in-process
5,810

 
5,286

 
893,115

 
888,243

Less: accumulated depreciation and amortization
(620,764
)
 
(610,229
)
 
$
272,351

 
$
278,014

Other non-current assets:
 
 
 
Executive Deferred Savings Plan(1)
$
174,752

 
$
162,160

Other non-current assets
13,777

 
12,499

 
$
188,529

 
$
174,659

Other current liabilities:
 
 
 
Compensation and benefits
$
179,452

 
$
224,496

Executive Deferred Savings Plan(1)
175,211

 
162,289

Customer credits and advances
80,734

 
81,994

Interest payable
46,208

 
19,395

Warranty
36,967

 
34,773

Income taxes payable
21,513

 
27,964

Other accrued expenses
89,109

 
111,297

 
$
629,194

 
$
662,208

Other non-current liabilities:
 
 
 
Pension liabilities
$
71,349

 
$
69,418

Income taxes payable
54,671

 
50,365

Other non-current liabilities
34,982

 
36,840

 
$
161,002

 
$
156,623



13

Table of Contents

________________
(1)
KLA-Tencor has a non-qualified deferred compensation plan (known as “Executive Deferred Savings Plan”) under which 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 the Company. The Company invests these funds in certain mutual funds and such investments are classified as trading securities in the condensed consolidated balance sheets. Distributions from the Executive Deferred Savings Plan commence following a participant’s retirement or termination of employment or on a specified date allowed per the Executive Deferred Savings Plan provisions, except in cases where such distributions are required to be delayed in order to avoid a prohibited distribution under Internal Revenue Code Section 409A. Participants can generally elect the distributions to be paid in lump sum or quarterly cash payments over a scheduled period for up to 15 years and are allowed to make subsequent changes to their existing elections as permissible under the Executive Deferred Savings Plan provisions. Changes in the Executive Deferred Savings Plan liability are recorded in selling, general and administrative expense in the condensed consolidated statements of operations. The expense (benefit) associated with changes in the liability included in selling, general and administrative expense was $5.8 million and $(10.2) million during the three months ended September 30, 2016 and 2015, respectively. Changes in the Executive Deferred Savings Plan assets are recorded as gains (losses), net in selling, general and administrative expense in the condensed consolidated statements of operations. The amount of net gains (losses), net included in selling, general and administrative expense was $5.9 million and $(10.0) million during the three months ended September 30, 2016 and 2015, respectively.
Accumulated Other Comprehensive Income (Loss)
The components of accumulated other comprehensive income (loss) (“OCI”) as of the dates indicated below were as follows:
(In thousands)
Currency Translation Adjustments
 
Unrealized Gains (Losses) on Available-for-Sale Securities
 
Unrealized Gains (Losses) on Cash Flow Hedges
 
Unrealized Gains (Losses) on Defined Benefit Plans
 
Total
Balance as of September 30, 2016
$
(27,718
)
 
$
846

 
$
481

 
$
(20,242
)
 
$
(46,633
)
 
 
 
 
 
 
 
 
 
 
Balance as of June 30, 2016
$
(32,424
)
 
$
3,451

 
$
775

 
$
(20,487
)
 
$
(48,685
)
The effects on net income of amounts reclassified from accumulated OCI to the Condensed Consolidated Statement of Operations for the indicated period were as follows (in thousands):
 
 
Location in the Condensed Consolidated
 
Three months ended
September 30,
Accumulated OCI Components
 
Statements of Operations
 
2016
 
2015
Unrealized gains (losses) on cash flow hedges from foreign exchange and interest rate contracts
 
Revenues
 
$
(1,481
)
 
$
685

 
 
Costs of revenues
 
(87
)
 
(472
)
 
 
Interest expense
 
189

 
189

 
 
Net gains (losses) reclassified from accumulated OCI
 
$
(1,379
)
 
$
402

Unrealized gains (losses) on available-for-sale securities
 
Other expense (income), net
 
$
204

 
$
17

The amounts reclassified out of accumulated OCI related to the Company’s defined benefit pension plans, which were recognized as a component of net periodic cost for the three months ended September 30, 2016 and 2015 were $0.4 million and $0.3 million, respectively. For additional details, refer to Note 10, “Employee Benefit Plans” in the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2016.

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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, 2016 (In thousands)
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
U.S. Treasury securities
$
271,546

 
$
514

 
$
(92
)
 
$
271,968

U.S. Government agency securities
423,741

 
426

 
(149
)
 
424,018

Municipal securities
3,008

 
1

 

 
3,009

Corporate debt securities
840,857

 
1,067

 
(599
)
 
841,325

Money market and other
581,240

 

 

 
581,240

Sovereign securities
21,972

 
3

 
(4
)
 
21,971

Subtotal
2,142,364

 
2,011

 
(844
)
 
2,143,531

Add: Time deposits(1)
30,546

 

 

 
30,546

Less: Cash equivalents
645,783

 

 
(2
)
 
645,781

Marketable securities
$
1,527,127

 
$
2,011

 
$
(842
)
 
$
1,528,296

As of June 30, 2016 (In thousands)
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
U.S. Treasury securities
$
326,321

 
$
1,181

 
$

 
$
327,502

U.S. Government agency securities
404,889

 
830

 
(14
)
 
405,705

Municipal securities
5,014

 
2

 

 
5,016

Corporate debt securities
676,259

 
2,372

 
(157
)
 
678,474

Money market and other
626,156

 

 

 
626,156

Sovereign securities
41,224

 
38

 
(5
)
 
41,257

Subtotal
2,079,863

 
4,423

 
(176
)
 
2,084,110

Add: Time deposits(1)
77,131

 

 

 
77,131

Less: Cash equivalents
778,451

 
1

 
(17
)
 
778,435

Marketable securities
$
1,378,543

 
$
4,422

 
$
(159
)
 
$
1,382,806

________________
(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 believes that it 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, 2016 (In thousands)
Fair Value
 
Gross
Unrealized
Losses(1)
Corporate debt securities
$
372,827

 
$
(597
)
U.S. Government agency securities
126,547

 
(149
)
U.S. Treasury securities
44,791

 
(92
)
Sovereign securities
13,036

 
(4
)
Municipal securities
2,006

 

Total
$
559,207

 
$
(842
)
__________________ 
(1)
As of September 30, 2016, 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.


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Table of Contents

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, 2016 (In thousands)
Amortized Cost
 
Fair Value
Due within one year
$
531,572

 
$
531,730

Due after one year through three years
995,555

 
996,566

 
$
1,527,127

 
$
1,528,296

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 and losses on available-for-sale securities for the three months ended September 30, 2016 and 2015 were immaterial.
NOTE 5 – GOODWILL AND PURCHASED INTANGIBLE ASSETS
Goodwill
Goodwill represents the excess of the purchase price over the fair value of the net tangible and identifiable intangible assets acquired in prior business combinations. The Company has four reporting units: Wafer Inspection, Patterning, Global Service and Support, and Others. The following table presents goodwill balances and movements by reporting unit during the three months ended September 30, 2016:
(In thousands)
 
Wafer Inspection
 
Patterning
 
Others
 
Total
Balance as of June 30, 2016
 
$
281,026

 
$
53,255

 
$
896

 
$
335,177

Goodwill adjustment
 
21

 

 

 
21

Balance as of September 30, 2016
 
$
281,047

 
$
53,255

 
$
896

 
$
335,198

Goodwill is net of accumulated impairment losses of $277.6 million, which were recorded prior to the fiscal year ended June 30, 2014. The changes in the gross goodwill balance during the three months ended September 30, 2016 resulted from foreign currency translation adjustments.
The Company performed a qualitative assessment of the goodwill by reporting unit as of November 30, 2015 during the three months ended December 31, 2015 as part of its annual goodwill impairment assessment 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, 2015, 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, 2016. The next annual assessment of goodwill by reporting unit is scheduled to be performed in the second quarter of the fiscal year ending June 30, 2017.
Purchased Intangible Assets
The components of purchased intangible assets as of the dates indicated below were as follows:
(In thousands)
 
 
As of
September 30, 2016
 
As of
June 30, 2016
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
 
$
141,659

 
$
138,660

 
$
2,999

 
$
141,659

 
$
138,160

 
$
3,499

Trade name/Trademark
4-10 years
 
19,893

 
19,893

 

 
19,893

 
19,743

 
150

Customer relationships
6-7 years
 
54,980

 
54,914

 
66

 
54,980

 
54,298

 
682

Total
 
 
$
216,532

 
$
213,467

 
$
3,065

 
$
216,532

 
$
212,201

 
$
4,331

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, 2016 and 2015, amortization expense for purchased intangible assets was $1.3 million and $3.7 million, respectively. Based on the intangible assets recorded as of September 30, 2016, 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)
2017 (remaining 9 months)
$
1,540

2018
1,525

Total
$
3,065

NOTE 6 – DEBT
The following table summarizes the debt of the Company as of September 30, 2016 and June 30, 2016:
 
As of September 30, 2016
 
As of June 30, 2016
 
Amount
(In thousands)
 
Effective
Interest Rate
 
Amount
(In thousands)
 
Effective
Interest Rate
Fixed-rate 2.375% Senior notes due on November 1, 2017
$
250,000

 
2.396
%
 
$
250,000

 
2.396
%
Fixed-rate 3.375% Senior notes due on November 1, 2019
250,000

 
3.377
%
 
250,000

 
3.377
%
Fixed-rate 4.125% Senior notes due on November 1, 2021
500,000

 
4.128
%
 
500,000

 
4.128
%
Fixed-rate 4.650% Senior notes due on November 1, 2024(1)
1,250,000

 
4.682
%
 
1,250,000

 
4.682
%
Fixed-rate 5.650% Senior notes due on November 1, 2034
250,000

 
5.670
%
 
250,000

 
5.670
%
Term loans
536,250

 
1.890
%
 
576,250

 
1.714
%
Total debt
3,036,250

 
 
 
3,076,250

 
 
Unamortized discount
(3,209
)
 
 
 
(3,312
)
 
 
Unamortized debt issuance costs
(14,474
)
 
 
 
(15,002
)
 
 
Total long-term debt
$
3,018,567

 
 
 
$
3,057,936

 
 
__________________ 
(1)
The effective interest rate disclosed above for this series of Senior Notes excludes the impact of the treasury rate lock hedge discussed below. The effective interest rate including the impact of the treasury rate lock hedge was 4.626%.
As of September 30, 2016, future principal payments for the long-term debt are summarized as follows. There are no scheduled payment for the term loans for fiscal years ending 2017 and 2018, since the Company made $148.1 million of principal prepayments as of September 30, 2016.
Fiscal year ending June 30:
Amount
(In thousands)
2017 (remaining 9 months)
$

2018
250,000

2019
30,000

2020
756,250

2021

Thereafter
2,000,000

Total payments
$
3,036,250


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Table of Contents

Senior Notes:
In November 2014, the Company issued $2.50 billion aggregate principal amount of senior, unsecured long-term notes (collectively referred to as “Senior Notes”). The Company issued the Senior Notes as part of the leveraged recapitalization plan under which the proceeds from the Senior Notes in conjunction with the proceeds from the term loans (described below) and cash on hand were used (x) to fund a special cash dividend of $16.50 per share, aggregating to approximately $2.76 billion, (y) to redeem $750.0 million of 2018 Senior Notes, including associated redemption premiums, accrued interest and other fees and expenses and (z) for other general corporate purposes, including repurchases of shares pursuant to the Company’s stock repurchase program. The interest rate specified for each series of the Senior Notes will be subject to adjustments from time to time if Moody’s Investor Service, Inc. (“Moody’s”) or Standard & Poor’s Ratings Services (“S&P”) or, under certain circumstances, a substitute rating agency selected by us as a replacement for Moody’s or S&P, as the case may be (a “Substitute Rating Agency”), downgrades (or subsequently upgrades) its rating assigned to the respective series of Senior Notes such that the adjusted rating is below investment grade. If the adjusted rating of any series of Senior Notes from Moody’s (or, if applicable, any Substitute Rating Agency) is decreased to Ba1, Ba2, Ba3 or B1 or below, the stated interest rate on such series of Senior Notes as noted above will increase by 25 bps, 50 bps, 75 bps or 100 bps, respectively (“bps” refers to Basis Points and 1% is equal to 100 bps). If the rating of any series of Senior Notes from S&P (or, if applicable, any Substitute Rating Agency) with respect to such series of Senior Notes is decreased to BB+, BB, BB- or B+ or below, the stated interest rate on such series of Senior Notes as noted above will increase by 25 bps, 50 bps, 75 bps or 100 bps, respectively. The interest rates on any series of Senior Notes will permanently cease to be subject to any adjustment (notwithstanding any subsequent decrease in the ratings by any of Moody’s, S&P and, if applicable, any Substitute Rating Agency) if such series of Senior Notes becomes rated “Baa1” (or its equivalent) or higher by Moody’s (or, if applicable, any Substitute Rating Agency) and “BBB+” (or its equivalent) or higher by S&P (or, if applicable, any Substitute Rating Agency), or one of those ratings if rated by only one of Moody’s, S&P and, if applicable, any Substitute Rating Agency, in each case with a stable or positive outlook. In October 2014, the Company entered into a series of forward contracts to lock the 10-year treasury rate (“benchmark rate”) on a portion of the Senior Notes with a notional amount of $1.00 billion in aggregate. For additional details, refer to Note 14, “Derivative Instruments and Hedging Activities.”
The original discount on the Senior Notes amounted to $4.0 million and is being amortized over the life of the debt. Interest is payable semi-annually on May 1 and November 1 of each year. The debt indenture (the “Indenture”) includes covenants that limit the Company’s ability to grant liens on its facilities and enter into sale and leaseback transactions, subject to certain allowances under which certain sale and leaseback transactions are not restricted. As of September 30, 2016, the Company was in compliance with all of its covenants under the Indenture associated with the Senior Notes.
In certain circumstances involving a change of control followed by a downgrade of the rating of a series of Senior Notes by at least two of Moody’s, S&P and Fitch Inc., unless the Company has exercised its right to redeem the Senior Notes of such series, the Company will be required to make an offer to repurchase all or, at the holder’s option, any part, of each holder’s Senior Notes of that series pursuant to the offer described below (the “Change of Control Offer”). In the Change of Control Offer, the Company will be required to offer payment in cash equal to 101% of the aggregate principal amount of Senior Notes repurchased plus accrued and unpaid interest, if any, on the Senior Notes repurchased, up to, but not including, the date of repurchase.
Based on the trading prices of the Senior Notes on the applicable dates, the fair value of the Senior Notes as of September 30, 2016 and June 30, 2016 was approximately $2.71 billion and $2.68 billion, respectively. While the Senior Notes are 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.

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Table of Contents

Credit Facility (Term Loans and Unfunded Revolving Credit Facility):
In November 2014, the Company entered into $750.0 million of five-year senior unsecured prepayable term loans and a $500.0 million unfunded revolving credit facility (collectively, the “Credit Facility”) under the Credit Agreement (the “Credit Agreement”). The interest under the Credit Facility will be payable on the borrowed amounts at the London Interbank Offered Rate (“LIBOR”) plus a spread, which is currently 125 bps, and this spread is subject to adjustment in conjunction with the Company’s credit rating downgrades or upgrades. The spread ranges from 100 bps to 175 bps based on the Company’s then effective credit rating. The Company is also obligated to pay an annual commitment fee of 15 bps on the daily undrawn balance of the revolving credit facility, which is also subject to an adjustment in conjunction with the Company’s credit rating downgrades or upgrades by Moody’s and S&P. The annual commitment fee ranges from 10 bps to 25 bps on the daily undrawn balance of the revolving credit facility, depending upon the then effective credit rating. Principal payments with respect to the term loans will be made on the last day of each calendar quarter, and any unpaid principal balance of the term loans, including accrued interest, shall be payable on November 14, 2019 (the “Maturity Date”). The Company may prepay the term loans and unfunded revolving credit facility at any time without a prepayment penalty. During the first quarter of the fiscal year ending June 30, 2017, the Company made term loan principal payments of $40.0 million.
Future principal payments for the Company’s term loans (without giving effect to $148.1 million of principal prepayments as of September 30, 2016 that shall be applied to the future scheduled quarterly payments) as of September 30, 2016, are as follows:
Fiscal Quarters Ending
 
Quarterly Payment
(In thousands)
December 31, 2016
 
$
9,375

March 31, 2017 through December 31, 2017
 
$
14,063

March 31, 2018 through September 30, 2019
 
$
18,750

December 31, 2019
 
$
487,500

The Credit Facility requires the Company to maintain an interest expense coverage ratio as described in the Credit Agreement, on a quarterly basis, covering the trailing four consecutive fiscal quarters of no less than 3.50 to 1.00. In addition, the Company is required to maintain the maximum leverage ratio as described in the Credit Agreement, on a quarterly basis, covering the trailing four consecutive fiscal quarters for the fiscal quarters as described below.
Fiscal Quarters Ending
 
Maximum Leverage Ratio
September 30, 2016
 
3.75:1.00
December 31, 2016 and March 31, 2017
 
3.50:1.00
Thereafter
 
3.00:1.00
The Company was in compliance with the financial covenants under the Credit Agreement as of September 30, 2016 and had no outstanding borrowings under the unfunded revolving credit facility.
NOTE 7 – EQUITY AND LONG-TERM INCENTIVE COMPENSATION PLANS
Equity Incentive Program
As of September 30, 2016, the Company had two plans under which the Company was able to issue equity incentive awards, such as restricted stock units and stock options, to its employees, consultants and members of its Board of Directors: the 2004 Equity Incentive Plan (the “2004 Plan”) and the 1998 Director Plan (the “Outside Director Plan”).
2004 Plan:
The 2004 Plan provides for the grant of options to purchase shares of the Company’s common stock, stock appreciation rights, restricted stock units, performance shares, performance units and deferred stock units to the Company’s employees, consultants and members of its Board of Directors. As of September 30, 2016, 4.1 million shares were available for issuance under the 2004 Plan.

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Table of Contents

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 counted against the total number of shares issuable under the 2004 Plan as follows, based on the grant date of the applicable award: (a) for any such awards granted before November 6, 2013, the awards counted against the 2004 Plan share reserve as 1.8 shares for every one share subject thereto; and (b) for any such awards granted on or after November 6, 2013, the awards count against the 2004 Plan share reserve as 2.0 shares for every one share subject thereto.
In addition, the plan administrator has the ability to grant “dividend equivalent” rights in connection with awards of restricted stock units, performance shares, performance units and deferred stock units before they are fully vested. The plan administrator, at its discretion, may grant a right to receive dividends on the aforementioned awards which may be settled in cash or Company stock at the discretion of the plan administrator subject to meeting the vesting requirement of the underlying awards.
Outside Director Plan
The Outside Director Plan only permits the issuance of stock options to the non-employee members of the Board of Directors. As of September 30, 2016, 1.7 million shares were available for grant under the Outside Director Plan.
Equity Incentive Plans - General Information
The following table summarizes the combined activity under the Company’s equity incentive plans for the indicated periods:
(In thousands)
Available
For Grant(1)
Balance as of June 30, 2016
6,778

Restricted stock units granted
(1,031
)
Restricted stock units canceled
35

Balance as of September 30, 2016
5,782

__________________ 
(1)
The number of restricted stock units reflects the application of the award multiplier as described above (1.8x or 2.0x depending on the grant date of the applicable award).
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. For restricted stock units granted without “dividend equivalent” rights, fair value is calculated using the closing price of the Company’s common stock on the grant date, adjusted to exclude the present value of dividends which are not accrued on those restricted stock units. The fair value for restricted stock units granted with “dividend equivalent” rights is determined using the closing price of the Company’s common stock on the grant date. As of September 30, 2016, the Company accrued $12.0 million of dividends payable, which included both a special cash dividend and quarterly cash dividends for the unvested restricted stock units outstanding as of the dividend record date. The fair value for purchase rights under the Company’s Employee Stock Purchase Plan is determined using a Black-Scholes valuation model.
The following table shows pre-tax stock-based compensation expense for the indicated periods: 
 
Three months ended
September 30,
(In thousands)
2016
 
2015
Stock-based compensation expense by:
 
 
 
Costs of revenues
$
1,262

 
$
1,464

Research and development
2,021

 
2,492

Selling, general and administrative
8,195

 
8,292

Total stock-based compensation expense
$
11,478

 
$
12,248

As a result of the early adoption of the accounting standard update on accounting for share-based payment awards in the three months ended September 30, 2016, the Company recorded excess tax benefits of $5.7 million in the provision for income taxes. See Note 1, “Description of Business and Basis of Presentation” for additional details.

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The following table shows stock-based compensation capitalized as inventory as of the dates indicated below: 
(In thousands)
As of
September 30, 2016
 
As of
June 30, 2016
Inventory
$
2,714

 
$
2,685

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, 2016 and restricted stock units outstanding as of September 30, 2016 and June 30, 2016:
Restricted Stock Units
Shares(1)
(In thousands)
 
Weighted-Average
Grant Date
Fair Value
Outstanding restricted stock units as of June 30, 2016(2)
1,849

 
$
56.41

Granted
515

 
$
68.74

Vested and released
(324
)
 
$
52.05

Withheld for taxes
(237
)
 
$
52.05

Forfeited
(18
)
 
$
62.65

Outstanding restricted stock units as of September 30, 2016(2)
1,785

 
$
61.28

__________________ 
(1)
Share numbers reflect actual shares subject to awarded restricted stock units. As described above, under the terms of the 2004 Plan, the number of shares subject to each award reflected in this number is multiplied by either 1.8x or 2.0x (depending on the grant date of the award) to calculate the impact of the award on the share reserve under the 2004 Plan.
(2)
Includes outstanding restricted stock units granted to senior management 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, 2016, 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 during the three months ended September 30, 2016 did not contain performance-bested vesting criteria.

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 vested 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 restricted stock units granted to the independent members of the board of directors vest on the first anniversary of the date of grant. 
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: 
 
Three months ended
September 30,
(In thousands, except for weighted-average grant date fair value)
2016
 
2015
Weighted-average grant date fair value per unit
$
68.74

 
$
50.44

Tax benefits realized by the Company in connection with vested and released restricted stock units
$
13,929

 
$
23,517

As of September 30, 2016, the unrecognized stock-based compensation expense balance related to restricted stock units was $81.7 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 total grant date fair value of vested restricted stock units was $29.2 million and $45.7 million in the three months ended September 30, 2016 and 2015, respectively. The intrinsic value of outstanding restricted stock units as of September 30, 2016 was $124.4 million.

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Cash-Based Long-Term Incentive Compensation
The Company has adopted a cash-based long-term incentive (“Cash LTI”) program for many of its employees as part of the Company’s employee compensation program. During the three months ended September 30, 2016 and 2015, the Company approved Cash LTI awards of $1.6 million and $0.3 million, respectively 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 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, 2016 and 2015, the Company recognized $12.2 million and $9.9 million, respectively, in compensation expense under the Cash LTI Plan. As of September 30, 2016, the unrecognized compensation balance (excluding the impact of estimated forfeitures) related to the Cash LTI Plan was $75.4 million.
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).
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,
 
2016
 
2015
Stock purchase plan:
 
 
 
Expected stock price volatility
20.6
%
 
23.9
%
Risk-free interest rate
0.4
%
 
0.1
%
Dividend yield
2.9
%
 
3.7
%
Expected life (in years)
0.5

 
0.5

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,
2016
 
2015
Tax benefits realized by the Company in connection with the disqualifying dispositions of shares purchased under the ESPP
$
704

 
$
380

Weighted-average fair value per share based on Black-Scholes model
$
14.06

 
$
11.34

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, 2016, a total of 1.4 million shares were reserved and available for issuance under the ESPP.

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Quarterly cash dividends
On August 4, 2016, the Company’s Board of Directors declared a regular quarterly cash dividend of $0.52 per share on the outstanding shares of the Company’s common stock, which was paid on September 1, 2016 to the stockholders of record as of the close of business on August 15, 2016. The total amount of regular quarterly cash dividends paid by the Company during each of the three months ended September 30, 2016 and 2015 was $81.6 million. The amount of accrued dividends payable for regular quarterly cash dividends on unvested restricted stock units with dividend equivalent rights was $2.7 million as of September 30, 2016 and June 30, 2016. These amounts will be paid upon vesting of the underlying unvested restricted stock units.
Special cash dividend
On November 19, 2014, the Company’s Board of Directors declared a special cash dividend of $16.50 per share on our outstanding common stock, which was paid on December 9, 2014 to the stockholders of record as of the close of business on December 1, 2014. The declaration and payment of the special cash dividend was part of the Company’s leveraged recapitalization transaction under which the special cash dividend was financed through a combination of existing cash and proceeds from the debt financing disclosed in Note 6, “Debt” that was completed during the three months ended December 31, 2014. As of the declaration date, the total amount of the special cash dividend accrued by the Company was approximately $2.76 billion, substantially all of which was paid out during the three months ended December 31, 2014, except for the aggregate special cash dividend of $43.0 million that was accrued for the unvested restricted stock units. As of September 30, 2016 and June 30, 2016, the Company had a total of$9.3 million and $16.9 million, respectively, of accrued dividends payable for the special cash dividend with respect to outstanding unvested restricted stock units, which will be paid when such underlying unvested restricted stock units vest. The Company paid a special cash dividend with respect to vested restricted stock units during the three months ended September 30, 2016 and 2015 of $7.7 million and $20.0 million, respectively. Other than the special cash dividend declared during the three months ended December 31, 2014, the Company historically has not declared any special cash dividends.
NOTE 8 – STOCK REPURCHASE PROGRAM
The Company’s Board of Directors has authorized a program for the Company to repurchase shares of the Company’s common stock. 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 were made 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, 2016, an aggregate of approximately 5.9 million shares were available for repurchase under the Company’s repurchase program.
Share repurchases for the indicated periods (based on the trade date of the applicable repurchase) were as follows:
 
Three months ended
September 30,
(In thousands)
2016
 
2015
Number of shares of common stock repurchased

 
2,877

Total cost of repurchases
$

 
$
146,234

As of September 30, 2015, the Company had repurchased 197,339 shares for $9.6 million, which repurchases had not settled prior to September 30, 2015. The amount was recorded as a component of other current liabilities for the period presented.
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 restricted stock units and stock options had been issued. The dilutive effect of outstanding restricted stock units and options 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.

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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,
2016
 
2015
Numerator:
 
 
 
Net income
$
178,101

 
$
104,897

Denominator:
 
 
 
Weighted-average shares-basic, excluding unvested restricted stock units
156,129

 
156,820

Effect of dilutive restricted stock units and options(1)
892

 
1,164

Weighted-average shares-diluted
157,021

 
157,984

Basic net income per share
$
1.14

 
$
0.67

Diluted net income per share
$
1.13

 
$
0.66

Anti-dilutive securities excluded from the computation of diluted net income per share
45

 
307

__________________
(1) There were no outstanding stock options as of September 30, 2016.
NOTE 10 – INCOME TAXES
The following table provides details of income taxes:

Three months ended
September 30,
(Dollar amounts in thousands)
2016
 
2015
Income before income taxes
$
222,220

 
$
134,299

Provision for income taxes
$
44,119

 
$
29,402

Effective tax rate
19.9
%
 
21.9
%
Tax expense was lower as a percentage of income before taxes during the three months ended September 30, 2016 compared to the three months ended September 30, 2015 primarily due to the impact of the following items:
Tax expense decreased by $5.7 million during the three months ended September 30, 2016 related to the recognition of excess tax benefits in the provision for income taxes as a result of early adoption of the accounting standard update on accounting for share-based payments. See Note 1, “Description of Business and Basis of Presentation” for additional details;
Tax expense decreased by $2.6 million during the three months ended September 30, 2016 when the Protecting Americans from Tax Hikes (PATH) Act of 2015 permanently reinstated the research credit on December 18, 2015 retroactively to January 1, 2015. Tax expense was not reduced by the research credit during the three months ended September 30, 2015 as the research credit had expired on December 31, 2014;
Tax expense decreased by $5.7 million during the three months ended September 30, 2016 related to a non-taxable increase in the value of the assets held within the Company's Executive Deferred Savings Plan; partially offset by
Tax expense decreased by $8.2 million during the three months ended September 30, 2015 related to a decrease in the Company’s unrecognized tax benefits from the expiration of the statute of limitations.
In the normal course of business, the Company is subject to examination by tax authorities throughout the world. The Company is subject to United States federal income tax examination for all years beginning from the fiscal year ended June 30, 2014. The Company is subject to state income tax examinations for all years beginning from the fiscal year ended June 30, 2012. 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, 2012. It is possible that certain examinations may be concluded in the next twelve months. The Company believes that it may recognize up to $3.9 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.

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NOTE 11 – LITIGATION AND OTHER LEGAL MATTERS
Litigation Related to Proposed Merger with Lam Research.
The California Class Actions. In connection with the October 21, 2015 announcement of the Merger transaction, four purported KLA-Tencor stockholders filed putative class actions on behalf of all KLA-Tencor stockholders. Three actions were filed in the California Superior Court for Santa Clara County and are captioned, Hedgecock v. KLA-Tencor Corp., et al., Case No. 115CV287329, Karr v. KLA-Tencor Corporation, et al., Case No. 115CV287331, (both filed on October 28, 2015) and Spoleto Corp. v. Wallace, et al., Case No. 115CV289552 (filed on December 29, 2015) (collectively, the “California Class Actions”). Plaintiffs in the Hedgecock and Karr actions filed amended complaints on December 21, 2015. The California Class Actions all name KLA-Tencor, the members of the KLA-Tencor Board, Lam Research, Merger Sub 1, and Merger Sub 2 (together with Merger Sub 1 and Lam Research, the “Lam Group”) as defendants. The California Class Actions allege that the members of the KLA-Tencor Board breached their fiduciary duties by, among other things, causing KLA-Tencor to agree to a merger transaction with the Lam Group at an unfair price and pursuant to an unfair process, and by making disclosures concerning the transaction that are materially misleading. Plaintiffs allege that the Lam Group aided and abetted such breaches. Plaintiffs seek to enjoin or rescind KLA-Tencor’s transaction with the Lam Group, as applicable, as well as an award of damages and attorneys’ fees, in addition to other relief.
The Delaware Chancery Court Class Action. One putative class action was filed on November 10, 2015, in the Court of Chancery in the State of Delaware and is captioned, Rooney v. Wallace, et al., Case No. 11700. On December 23, 2015, plaintiff Rooney filed an amended complaint. The Rooney action was filed against the members of the KLA-Tencor Board and similar to the California Class Actions alleges that the members of the KLA-Tencor Board breached their fiduciary duties by, among other things, causing KLA-Tencor to agree to a merger transaction with Lam Research at an unfair price and pursuant to an unfair process, and by making disclosures concerning the transaction that are materially misleading. Plaintiff Rooney seeks to enjoin or rescind KLA-Tencor’s transaction with Lam Research, as applicable, as well as an award of attorneys’ fees, in addition to other relief.
Agreement in Principle to Resolve Merger-Related Litigation. On or about December 29, 2015, plaintiffs in all four actions agreed to coordinate and proceed in the California Superior Court. On February 5, 2016, an agreement in principle was reached with the plaintiffs in the Rooney Action, Hedgecock Action, and Spoleto Action to settle those actions. Pursuant to the agreement in principle, as set forth in a signed memorandum of understanding, the parties agreed to resolve disputed legal claims and KLA-Tencor and Lam agreed to make certain supplemental disclosures regarding the proposed Merger, as set forth in the Form 8-K filed by KLA-Tencor on February 5, 2016. None of the defendants in these actions has admitted wrongdoing of any kind, including that there were any inadequacies in any disclosure, any breach of any fiduciary duty, or aiding or abetting any of the foregoing. On February 17, 2016, the California Superior Court dismissed the Karr action pursuant to a stipulation by the parties.
In light of the termination of the Merger Agreement, KLA-Tencor has discussed dismissal of the Rooney, Hedgecock, and Spoleto actions with the plaintiffs.
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.
NOTE 12 – COMMITMENTS AND CONTINGENCIES
Employee Retention Commitments. In connection with the retention program adopted at the time the Company entered into the Merger Agreement with Lam Research, the Company has an estimated $24.1 million of employee-related retention commitments as of September 30, 2016 which are expected to be paid during the quarter ended December 31, 2017.

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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 and proceeds from sales of LCs for the indicated periods:
 
Three months ended
September 30,
(In thousands)
2016
 
2015
Receivables sold under factoring agreements
$
56,733

 
$
33,844

Proceeds from sales of LCs
$
3,408

 
$

Factoring and LC fees for the sale of certain trade receivables were recorded in other expense (income), 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 $2.4 million and $2.1 million for the three months ended September 30, 2016 and 2015, respectively.
The following is a schedule of expected operating lease payments:
Fiscal year ending June 30,
Amount
(In thousands)
2017 (remaining 9 months)
$
6,312

2018
5,719

2019
2,893

2020
2,068

2021
544

2022 and thereafter
3,343

Total minimum lease payments
$
20,879

Purchase Commitments. KLA-Tencor maintains commitments to purchase inventory from its suppliers as well as goods and services in the ordinary course of business. 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 estimate of its significant purchase commitments is approximately $340.6 million as of September 30, 2016 which 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, 2016, the Company had committed $121.0 million for 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 regular 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)
2016
 
2015
Beginning balance
$
34,773

 
$
36,413

Accruals for warranties issued during the period
10,902

 
9,039

Changes in liability related to pre-existing warranties
(445
)
 
(183
)
Settlements made during the period
(8,263
)
 
(9,377
)
Ending balance
$
36,967

 
$
35,892

The Company maintains guarantee arrangements available through various financial institutions for up to $22.5 million, of which $19.2 million had been issued as of September 30, 2016, 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 commitments on pricing, tool reliability, spare parts stocking levels, response time and other commitments. 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 significant 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 — RESTRUCTURING CHARGES
The Company has in recent years undertaken a number of cost reduction activities, including workforce reductions, in an effort to lower its ongoing expense run rate. The program in the United States is accounted for in accordance with the authoritative guidance related to compensation for non-retirement post-employment benefits, whereas the programs in the Company’s international locations are accounted for in accordance with the authoritative guidance for contingencies.

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During the fourth quarter of fiscal year ended 2015, the Company implemented a plan to reduce its global employee workforce to streamline the organization and business processes in response to changing customer requirements in the industry. The goals of this reduction were to enable continued innovation, direct the Company’s resources toward its best opportunities and lower its ongoing expense run rate. The Company substantially completed its global workforce reduction during the fiscal year ended June 30, 2016. Restructuring charges for the three months ended September 30, 2015 were $7.1 million, of which $2.8 million was recorded to costs of revenues, $1.0 million to research and development expense and $3.3 million to selling, general and administrative expense lines in the condensed consolidated statements of operations. Restructuring charges for the three months ended September 30, 2016 were immaterial.
The following table shows the activity which is primarily related to accrued severance and benefits for the three months ended September 30, 2016 and 2015:
 
Three months ended
September 30,
(In thousands)
2016
 
2015
Beginning balance
$
587

 
$
24,887

Restructuring costs

 
7,066

Adjustments
(26
)
 
373

Cash payments
(274
)
 
(19,265
)
Ending balance
$
287

 
$
13,061

The remaining accrual for severance and benefits as of September 30, 2016 is expected to be substantially paid out by the end of the Company’s quarter ending December 31, 2016.
NOTE 14 – 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 recognized in other expense (income), net in the condensed consolidated statements 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.
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, the New Taiwan dollar 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 other expense (income), 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.

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In October 2014, in anticipation of the issuance of the Senior Notes, the Company entered into a series of forward contracts (“Rate Lock Agreements”) to lock the benchmark rate on a portion of the Senior Notes. The objective of the Rate Lock Agreements was to hedge the risk associated with the variability in interest rates due to the changes in the benchmark rate leading up to the closing of the intended financing, on the notional amount being hedged. The Rate Lock Agreements had a notional amount of $1.00 billion in aggregate which matured in the second quarter of the fiscal year ended June 30, 2015. The Company designated each of the Rate Lock Agreements as a qualifying hedging instrument and accounted for as a cash flow hedge, under which the effective portion of the gain or loss on the close out of the Rate Lock Agreements was initially recognized in accumulated other comprehensive income (loss) as a reduction of total stockholders’ equity and subsequently amortized into earnings as a component of interest expense over the term of the underlying debt. The ineffective portion, if any, was recognized in earnings immediately. The Rate Lock Agreements were terminated on the date of pricing of the $1.25 billion of 4.650% Senior Notes due in 2024 and the Company recorded the fair value of $7.5 million as a gain within accumulated other comprehensive income (loss) as of December 31, 2014. The Company recognized $0.2 million for each of the three months ended September 30, 2016 and 2015 for the amortization of the gain recognized in accumulated other comprehensive income (loss), which amount reduced the interest expense. As of September 30, 2016, the unamortized portion of the fair value of the forward contracts for the rate lock agreements was $6.1 million.
Derivatives in Cash Flow Hedging Relationships: Foreign Exchange and Interest Rate 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
2016
 
2015
Derivatives Designated as Hedging Instruments
 
 
 
 
Losses in accumulated OCI on derivatives (effective portion)
Accumulated OCI
$
(1,838
)
 
$
(1,861
)
Gains (losses) reclassified from accumulated OCI into income (effective portion):
Revenues
$
(1,481
)
 
$
685

 
Costs of revenues
(87
)
 
(472
)
 
Interest expense
189

 
189

 
Net gains (losses) reclassified from accumulated OCI into income (effective portion)
$
(1,379
)
 
$
402

Losses recognized in income on derivatives (ineffective portion and amount excluded from effectiveness testing)
Other expense (income), net
$
(11
)
 
$
(126
)
Derivatives Not Designated as Hedging Instruments
 
 
 
 
Losses recognized in income
Other expense (income), net
$
(164
)
 
$
(6,382
)
The U.S. dollar equivalent of all outstanding notional amounts of hedge contracts, with maximum remaining maturities of approximately seven months as of September 30, 2016 and June 30, 2016 was as follows:
(In thousands)
As of
September 30, 2016
 
As of
June 30, 2016
Cash flow hedge contracts
 
 
 
Purchase
$
8,058

 
$
7,591

Sell
$
98,256

 
$
91,793

Other foreign currency hedge contracts
 
 
 
Purchase
$
113,793

 
$
122,275

Sell
$
114,506

 
$
115,087


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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, 2016
 
As of
June 30, 2016
 
Balance Sheet Location
 
As of
September 30, 2016
 
As of
June 30, 2016
(In thousands)
 
Fair Value
 
 
Fair Value
Derivatives designated as hedging instruments
 
 
 
 
 
 
 
 
 
 
 
Foreign exchange contracts
Other current assets
 
$
571

 
$
342

 
Other current liabilities
 
$
3,104

 
$
4,736

Total derivatives designated as hedging instruments
 
 
$
571

 
$
342

 
 
 
$
3,104

 
$
4,736

Derivatives not designated as hedging instruments
 
 
 
 
 
 
 
 
 
 
 
Foreign exchange contracts
Other current assets
 
$
121

 
$
753

 
Other current liabilities
 
$
4,533

 
$
6,911

Total derivatives not designated as hedging instruments
 
 
$
121

 
$
753

 
 
 
$
4,533

 
$
6,911

Total derivatives
 
 
$
692

 
$
1,095

 
 
 
$
7,637

 
$
11,647

The following table provides the balances and changes in accumulated OCI, before taxes, related to derivative instruments for the indicated periods:
 
Three months ended
September 30,
(In thousands)
2016
 
2015
Beginning balance
$
1,210

 
$
7,110

Amount reclassified to income
1,379

 
(402
)
Net change in unrealized gains or losses
(1,838
)
 
(1,861
)
Ending balance
$
751

 
$
4,847

Offsetting of Derivative Assets and Liabilities
KLA-Tencor presents derivatives at gross fair values in the Condensed Consolidated Balance Sheets. 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, 2016 and June 30, 2016, information related to the offsetting arrangements was as follows (in thousands):
As of September 30, 2016
 
 
 
 
 
Gross Amounts of Derivatives Not Offset in the Condensed Consolidated Balance Sheets
 
 
Description
 
Gross Amounts of Derivatives
 
Gross Amounts of Derivatives Offset in the Condensed Consolidated Balance Sheets
 
Net Amount of Derivatives Presented in the Condensed Consolidated Balance Sheets
 
Financial Instruments
 
Cash Collateral Received
 
Net Amount
Derivatives - Assets
 
$
692

 
$

 
$
692

 
$
(172
)
 
$

 
$
520

Derivatives - Liabilities
 
$
(7,637
)
 
$

 
$
(7,637
)
 
$
172

 
$

 
$
(7,465
)
As of June 30, 2016
 
 
 
 
 
Gross Amounts of Derivatives Not Offset in the Condensed Consolidated Balance Sheets
 
 
Description
 
Gross Amounts of Derivatives
 
Gross Amounts of Derivatives Offset in the Condensed Consolidated Balance Sheets
 
Net Amount of Derivatives Presented in the Condensed Consolidated Balance Sheets
 
Financial Instruments
 
Cash Collateral Received
 
Net Amount
Derivatives - Assets
 
$
1,095

 
$

 
$
1,095

 
$
(843
)
 
$

 
$
252

Derivatives - Liabilities
 
$
(11,647
)
 
$

 
$
(11,647
)
 
$
843

 
$

 
$
(10,804
)

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NOTE 15 – RELATED PARTY TRANSACTIONS
During the three months ended September 30, 2016 and 2015, 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 a board member, including Citrix Systems, Inc., Keysight Technologies, Inc., MetLife Insurance K.K. and NetApp, Inc. 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)
2016
 
2015
Total purchases
$
357

 
$
404

The receivable and payable balances from these parties were immaterial at September 30, 2016 and June 30, 2016. Management believes that such transactions are at arm’s length and on similar terms as would have been obtained from unaffiliated third parties.
NOTE 16 – 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 its 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 China, Germany, Israel and Singapore and sales, marketing and service offices in Japan, the rest of the Asia Pacific region and Western Europe. For geographical revenue reporting, revenues are attributed to the geographic location in which the customer is located. Long-lived assets consist of land, property and equipment, net 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)
2016
 
2015
Revenues:
 
 
 
 
 
 
 
Taiwan
$
273,692

 
35
%
 
$
254,047

 
40
%
Korea
135,089

 
18
%
 
73,433

 
11
%
Japan
104,784

 
14
%
 
71,618

 
11
%
North America
87,266

 
12
%
 
109,208

 
17
%
China
85,689

 
12
%
 
75,352

 
12
%
Europe & Israel
34,848

 
5
%
 
39,846

 
6
%
Rest of Asia
29,305

 
4
%
 
19,140

 
3
%
Total
$
750,673

 
100
%
 
$
642,644

 
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)
2016
 
2015
Revenues:
 
 
 
 
 
 
 
Wafer Inspection
$
359,009

 
48
%
 
$
227,783

 
35
%
Patterning
172,614

 
23
%
 
198,085

 
31
%
Global Service and Support(1)
203,130

 
27
%
 
199,871

 
31
%
Other
15,920

 
2
%
 
16,905

 
3
%
Total
$
750,673

 
100
%
 
$
642,644

 
100
%
__________________ 
(1) The Global Service and Support revenues includes service revenues as presented in the condensed consolidated statements of operations as well as certain product revenues, primarily revenues from the Company’s K-T Certified business.
In the three months ended September 30, 2016, three customers accounted for approximately 29%, 13%, and 11% of total revenues. In the three months ended September 30, 2015, one customer accounted for approximately 23% of total revenues. Four customers and two customers on an individual basis accounted for greater than 10% of net accounts receivables as of September 30, 2016 and June 30, 2016, respectively.
Long-lived assets by geographic region as of the dates indicated below were as follows: 
(In thousands)
As of
September 30, 2016
 
As of
June 30, 2016
Long-lived assets:
 
 
 
United States
$
176,342

 
$
182,597

Singapore
41,508

 
41,658

Israel
31,079

 
30,844

Europe
13,182

 
13,347

Rest of Asia
10,240

 
9,568

Total
$
272,351

 
$
278,014

NOTE 17 – SUBSEQUENT EVENT

On October 5, 2016, the Company and Lam Research entered into an agreement terminating the Merger Agreement. The termination agreement provides that no termination fees will be payable by either party.


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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, including profitability; orders for our products and capital equipment generally; sales of semiconductors; the investments by our customers in advanced technologies and new materials; 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; our future product shipments and 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 effective income tax rate; our recognition of tax benefits; 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, cash generated from operations and unfunded revolving line of credit under a Credit Agreement (the “Credit Agreement”) to meet our operating and working capital requirements, including debt service and payment thereof; future dividends, and stock repurchases; our compliance with the financial covenants under the Credit Agreement; the expected timing of the completion of our global employee workforce reduction; the additional charges that we may incur in connection with our global employee workforce reduction; the expected cost savings that we expect to recognize as a result of such workforce reduction; the adoption of new accounting pronouncements; and our repayment of our outstanding indebtedness.
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, 2016, filed with the Securities and Exchange Commission on August 5, 2016. 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 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 LED and data storage industries, as well as general materials research.

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Table of Contents

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, detect, analyze and resolve critical product defects that arise in that environment in order to control nanometric level manufacturing processes. 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, particularly in the foundry and logic markets, which have higher levels of process control adoption than the memory market.
As we are a supplier to the global semiconductor and semiconductor-related industries, 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. We are also subject to the cyclical capital spending that has historically characterized the semiconductor and semiconductor-related industries. The timing, length, intensity and volatility of the capacity-oriented capital spending cycles of our customers are unpredictable.
The semiconductor industry has also been characterized by constant technological innovation. The growing use of increasingly sophisticated semiconductor devices in mobile consumer products has caused many of our customers to invest in additional semiconductor manufacturing capabilities and capacity. On the other hand, higher design costs for the most advanced ICs could economically constrain leading-edge manufacturing technology customers to focus their resources on only the large technologicall