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, 2017
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, a smaller reporting company or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer x
 
 
 
Accelerated filer ¨
Non-accelerated filer ¨
 
(Do not check if a smaller reporting company)
 
Smaller reporting company ¨
 
 
 
 
Emerging growth company ¨
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨
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 13, 2017, there were 156,707,903 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,
2017
 
June 30,
2017
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
1,320,697

 
$
1,153,051

Marketable securities
1,735,787

 
1,863,689

Accounts receivable, net
666,738

 
571,117

Inventories
762,401

 
732,988

Other current assets
73,873

 
71,221

Total current assets
4,559,496

 
4,392,066

Land, property and equipment, net
279,872

 
283,975

Goodwill
349,678

 
349,526

Deferred income taxes
282,302

 
291,967

Purchased intangibles, net
17,763

 
18,963

Other non-current assets
201,287

 
195,676

Total assets
$
5,690,398

 
$
5,532,173

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
138,657

 
$
147,380

Deferred system profit
209,267

 
180,861

Unearned revenue
61,484

 
65,507

Current portion of long-term debt
249,996

 
249,983

Other current liabilities
806,636

 
649,431

Total current liabilities
1,466,040

 
1,293,162

Non-current liabilities:
 
 
 
Long-term debt
2,524,842

 
2,680,474

Unearned revenue
60,456

 
59,713

Other non-current liabilities
175,104

 
172,407

Total liabilities
4,226,442

 
4,205,756

Commitments and contingencies (Note 12 and Note 13)

 

Stockholders’ equity:
 
 
 
Common stock and capital in excess of par value
518,223

 
529,283

Retained earnings
996,514

 
848,457

Accumulated other comprehensive income (loss)
(50,781
)
 
(51,323
)
Total stockholders’ equity
1,463,956

 
1,326,417

Total liabilities and stockholders’ equity
$
5,690,398

 
$
5,532,173

 
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)
2017
 
2016
Revenues:
 
 
 
Product
$
760,787

 
$
561,753

Service
208,794

 
188,920

Total revenues
969,581

 
750,673

Costs and expenses:
 
 
 
Costs of revenues
353,449

 
277,836

Research and development
146,732

 
129,233

Selling, general and administrative
107,713

 
94,388

Interest expense
30,576

 
30,732

Other expense (income), net
(5,041
)
 
(3,736
)
Income before income taxes
336,152

 
222,220

Provision for income taxes
55,216

 
44,119

Net income
$
280,936

 
$
178,101

Net income per share:
 
 
 
Basic
$
1.79

 
$
1.14

Diluted
$
1.78

 
$
1.13

Cash dividends declared per share
$
0.59

 
$
0.52

Weighted-average number of shares:
 
 
 
Basic
156,826

 
156,129

Diluted
157,846

 
157,021


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)
2017
 
2016
Net income
$
280,936

 
$
178,101

Other comprehensive income (loss):
 
 
 
Currency translation adjustments:
 
 
 
Change in currency translation adjustments
1,558

 
3,924

Change in income tax benefit or expense
(503
)
 
782

Net change related to currency translation adjustments
1,055

 
4,706

Cash flow hedges:
 
 
 
Change in net unrealized gains or losses
444

 
(1,838
)
Reclassification adjustments for net gains or losses included in net income
(2,118
)
 
1,379

Change in income tax benefit or expense
598

 
165

Net change related to cash flow hedges
(1,076
)
 
(294
)
Net change related to unrecognized losses and transition obligations in connection with defined benefit plans
(34
)
 
245

Available-for-sale securities:
 
 
 
Change in net unrealized gains or losses
667

 
(2,877
)
Reclassification adjustments for net gains or losses included in net income
(6
)
 
(204
)
Change in income tax benefit or expense
(64
)
 
476

Net change related to available-for-sale securities
597

 
(2,605
)
Other comprehensive income (loss)
542

 
2,052

Total comprehensive income
$
281,478

 
$
180,153


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)
2017
 
2016
Cash flows from operating activities:
 
 
 
Net income
$
280,936

 
$
178,101

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation and amortization
15,282

 
14,422

Asset impairment charges
1,000

 
358

Non-cash stock-based compensation expense
14,031

 
11,478

Net gain on sales of marketable securities and other investments
(20
)
 
(204
)
Changes in assets and liabilities, net of business acquisition:
 
 
 
Accounts receivable, net
(95,621
)
 
(38,241
)
Inventories
(20,194
)
 
1,187

Other assets
(2,235
)
 
19,477

Accounts payable
(8,877
)
 
(1,547
)
Deferred system profit
28,406

 
11,089

Other liabilities
160,921

 
(26,343
)
Net cash provided by operating activities
373,629

 
169,777

Cash flows from investing activities:
 
 
 
Acquisition of non-marketable securities

 
(1,470
)
Business acquisition
(710
)
 

Capital expenditures, net
(15,756
)
 
(9,883
)
Purchases of available-for-sale securities
(191,744
)
 
(457,512
)
Proceeds from sale of available-for-sale securities
50,095

 
111,106

Proceeds from maturity of available-for-sale securities
268,665

 
197,100

Purchases of trading securities
(11,876
)
 
(52,465
)
Proceeds from sale of trading securities
14,320

 
45,301

Net cash provided by (used in) investing activities
112,994

 
(167,823
)
Cash flows from financing activities:
 
 
 
Repayment of debt
(156,250
)
 
(40,000
)
Tax withholding payments related to vested and released restricted stock units
(23,628
)
 
(17,376
)
Common stock repurchases
(39,927
)
 

Payment of dividends to stockholders
(100,327
)
 
(89,313
)
Net cash used in financing activities
(320,132
)
 
(146,689
)
Effect of exchange rate changes on cash and cash equivalents
1,155

 
2,572

Net increase (decrease) in cash and cash equivalents
167,646

 
(142,163
)
Cash and cash equivalents at beginning of period
1,153,051

 
1,108,488

Cash and cash equivalents at end of period
$
1,320,697

 
$
966,325

Supplemental cash flow disclosures:
 
 
 
Income taxes paid, net
$
23,858

 
$
39,411

Interest paid
$
3,005

 
$
3,243

Non-cash activities:
 
 
 
Purchase of land, property and equipment, net - investing activities
$
4,734

 
$
1,974

Business acquisition holdback amounts - investing activities
$
4,780

 
$

Unsettled common stock repurchase - financing activities
$
848

 
$

Dividends payable - financing activities
$
7,011

 
$
12,045

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

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

NOTE 1 – BASIS OF PRESENTATION
Basis of Presentation. The condensed consolidated financial statements have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations. In the opinion of management, the unaudited interim financial statements reflect all adjustments (consisting only of normal, recurring adjustments) necessary for a fair statement of the financial position, results of operations, 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, 2017, filed with the SEC on August 4, 2017.
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, 2017 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, 2018.
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.
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.

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In many instances, products are sold in stand-alone arrangements. Services are sold separately through renewals of annual maintenance contracts. The Company 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.
The Company enters into volume purchase agreements with some of its customers. The Company accrues the estimated credits earned by its customers for such incentives, and in situations when the credit levels vary depending upon sales volume, the Company updates its accrual based on the amount that the Company estimates will be purchased pursuant to the volume purchase agreements. Accruals for customer credits are recorded as an offset to revenue or deferred revenue.
 Spare parts revenue is recognized when the parts have been shipped, risk of loss has passed to the customer and collection of the resulting receivable is reasonably assured.
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 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 Company adopted this update beginning in the first quarter of its fiscal year ending June 30, 2018 on a prospective basis and there was no impact of adoption on its condensed consolidated financial statements.
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. The new standard may be applied retrospectively to each prior period presented (“full retrospective transition method”) or retrospectively with the cumulative effect recognized as of the date of adoption (“modified retrospective transition method”). The FASB has also issued several amendments to the standard since its initial issuance. The Company intends to adopt the new standard in the first quarter of its fiscal year ending June 30, 2019 and elected a modified retrospective transition method to be applied to completed and incomplete contracts as of the adoption date.
To address the significant implementation requirements of the accounting standard update, the Company has established a revenue project steering committee and cross-functional implementation team for the implementation of the standard, including a review of all significant revenue arrangements to identify any differences in the timing, measurement, presentation of revenue recognition including new disclosure requirements.
The Company has completed its preliminary assessment of the potential impact that the implementation of this new standard will have on its consolidated financial statements and believes the most significant impact may include the following:

The Company will account for the standard 12-month warranty for a majority of its products that is not separately paid for by the customers as a performance obligation since the Company provides for necessary repairs as well as preventive maintenance services for such products. The estimated fair value of the service will be deferred and recognized ratably as revenue over the warranty period.

The Company will generally recognize revenue for its products at a point of time based on judgment of whether or not the Company has satisfied its performance obligation by transferring control of the product to the customer. In evaluating whether or not control has been transferred to the customer, the Company will consider whether or not certain indicators have been met. Not all of the indicators need to be met for the Company to conclude that control has transferred to the customer. The Company will be required to use significant judgment to evaluate whether or not the factors indicate that the customer has obtained control of the product and the following factors will be considered in evaluating whether or not control has transferred to the customer: the Company has a present right to payment; the customer has legal title; the customer has physical possession; the customer has significant risk and rewards of ownership; and the customer has accepted the product, or whether customer acceptance is considered a formality based on history of acceptance of similar products.

The Company will recognize revenue for software licenses at the time of delivery since the VSOE requirement for undelivered element such as post-contract support is eliminated and companies are allowed to use established or best estimate selling price for the undelivered element to allocate and defer the revenue. As a result, the Company will recognize as revenue a portion of the sales price upon delivery of the software, compared to the current practice of recognizing the entire sales price ratably over the term of the service contract due to the lack of VSOE.
The Company will continue to assess the impact of the new standard, including potential changes to the accounting policies, business processes, systems and internal controls over financial reporting and its preliminary assessment of the impact is subject to change.

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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 June 30, 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.
In October 2016, the FASB issued an accounting standard update to recognize the income tax consequences of intra-entity transfers of assets other than inventory when they occur. This eliminates the exception to postpone recognition until the asset has been sold to an outside party. This standard is effective for the Company beginning in the first quarter of its fiscal year ending June 30, 2019, and early adoption is permitted. It is required to be applied on a modified retrospective basis through a cumulative-effect adjustment to the balance sheet as of the beginning of the fiscal year of adoption. The Company is currently evaluating the impact of this accounting standard update on its condensed consolidated financial statements.
In January 2017, the FASB issued an accounting standard update to simplify the subsequent measurement of goodwill by removing the second step of the two-step impairment test, which requires an entity to determine the fair value of assets and liabilities similar to what is required in a purchase price allocation. Under the update, goodwill impairment will be calculated as the amount by which a reporting unit’s carrying value exceeds its fair value. This standard is effective for the Company beginning in the first quarter of its fiscal year ending June 30, 2021 and requires a prospective approach to adoption. Early adoption is permitted. The Company is currently evaluating the impact of this accounting standard update on its condensed consolidated financial statements.
In January 2017, the FASB issued an accounting standard on clarifying the definition of a business, with the objective of adding guidance to assist entities with evaluating whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses. The standard is effective for the Company for its fiscal year ending June 30, 2019.  The Company is currently evaluating the impact of this accounting standard update on its consolidated financial statements. 
In March 2017, the FASB issued an accounting standard update that changes the income statement classification of net periodic benefit cost related to defined benefit pension and/or other postretirement benefit plans. Under the update, employers will present the service cost component of net periodic benefit cost in the same statement of operations line item(s) as other employee compensation costs arising from services rendered during the period. Only the service cost component will be eligible for capitalization in assets. Employers will present the other components of the net periodic benefit costs separately from the line item(s) that includes the service cost and outside of any subtotal of operating income, if one is presented. The standard is effective for the Company beginning in the first quarter of its fiscal year ending June 30, 2019 and early adoption is permitted. It is required to be applied retrospectively, except for the provision regarding capitalization in assets which is required to be applied prospectively. The Company is currently evaluating the impact of this accounting standard update on its condensed consolidated financial statements.
In May 2017, the FASB issued an accounting standard update regarding stock compensation that provides guidance about which changes to the terms and conditions of a share-based payment award require an entity to apply modification accounting in order to reduce diversity in practice and reduce complexity.   The update is effective for the Company beginning in the first quarter of the Company’s fiscal year ending June 30, 2019 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 consolidated financial statements.

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In August 2017, the FASB issued an accounting standard update to hedge accounting to better align the Company’s risk management activities by refining financial and non-financial hedging strategy eligibilities. This update also amends the presentation and disclosure requirements to increase transparency to better understand an entity’s risk exposures and how hedging strategies are used to manage those exposures. This standard update is effective for the Company beginning in the first quarter of its fiscal year ending June 30, 2020, and early adoption is permitted. 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 its debt and 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 assets and 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.
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, 2017, because they were valued using quoted market prices, broker/dealer quotes or alternative pricing sources with observable levels of price transparency. As of September 30, 2017, the types of instruments valued based on quoted market prices in active markets included money market funds, U.S. Treasury securities, and certain U.S. Government agency securities. Such instruments are generally classified within Level 1 of the fair value hierarchy.
As of September 30, 2017, the types of instruments valued based on other observable inputs included corporate debt securities and sovereign securities. The market inputs used to value these instruments generally consist of market yields, reported trades and broker/dealer quotes. Such instruments are generally classified within Level 2 of the fair value hierarchy.
The principal market in which the Company executes its foreign currency contracts is the institutional market in an over-the-counter environment with a relatively high level of price transparency. The market participants 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.

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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 September 30, 2017 (In thousands)
Total
 
Quoted Prices in
Active Markets
for Identical
Assets (Level 1)
 
Significant Other
Observable Inputs
(Level 2)
Assets
 
 
 
 
 
Cash equivalents:
 
 
 
 
 
Money market funds and other
$
923,316

 
$
923,316

 
$

Marketable securities:
 
 
 
 
 
Corporate debt securities
965,735

 

 
965,735

Sovereign securities
14,531

 

 
14,531

U.S. Government agency securities
362,196

 
362,196

 

U.S. Treasury securities
381,361

 
381,361

 

Total cash equivalents and marketable securities(1)
2,647,139

 
1,666,873

 
980,266

Other current assets:
 
 
 
 
 
Derivative assets
4,043

 

 
4,043

Other non-current assets:
 
 
 
 
 
Executive Deferred Savings Plan
187,785

 
140,307

 
47,478

Total financial assets(1)
$
2,838,967

 
$
1,807,180

 
$
1,031,787

Liabilities
 
 
 
 
 
Other current liabilities:
 
 
 
 
 
Derivative liabilities
$
(1,235
)
 
$

 
$
(1,235
)
Total financial liabilities
$
(1,235
)
 
$

 
$
(1,235
)
________________
(1) Excludes cash of $360.0 million held in operating accounts and time deposits of $49.3 million as of September 30, 2017.


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Table of Contents

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, 2017 (In thousands)
Total
 
Quoted Prices in
Active Markets
for Identical
Assets (Level 1)
 
Significant Other
Observable Inputs
(Level 2)
Assets
 
 
 
 
 
Cash equivalents:
 
 
 
 
 
Corporate debt securities
$
76,472

 
$

 
$
76,472

Money market funds and other
616,039

 
616,039

 

U.S. Government agency securities
117,417

 

 
117,417

Sovereign securities
10,050

 

 
10,050

Marketable securities:
 
 
 
 
 
Corporate debt securities
1,042,723

 

 
1,042,723

Sovereign securities
42,515

 

 
42,515

U.S. Government agency securities
391,409

 
368,121

 
23,288

U.S. Treasury securities
373,299

 
373,299

 

Total cash equivalents and marketable securities(1)
2,669,924

 
1,357,459

 
1,312,465

Other current assets:
 
 
 
 
 
Derivative assets
5,931

 

 
5,931

Other non-current assets:
 
 
 
 
 
Executive Deferred Savings Plan
182,150

 
136,145

 
46,005

Total financial assets(1)
$
2,858,005

 
$
1,493,604

 
$
1,364,401

Liabilities
 
 
 
 
 
Other current liabilities:
 
 
 
 
 
Derivative liabilities
$
(1,275
)
 
$

 
$
(1,275
)
Total financial liabilities
$
(1,275
)
 
$

 
$
(1,275
)
________________
(1) Excludes cash of $307.4 million held in operating accounts and time deposits of $39.4 million as of June 30, 2017.
There were no transfers between Level 1 and Level 2 fair value measurements during the three months ended September 30, 2017. 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, 2017 or June 30, 2017.



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Table of Contents

NOTE 3 – FINANCIAL STATEMENT COMPONENTS
Balance Sheet Components
(In thousands)
As of
September 30, 2017
 
As of
June 30, 2017
Accounts receivable, net:
 
 
 
Accounts receivable, gross
$
678,423

 
$
592,753

Allowance for doubtful accounts
(11,685
)
 
(21,636
)
 
$
666,738

 
$
571,117

Inventories:
 
 
 
Customer service parts
$
240,957

 
$
245,172

Raw materials
248,340

 
240,389

Work-in-process
210,514

 
193,026

Finished goods
62,590

 
54,401

 
$
762,401

 
$
732,988

Other current assets:
 
 
 
Prepaid expenses
$
43,403

 
$
36,146

Income tax related receivables
20,340

 
22,071

Other current assets
10,130

 
13,004

 
$
73,873

 
$
71,221

Land, property and equipment, net:
 
 
 
Land
$
40,613

 
$
40,617

Buildings and leasehold improvements
321,935

 
319,306

Machinery and equipment
555,666

 
551,277

Office furniture and fixtures
21,674

 
21,328

Construction-in-process
6,590

 
4,597

 
946,478

 
937,125

Less: accumulated depreciation and amortization
(666,606
)
 
(653,150
)
 
$
279,872

 
$
283,975

Other non-current assets:
 
 
 
Executive Deferred Savings Plan(1)
$
187,785

 
$
182,150

Other non-current assets
13,502

 
13,526

 
$
201,287

 
$
195,676

Other current liabilities:
 
 
 
Compensation and benefits
$
241,746

 
$
172,707

Executive Deferred Savings Plan(1)
187,957

 
183,603

Other accrued expenses
127,017

 
116,039

Customer credits and advances
122,486

 
95,188

Warranty
46,439

 
45,458

Interest payable
46,217

 
19,396

Income taxes payable
34,774

 
17,040

 
$
806,636

 
$
649,431

Other non-current liabilities:
 
 
 
Pension liabilities
$
74,524

 
$
72,801

Income taxes payable
71,474

 
68,439

Other non-current liabilities
29,106

 
31,167

 
$
175,104

 
$
172,407



14

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 associated with changes in the liability included in selling, general and administrative expense was $6.8 million and $5.8 million during the three months ended September 30, 2017 and 2016, 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 included in selling, general and administrative expense was $6.9 million and $5.9 million during the three months ended September 30, 2017 and 2016, 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, 2017
$
(29,599
)
 
$
(3,272
)
 
$
4,145

 
$
(22,055
)
 
$
(50,781
)
 
 
 
 
 
 
 
 
 
 
Balance as of June 30, 2017
$
(30,654
)
 
$
(3,869
)
 
$
5,221

 
$
(22,021
)
 
$
(51,323
)
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
 
2017
 
2016
Unrealized gains (losses) on cash flow hedges from foreign exchange and interest rate contracts
 
Revenues
 
$
968

 
$
(1,481
)
 
 
Costs of revenues
 
961

 
(87
)
 
 
Interest expense
 
189

 
189

 
 
Net gains (losses) reclassified from accumulated OCI
 
$
2,118

 
$
(1,379
)
Unrealized gains (losses) on available-for-sale securities
 
Other expense (income), net
 
$
6

 
$
204

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, 2017 and 2016 were $0.4 million, respectively. For additional details, refer to Note 11, “Employee Benefit Plans” in the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2017.

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Table of Contents

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, 2017 (In thousands)
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
Corporate debt securities
$
966,542

 
$
723

 
$
(1,530
)
 
$
965,735

Money market funds and other
923,316

 

 

 
923,316

Sovereign securities
14,558

 
1

 
(28
)
 
14,531

U.S. Government agency securities
363,751

 
31

 
(1,586
)
 
362,196

U.S. Treasury securities
382,824

 
21

 
(1,484
)
 
381,361

Subtotal
2,650,991

 
776

 
(4,628
)
 
2,647,139

Add: Time deposits(1)
49,316

 

 

 
49,316

Less: Cash equivalents
960,668

 

 

 
960,668

Marketable securities
$
1,739,639

 
$
776

 
$
(4,628
)
 
$
1,735,787

As of June 30, 2017 (In thousands)
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
Corporate debt securities
$
1,120,548

 
$
598

 
$
(1,951
)
 
$
1,119,195

Money market funds and other
616,039

 

 

 
616,039

Sovereign securities
52,621

 

 
(56
)
 
52,565

U.S. Government agency securities
510,553

 
62

 
(1,789
)
 
508,826

U.S. Treasury securities
374,676

 
52

 
(1,429
)
 
373,299

Subtotal
2,674,437

 
712

 
(5,225
)
 
2,669,924

Add: Time deposits(1)
39,389

 

 

 
39,389

Less: Cash equivalents
845,639

 

 
(15
)
 
845,624

Marketable securities
$
1,868,187

 
$
712

 
$
(5,210
)
 
$
1,863,689

________________
(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, 2017 (In thousands)
Fair Value
 
Gross
Unrealized
Losses(1)
Corporate debt securities
$
581,581

 
$
(1,530
)
U.S. Government agency securities
341,545

 
(1,586
)
U.S. Treasury securities
361,406

 
(1,484
)
Sovereign securities
12,534

 
(28
)
Total
$
1,297,066

 
$
(4,628
)
__________________ 
(1)
As of September 30, 2017, the amount of total gross unrealized losses related to investments that had been in a continuous loss position for 12 months or more was $1.5 million.


16

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, 2017 (In thousands)
Amortized Cost
 
Fair Value
Due within one year
$
497,313

 
$
496,788

Due after one year through three years
1,242,326

 
1,238,999

 
$
1,739,639

 
$
1,735,787

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, 2017 and 2016 were immaterial.

NOTE 5 - BUSINESS COMBINATION
On June 9, 2017, the Company completed the acquisition of the outstanding shares of a privately-held company that designs and manufactures optical profilers and defect inspection systems for advanced semiconductor packaging, LED and data storage industries, for total purchase consideration of $37.1 million, including cash paid of $31.8 million, inclusive of a post-closing working capital adjustment payment. The remaining acquisition holdback amount of $4.8 million will be paid before the end of calendar year 2017. The primary reason for the acquisition is to expand the Company’s portfolio of products.

The following table represents the preliminary purchase price allocation and summarizes the aggregate estimated fair value of the net assets acquired, including a post-closing working capital adjustment:
(In thousands)
Preliminary Purchase Price Allocation
Intangible assets
$
17,660

Goodwill
14,451

Assets acquired (including cash and marketable securities of $3.2 million)
6,294

Liabilities assumed
(1,334
)
  Fair value of net assets acquired
$
37,071


Goodwill represents the excess of the purchase price over the fair value of the net tangible and identifiable intangible assets acquired. The $14.5 million of goodwill was assigned to the Global Service and Support (“GSS”), and the Other reporting units. None of the goodwill recognized is deductible for income tax purposes.
NOTE 6 – 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 the movements by reporting unit during the three months ended September 30, 2017:
(In thousands)
 
Wafer Inspection
 
Patterning
 
GSS
 
Others
 
Total
Balance as of June 30, 2017
 
$
281,095

 
$
53,255

 
$
2,856

 
$
12,320

 
$
349,526

Foreign currency and other adjustments
 
(19
)
 

 
34

 
137

 
152

Balance as of September 30, 2017
 
$
281,076

 
$
53,255

 
$
2,890

 
$
12,457

 
$
349,678

Goodwill is net of accumulated impairment losses of $277.6 million, which were recorded prior to the fiscal year ended June 30, 2014.

17

Table of Contents

The Company performed a qualitative assessment of the goodwill by reporting unit as of November 30, 2016 during the three months ended December 31, 2016 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, 2016, 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, 2017. 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, 2018.
Purchased Intangible Assets
The components of purchased intangible assets as of the dates indicated below were as follows:
(In thousands)
 
 
As of
September 30, 2017
 
As of
June 30, 2017
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
 
$
157,259

 
$
141,401

 
$
15,858

 
$
157,259

 
$
140,346

 
$
16,913

Trade name/Trademark
7 years
 
20,993

 
19,942

 
1,051

 
20,993

 
19,902

 
1,091

Customer relationships
7-8 years
 
55,680

 
54,998

 
682

 
55,680

 
54,959

 
721

Backlog
<1 year
 
260

 
88

 
172

 
260

 
22

 
238

Total
 
 
$
234,192

 
$
216,429

 
$
17,763

 
$
234,192

 
$
215,229

 
$
18,963

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.
For the three months ended September 30, 2017 and 2016, amortization expense for purchased intangible assets was $1.2 million and $1.3 million, respectively. Based on the intangible assets recorded as of September 30, 2017, 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)
2018 (remaining 9 months)
$
3,051

2019
2,486

2020
2,486

2021
2,486

2022
2,486

Thereafter
4,768

Total
$
17,763


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Table of Contents

NOTE 7 – DEBT
The following table summarizes the debt of the Company as of September 30, 2017 and June 30, 2017:
 
As of September 30, 2017
 
As of June 30, 2017
 
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
290,000

 
2.550
%
 
446,250

 
2.137
%
Total debt
2,790,000

 
 
 
2,946,250

 
 
Unamortized discount
(2,798
)
 
 
 
(2,901
)
 
 
Unamortized debt issuance costs
(12,364
)
 
 
 
(12,892
)
 
 
Total debt
$
2,774,838

 
 
 
$
2,930,457

 
 
Reported as:
 
 
 
 
 
 
 
Current portion of long-term debt
$
249,996

 
 
 
$
249,983

 
 
Long-term debt
2,524,842

 
 
 
2,680,474

 
 
 Total debt
$
2,774,838

 
 
 
$
2,930,457

 
 
__________________ 
(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, 2017, future principal payments for the debt are summarized as follows:
Fiscal year ending June 30:
Amount
(In thousands)
2018 (remaining 9 months)
$
250,000

2019

2020
540,000

2021

2022
500,000

Thereafter
1,500,000

Total payments
$
2,790,000


19

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, 2017, 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, 2017 and June 30, 2017 was approximately $2.68 billion and $2.67 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.

20

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, 2018, the Company made term loan principal payments of $156.3 million. The remaining term loan balance of $290.0 million as of September 30, 2017 is due on the maturity date.
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 of 3.00 to 1.00, covering the trailing four consecutive fiscal quarters for each fiscal quarter.
The Company was in compliance with all covenants under the Credit Agreement as of September 30, 2017 and had no outstanding borrowings under the unfunded revolving credit facility.
NOTE 8 – EQUITY AND LONG-TERM INCENTIVE COMPENSATION PLANS
Equity Incentive Program
As of September 30, 2017, 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, 2017, 2.5 million shares were available for issuance under the 2004 Plan.
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, 2017, 1.7 million shares were available for grant under the Outside Director Plan.

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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, 2017
4,710

Restricted stock units granted (2)
(565
)
Restricted stock units granted adjustment (3)
33

Restricted stock units canceled
2

Balance as of September 30, 2017
4,180

__________________ 
(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).
(2)
Includes restricted stock units granted to senior management during the three months ended September 30, 2017 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, 2017, it had not yet been determined the extent to which (if at all) the performance-based vesting criteria had been satisfied. Therefore, this line item includes all such performance-based restricted stock units granted during the three months ended September 30, 2017, reported at the maximum possible number of shares that may ultimately be issuable if all applicable performance-based criteria are achieved at their maximum levels and all applicable service-based criteria are fully satisfied (0.3 million shares for the three months ended September 30, 2017 reflects the application of the multiplier described above).
(3)
Represents the portion of restricted stock units granted with performance-based vesting criteria and reported at the actual number of shares issued upon achievement of the performance vesting criteria during the three months ended September 30, 2017.
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, 2017, the Company accrued $7.0 million of dividends payable, which included both a special cash dividend and regular 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)
2017
 
2016
Stock-based compensation expense by:
 
 
 
Costs of revenues
$
1,416

 
$
1,262

Research and development
2,171

 
2,021

Selling, general and administrative
10,444

 
8,195

Total stock-based compensation expense
$
14,031

 
$
11,478

The following table shows stock-based compensation capitalized as inventory as of the dates indicated below: 
(In thousands)
As of
September 30, 2017
 
As of
June 30, 2017
Inventory
$
2,915

 
$
2,820


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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, 2017 and restricted stock units outstanding as of September 30, 2017 and June 30, 2017:
Restricted Stock Units
Shares(1)
(In thousands)
 
Weighted-Average
Grant Date
Fair Value
Outstanding restricted stock units as of June 30, 2017(2)
2,241

 
$
68.24

Granted(2)
283

 
$
88.96

Granted adjustments(3)
(17
)
 
$
74.26

Vested and released
(334
)
 
$
61.80

Withheld for taxes
(257
)
 
$
61.80

Forfeited
(1
)
 
$
80.15

Outstanding restricted stock units as of September 30, 2017(2)
1,915

 
$
73.23

__________________ 
(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 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, 2017, it had not yet been determined the extent to which (if at all) the performance-based vesting criteria had been satisfied. Therefore, this line item includes all such performance-based restricted stock units, reported at the maximum possible number of shares (0.3 million shares for the fiscal year ended June 30, 2016, 42 thousand shares for the fiscal year ended June 30, 2017 and 0.2 million shares for the three months ended September 30, 2017) that may ultimately be issuable if all applicable performance-based criteria are achieved at their maximum and all applicable service-based criteria are fully satisfied.
(3)
Represents the portion of restricted stock units granted with performance-based vesting criteria and reported at the actual number of shares issued upon achievement of the performance vesting criteria during three months ended September 30, 2017.

The restricted stock units granted by the Company generally vest (a) with respect to awards with only service-based vesting criteria, in three or four equal installments 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 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 the restricted stock units vested 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)
2017
 
2016
Weighted-average grant date fair value per unit
$
88.96

 
$
68.74

Grant date fair value of vested restricted stock units
$
36,534

 
$
29,208

Tax benefits realized by the Company in connection with vested and released restricted stock units
$
18,412

 
$
13,929


As of September 30, 2017, the unrecognized stock-based compensation expense balance related to restricted stock units was $112.3 million, excluding the impact of estimated forfeitures, and will be recognized over a weighted-average remaining contractual term and an estimated weighted-average amortization period of 1.8 years. The intrinsic value of outstanding restricted stock units as of September 30, 2017 was $203.0 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, 2017 and 2016, the Company approved Cash LTI awards of $2.1 million and $1.6 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 three or four equal installments, with one-third or one-fourth of the aggregate amount of the Cash LTI award vesting on each anniversary of the grant date over a three or 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, 2017 and 2016, the Company recognized $14.8 million and $12.2 million, respectively, in compensation expense under the Cash LTI Plan. As of September 30, 2017, the unrecognized compensation balance (excluding the impact of estimated forfeitures) related to the Cash LTI Plan was $113.4 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,
 
2017
 
2016
Stock purchase plan:
 
 
 
Expected stock price volatility
25.9
%
 
20.6
%
Risk-free interest rate
0.9
%
 
0.4
%
Dividend yield
2.6
%
 
2.9
%
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,
2017
 
2016
Tax benefits realized by the Company in connection with the disqualifying dispositions of shares purchased under the ESPP
$
847

 
$
704

Weighted-average fair value per share based on Black-Scholes model
$
19.04

 
$
14.06

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, 2017, a total of 2.7 million shares were reserved and available for issuance under the ESPP.

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Table of Contents

Quarterly cash dividends
On August 3, 2017, the Company’s Board of Directors declared a regular quarterly cash dividend of $0.59 per share on the outstanding shares of the Company’s common stock, which was paid on September 1, 2017 to the stockholders of record as of the close of business on August 15, 2017. The total amount of regular quarterly cash dividends and dividend equivalents paid by the Company during the three months ended September 30, 2017 and 2016 was $94.1 million and $81.6 million, respectively. The amount of accrued dividends payable for regular quarterly cash dividends on unvested restricted stock units with dividend equivalent rights as of September 30, 2017 and June 30, 2017 was $4.2 million and $4.8 million, respectively. These amounts will be paid upon vesting of the underlying 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 7, “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, 2017 and June 30, 2017, the Company had a total of $2.8 million and $9.0 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, 2017 and 2016 of $6.2 million and $7.7 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 dividend.
NOTE 9 – 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, 2017, an aggregate of approximately 5.2 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)
2017
 
2016
Number of shares of common stock repurchased
433

 

Total cost of repurchases
$
40,775

 
$

As of September 30, 2017, the Company had repurchased 8,079 shares for $0.8 million, which repurchases had not settled prior to September 30, 2017. The amount was recorded as a component of other current liabilities for the period presented.
NOTE 10 – 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.

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Table of Contents

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,
2017
 
2016
Numerator:
 
 
 
Net income
$
280,936

 
$
178,101

Denominator:
 
 
 
Weighted-average shares-basic, excluding unvested restricted stock units
156,826

 
156,129

Effect of dilutive restricted stock units and options(1)
1,020

 
892

Weighted-average shares-diluted
157,846

 
157,021

Basic net income per share
$
1.79

 
$
1.14

Diluted net income per share
$
1.78

 
$
1.13

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

 
45

__________________
(1) The Company has not had any outstanding stock options since August 2016.
NOTE 11 – INCOME TAXES
The following table provides details of income taxes:

Three months ended
September 30,
(Dollar amounts in thousands)
2017
 
2016
Income before income taxes
$
336,152

 
$
222,220

Provision for income taxes
$
55,216

 
$
44,119

Effective tax rate
16.4
%
 
19.9
%
The Company’s effective tax rate was lower during the three months ended September 30, 2017 compared to the three months ended September 30, 2016, primarily due to an increase in the proportion of the Company’s earnings generated in jurisdictions with tax rates lower than the U.S. statutory rate during the three months ended September 30, 2017.
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, 2013. 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, 2013. The Company is under income tax examination in Israel for the fiscal years ended June 30, 2013 through June 30, 2016. The Company believes that adequate amounts have been reserved for any adjustments that may ultimately result from any examination of these years.
It is possible that certain examinations may be concluded in the next twelve months. The Company believes that it may recognize up to $23.5 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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Table of Contents

NOTE 12 – LITIGATION AND OTHER LEGAL MATTERS
The Company is named from time to time as a party to lawsuits and other types of legal proceedings and claims in the normal course of its business. Actions filed against the Company include commercial, intellectual property, customer, and labor and employment related claims, including complaints of alleged wrongful termination and potential class action lawsuits regarding alleged violations of federal and state wage and hour and other laws. In general, legal proceedings and claims, regardless of their merit, and associated internal investigations (especially those relating to intellectual property or confidential information disputes) are often expensive to prosecute, defend or conduct and may divert management’s attention and other company resources. Moreover, the results of legal proceedings are difficult to predict, and the costs incurred in litigation can be substantial, regardless of outcome. The Company believes the amounts provided in its condensed consolidated financial statements are adequate in light of the probable and estimated liabilities. However, because such matters are subject to many uncertainties, the ultimate outcomes are not predictable, and there can be no assurances that the actual amounts required to satisfy alleged liabilities from the matters described above will not exceed the amounts reflected in the Company’s condensed consolidated financial statements or will not have a material adverse effect on its results of operations, financial condition or cash flows.
NOTE 13 – COMMITMENTS AND CONTINGENCIES
Factoring. KLA-Tencor has agreements (referred to as “factoring agreements”) with financial institutions to sell certain of its trade receivables and promissory notes from customers without recourse. The Company does not believe it is at risk for any material losses as a result of these agreements. In addition, the Company periodically sells certain letters of credit (“LCs”), without recourse, received from customers in payment for goods and services.
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)
2017
 
2016
Receivables sold under factoring agreements
$
31,901

 
$
56,733

Proceeds from sales of LCs
$
5,571

 
$
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 $2.5 million and $2.4 million for the three months ended September 30, 2017 and 2016, respectively.
The following is a schedule of expected operating lease payments:
Fiscal year ending June 30,
Amount
(In thousands)
2018 (remaining 9 months)
$
9,165

2019
6,391

2020
4,915

2021
3,469

2022
1,450

2023 and thereafter
2,531

Total minimum lease payments
$
27,921

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 $442.0 million as of September 30, 2017 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.

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Table of Contents

Cash Long-Term Incentive Plan. As of September 30, 2017, the Company had committed $163.5 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 three or four equal installments, with one-third or one-fourth of the aggregate amount of the Cash LTI award vesting on each yearly anniversary of the grant date over a three or 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 and maintain 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.
The following table provides the changes in the product warranty accrual for the indicated periods:
 
Three months ended
September 30,
(In thousands)
2017
 
2016
Beginning balance
$
45,458

 
$
34,773

Accruals for warranties issued during the period
13,096

 
10,902

Changes in liability related to pre-existing warranties
(2,531
)
 
(445
)
Settlements made during the period
(9,584
)
 
(8,263
)
Ending balance
$
46,439

 
$
36,967

The Company maintains guarantee arrangements available through various financial institutions for up to $23.4 million, of which $18.5 million had been issued as of September 30, 2017, 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.

28

Table of Contents

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 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.
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 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, 2017 and 2016 for the amortization of the gain recognized in accumulated other comprehensive income (loss), which amount reduced the interest expense. As of September 30, 2017, the unamortized portion of the fair value of the forward contracts for the rate lock agreements was $5.3 million.

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Table of Contents

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
2017
 
2016
Derivatives Designated as Hedging Instruments
 
 
 
 
Gains (losses) in accumulated OCI on derivatives (effective portion)
Accumulated OCI
$
444

 
$
(1,838
)
Gains (losses) reclassified from accumulated OCI into income (effective portion):
Revenues
$
968

 
$
(1,481
)
 
Costs of revenues
961

 
(87
)
 
Interest expense
189

 
189

 
Net gains (losses) reclassified from accumulated OCI into income (effective portion)
$
2,118

 
$
(1,379
)
Gains (losses) recognized in income on derivatives (ineffective portion and amount excluded from effectiveness testing)
Other expense (income), net
$
(71
)
 
$
(11
)
Derivatives Not Designated as Hedging Instruments
 
 
 
 
Gains (losses) recognized in income
Other expense (income), net
$
439

 
$
(164
)

The U.S. dollar equivalent of all outstanding notional amounts of hedge contracts, with maximum remaining maturities of approximately ten months as of September 30, 2017 and June 30, 2017, respectively was as follows:
(In thousands)
As of
September 30, 2017
 
As of
June 30, 2017
Cash flow hedge contracts
 
 
 
Purchase
$
17,552

 
$
19,305

Sell
$
96,790

 
$
128,672

Other foreign currency hedge contracts
 
 
 
Purchase
$
146,392

 
$
165,563

Sell
$
134,258

 
$
118,504

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, 2017
 
As of
June 30, 2017
 
Balance Sheet 
Location
 
As of
September 30, 2017
 
As of
June 30, 2017
(In thousands)
 
Fair Value
 
 
Fair Value
Derivatives designated as hedging instruments
 
 
 
 
 
 
 
 
 
 
 
Foreign exchange contracts
Other current assets
 
$
1,728

 
$
2,198

 
Other current liabilities
 
$

 
$
72

Total derivatives designated as hedging instruments
 
 
$
1,728

 
$
2,198

 
 
 
$

 
$
72

Derivatives not designated as hedging instruments
 
 
 
 
 
 
 
 
 
 
 
Foreign exchange contracts
Other current assets
 
$
2,315

 
$
3,733

 
Other current liabilities
 
$
1,235

 
$
1,203

Total derivatives not designated as hedging instruments
 
 
$
2,315

 
$
3,733

 
 
 
$
1,235

 
$
1,203

Total derivatives
 
 
$
4,043

 
$
5,931

 
 
 
$
1,235

 
$
1,275


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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)
2017
 
2016
Beginning balance
$
8,126

 
$
1,210

Amount reclassified to income
(2,118
)
 
1,379

Net change in unrealized gains or losses
444

 
(1,838
)
Ending balance
$
6,452

 
$
751

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, 2017 and June 30, 2017, information related to the offsetting arrangements was as follows (in thousands):
As of September 30, 2017
 
 
 
 
 
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
 
$
4,043

 
$

 
$
4,043

 
$
(1,017
)
 
$

 
$
3,026

Derivatives - Liabilities
 
$
(1,235
)
 
$

 
$
(1,235
)
 
$
1,017

 
$

 
$
(218
)
As of June 30, 2017
 
 
 
 
 
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
 
$
5,931

 
$

 
$
5,931

 
$
(1,275
)
 
$

 
$
4,656

Derivatives - Liabilities
 
$
(1,275
)
 
$

 
$
(1,275
)
 
$
1,275

 
$

 
$

NOTE 15 – RELATED PARTY TRANSACTIONS
During the three months ended September 30, 2017 and 2016, 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, were, during the periods presented, an executive officer or a board member of a subsidiary, 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)
2017
 
2016
Total revenues
$
2

 
$

Total purchases
$
704

 
$
357

The Company’s receivable and payable balances from these parties were immaterial at September 30, 2017 and June 30, 2017. Management believes that such transactions are at arm’s length and on similar terms as would have been obtained from unaffiliated third parties.

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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 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)
2017
 
2016
Revenues:
 
 
 
 
 
 
 
Korea
$
274,678

 
28
%
 
$
135,089

 
18
%
China
168,339

 
17
%
 
85,689

 
12
%
Japan
146,435

 
15
%
 
104,784

 
14
%
Taiwan
138,559

 
14
%
 
273,692

 
35
%
North America
129,250

 
13
%
 
87,266

 
12
%
Europe & Israel
83,505

 
9
%
 
34,848

 
5
%
Rest of Asia
28,815

 
4
%
 
29,305

 
4
%
Total
$
969,581

 
100
%
 
$
750,673

 
100
%
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)
2017
 
2016
Revenues:
 
 
 
 
 
 
 
Wafer Inspection
$
389,420

 
40
%
 
$
359,009

 
48
%
Patterning
294,350

 
30
%
 
172,614

 
23
%
Global Service and Support(1)
260,498

 
27
%
 
207,986

 
28
%
Other
25,313

 
3
%
 
11,064

 
1
%
Total
$
969,581

 
100
%
 
$
750,673

 
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 Pro business.

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In the three months ended September 30, 2017, one customer accounted for approximately 28% of total revenues. In the three months ended September 30, 2016, three customers accounted for approximately 29%, 13% and 11% of total revenues. Two customers on an individual basis accounted for greater than 10% of net accounts receivables as of September 30, 2017 and June 30, 2017, respectively.
Long-lived assets by geographic region as of the dates indicated below were as follows: 
(In thousands)
As of
September 30, 2017
 
As of
June 30, 2017
Long-lived assets:
 
 
 
United States
$
185,000

 
$
191,096

Singapore
40,531

 
39,118

Israel
29,850

 
30,182

Europe
13,351

 
13,300

Rest of Asia
11,140

 
10,279

Total
$
279,872

 
$
283,975


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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, 2017, filed with the Securities and Exchange Commission on August 4, 2017. 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 advanced packaging, light emitting diode (“LED”), power devices, compound semiconductor and data storage industries, as well as general materials research.

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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 or expansion plans. 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. In the global semiconductor related industries, China is emerging as a major region for manufacturing of logic and memory chips, adding to its role as the world’s largest consumer of ICs. Government initiatives are propelling China to expand its domestic manufacturing capacity and attracting semiconductor manufacturers from Taiwan, Korea, Japan and the US. China is currently seen as an important long term growth region for the semiconductor capital equipment sector. 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. Currently, there are multiple drivers for growth in the industry with increased demand for chips providing computation power and connectivity for Artificial Intelligence (“AI”) applications and support for mobile devices at the leading edge of foundry chip manufacturing. Qualification of early extreme ultraviolet (“EUV”) lithography processes and equipment is driving growth at leading logic/foundry and dynamic random-access memory (“DRAM”) manufacturers. Expansion of the Internet of Things (“IoT”) together with increasing acceptance of advanced driver assistance systems (“ADAS”) in anticipation of the introduction of autonomous cars have begun to accelerate legacy-node technology conversions and capacity expansions. Intertwined in these areas, spurred by data storage and connectivity needs, is the growth in demand for memory chips. 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 technologically advanced products and applications. We believe that, over the long term, our customers will continue to invest in advanced technologies and new materials to enable smaller design rules and higher density applications that fuel demand for process control equipment, although the growth for such equipment may be adversely impacted by higher design costs for advanced ICs, reuse of installed products, and delays in production ramps by our customers in response to higher costs and technical challenges at more advanced technology nodes.
The demand for our products and our revenue levels are driven by our customers’ needs to solve the process challenges that they face as they adopt new technologies required to fabricate advanced ICs that are incorporated into sophisticated mobile devices. The timing for our customers in ordering and taking delivery of process control and yield management equipment is also determined by our customers’ requirements to meet the next generation production ramp schedules, and the timing for capacity expansion to meet end customer demand. During the three months ended September 30, 2017, revenues for our process control equipment increased from the quarter ended June 30, 2017, as a result of strong demand from our memory and logic market customers. Our earnings will depend not only on our revenue levels, but also on the amount of research and development spending required to meet our customers’ technology roadmaps. We have maintained production volumes and capacity to meet anticipated customer requirements and remain at risk of incurring significant inventory-related and other restructuring charges if business conditions deteriorate. Over the past year, our customers have taken delivery of higher volumes of process control equipment than they did in the previous year. However, any delay or push out by our customers in taking delivery of process control and yield management equipment may cause earnings volatility, due to increases in the risk of inventory related charges as well as timing of revenue recognition.

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The following table sets forth some of our key quarterly unaudited financial information: