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: March 31, 2010

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 0-09992

 

 

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 Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ¨    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer x   Accelerated filer ¨   Non-accelerated filer ¨   Smaller reporting company ¨
    (Do not check if a smaller reporting company)  

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

As of April 15, 2010, there were 169,993,702 shares of the registrant’s Common Stock, $0.001 par value, outstanding.

 

 

 

 


Table of Contents

INDEX

 

 

          Page
Number
PART I    FINANCIAL INFORMATION   

Item 1

   Financial Statements (Unaudited)   
  

Condensed Consolidated Balance Sheets as of March 31, 2010 and June 30, 2009

   3
  

Condensed Consolidated Statements of Operations for the Three Months and Nine Months Ended March 31, 2010 and 2009

   4
  

Condensed Consolidated Statements of Cash Flows for the Nine Months Ended March 31, 2010 and 2009

   5
  

Notes to Condensed Consolidated Financial Statements

   6

Item 2

   Management’s Discussion and Analysis of Financial Condition and Results of Operations    32

Item 3

   Quantitative and Qualitative Disclosures About Market Risk    47

Item 4

   Controls and Procedures    47
PART II    OTHER INFORMATION   

Item 1

   Legal Proceedings    48

Item 1A

   Risk Factors    48

Item 2

   Unregistered Sales of Equity Securities and Use of Proceeds    57

Item 6

   Exhibits    58
SIGNATURES    59
EXHIBIT INDEX    60

 

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PART I. FINANCIAL INFORMATION

 

ITEM 1. FINANCIAL STATEMENTS

KLA-TENCOR CORPORATION

Condensed Consolidated Balance Sheets

 

 

(In thousands)

   March 31,
2010
    June 30,
2009
 
     (unaudited)        

ASSETS

    

Current assets:

    

Cash and cash equivalents

   $ 543,505      $ 524,967   

Marketable securities

     1,010,019        804,917   

Accounts receivable, net

     322,542        210,143   

Inventories, net

     374,435        370,206   

Deferred income taxes

     270,155        261,121   

Other current assets

     154,911        227,263   
                

Total current assets

     2,675,567        2,398,617   

Land, property and equipment, net

     243,758        291,878   

Goodwill

     328,177        329,379   

Purchased intangibles, net

     125,854        149,080   

Other non-current assets

     416,489        440,584   
                

Total assets

   $ 3,789,845      $ 3,609,538   
                

LIABILITIES AND STOCKHOLDERS’ EQUITY

    

Current liabilities:

    

Accounts payable

   $ 91,645      $ 63,485   

Deferred system profit

     166,956        95,820   

Unearned revenue

     33,142        46,236   

Other current liabilities

     395,019        341,441   
                

Total current liabilities

     686,762        546,982   

Non-current liabilities:

    

Long-term debt

     745,611        745,204   

Income tax payable

     46,323        49,738   

Unearned revenue

     21,471        23,059   

Other non-current liabilities

     70,654        60,163   
                

Total liabilities

     1,570,821        1,425,146   

Commitments and contingencies (Note 13 and Note 14)

    

Stockholders’ equity:

    

Common stock and capital in excess of par value

     898,155        835,477   

Retained earnings

     1,339,010        1,370,132   

Accumulated other comprehensive income (loss)

     (18,141     (21,217
                

Total stockholders’ equity

     2,219,024        2,184,392   
                

Total liabilities and stockholders’ equity

   $ 3,789,845      $ 3,609,538   
                

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
March 31,
    Nine months ended
March 31,
 

(In thousands, except per share data)

   2010    2009     2010    2009  

Revenues:

          

Product

   $ 349,787    $ 207,332      $ 893,984    $ 885,900   

Service

     128,512      102,280        367,357      352,814   
                              

Total revenues

     478,299      309,612        1,261,341      1,238,714   
                              

Costs and operating expenses:

          

Costs of revenues

     208,565      209,223        587,743      700,203   

Engineering, research and development

     84,741      82,609        246,251      292,236   

Selling, general and administrative

     93,714      90,061        274,023      342,505   

Goodwill and purchased intangible asset impairment

     —        —          —        446,744   
                              

Total costs and operating expenses

     387,020      381,893        1,108,017      1,781,688   
                              

Income (loss) from operations

     91,279      (72,281     153,324      (542,974

Interest income and other, net

     3,084      8,723        28,846      28,154   

Interest expense

     14,092      13,609        41,091      41,335   
                              

Income (loss) before income taxes

     80,271      (77,167     141,079      (556,155

Provision for (benefit from) income taxes

     23,255      5,660        41,864      (58,363
                              

Net income (loss)

   $ 57,016    $ (82,827   $ 99,215    $ (497,792
                              

Net income (loss) per share:

          

Basic

   $ 0.33    $ (0.49   $ 0.58    $ (2.92
                              

Diluted

   $ 0.33    $ (0.49   $ 0.57    $ (2.92
                              

Cash dividend paid per share

   $ 0.15    $ 0.15      $ 0.45    $ 0.45   
                              

Weighted average number of shares:

          

Basic

     171,506      169,934        171,202      170,349   
                              

Diluted

     173,357      169,934        173,432      170,349   
                              

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

 

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KLA-TENCOR CORPORATION

Condensed Consolidated Statements of Cash Flows

(Unaudited)

 

 

     Nine months ended
March 31,
 

(In thousands)

   2010     2009  

Cash flows from operating activities:

    

Net income (loss)

   $ 99,215      $ (497,792

Adjustments to reconcile net income (loss) to net cash provided by operating activities:

    

Depreciation and amortization

     67,794        110,116   

Goodwill, purchased intangible asset and long-lived asset impairment charges

     10,592        451,982   

Gain on sale of real estate assets

     (2,984     (3,718

Non-cash stock-based compensation

     62,523        79,443   

Provision for doubtful accounts

     —          24,097   

Tax charge from equity awards

     (5,133     (4,657

Excess tax benefit from equity awards

     —          (1,691

Net loss (gain) on sale of marketable securities and other investments

     (3,689     475   

Changes in assets and liabilities, net of assets acquired and liabilities assumed in business combinations:

    

Decrease (increase) in accounts receivable, net

     (107,361     240,070   

Decrease (increase) in inventories

     (1,254     67,138   

Decrease in other assets

     75,299        58,672   

Increase (decrease) in accounts payable

     28,459        (53,516

Increase (decrease) in deferred system profit

     71,136        (76,610

Increase (decrease) in other liabilities

     69,925        (271,763
                

Net cash provided by operating activities

     364,522        122,246   
                

Cash flows from investing activities:

    

Acquisition of business, net of cash received

     (1,500     (141,399

Capital expenditures, net

     (24,411     (20,246

Proceeds from sale of assets

     5,878        21,814   

Purchase of available-for-sale securities

     (863,289     (659,547

Proceeds from sale of available-for-sale securities

     514,926        438,831   

Proceeds from maturity of available-for-sale securities

     129,036        77,333   

Purchase of trading securities

     (54,555     (46,838

Proceeds from sale of trading securities

     64,975        52,240   
                

Net cash used in investing activities

     (228,940     (277,812
                

Cash flows from financing activities:

    

Issuance of common stock

     23,813        27,137   

Tax withholding payments related to vested and released restricted stock units

     (12,913     (11,703

Common stock repurchases

     (54,630     (226,515

Payment of dividends to stockholders

     (77,023     (76,659

Excess tax benefit from equity awards

     —          1,691   
                

Net cash used in financing activities

     (120,753     (286,049
                

Effect of exchange rate changes on cash and cash equivalents

     3,709        (21,562
                

Net increase (decrease) in cash and cash equivalents

     18,538        (463,177

Cash and cash equivalents at beginning of period

     524,967        1,128,106   
                

Cash and cash equivalents at end of period

   $ 543,505      $ 664,929   
                

Supplemental cash flow disclosures:

    

Income tax refunds received, net

   $ (42,971   $ (17,870
                

Interest paid

   $ 26,432      $ 29,547   
                

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

 

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KLA-TENCOR CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

NOTE 1 – BASIS OF PRESENTATION

Basis of Presentation. The condensed consolidated financial statements have been prepared by KLA-Tencor Corporation (“KLA-Tencor” or the “Company”) pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations. In the opinion of management, the unaudited interim financial statements reflect all adjustments (consisting only of normal, recurring adjustments) necessary for a fair statement of the financial position, results of operations and cash flows for the periods indicated. These financial statements and notes, however, should be read in conjunction with Item 8, “Financial Statements and Supplementary Data” included in the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2009, filed with the SEC on August 7, 2009.

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 Company has included the results of operations of acquired companies from the date of acquisition.

The results of operations for the three and nine months ended March 31, 2010 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, 2010.

Certain reclassifications have been made to the prior year’s Condensed Consolidated Balance Sheet to conform to the current year presentation. The reclassifications had no effect on the Condensed Consolidated Statements of Operations or Cash Flows.

Management Estimates. The preparation of the condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of 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.

Recent Accounting Pronouncements. In February 2010, the SEC issued a policy statement and staff work plan regarding the potential use by U.S. issuers of financial statements prepared in accordance with International Financial Reporting Standards (“IFRS”). IFRS is a comprehensive series of accounting standards published by the International Accounting Standards Board. Under the proposed timeline set forth by the SEC, the Company could be required in fiscal year 2015 to prepare financial statements in accordance with IFRS, and the SEC is expected to make a determination in 2011 regarding the mandatory adoption of IFRS. The Company is currently assessing the impact that this potential change would have on its consolidated financial statements, and it will continue to monitor the development of the potential implementation of IFRS.

In February 2010, the Financial Accounting Standards Board (“FASB”) amended its guidance on subsequent events. The amendment states that entities that are required to file or furnish their financial statements with the SEC are no longer required to disclose the date through which the entity has evaluated subsequent events. This amendment is effective for the Company’s interim reporting period ended March 31, 2010, and the implementation did not have an impact on the Company’s financial position, results of operations or cash flows as it is disclosure-only in nature.

In January 2010, the FASB issued authoritative guidance for fair value measurements. This guidance now requires a reporting entity to disclose separately the amounts of significant transfers in and out of Level 1 and Level 2 fair value measurements and also to describe the reasons for these transfers. This authoritative guidance also requires enhanced disclosure of activity in Level 3 fair value measurements. The guidance for Level 1 and Level 2 fair value measurements is effective for the Company’s interim reporting period ended March 31, 2010. The implementation did not have an impact on the Company’s financial position, results of operations or cash flows as it is disclosure-only in nature. The guidance for Level 3 fair value measurements disclosures becomes effective for the Company’s interim reporting period ending September 30, 2011, and the Company does not expect that this guidance will have an impact on its financial position, results of operations or cash flows as it is disclosure-only in nature.

In October 2009, the FASB amended its Emerging Issues Task Force (“EITF”) authoritative guidance addressing revenue arrangements with multiple deliverables. The guidance requires revenue to be allocated to multiple elements using relative fair value based on vendor-specific objective evidence, third-party evidence or estimated selling price. The residual method also becomes obsolete under this guidance. This guidance is effective for the Company’s interim reporting period ending September 30, 2010, and allows for early adoption. The Company elected to early adopt the accounting guidance at the beginning of the second quarter of its fiscal year ending June 30, 2010 and has applied the adoption retrospectively to the beginning of the fiscal year to apply the guidance to transactions originating or materially modified after June 30, 2009. The implementation resulted in additional qualitative disclosures but did not have a material impact on the Company’s financial position, results of operations or cash flows.

In October 2009, the FASB amended the authoritative guidance addressing certain revenue arrangements that include software elements. This guidance states that tangible products with hardware and software components that work together to deliver the product

 

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functionality are considered non-software products, and the accounting guidance for revenue arrangements with multiple deliverables is to be followed with respect to such products. This guidance is effective for the Company’s interim reporting period ending September 30, 2010, and allows for early adoption. The Company elected to early adopt the accounting guidance at the beginning of the second quarter of its fiscal year ending June 30, 2010 and has applied the adoption retrospectively to the beginning of the fiscal year to apply the guidance to transactions originating or materially modified after June 30, 2009. The implementation resulted in additional qualitative disclosures but did not have a material impact on the Company’s financial position, results of operations or cash flows.

In August 2009, the FASB issued authoritative guidance for measuring liabilities at fair value that reaffirms the previously existing definition of fair value and reintroduces the concept of entry value into the determination of fair value of liabilities. Entry value is the amount an entity would receive to enter into an identical liability. The guidance was effective for the Company’s interim reporting period ended December 31, 2009. The implementation did not have a material impact on the Company’s financial position, results of operations or cash flows.

In June 2009, the FASB issued authoritative guidance for consolidations that changes how a company determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. The determination of whether a company is required to consolidate an entity is based on, among other things, an entity’s purpose and design and a company’s ability to direct the activities of the entity that most significantly impact the entity’s economic performance. This guidance is effective for the Company’s interim reporting period ending September 30, 2010. The Company is currently evaluating the impact of the guidance on its financial position, results of operations and cash flows.

In June 2009, the FASB issued authoritative guidance to establish the FASB Accounting Standards Codification as the source of authoritative accounting principles and the framework for selecting the principles used in the preparation of financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting principles in the United States. This guidance was effective for the Company’s interim reporting period ended September 30, 2009 and only impacted references for accounting guidance.

In April 2009, the FASB issued authoritative guidance for business combinations that amends the provisions related to the initial recognition and measurement, subsequent measurement and disclosure of assets and liabilities arising from contingencies in a business combination. This guidance will require such contingencies to be recognized at fair value on the acquisition date if fair value can be reasonably estimated during the allocation period. Otherwise, entities would typically account for the acquired contingencies in accordance with authoritative guidance for contingencies. The guidance became effective for the Company’s business combinations for which the acquisition date is on or after July 1, 2009. The Company did not complete any material business combinations during the three or nine months ended March 31, 2010, and the effect of this guidance, if any, on the Company’s financial position, results of operations and cash flows in future periods will depend on the nature and significance of business combinations subject to this guidance.

In April 2009, the FASB issued authoritative guidance to increase the frequency of fair value disclosures of financial instruments, thereby enhancing consistency in financial reporting. The guidance relates to fair value disclosures for any financial instruments that are not currently reflected on a company’s balance sheet at fair value. Prior to the effective date of this guidance, fair values for these types of financial assets and liabilities had only been disclosed once a year. The guidance requires these disclosures on a quarterly basis, providing qualitative and quantitative information about fair value estimates for all those financial instruments not measured on the balance sheet at fair value. The disclosure requirement under this guidance was effective for the Company’s interim reporting period ended September 30, 2009. The implementation did not have an impact on the Company’s financial position, results of operations or cash flows as it is disclosure-only in nature.

In December 2008, the FASB issued authoritative guidance for an employer’s disclosures about plan assets of a defined benefit pension or other post-retirement plan. The guidance requires annual disclosures surrounding how investment allocation decisions are made, including the factors that are pertinent to an understanding of investment policies and strategies. The annual disclosure requirement under this guidance is effective for the Company’s fiscal year ending June 30, 2010. The guidance does not change the accounting treatment for post-retirement benefit plans.

In April 2008, the FASB issued authoritative guidance for general intangibles other than goodwill, amending the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset. This guidance is effective for intangible assets acquired on or after July 1, 2009. The adoption did not have a material impact on the Company’s financial position, results of operations or cash flows.

 

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Revenue Recognition for Certain Arrangements with Software Elements and/or Multiple Deliverables

As discussed above, in October 2009, the FASB amended the accounting standards for revenue recognition to remove tangible products containing software components and non-software components that function together to deliver the product’s essential functionality from the scope of industry-specific software revenue recognition guidance. In October 2009, the FASB also amended the accounting standards for multiple-deliverable revenue arrangements to:

 

   

provide updated guidance on how the deliverables in an arrangement should be separated, and how the consideration should be allocated;

 

   

eliminate the use of the residual method and require an entity to allocate revenue using the relative selling price method; and

 

   

require an entity to allocate revenue in an arrangement using estimated selling prices (“ESP”) of deliverables if it does not have vendor-specific objective evidence (“VSOE”) or third-party evidence (“TPE”) of selling price. Valuation terms are defined as follows:

 

   

VSOE – the price at which the Company sells the element in a separate stand-alone transaction.

 

   

TPE – evidence from the Company or other companies of the value of a largely interchangeable element in a transaction.

 

   

ESP – the Company’s best estimate of the selling price of an element in a transaction.

The Company elected to early adopt this accounting guidance at the beginning of its second quarter of the fiscal year ending June 30, 2010 and has applied the adoption retrospectively to the beginning of the fiscal year to apply the guidance to transactions originating or materially modified after June 30, 2009. The implementation resulted in additional qualitative disclosures that are included below but did not have a material impact on the Company’s financial position, results of operations or cash flows.

In terms of the timing and pattern of revenue recognition, the new accounting guidance for revenue recognition is not expected to have a significant effect on revenues in periods after the initial adoption when applied to multiple element arrangements based on current sales strategies.

For transactions entered into through June 30, 2009, the Company primarily recognized revenue based on the guidance in Staff Accounting Bulletin No. 104. During the period, for the majority of the Company’s arrangements involving multiple deliverables, the entire amount of the sales contract was allocated to each respective element based on its relative selling price, using fair value. In the limited circumstances when the Company was not able to determine fair value for the deliverables in the arrangement, but was able to obtain fair value for the undelivered elements, revenue was allocated using the residual method. Under the residual method, the amount of revenue allocated to delivered elements equaled the total arrangement consideration less the aggregate selling price of any undelivered elements, and no revenue was recognized until all elements without fair value had been delivered. If fair value of any undelivered elements did not exist, the entire amount of the sales contract was deferred until all elements were accepted by the customer.

This guidance does not generally change the units of accounting for the Company’s revenue transactions. The Company typically recognizes revenue for system sales upon acceptance by the customer that the system has been installed and is operating according to predetermined specifications. Under certain circumstances, however, the Company recognizes revenue upon shipment, prior to written acceptance by the customer. The portion of revenue associated with installation is deferred based on relative sales price and recognized upon completion of the installation. Spare parts revenue is recognized when the product has been shipped and risk of loss has passed to the customer, and collectability 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 contract, such as consulting and training revenue, is recognized when the related services are performed, and collectability is reasonably assured. The Company’s arrangements generally do not include any provisions for cancellation, termination or refunds that would significantly impact recognized revenue.

The Company enters into revenue arrangements that may consist of multiple deliverables of its products and services where certain elements of a sales contract are not delivered and accepted in one reporting period.

In many instances, products are sold in stand-alone arrangements. Services are sold separately through renewals of annual maintenance contracts. As a result, for substantially all of the arrangements with multiple deliverables pertaining to products and services, the Company uses VSOE or 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 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.

 

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NOTE 2 – FAIR VALUE MEASUREMENTS

On July 1, 2009, the Company adopted the newly issued accounting standard for fair value measurements of all non-financial assets and non-financial liabilities not recognized or disclosed at fair value in the financial statements on a recurring basis. The Company’s financial assets are measured and recorded at fair value, except for equity investments in privately-held companies. These equity investments are generally accounted for under the cost method of accounting and are periodically assessed for other-than-temporary impairment when an event or circumstance indicates that an other-than-temporary decline in value may have occurred. The Company’s non-financial assets, such as goodwill, intangible assets, and property, plant 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.

As of March 31, 2010, the Company did not elect the fair value option that permits companies to measure eligible financial instruments at fair value for any financial assets and liabilities that were not previously measured at fair value, with the exception of the Put Option related to the auction rate securities repurchase agreement with UBS AG referenced in Note 4, “Marketable Securities.”

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 under the guidance are described below:

 

Level 1    Valuations based on unadjusted quoted prices in active markets for identical assets or liabilities that the entity has the ability to access.
Level 2    Valuations based on unadjusted quoted prices for similar assets or liabilities, unadjusted 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.

Most of the Company’s financial instruments are classified within Level 1 or Level 2 of the fair value hierarchy because they are valued using quoted market prices, broker or dealer quotations, or alternative pricing sources with reasonable levels of price transparency. The types of instruments valued based on quoted market prices in active markets include money market funds and U.S. Treasury securities. Such instruments are generally classified within Level 1 of the fair value hierarchy.

The types of instruments valued based on other observable inputs include U.S. agency securities, commercial paper, U.S. corporate bonds and municipal obligations. The market inputs used to value these instruments generally consist of market yields, reported trades and broker/dealer quotes. Such instruments are generally classified within Level 2 of the fair value hierarchy.

The principal market in which the Company executes its foreign currency contracts is the institutional market in an over-the-counter environment with a relatively high level of price transparency. The market participants usually are large commercial banks. The Company’s foreign currency contracts’ valuation inputs are based on quoted prices and quoted pricing intervals from public data sources and do not involve management judgment. These contracts are typically classified within Level 2 of the fair value hierarchy.

The types of instruments valued based on unobservable inputs include the auction rate securities held by the Company. Such instruments are generally classified within Level 3 of the fair value hierarchy. The Company estimated the fair value of these auction rate securities using a discounted cash flow model incorporating assumptions that market participants would use in their estimates of fair value. Some of these assumptions include estimates for interest rates, timing and amount of cash flows and expected holding periods of the auction rate securities.

Financial assets and liabilities measured at fair value on a recurring basis as of March 31, 2010 were as follows:

 

(In thousands)

   Total    Quoted Prices in
Active Markets
for Identical
Assets (Level  1)
   Significant Other
Observable Inputs
(Level 2)
   Significant
Unobservable Inputs
(Level 3)

U.S. Treasuries

   $ 53,057    $ 33,989    $ 19,068    —  

U.S. Government agency securities

     285,960      280,884      5,076    —  

Municipal bonds

     57,499      —        57,499    —  

Corporate debt securities

     586,427      —        586,427    —  

Money market, bank deposits and other

     404,558      404,502      56    —  

Sovereign securities

     9,383      4,138      5,245    —  

Auction rate securities

     26,147      —        —      26,147
                         

Total marketable securities

     1,423,031      723,513      673,371    26,147
                         

 

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(In thousands)

   Total     Quoted Prices in
Active Markets
for Identical
Assets (Level  1)
   Significant Other
Observable Inputs
(Level 2)
    Significant
Unobservable Inputs
(Level 3)

Money market and other

     2,631        2,631      —          —  

Mutual funds

     115,188        115,188      —          —  
                             

Executive deferred savings plan

     117,819        117,819      —          —  
                             

Derivative assets

     4,400        —        2,125        2,275

Total financial assets

   $ 1,545,250      $ 841,332    $ 675,496      $ 28,422
                             

Derivative liabilities

   $ (2,267   $ —      $ (2,267   $ —  
                             

Total financial liabilities

   $ (2,267   $ —      $ (2,267   $ —  
                             

Assets and liabilities measured at fair value on a recurring basis were presented on the Company’s Condensed Consolidated Balance Sheet as of March 31, 2010 as follows:

 

(In thousands)

   Total     Quoted Prices in
Active Markets
for Identical
Assets (Level  1)
   Significant Other
Observable Inputs
(Level 2)
    Significant
Unobservable Inputs
(Level 3)

Cash equivalents

   $ 413,012      $ 395,443    $ 17,569      $ —  

Marketable securities

     1,010,019        328,070      655,802        26,147

Other current assets

     4,400        —        2,125        2,275

Other non-current assets

     117,819        117,819      —          —  
                             

Total financial assets

   $ 1,545,250      $ 841,332    $ 675,496      $ 28,422
                             

Other current liabilities

   $ (2,267   $ —      $ (2,267   $ —  
                             

Total financial liabilities

   $ (2,267   $ —      $ (2,267   $ —  
                             

Changes in our Level 3 securities for the three and nine months ended March 31, 2010 and 2009 were as follows:

 

 

(In thousands)

   Three months ended
March 31,
    Nine months ended
March 31,
 
   2010     2009     2010     2009  

Beginning aggregate estimated fair value of Level 3 securities

   $ 32,365      $ 40,879      $ 40,584      $ 42,147   

Total realized and unrealized gains

        

Unrealized gain included in other comprehensive income

     —          —          —          22   

Unrealized gain (loss) included in income

     7        192        63        (6,495

Reversal of unrealized loss associated with transfer of securities to trading securities

     —          —          —          1,281   

Net purchases (settlements)

     (3,950     (500     (12,225     3,616   
                                

Ending aggregate estimated fair value of Level 3 securities

   $ 28,422      $ 40,571      $ 28,422      $ 40,571   
                                

 

 

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NOTE 3 – BALANCE SHEET COMPONENTS

 

(In thousands)

   March 31,
2010
    June 30,
2009
 

Accounts receivable, net

    

Accounts receivable, gross

   $ 357,623      $ 245,618   

Allowance for doubtful accounts

     (35,081     (35,475
                
   $ 322,542      $ 210,143   
                

Inventories, net

    

Service parts

   $ 135,862      $ 146,724   

Raw materials

     110,637        99,383   

Work-in-process

     78,357        66,292   

Finished goods and demonstration equipment

     49,579        57,807   
                
   $ 374,435      $ 370,206   
                

Other current assets

    

Prepaid expenses

   $ 36,528      $ 61,854   

Income tax related receivables

     72,119        138,500   

Other current assets

     46,264        26,909   
                
   $ 154,911      $ 227,263   
                

Land, property and equipment, net

    

Land

   $ 41,836      $ 52,493   

Buildings and improvements

     122,615        132,872   

Machinery and equipment

     446,051        410,643   

Office furniture and fixtures

     24,778        23,976   

Leasehold improvements

     96,288        106,811   

Construction in progress

     7,651        1,171   
                
     739,219        727,966   

Less: accumulated depreciation and amortization

     (495,461     (436,088
                
   $ 243,758      $ 291,878   
                

Other non-current assets

    

Long-term investments

   $ 139,118      $ 128,776   

Deferred tax assets – long-term

     261,648        295,536   

Other

     15,723        16,272   
                
   $ 416,489      $ 440,584   
                

Other current liabilities

    

Warranty and retrofit obligations

   $ 19,158      $ 21,812   

Compensation and benefits

     260,662        176,828   

Income taxes payable

     13,766        15,536   

Interest payable

     21,706        8,769   

Accrued litigation costs

     7,907        4,848   

Other accrued expenses

     71,820        113,648   
                
   $ 395,019      $ 341,441   
                

 

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NOTE 4 – MARKETABLE SECURITIES

The amortized costs and estimated fair value of marketable securities as of March 31, 2010 and June 30, 2009 are as follows:

 

 

As of March 31, 2010 (In thousands)

   Amortized
Cost
   Gross
Unrealized
Gains
   Gross
Unrealized
Losses
    Fair
Value

U.S. Treasuries

   $ 53,083    $ 2    $ (28   $ 53,057

U.S. Government agency securities

     285,273      883      (196     285,960

Municipal bonds

     57,108      400      (9     57,499

Corporate debt securities

     580,911      5,816      (300     586,427

Money market, bank deposits and other

     404,558      —        —          404,558

Sovereign securities

     9,320      63      —          9,383

Auction rate securities

     28,425      —        (2,278     26,147
                            

Subtotal

     1,418,678      7,164      (2,811     1,423,031

Less: Cash equivalents

     413,009      4      (1     413,012
                            

Marketable securities

   $ 1,005,669    $ 7,160    $ (2,810   $ 1,010,019
                            

As of June 30, 2009 (In thousands)

   Amortized
Cost
   Gross
Unrealized
Gains
   Gross
Unrealized
Losses
    Fair
Value

U.S. Treasuries

   $ 85,843    $ 576    $ (7   $ 86,412

U.S. Government agency securities

     277,762      2,089      (155     279,696

Municipal bonds

     30,228      260      (68     30,420

Corporate debt securities

     349,522      3,478      (557     352,443

Money market, bank deposits and other

     325,014      —        —          325,014

Sovereign securities

     10,319      73      (31     10,361

Auction rate securities

     40,650      —        (2,482     38,168
                            

Subtotal

     1,119,338      6,476      (3,300     1,122,514

Less: Cash equivalents

     317,597      —        —          317,597
                            

Marketable securities

   $ 801,741    $ 6,476    $ (3,300   $ 804,917
                            

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. The fair value of these securities is impacted by market interest rates and credit spreads. The rise of market interest rates or credit spreads may lower the fair value of our investment portfolio. As of March 31, 2010, none of the unrealized losses of the securities are a result of other-than-temporary credit impairments. The Company believes it will realize the full value of these investments upon maturity.

The following table summarizes the fair value of its investments that had gross unrealized losses as of March 31, 2010:

 

(In thousands)

   Fair Value    Gross
Unrealized
Losses(1)
 

U.S. Treasuries

   $ 48,695    $ (28

U.S. Government agency securities

     131,402      (196

Municipal bonds

     5,829      (9

Corporate debt securities

     102,617      (300

Auction rate securities (2)

     26,147      (2,278
               

Total

   $ 314,690    $ (2,811
               

 

(1) Of the total gross unrealized losses, there were no amounts from available-for-sale securities that have been in a loss position for 12 months or more.
(2) The auction rate securities have been in a continuous loss position for more than 12 months and are classified as trading securities.

 

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The contractual maturities of securities classified as available-for-sale as of March 31, 2010, regardless of the consolidated balance sheet classification, are as follows:

 

(In thousands)

   Amortized
Cost
   Estimated
Fair Value

Due within one year

   $ 233,757    $ 235,766

Due after one year through three years

     743,487      748,106
             
   $ 977,244    $ 983,872
             

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. Net realized gains for the three and nine months ended March 31, 2010 were approximately $0.8 million and $2.8 million, respectively.

The Company’s investment portfolio includes auction rate securities, which are investments with contractual maturities generally between 20 to 30 years. They are usually found in the form of municipal bonds, preferred stock, a pool of student loans, or collateralized debt obligations whose interest rates are reset. The reset typically occurs every seven to forty-nine days, through an auction process. At the end of each reset period, investors can sell or continue to hold the securities at par. The auction rate securities held by the Company are backed by student loans and are collateralized, insured and guaranteed by the United States Federal Department of Education. In addition, all auction rate securities held by the Company are rated by the major independent rating agencies as either AAA or Aaa. In February 2008, because sell orders exceeded buy orders, auctions failed for approximately $48.2 million in par value of municipal auction rate securities held by the Company. These failures are not believed to be a credit issue, but rather caused by a lack of liquidity. The funds associated with these failed auctions may not be accessible until the issuer calls the security, a successful auction occurs, a buyer is found outside of the auction process, or the security matures. Prior to June 30, 2009, a total of $7.6 million of the auction rate securities held by the Company were called at par value by the issuer (therefore no losses were recognized on these securities). During the three and nine months ended March 31, 2010, an additional $4.0 million and $12.3 million, respectively, of the auction rate securities were called at par value by the issuer. The fair value of the auction rate securities at March 31, 2010 was $26.1 million (par value of $28.4 million), which is included in marketable securities under current assets.

By letter dated August 8, 2008, the Company received notification from UBS AG (“UBS”), in connection with a settlement entered into between UBS and certain regulatory agencies, offering to repurchase all of the Company’s auction rate security holdings at par value. The Company formally accepted the settlement offer and entered into a repurchase agreement (“Agreement”) with UBS on November 11, 2008 (“Acceptance Date”). By accepting the Agreement, the Company (1) received the right (“Put Option”) to sell its auction rate securities at par value to UBS between June 30, 2010 and June 30, 2012 and (2) gave UBS the right to purchase the auction rate securities from the Company any time after the Acceptance Date as long as the Company receives the par value. The Company’s intention is to exercise its right with UBS to sell these auction rate securities at par value at the earliest date possible, which is June 30, 2010. However, if the Put Option is not exercised before June 30, 2012, it will expire, and UBS will have no further rights or obligation to buy the auction rate securities.

The Agreement covers $28.4 million par value (fair value of $26.1 million) of the auction rate securities held by the Company as of March 31, 2010. The Company is accounting for the Put Option as a freestanding financial instrument and elected to record the value under the fair value option during the three months ended March 31, 2010. The fair value of the Put Option was $2.3 million and $2.4 million as of March 31, 2010 and June 30, 2009, respectively.

During the three months ended December 31, 2008, the Company made an election pursuant to authoritative guidance for debt and equity investments to transfer these auction rate securities from available-for-sale to trading securities. The transfer to trading securities reflects the Company’s intent to exercise the Put Option during the period June 30, 2010 to June 30, 2012. During the three months ended March 31, 2010, the Company recognized an increase in the fair value of the auction rate securities of $0.7 million, which is included in interest income and other, net. There was no change in the fair value of the auction rate securities for the nine months ended March 31, 2010.

The Company expects that the future changes in the fair value of the Put Option will continue to be largely offset by the fair value movements in the auction rate securities. The Company estimated the fair value of the auction rate securities using a discounted cash flow model incorporating assumptions that market participants would use in their estimates of fair value. Some of these assumptions include estimates for interest rates, timing and amount of cash flows and expected holding periods of the auction rate securities. The Company estimated the fair value of the Put Option using the expected value that the Company will receive from UBS, which was calculated as the difference between the anticipated recognized losses and par value of the auction rate securities as of the option exercise date. This value was discounted by using UBS’s credit default swap rate to account for the credit considerations of the counterparty risk. The Company does not believe that the lack of liquidity of its auction rate securities will have a material impact on its overall ability to meet its cash requirements for the foreseeable future.

 

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Executive Deferred Savings Plan

The Company maintains an Executive Deferred Savings Plan, which is a non-qualified deferred compensation plan whereby non-employee directors and certain highly compensated employees may defer a portion of their salary and bonus. Participants are credited with returns based on their allocation of their account balances among measurement funds. The Company administers the investment of these funds, and the participants remain general creditors of the Company. Distributions from the plan commence the quarter following a participant’s retirement or termination of employment. The Company classifies these deferred compensation plan investments as trading securities. As of March 31, 2010, the Company had a deferred compensation plan related asset and liability of $117.8 million and $118.5 million included as a component of other non-current assets and other current liabilities on the Condensed Consolidated Balance Sheet, respectively. As of June 30, 2009, the Company had a deferred compensation plan related asset and liability of $107.2 million and $108.3 million included as a component of other non-current assets and other current liabilities on the Condensed Consolidated Balance Sheet, respectively.

NOTE 5 – BUSINESS COMBINATIONS

The Company accounts for business combinations using the purchase method of accounting. Consideration includes the cash paid and the value of options assumed, if any, less any cash acquired, and excludes contingent employee compensation payable in cash.

During the three months ended March 31, 2010, the Company acquired a manufacturer of high-resolution surface metrology systems for industrial and academic uses for net cash consideration of approximately $1.5 million, plus potential future earnout payments based upon post-closing business performance. The acquisition has been accounted for as a business combination. This acquisition has expanded the breadth of the Company's existing surface metrology product portfolio and provided enhanced value to the Company’s customers by enabling them to select the optimal combination of performance and price required for their research or production needs.

During the three months ended September 30, 2008, the Company completed its acquisition of the Microelectronic Inspection Equipment business unit (“MIE business unit”) of Vistec Semiconductor Systems for net cash consideration of approximately $141.4 million. The acquired MIE business unit is a provider of mask registration measurement tools, scanning electron microscopy (“SEM”) based tools for mask critical dimension measurement and macro defect inspection systems.

The following table represents the final purchase price allocation and summarizes the aggregate estimated fair values of the net assets acquired on the closing date of the acquisition of the MIE business unit:

 

(In thousands)

   Final
Purchase
Price Allocation
 

Cash

   $ 14,219   

Current assets

     60,094   

Intangibles:

  

Existing technology

     39,800   

Patents

     18,200   

Trade name/Trademarks

     4,800   

Customer relationships

     19,300   

In-process R&D (“IPR&D”)

     8,600   

Backlog

     6,750   

Other intangible assets

     9,950   

Non-current assets

     2,749   

Goodwill

     33,071   

Liabilities assumed

     (61,915
        

Cash consideration – paid

   $ 155,618   
        

Goodwill represents the excess of the purchase price over the fair value of the net tangible and identifiable intangible assets acquired. The $33.1 million of goodwill was assigned to the defect inspection reporting unit and is not expected to be deductible for tax purposes. This acquisition has provided the Company with a line of mask registration measurement tools to complement the Company’s mask inspection products. In addition, through the acquisition the Company has acquired a provider of SEM-based tools for mask critical dimension measurement. Other technologies of the MIE business unit acquired by the Company in the transaction include macro defect inspection systems, overlay measurement systems for microelectromechanical systems (“MEMS”) applications and software packages for defect classification and data analysis.

 

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The results of operations of the acquired MIE business unit are included in the accompanying Condensed Consolidated Statement of Operations from the closing date of the acquisition on September 30, 2008. Pro forma earnings information has not been presented because the effect of the acquisition of the MIE business unit is not material.

The fair value of the purchased IPR&D and identified intangibles was determined using the income approach, which discounts expected future cash flows from projects to their net present value. Each project was analyzed to determine the technological innovations included; the utilization of core technology; the complexity, cost and time to complete development; any alternative future use or current technological feasibility; and the stage of completion. Future cash flows were estimated, taking into account the expected life cycles of the products and the underlying technology, relevant market sizes and industry trends. The Company determined a discount rate for each project based on the relative risks inherent in the project’s development horizon, the estimated costs of development, and the level of technological change in the project and the industry, among other factors.

The Company expensed IPR&D of $8.6 million upon the completion of the acquisition of the MIE business unit in the three months ended September 30, 2008, in connection with acquired intellectual property for which technological feasibility had not been established and no future alternative uses existed.

NOTE 6 – GOODWILL AND PURCHASED INTANGIBLE ASSETS

Goodwill

The following table presents goodwill balances and the movements during the nine months ended March 31, 2010 and 2009:

 

 

     Nine months ended March 31,  

(In thousands)

   2010     2009  

Gross beginning balance as of beginning of fiscal year

   $ 605,965      $ 601,882   

Accumulated impairment losses

     (276,586     —     
                

Net beginning balance as of beginning of fiscal year

     329,379        601,882   

Acquisitions

     877        33,071   

Net exchange differences

     (2,079     (47,082

Adjustments

     —          10,013   

Impairment

     —          (276,586
                

Net ending balance as of March 31

   $ 328,177      $ 321,298   
                

(In thousands)

   As of
March 31, 2010
    As of
March 31, 2009
 

Gross goodwill balance

   $ 604,763      $ 597,884   

Accumulated impairment losses

     (276,586     (276,586
                

Net goodwill balance

   $ 328,177      $ 321,298   
                

Goodwill represents the excess of the purchase price over the fair value of the net tangible and identifiable intangible assets acquired in each business combination. The Company completed its annual evaluation of the goodwill by reporting unit during the three month period ended December 31, 2009 and concluded that there was no impairment. As of December 31, 2009, the Company’s assessment of goodwill impairment indicated that the fair values of the Company’s reporting units were substantially in excess of their estimated carrying values, and therefore goodwill in the reporting units was not impaired.

During the fiscal year ended June 30, 2009, the Company completed its annual evaluation of the goodwill by reporting unit as of December 31, 2008. As a result of the global economic downturn, reductions to the Company’s revenue, operating income and cash flow forecasts, and a significant reduction in the Company’s market capitalization, the Company determined that the goodwill related to its Metrology reporting unit was impaired as of December 31, 2008. As a result, the Company recorded an impairment charge of $272.1 million, which represented the entire goodwill amount related to the Metrology reporting unit, during the three months ended December 31, 2008. The Company’s assessment of goodwill impairment indicated that the fair values of the Company’s other reporting units exceeded their estimated carrying values, and therefore goodwill in those reporting units was not impaired.

Fair value of a reporting unit is determined by using a weighted combination of two market-based approaches and an income approach, as this combination is deemed to be the most indicative of the Company’s fair value in an orderly transaction between market participants and is consistent in principle with the methodology used for goodwill evaluation in the prior year. Under one of the market-based approaches, the Company utilizes information regarding the Company as well as publicly available industry information to determine earnings multiples and sales multiples that are used to value the Company’s reporting units. The Company assigns an equal weighting to the second market-based approach – calculation of fair value of a reporting unit based on its discounted cash flow. Under the income approach, the Company determines fair value based on estimated future cash flows of each reporting

 

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unit, discounted by an estimated weighted-average cost of capital, which reflects the overall level of inherent risk of a reporting unit and the rate of return an outside investor would expect to earn. Determining the fair value of a reporting unit is judgmental in nature and requires the use of significant estimates and assumptions, including revenue growth rates, operating margins, discount rates and future market conditions, among others.

Purchased Intangible Assets

The components of purchased intangible assets as of March 31, 2010 and June 30, 2009 were as follows:

 

(Dollar amounts in thousands)

        As of March 31, 2010    As of June 30, 2009

Category

   Range of
Useful Lives
   Gross
Carrying
Amount
   Accumulated
Amortization
and
Impairment
   Net
Amount
   Gross
Carrying
Amount
   Accumulated
Amortization
and
Impairment
   Net
Amount

Existing technology

   4-7 years    $ 133,066    $ 70,707    $ 62,359    $ 131,966    $ 56,367    $ 75,599

Patents

   6-13 years      57,649      32,623      25,026      57,626      27,847      29,779

Trade name / Trademark

   4-10 years      19,894      10,646      9,248      19,616      9,221      10,395

Customer relationships

   6-7 years      54,823      26,116      28,707      54,409      21,673      32,736

Other

   0-1 year      16,199      15,685      514      16,759      16,188      571
                                            

Total

      $ 281,631    $ 155,777    $ 125,854    $ 280,376    $ 131,296    $ 149,080
                                            

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. During the fiscal year ended June 30, 2008, the Company identified a certain business unit as held for sale. This business unit was subsequently sold during the three months ended December 31, 2009, and the Company recognized a gain of $0.8 million in connection with the sale.

During the quarter ended December 31, 2008, the economic conditions that affect the Company’s industry deteriorated, which led our customers to scale back their production operations and reduce their capital expenditures. At that time, industry analysts expected demand for semiconductor capital equipment to continue to remain weak until macroeconomic conditions improved. In addition, the Company experienced a significant decline in its stock price, resulting in a significant reduction in the Company’s market capitalization. These factors were taken into account as the Company performed an assessment of its purchased intangible assets during the quarter ended December 31, 2008 to test for recoverability in accordance with the authoritative guidance on impairment of long-lived assets. The assessment of recoverability is based on management’s estimates. Based on the assessment, the Company recorded an intangible asset impairment charge of $162.8 million during the three months ended December 31, 2008, of which $73.1 million related to existing technology, $26.3 million to patents, $38.1 million to customer relationships, $16.6 million to trademarks and $8.7 million to other intangible assets.

For the three months ended March 31, 2010 and 2009, amortization expense for purchased intangible assets was $8.6 million and $16.7 million, respectively. For the nine months ended March 31, 2010 and 2009, amortization expense for other intangible assets was $25.3 million and $57.7 million, respectively. Based on the intangible assets recorded as of March 31, 2010, 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)

2010 (remaining 3 months)

   $ 8,518

2011

     32,705

2012

     29,931

2013

     20,658

2014

     15,238

Thereafter

     18,804
      

Total

   $ 125,854
      

NOTE 7 – LONG-TERM DEBT

In April 2008, the Company issued $750 million aggregate principal amount of 6.90% senior, unsecured long-term debt due in 2018 with an effective interest rate of 7.00%. The discount on the debt amounted to $5.4 million and is being amortized over the life of the debt using the straight-line method as opposed to the interest method due to immateriality. Interest is payable semi-annually on November 1 and May 1. The debt indenture includes covenants that limit the Company’s ability to grant liens on its facilities and to enter into sale and leaseback transactions, subject to significant allowances under which certain sale and leaseback transactions are not restricted. The Company was in compliance with all of its covenants as of March 31, 2010.

 

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In certain circumstances involving a change of control followed by a downgrade of the rating of the Company’s senior notes, the Company will be required to make an offer to repurchase the senior notes at a purchase price equal to 101% of the aggregate principal amount of the notes repurchased, plus accrued and unpaid interest. The Company’s ability to repurchase the senior notes in such event may be limited by law, by the indenture associated with the senior notes, or by the terms of other agreements to which the Company may be party at such time. If the Company fails to repurchase the senior notes as required by the indenture, it would constitute an event of default under the indenture governing the senior notes which, in turn, may also constitute an event of default under other of the Company’s obligations.

Based on the trading prices of the debt as of March 31, 2010 and June 30, 2009, the estimated fair value of the debt was $794.6 million and $702.0 million, respectively.

NOTE 8 – STOCK-BASED COMPENSATION

Equity Incentive Program

Under the Company’s current equity incentive program, the Company issues equity awards from its 2004 Equity Incentive Plan (the “2004 Plan”), which provides for the grant of options to purchase shares of its common stock, stock appreciation rights, restricted stock units, performance shares, performance units and deferred stock units to its employees, consultants and members of its Board of Directors. The 2004 Plan was approved by the Company’s stockholders on October 18, 2004 and permits the issuance of up to 32.0 million shares of common stock, including 11.0 million shares approved by the Company’s stockholders on November 4, 2009. As of March 31, 2010, 13.5 million shares were available for grant 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 1.8 shares for every one share subject thereto. During the nine months ended March 31, 2010, approximately 0.3 million restricted stock units were granted to senior management with performance-based and service-based vesting criteria.

The following table summarizes the combined activity under the Company’s equity incentive plans for the indicated period:

 

 

(In thousands)

   Available
For Grant
 

Balances at June 30, 2009(1)

   7,702   

Shares added to 2004 Plan

   11,000   

Restricted stock units granted(2)

   (5,184

Restricted stock units canceled(2)

   1,075   

Restricted stock units traded for taxes(3)

   244   

Options canceled/expired/forfeited

   1,046   

Plan shares expired(4)

   (784
      

Balances at March 31, 2010(1)

   15,099   
      

 

(1) Includes shares available for issuance under the 2004 Plan, as well as under the Company’s 1998 Outside Director Option Plan (the “Outside Director Plan”), which only permits the issuance of stock options to the Company’s non-employee directors. As of March 31, 2010, approximately 1.6 million shares were available for grant under the Outside Director Plan.
(2) 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 1.8 shares for every one share subject thereto.
(3) Effective November 4, 2009, any shares withheld by the Company after such date in satisfaction of applicable withholding taxes upon the issuance, vesting or settlement of equity awards under the 2004 Plan will no longer be available for future issuance under the 2004 Plan.
(4) Represents the portion of shares listed as “Options canceled/expired/forfeited” above that were issued under the Company’s equity incentive plans other than the 2004 Plan or the Outside Director Plan. Because the Company is only currently authorized to issue equity awards under the 2004 Plan and the Outside Director Plan, any equity awards that are canceled, expire or are forfeited under any other Company equity incentive plan do not result in additional shares being available to the Company for future grant.

Except for options granted to non-employee directors as part of their regular compensation package for service through the end of the first quarter of fiscal year 2008, the Company has granted only restricted stock units under its equity incentive program since September 2006. For the preceding several years until June 30, 2006, stock options were generally granted at the market price of the Company’s common stock on the date of grant (except for the retroactively priced options which were granted primarily prior to the fiscal year ended June 30, 2002), with a vesting period of five years and an exercise period not to exceed seven years (ten years for options granted prior to July 1, 2005) from the date of issuance. Restricted stock units may be granted with varying criteria such as service-based and/or performance-based vesting.

 

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The fair value of stock-based awards is measured at the grant date and is recognized as expense over the employee’s requisite service period. The fair value is determined using a Black-Scholes valuation model for stock options and for purchase rights under the Company’s Employee Stock Purchase Plan and using the closing price of the Company’s common stock on the grant date for restricted stock units.

The following table shows pre-tax stock-based compensation expense for the three and nine months ended March 31, 2010 and 2009:

 

 

(In thousands)

   Three months ended
March 31,
   Nine months ended
March 31,
   2010    2009    2010    2009

Stock-based compensation expense:

           

Costs of revenues

   $ 3,793    $ 4,706    $ 10,406    $ 14,841

Engineering, research and development

     6,843      7,524      20,113      24,477

Selling, general and administrative

     10,833      10,528      32,004      40,125
                           

Total stock-based compensation expense

   $ 21,469    $ 22,758    $ 62,523    $ 79,443
                           

Stock Options

The following table summarizes the activities and weighted-average exercise price for stock options under all plans during the nine months ended March 31, 2010:

 

Stock Options

   Shares
(In thousands)
    Weighted-Average
Exercise Price

Outstanding stock options as of June 30, 2009

   12,979      $ 43.49

Granted

   —        $ —  

Exercised

   (452   $ 33.01

Cancelled/expired/forfeited

   (1,046   $ 45.04
        

Outstanding stock options as of March 31, 2010

   11,481      $ 43.76
        

Vested and exercisable as of March 31, 2010

   11,088      $ 43.66
        

The Company has not issued any stock options since November 1, 2007. The weighted-average remaining contractual terms for total options outstanding under all plans and for total options exercisable under all plans were 3.0 years and 3.0 years, respectively. The aggregate intrinsic value for the options exercisable as of March 31, 2010 was $1.9 million.

The authoritative guidance on stock-based compensation permits companies to select the option-pricing model used to estimate the fair value of their stock-based compensation awards. The Black-Scholes option-pricing model requires the input of highly subjective assumptions, including the option’s expected life and the price volatility of the underlying stock. The expected stock price volatility assumption was based on market-based implied volatility from traded options on the Company’s stock.

The following table shows the total intrinsic value of options exercised, total cash received from employees as a result of employee stock option exercises, and tax benefits realized by the Company in connection with these stock option exercises for the three and nine months ended March 31, 2010 and 2009:

 

(In thousands)

   Three months ended
March 31,
   Nine months ended
March 31,
   2010    2009    2010    2009

Total intrinsic value of options exercised

   $ 60    $ —      $ 1,165    $ 10,631

Total cash received from employees as a result of employee stock option exercises

   $ 351    $ —      $ 14,929    $ 9,585

Tax benefits realized by the Company in connection with these exercises

   $ 23    $ —      $ 429    $ 4,014

As of March 31, 2010, the unrecognized stock-based compensation balance related to stock options was $5.5 million and will be recognized over an estimated weighted-average amortization period of 0.7 years.

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

 

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The following table shows the amount of stock-based compensation that was capitalized as inventory as of March 31, 2010 and June 30, 2009:

 

(In thousands)

   March 31,
2010
   June 30,
2009

Inventory

   $ 6,519    $ 6,561

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, traded for taxes, and forfeited during the nine months ended March 31, 2010 and restricted stock units outstanding as of March 31, 2010 and June 30, 2009:

 

 

Restricted Stock Units

   Shares
(In thousands) (1)
    Weighted-Average
Grant Date
Fair Value

Outstanding restricted stock units as of June 30, 2009

   5,464      $ 24.77

Granted

   2,880      $ 22.18

Vested and released

   (806   $ 29.64

Traded for taxes

   (395   $ 30.91

Forfeited

   (597   $ 25.21
        

Outstanding restricted stock units as of March 31, 2010

   6,546      $ 22.62
        

 

(1) Share numbers reflect actual shares subject to awarded restricted stock units. Under the terms of the 2004 Plan, each of the share numbers presented in this column are multiplied by 1.8 to calculate their impact on the share reserve under the 2004 Plan.

The restricted stock units granted by the Company since the beginning of the fiscal year ended June 30, 2007 generally vest in two equal installments on the second and fourth anniversaries of the date of grant. Prior to the fiscal year ended June 30, 2007, the restricted stock units granted by the Company generally vested in two equal installments over four or five years from the anniversary date of the grant. The value of the restricted stock units is based on the closing market price of the Company’s common stock on the date of award. The restricted stock units have been awarded under the Company’s 2004 Plan, and each unit will entitle the recipient to one share of common stock when the applicable vesting requirements for that unit are satisfied. However, for each share actually issued under the awarded restricted stock units, the share reserve under the 2004 Plan will be reduced by 1.8 shares, as provided under the terms of the 2004 Plan.

As of March 31, 2010, the unrecognized stock-based compensation balance related to restricted stock units was $112.2 million and will be recognized over an estimated weighted-average amortization period of 2.5 years.

In connection with the vested and released restricted stock units, the Company realized tax benefits as follows during the three and nine months ended March 31, 2010 and 2009:

 

(In thousands)

   Three months ended
March 31,
   Nine months ended
March 31,
   2010    2009    2010    2009

Tax benefits realized in connection with vested and released restricted stock units

   $ 776    $ 500    $ 13,931    $ 12,967

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 fair market value of the common stock at the time of enrollment into the offering period versus the fair market value on the date of purchase.

During the quarter ended December 31, 2008, the Company’s Board of Directors, as part of the Company’s ongoing efforts to reduce operating expenses, approved amendments to the ESPP so as to, among other things, reduce each offering period under the ESPP (and therefore the length of the look-back period) from 24 months to 6 months. This change became effective January 1, 2009, such that the offering period that began on January 1, 2009 had a duration of six months, and the purchase price with respect to such offering period was 85% of the lesser of (i) the fair market value of the Company’s common stock at the commencement of the six-month offering period or (ii) the fair market value of the Company’s common stock on the purchase date.

During the quarter ended March 31, 2009, the Company’s Board of Directors approved further amendments to the ESPP in continuation of the Company’s cost reduction efforts. Those amendments to the ESPP (a) eliminated the look-back feature (i.e., the

 

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reference to the fair market value of the Company’s common stock at the commencement of the applicable six-month offering period) and (b) reduced the purchase price discount from 15% to 5%. These changes were effective July 1, 2009, such that the purchase price with respect to the six-month offering period that began on July 1, 2009 was 95% of the fair market value of the Company’s common stock on the December 31, 2009 purchase date.

During the quarter ended December 31, 2009, in response to improvements in the business conditions within the industries that the Company serves, the Company’s Board of Directors approved amendments to the ESPP that (a) reinstated the six-month look-back feature and (b) increased the purchase price discount from 5% to 15%. These changes became effective January 1, 2010, such that the purchase price with respect to each offering period beginning on or after such date will be 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 estimated 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
March 31,
    Nine months ended
March 31,
 
     2010     2009     2010     2009  

Stock purchase plan:

        

Expected stock price volatility

   35   ( *)    35   41

Risk-free interest rate

   0.21   ( *)    0.21   1.8

Dividend yield

   1.63   ( *)    1.63   1.4

Term in years

   0.5      ( *)    0.5      1.3   

 

* There were no new valuations recorded during the three months ended March 31, 2009.

No compensation cost was recognized with respect to the ESPP for the six months ended December 31, 2009, as the purchase price for the ESPP offering period that ended on December 31, 2009 was based solely on the market price of the shares at the December 31, 2009 purchase date and the discount on the purchase price was 5%. As a result, no valuations were recorded during the six months ended December 31, 2009, and therefore the assumptions set forth in the table above for the three and nine months ended March 31, 2010 were identical.

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 issue under the ESPP during the forthcoming fiscal year. During the fiscal year ended June 30, 2009, a total of 2.0 million additional shares were reserved under the ESPP, and an additional 2.0 million shares have been reserved under the ESPP with respect to the fiscal year ending June 30, 2010. As of March 31, 2010 (taking into account the shares that have been added to the ESPP with respect to the fiscal year ending June 30, 2010), a total of 3.1 million shares were reserved and available for issuance under the ESPP.

In connection with the disqualifying dispositions of shares purchased under the ESPP, the Company realized tax benefits as follows during the three and nine months ended March 31, 2010 and 2009:

 

 

(In thousands)

   Three months ended
March 31,
   Nine months ended
March 31,
   2010    2009    2010    2009

Tax benefits realized in connection with disqualifying dispositions of ESPP shares

   $ 65    $ 294    $ 932    $ 590
                           

Executive Severance and Consulting Agreement

During August 2008, the Company announced that effective January 1, 2009, John H. Kispert, the Company’s former President and Chief Operating Officer, would cease to be an employee of the Company. In accordance with the terms of a Severance and Consulting Agreement entered into between the Company and Mr. Kispert dated August 28, 2008, Mr. Kispert received, in addition to certain cash payments and benefits, the following benefits related to his outstanding equity awards: (i) accelerated, pro-rated vesting of the unvested portion (as of the date that his employment with the Company terminated) of all of his outstanding restricted stock units, such that a percentage of the unvested portion of each such restricted stock unit grant, representing the portion of the entire service vesting period under such grant that had been served by Mr. Kispert as of the date that he ceased to be an employee of the Company, was accelerated; (ii) the acceleration of the delivery of all restricted stock units for which vesting was accelerated in accordance with the provisions of the Severance and Consulting Agreement; and (iii) the extension of the post-termination exercise period of each of Mr. Kispert’s stock options so that each such option remained exercisable for twelve months following the date Mr. Kispert ceased to be an employee of the Company, but in no event beyond the original term of the award. In connection with the stock-related benefits

 

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agreed to under such agreement, the Company recorded an additional non-cash, stock-based compensation charge of approximately $4.7 million during the three months ended September 30, 2008, which is included as a component of selling, general and administrative (“SG&A”) expense.

NOTE 9 – STOCK REPURCHASE PROGRAM

Since July 1997, the Board of Directors has authorized the Company to systematically repurchase in the open market up to 62.8 million shares of its common stock under a repurchase program. This program was put into place to reduce the dilution from KLA-Tencor’s equity incentive plans and employee stock purchase plan, and to return excess cash to the Company’s shareholders. Subject to market conditions, applicable legal requirements and other factors, the repurchases will be made from time to time in the open market in compliance with applicable securities laws, including the Securities Exchange Act of 1934 and the rules promulgated thereunder such as Rule 10b-18. In October 2008, the Company suspended its stock repurchase program, and the Company subsequently restarted the program in February 2010. At March 31, 2010, 7.8 million shares were available for repurchase under the Company’s repurchase program.

Share repurchases for the three and nine months ended March 31, 2010 and 2009 were as follows:

 

(In thousands)

   Three months ended
March 31,
   Nine months ended
March 31,
   2010    2009    2010    2009

Number of shares of common stock repurchased

     1,990    —        1,990      6,410

Total cost of repurchases

   $ 59,257    —      $ 59,257    $ 218,698

At March 31, 2010, $4.6 million of the above total cost of repurchases for the three months ended March 31, 2010 was unpaid and recorded in other current liabilities. During the three months ended September 30, 2008, the Company settled purchases amounting to $7.8 million related to transactions that had occurred during the period ended June 30, 2008.

NOTE 10 – NET INCOME (LOSS) PER SHARE

Basic net income (loss) per share is calculated by dividing net income (loss) available to common stockholders by the weighted-average number of common shares outstanding during the period. Diluted net income (loss) per share is calculated by using the weighted-average number of common shares outstanding during the period, increased to include the number of additional shares of common stock that would have been outstanding if the shares of common stock underlying the Company’s outstanding dilutive stock options and restricted stock units had been issued. The dilutive effect of outstanding options and restricted stock units is reflected in diluted earnings per share by application of the treasury stock method. Under the treasury stock method, the amount the employee must pay for exercising stock options, the amount of compensation cost for future service that the Company has not yet recognized, and the amount of tax benefits that would be recorded in additional paid-in capital when the award becomes deductible are assumed to be used to repurchase shares. The following table sets forth the computation of basic and diluted net income (loss) per share:

 

 

(In thousands, except per share amounts)

   Three months ended
March 31,
    Nine months ended
March 31,
 
   2010    2009     2010    2009  

Numerator:

          

Net income (loss)

   $ 57,016    $ (82,827   $ 99,215    $ (497,792

Denominator:

          

Weighted average shares outstanding(1)

     171,506      169,934        171,202      170,349   

Effect of dilutive options and restricted stock units

     1,851      —          2,230      —     
                              

Denominator for diluted income (loss) per share

     173,357      169,934        173,432      170,349   
                              

Basic net income (loss) per share

   $ 0.33    $ (0.49   $ 0.58    $ (2.92

Diluted net income (loss) per share

   $ 0.33    $ (0.49   $ 0.57    $ (2.92

Potentially dilutive securities(2)

     11,510      19,405        11,311      19,405   

 

(1) Outstanding shares do not include unvested restricted stock units.
(2) The potentially dilutive securities are excluded from the computation of diluted net income (loss) per share for the above periods because their effect would have been anti-dilutive.

The total amount of dividends paid during the three months ended March 31, 2010 and 2009 was $25.7 million and $25.5 million, respectively. The total amount of dividends paid during the nine months ended March 31, 2010 and 2009 was $77.0 million and $76.7 million, respectively.

 

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NOTE 11 – COMPREHENSIVE INCOME (LOSS)

The components of comprehensive income (loss), net of tax, are as follows:

 

(In thousands)

   Three months ended
March 31,
    Nine months ended
March 31,
 
   2010     2009     2010    2009  

Net income (loss)

   $ 57,016      $ (82,827   $ 99,215    $ (497,792

Other comprehensive income (loss):

         

Currency translation adjustments

     (1,870     (35,348     1,691      (116,905

Gain on cash flow hedging instruments, net

     4        4,571        724      3,069   

Change in unrecognized losses and transition obligation related to pension and post-retirement plans

     20        1,312        56      1,541   

Unrealized gain (loss) on investments

     681        (175     606      3,222   
                               

Other comprehensive income (loss)

     (1,165     (29,640     3,077      (109,073
                               

Total comprehensive income (loss)

   $ 55,851      $ (112,467   $ 102,292    $ (606,865
                               

NOTE 12 – INCOME TAXES

The following table provides details of income taxes:

 

(Dollar amounts in thousands)

   Three months ended
March 31,
    Nine months ended
March 31,
 
   2010     2009     2010     2009  

Income (loss) before income taxes

   $ 80,271      $ (77,167   $ 141,079      $ (556,155

Provision for (benefit from) taxes

     23,255        5,660        41,864        (58,363

Effective tax rate

     29.0     (7.3 %)      29.7     10.5

Tax expense was positively impacted during the three months and nine months ended March 31, 2010 by a non-taxable increase in the assets held within the Company’s Executive Deferred Savings Plan and a reduction of the gross unrecognized tax benefits from a lapsing of the statute of limitations based on authoritative tax guidance.

Tax expense was negatively impacted during the three months and nine months ended March 31, 2010 due to shortfalls from employee stock activity and the tax effect of inter-company dividends.

Windfall tax benefits arise when a company’s tax deduction for employee stock activity exceeds book compensation for the same activity. A shortfall arises when the tax deduction is less than book compensation. Windfalls are recorded as increases to capital in excess of par value. Shortfalls are recorded as decreases to capital in excess of par value to the extent that cumulative windfalls exceed cumulative shortfalls. Shortfalls in excess of cumulative windfalls are recorded as provision for income taxes.

Tax expense was negatively impacted during the three months ended March 31, 2009 by the adoption of California budget legislation, signed on February 20, 2009, which will allow a taxpayer to elect an alternative method to attribute taxable income to California for tax years beginning on or after January 1, 2011. The enactment of this legislation resulted in an expense to reduce non-current deferred tax assets.

Tax expense was negatively impacted during the nine months ended March 31, 2009 by the adoption of the California budget legislation described in the preceding paragraph, as well as a goodwill impairment charge related to certain business units recorded during the nine months ended March 31, 2009, which was non-deductible for tax purposes.

In the normal course of business, the Company is subject to examination by taxing authorities throughout the world. The Company has been notified of a pending United States federal income tax examination for the fiscal years ended June 30, 2007 through June 30, 2009, which represents all completed years for which the statute of limitation has not expired. The Company is subject to state income tax examinations for all years beginning from the fiscal year ended June 30, 2005. The Company is also subject to examinations in major foreign jurisdictions, including Japan, Israel and Singapore, for all years beginning from the fiscal year ended June 30, 2004 and is currently under tax examinations in various other foreign tax jurisdictions. It is possible that certain examinations may be concluded in the next twelve months. The Company believes it is possible that it may recognize up to $9.6 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 agreements with various foreign tax authorities.

NOTE 13 – LITIGATION AND OTHER LEGAL MATTERS

Government Inquiries and SEC Settlement Relating to Historical Stock Option Practices. On May 23, 2006, the Company received a subpoena from the United States Attorney’s Office (“USAO”) requesting information relating to the Company’s past stock option grants and related accounting matters. Also on May 23, 2006, the Company received a letter from the SEC making an informal

 

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inquiry and request for information on the same subject matters. The Company learned on February 2, 2007 that the SEC had opened a formal investigation into these matters. The Company cooperated fully with the SEC investigation. On July 25, 2007, the Company announced that it had reached a settlement with the SEC by consenting to the entry of a permanent injunction against future violations of the reporting, books and records, and internal controls provisions of the federal securities laws. The settlement resolves completely the SEC investigation into the Company’s historical stock option granting practices. KLA-Tencor was not charged by the SEC with fraud, nor was the Company required to pay any civil penalty, fine or money damages as part of the settlement. On July 31, 2008, the USAO informed the Company that it had closed its investigation and had determined not to take any action against the Company. Both the SEC and USAO investigations with respect to the Company are now closed.

The Company has also responded to inquiries from the U.S. Department of Labor (“DOL”), which conducted an examination of the Company’s 401(k) Savings Plan prompted by the Company’s stock option issues. The Company cooperated fully with this examination, and the DOL has advised the Company that it has closed its examination with no further action, subject to confirmation of resolution of any potential claims on behalf of the Company’s 401(k) Savings Plan in connection with its investments in the Company’s stock. The Company believes there is no basis for any such claims; however, an independent fiduciary appointed to act in the best interests of the Company’s 401(k) Savings Plan has elected to participate in the previously announced settlement of the shareholder class action of all potential non-ERISA claims (described below), which will involve no additional cost to the Company, and the Company has entered into a separate settlement with the independent fiduciary of any and all potential ERISA claims, in which the Company denied all liability and paid the Company’s 401(k) Savings Plan a total of $25,000. As a result, the DOL examination has been concluded without any material adverse consequence to the Company. In addition, the Internal Revenue Service conducted an audit covering calendar year 2006 related to the Company’s historical stock option practices, which was concluded in July 2008 with a payment by the Company of $0.1 million. There can be no assurance that other inquiries, investigations or actions will not be started by other United States federal or state regulatory agencies or by foreign governmental agencies.

Shareholder Derivative Litigation Relating to Historical Stock Option Practices. Beginning on May 22, 2006, several persons and entities identifying themselves as shareholders of KLA-Tencor filed derivative actions purporting to assert claims on behalf of and in the name of the Company against several of the Company’s current and former directors and officers relating to its accounting for stock options issued from 1994 to the present. The complaints in these actions allege that the individual defendants breached their fiduciary duties and other obligations to the Company and violated state and federal securities laws in connection with the Company’s historical stock option granting process, its accounting for past stock options, and historical sales of stock by the individual defendants. Three substantially similar actions are pending, one in the U.S. District Court for the Northern District of California (the “Federal Derivative Action,” which consists of three separate lawsuits consolidated into one action); one in the California Superior Court for Santa Clara County; and one in the Delaware Chancery Court.

The plaintiffs in the derivative actions have asserted claims for violations of Sections 10(b) (including Rule 10b-5 thereunder), 14(a), and 20(a) of the Securities Exchange Act of 1934, unjust enrichment, breach of fiduciary duty and aiding and abetting such breach, negligence, misappropriation of information, abuse of control, gross mismanagement, waste of corporate assets, breach of contract, constructive fraud, rescission, and violations of California Corporations Code section 25402, as well as a claim for an accounting of all stock option grants made to the named defendants. KLA-Tencor is named as a nominal defendant in these actions. On behalf of KLA-Tencor, the plaintiffs seek unspecified monetary and other relief against the named defendants. The plaintiffs are James Ziolkowski, Mark Ziering, Alaska Electrical Pension Fund, Jeffrey Rabin and Benjamin Langford. The individual named defendants are current directors and officers Edward W. Barnholt, Robert T. Bond, Stephen P. Kaufman, and Richard P. Wallace; and former directors and officers H. Raymond Bingham, Robert J. Boehlke, Leo Chamberlain, Gary E. Dickerson, Richard J. Elkus, Jr., Dennis J. Fortino, Jeffrey L. Hall, John H. Kispert, Kenneth Levy, Michael E. Marks, Stuart J. Nichols, Arthur P. Schnitzer, Kenneth L. Schroeder, Jon D. Tompkins and Lida Urbanek. Current director David C. Wang and former directors Dennis J. Fortino, Michael E. Marks and Dean O. Morton were originally named as defendants in one of the derivative actions filed in the U.S. District Court for the Northern District of California (the “Federal District Court”), but were dropped as named defendants as of December 22, 2006 upon the filing of a consolidated complaint in the Federal Derivative Action.

The Company’s Board of Directors appointed a Special Litigation Committee (“SLC”) composed solely of independent directors to conduct an independent investigation of the claims asserted in the derivative actions and to determine the Company’s position with respect to those claims. On March 25, 2008, the SLC filed a motion to terminate the Federal Derivative Action and to approve certain settlements with Gary E. Dickerson, Kenneth Levy, Kenneth Schroeder and Jon D. Tompkins related to the claims brought against them in connection with the derivative actions. The Court denied the motion to terminate and to approve the settlements on December 12, 2008. The SLC filed an appeal and petition for writ of mandate challenging that decision to the United States Court of Appeals for the Ninth Circuit, which dismissed the appeal on May 8, 2009 and denied the petition for writ of mandate on July 10, 2009. The parties participated in mediation and settlement discussions regarding the derivative claims in the Federal Derivative Action.

On March 15, 2010, the Company entered into a Stipulation of Settlement (the “Stipulation”) with all parties to the Federal Derivative Action to resolve the Federal Derivative Action in its entirety, subject to approval by the Federal District Court (the “Proposed Settlement”). On March 25, 2010, the Federal District Court entered an order (the “Preliminary Order”) preliminarily approving the Proposed Settlement and scheduling a hearing for consideration of final approval of the Proposed Settlement on May 24, 2010.

 

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As set forth more fully in the Stipulation, under the Proposed Settlement, among other things, (i) the Company will receive cash payments totaling $24 million from insurers; (ii) the Company will receive additional cash payments of approximately $9.2 million from certain of the settling defendants; (iii) certain of the settling defendants relinquished compensation and other benefits, yielding an additional financial benefit to the Company of approximately $9.4 million; (iv) the Company will pay attorneys’ fees to plaintiffs’ counsel in the amount of $8 million in cash, in addition to $8 million in shares of Company common stock to be issued following the Effective Date as defined in the Stipulation (with the number of shares determined by dividing $8 million by the average daily closing price of the Company’s common stock for the ten trading days immediately preceding the Effective Date as defined in the Stipulation); (v) the Federal Derivative Action will be dismissed with prejudice; (vi) the Company, settling defendants, related parties, and plaintiffs and their counsel will be released from claims related to the Federal Derivative Action and the matters that were or could have been alleged therein, and further litigation on such claims will be barred; and (vii) the Company will commit to maintain certain corporate governance enhancements, including certain previously implemented policies, procedures and guidelines relating to the Company’s board of directors composition, stock option granting practices and procedures, and internal controls and procedures. As provided in the Stipulation, the Proposed Settlement will become final and effective following entry of judgment thereon by the Federal District Court, finality of that judgment, and final dismissal of the related shareholder derivative actions pending in the California Superior Court and Delaware Chancery Court. The Proposed Settlement represents a compromise of contested claims and does not contain any admission of wrongdoing or fault on the part of the Company, its board of directors or executive officers, or the other individual defendants to the action, all of whom deny all liability and claims of wrongdoing as part of the Proposed Settlement. This summary of the terms of the Stipulation is qualified entirely by reference to the copy of the Stipulation filed as Exhibit 99.1 to the Current Report on Form 8-K filed by the Company with the SEC on March 26, 2010, the content of which is incorporated by reference herein. During the three months ended March 31, 2010, the Company recorded a charge of $1.7 million to selling, general and administrative expenses, reflecting the anticipated net amount to be paid by the Company in connection with the Proposed Settlement and the Company’s settlements during such period of separate matters with Mr. Schroeder and Mr. Levy that are further described below.

The California Superior Court action was stayed by order of the court on March 18, 2010 pending consideration by the Federal District Court of the Proposed Settlement of the Federal Derivative Action. The Delaware Chancery Court action has been stayed since March 17, 2009 in deference to the Federal Derivative Action.

As part of the derivative lawsuit filed in the Delaware Chancery Court on July 21, 2006, a plaintiff claiming to be a KLA-Tencor shareholder also asserted a separate putative class action claim against the Company and certain of its current and former directors and officers alleging that shareholders incurred damage due to purported dilution of KLA-Tencor common stock resulting from historical stock option granting practices. On March 17, 2009, the Delaware Chancery Court dismissed the putative class action claim and stayed the derivative claims in the action. Plaintiff sought leave to appeal this decision, which the Chancery Court denied on April 14, 2009. Plaintiff subsequently filed a notice of appeal with the Delaware Supreme Court seeking to overturn the Chancery Court’s denial of the application to appeal, which the Delaware Supreme Court denied on April 27, 2009. Plaintiff in the Delaware Chancery Court action advised the Company on March 19, 2010 that the Delaware Chancery Court action will be dismissed with prejudice upon final approval of the Proposed Settlement by the Federal District Court.

Notwithstanding the Proposed Settlement described above, if the Federal District Court does not grant final approval to the Proposed Settlement, or if the Effective Date as defined in the Stipulation does not occur, the derivative actions may continue. The Company therefore cannot predict with certainty whether these derivative actions are likely to result in any material recovery by or expense to KLA-Tencor.

Shareholder Class Action Litigation Relating to Historical Stock Option Practices. KLA-Tencor and various of its current and former directors and officers were named as defendants in putative securities class action filed on June 29, 2006 in the U.S. District Court for the Northern District of California. Two similar actions were filed later in the same court, and all three cases were consolidated into a single action. On September 26, 2008, Judge Charles Breyer of the Northern District granted final approval of a settlement resolving all class claims and dismissing with prejudice all claims brought by the consolidated action. The class action had alleged material misrepresentations in the Company’s SEC filings and public statements and brought claims under Section 10(b) and Rule 10b-5 thereunder, Section 14(a), Section 20(a), and Section 20A of the Securities Exchange Act of 1934 as a result of the Company’s past stock option grants and related accounting and reporting. The settlement resolved all claims against all defendants, who were KLA-Tencor, Edward W. Barnholt, H. Raymond Bingham, Robert T. Bond, Gary E. Dickerson, Richard J. Elkus, Jr., Jeffrey L. Hall, Stephen P. Kaufman, John H. Kispert, Kenneth Levy, Michael E. Marks, Stuart J. Nichols, Kenneth L. Schroeder, Jon D. Tompkins, Lida Urbanek and Richard P. Wallace.

The Company made a payment of $65.0 million to the settlement class as a term of the court-approved settlement during the three months ended September 30, 2008, which provides a full release of KLA-Tencor and the other named defendants in connection with the allegations raised in the lawsuit. The Company had reached an agreement in principle to resolve the action prior to December 31, 2007, and therefore an amount of $65.0 million was accrued by a charge to selling, general and administrative expenses during the three months ended December 31, 2007.

Another plaintiff, Chris Crimi, filed a putative class action complaint in the Superior Court of the State of California for the County of Santa Clara on September 4, 2007 against the Company and certain of its current and former directors and officers. The

 

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plaintiff sought to represent a class consisting of persons who held KLA-Tencor common stock between September 20, 2002 and September 27, 2006, originally alleging causes of action for breach of fiduciary duty and rescission based on alleged misstatements and omissions in the Company’s SEC filings concerning the Company’s past stock option grants, and seeking unspecified damages based upon purported dilution of the Company’s stock, injunctive relief, and rescission. The plaintiff named the Company, Edward W. Barnholt, H. Raymond Bingham, Robert T. Bond, Richard J. Elkus, Jr., Stephen P. Kaufman, Kenneth Levy, Michael E. Marks, Dean O. Morton, Kenneth L. Schroeder, Jon D. Tompkins, and Richard P. Wallace as defendants in the action. The Company filed a demurrer to the complaint, which was sustained, and then removed the case to the U.S. District Court for the Northern District of California upon plaintiff’s filing an amended complaint. The Company then filed a motion to dismiss the action in the Northern District of California, which was granted in part, with the remaining claims being remanded back to the California Superior Court on September 12, 2008. The Company filed a demurrer to plaintiff’s Second Amended Complaint and plaintiff responded by agreeing to dismiss the action with prejudice, bringing an end to this action.

Litigation with Former CEO Kenneth Schroeder. On April 17, 2009, Kenneth Schroeder, the Company’s former Chief Executive Officer, served the Company with a lawsuit filed in the California Superior Court for Santa Clara County asserting various contract and tort claims in connection with the Company’s termination of Mr. Schroeder and the cancellation of certain of his stock options and restricted stock units in October 2006. The Company filed a motion to compel arbitration of Mr. Schroeder’s claims on June 15, 2009. After the Company filed the motion to compel, Mr. Schroeder stipulated to arbitration, and the California Superior Court for Santa Clara County issued an order compelling the arbitration of his claims and staying the state court action on July 27, 2009. Mr. Schroeder initiated an AAA arbitration claim against the Company on August 7, 2009. In response, the Company filed an Answer and Counterclaim on September 14, 2009. The Company alleged counterclaims against Mr. Schroeder for breach of fiduciary duty, unjust enrichment, fraudulent concealment, declaratory relief and equitable indemnification.

On March 15, 2010, the Company entered into a settlement agreement with Mr. Schroeder. Under the terms of the settlement, the Company will pay Mr. Schroeder $16.5 million, the parties will release and dismiss their respective claims, and the Company’s ongoing obligation to indemnify and advance Mr. Schroeder’s costs of defending certain litigation brought against him by the SEC will be subject to express limitations. The settlement with Mr. Schroeder will become final upon the effectiveness of the Proposed Settlement of the Federal Derivative Action. The settlement with Mr. Schroeder does not alter, restrict or impair the parties’ rights and obligations under the Proposed Settlement of the Federal Derivative Action. Because the effectiveness of this settlement is subject to the effectiveness of the Proposed Settlement of the Federal Derivative Action, the Company cannot predict with certainty the final outcome or estimate the likelihood or potential dollar amount of any adverse result in this litigation.

Settlement with Former CEO and Chairman of the Board Kenneth Levy. Kenneth Levy, the Company’s former Chief Executive Officer and Chairman of the Board, asserted breach of contract and tort claims against the Company for approximately $8.3 million in damages arising from the Company’s alleged refusal to allow Mr. Levy to exercise certain of his stock options in 2007 and 2008. On March 15, 2010, the Company entered into a settlement agreement with Mr. Levy. Under the parties’ settlement of those claims, the Company will pay Mr. Levy $2.375 million, and the parties will exchange mutual releases. The settlement with Mr. Levy will become final upon the effectiveness of the Proposed Settlement of the Federal Derivative Action. The settlement with Mr. Levy does not alter, restrict or impair the parties’ rights and obligations under the Proposed Settlement of the Federal Derivative Action. Because the effectiveness of this settlement is subject to the effectiveness of the Proposed Settlement of the Federal Derivative Action, the Company cannot predict with certainty the final outcome or estimate the likelihood or potential dollar amount of any adverse result in this matter.

Indemnification Obligations. Subject to certain limitations, the Company is obligated to indemnify its current and former directors, officers and employees in connection with the investigation of the Company’s historical stock option practices and the related litigation and ongoing government inquiry. 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. The Company is currently paying or reimbursing legal expenses being incurred in connection with these matters by a number of its current and former directors, officers and employees. It is also paying defense costs to two former officers and employees facing SEC civil actions to which the Company is not a party. Although the maximum potential amount of future payments KLA-Tencor could be required to make under these agreements is theoretically unlimited, the Company believes the fair value of this liability, to the extent estimable, is appropriately considered within the reserve it has established for currently pending legal proceedings.

Other Legal Matters. The Company is named from time to time as a party to lawsuits 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. Litigation, in general, and intellectual property and securities litigation in particular, can be expensive and disruptive to normal business operations. 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 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

 

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alleged liabilities from the matters described above will not exceed the amounts reflected in the Company’s financial statements or will not have a material adverse effect on its results of operations, financial condition or cash flows.

NOTE 14 – COMMITMENTS AND CONTINGENCIES

Factoring. KLA-Tencor has agreements with financial institutions to sell certain of its trade receivables and promissory notes from customers without recourse. KLA-Tencor does not believe it is at risk for any material losses as a result of these agreements. In addition, from time to time KLA-Tencor will discount without recourse Letters of Credit (“LCs”) received from customers in payment for goods.

The following table shows total receivables sold under factoring agreements, proceeds from sales of LCs and related discounting fees paid for the three and nine months ended March 31, 2010 and 2009:

 

 

     Three months ended    Nine months ended

(In thousands)

   March 31,
2010
   March 31,
2009
   March 31,
2010
   March 31,
2009

Receivables sold under factoring agreements

   $ 16,968    $ 50,143    $ 86,987    $ 208,782

Proceeds from sales of LCs

   $ 13,384    $ —      $ 23,891    $ 10,666

Discounting fees paid on sales of LCs(1)

   $ 26    $ —      $ 149    $ 44

 

(1) Discounting fees were equivalent to interest expense and were recorded in interest income and other, net.

Facilities. KLA-Tencor leases certain of its facilities under arrangements that are accounted for as operating leases. The following is a schedule of the remaining estimated operating lease payments (in thousands):

 

 

Fiscal year ending June 30,

   Amount

2010 (remaining 3 months)

   $ 2,474

2011

     7,981

2012

     5,294

2013

     3,632

2014

     2,564

2015 and thereafter

     6,413
      

Total minimum lease payments

   $ 28,358
      

Rent expense was approximately $2.1 million and $2.4 million for the three months ended March 31, 2010 and 2009, respectively. Rent expense was approximately $7.0 million and $8.3 million for the nine months ended March 31, 2010 and 2009, respectively.

Purchase Commitments. KLA-Tencor maintains certain open inventory purchase commitments with its suppliers to ensure a smooth and continuous supply for key components. KLA-Tencor’s liability under these purchase commitments is generally restricted to a forecasted time-horizon as mutually agreed upon between the parties. This forecast time-horizon can vary among different suppliers. The Company’s open inventory purchase commitments were approximately $199.5 million as of March 31, 2010 and are primarily due within the next 12 months. Actual expenditures will vary based upon the volume of the transactions and length of contractual service provided. In addition, the amounts paid under these arrangements may change in the event that the arrangements are renegotiated or canceled. Certain agreements provide for potential cancellation penalties.

Guarantees. KLA-Tencor typically provides standard warranty coverage on its systems for 40 hours per week for 12 months, providing labor and parts necessary to repair the systems during the warranty period. KLA-Tencor 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, KLA-Tencor calculates the average service hours and parts expense per system and applies the actual labor and overhead rates to determine the estimated warranty charge. KLA-Tencor updates these estimated charges on a quarterly basis. The actual product performance and/or field expense profiles may differ, and in those cases KLA-Tencor adjusts its warranty accruals accordingly.

 

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The following table provides the balances and changes in the product warranty accrual for the three and nine months ended March 31, 2010 and 2009:

 

(In thousands)

   Three months ended
March 31,
    Nine months ended
March 31,
 
   2010     2009     2010     2009  

Beginning balance

   $ 15,726      $ 27,029      $ 18,213      $ 38,700   

Accruals for warranties issued during the period

     5,986        3,452        16,713        12,656   

Changes in liability related to pre-existing warranties

     (345     (2,103     (2,924     (701

Settlements made during the period

     (4,120     (7,247     (14,755     (29,524
                                

Ending balance

   $ 17,247      $ 21,131      $ 17,247      $ 21,131   
                                

Subject to certain limitations, KLA-Tencor indemnifies its current and former officers and directors for certain events or occurrences. Although the maximum potential amount of future payments KLA-Tencor could be required to make under these agreements is theoretically unlimited, the Company believes the fair value of this liability, to the extent estimable, is appropriately considered within the reserve it has established for currently pending legal proceedings.

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 a breach of warranties, representations and covenants related to such matters 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.

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.

The Company maintains guarantee arrangements of $16.7 million in various locations to fund customs guarantees for VAT and LC needs of its subsidiaries in Europe and Asia. Approximately $11.9 million was outstanding under these arrangements as of March 31, 2010.

NOTE 15 – RESTRUCTURING CHARGES

In March 2009, the Company announced a plan to further reduce its global workforce by approximately 10%, which followed the Company’s announcement in November 2008 of a global workforce reduction of approximately 15%. The Company has undertaken a number of cost reduction activities, including these workforce reductions, in an effort to lower its quarterly operating expense run rate. The program in the United States is accounted for in accordance with the authoritative guidance related to compensation for non-retirement post-employment benefits, whereas the programs in the international locations are accounted for in accordance with the authoritative guidance for contingencies. During the three months ended March 31, 2010, the Company recorded a $1.2 million net restructuring charge, of which $0.3 million was recorded to costs of revenues and $0.9 million was recorded to selling, general and administrative expense. This charge represents the estimated minimum liability associated with expected termination benefits to be provided to employees after employment.

 

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The following table shows the activity primarily related to severance and benefits expense for the three and nine months ended March 31, 2010 and 2009:

 

 

(In thousands)

   Three months ended
March 31,
    Nine months ended
March 31,
 
   2010     2009     2010     2009  

Beginning balance

   $ 4,578      $ 18,707      $ 8,086      $ 1,333   

Restructuring costs

     1,398        16,788        5,242        39,930   

Adjustments

     (202     (222     (887     (1,555

Cash payments

     (5,038     (13,024     (11,705     (17,459
                                

Ending balance

   $ 736      $ 22,249      $ 736      $ 22,249   
                                

Substantially all of the remaining accrued restructuring balance related to the Company’s workforce reductions is expected to be paid out by the end of calendar year 2010.

NOTE 16 – DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES

The authoritative guidance requires companies to recognize all derivative instruments and hedging activities, including foreign currency exchange contracts, as either assets or liabilities at fair value on the balance sheet. Changes in the fair value of derivatives that do not qualify for hedge treatment, as well as the ineffective portion of any hedges, are reflected in the Condensed Consolidated Statement of Operations. In accordance with the guidance, the Company designates foreign currency forward exchange 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 options to hedge against future movements in foreign exchange rates that affect certain existing and forecasted foreign currency denominated sales and purchase transactions, such as the Japanese yen, the euro and the Israeli shekel. KLA-Tencor does not use derivative financial instruments for speculative or trading purposes. 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 counter-party 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 financial losses.

For derivative instruments that are designated and qualify as cash flow hedges, the effective portion of the gain or loss on the derivative is reported as a component of accumulated other comprehensive income (loss) (“OCI”) and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. Changes in the fair value of currency forward exchange and option contracts due to changes in time value are excluded from the assessment of effectiveness. Gains and losses on the derivative representing either hedge ineffectiveness or hedge components excluded from the assessment of effectiveness are recognized in current earnings.

For derivative instruments that are not designated as accounting hedges, gains and losses are recognized in interest income and other, net. The majority of such derivatives are foreign currency forward contracts to hedge certain foreign currency denominated assets or liabilities. The gains and losses on these derivatives are largely offset by the changes in the fair value of the assets or liabilities being hedged.

 

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Derivatives in Cash Flow Hedging Relationships: Foreign Exchange Contracts

The location and amounts of designated and non-designated derivative instruments’ gains and losses in the condensed consolidated financial statements for the three and nine months ended March 31, 2010 and 2009 are as follows:

 

 

    Location in Financial Statements  
    Three months ended March 31, 2010     Three months ended March 31, 2009  

(In thousands)

  Accumulated
OCI
    Revenues     Costs of
revenues
    Interest
income
and
other,
net
    Total     Accumulated
OCI
    Revenues     Costs of
revenues
    Interest
income
and
other,
net
    Total  

Derivatives Designated as Hedging Instruments

                   

Gain (loss) in accumulated OCI on derivative (effective portion)

  $ (460         $ (460   $ 3,240            $ 3,240   
                                                                               

Loss reclassified from accumulated OCI into income (effective portion)

    $ (215   $ (251     $ (466     $ (3,817   $ (316     $ (4,133
                                                                               

Gain (loss) recognized in income on derivative (ineffectiveness portion and amount excluded from effectiveness testing)

        $ 33      $ 33            $ (205   $ (205
                                                                               

Derivatives Not Designated as Hedging Instruments

                   

Gain (loss) recognized in income

        $ (3,422   $ (3,422         $ 3,658      $ 3,658   
                                                                               
    Nine months ended March 31, 2010     Nine months ended March 31, 2009  

(In thousands)

  Accumulated
OCI
    Revenues     Costs of
revenues
    Interest
income
and
other,
net
    Total     Accumulated
OCI
    Revenues     Costs of
revenues
    Interest
income
and
other,
net
    Total  

Derivatives Designated as Hedging Instruments

                   

Loss in accumulated OCI on derivative (effective portion)

  $ (862         $ (862   $ (5,211         $ (5,211
                                                                               

Loss reclassified from accumulated OCI into income (effective portion)

    $ (1,797   $ (227     $ (2,024     $ (9,784   $ (377     $ (10,161
                                                                               

Gain (loss) recognized in income on derivative (ineffectiveness portion and amount excluded from effectiveness testing)

        $ (286   $ (286         $ (611   $ (611
                                                                               

Derivatives Not Designated as Hedging Instruments

                   

Loss recognized in income

        $ (5,534   $ (5,534         $ (35,648   $ (35,648
                                                                               

The Company’s outstanding hedge contracts, with maximum maturity of 18 months, were as follows:

 

(In thousands)

   As of
March 31, 2010
    As of
June 30, 2009
 

Cash flow hedge contracts

    

Purchase

   $ 10,384      $ —     

Sell

     (32,434     (36,938

Other foreign currency hedge contracts

    

Purchase

     102,481        73,914   

Sell

     (56,447     (106,080
                

Net

   $ 23,984      $ (69,104
                

 

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The location and fair value amounts of the Company’s derivative instruments reported in its Condensed Consolidated Balance Sheets as of March 31, 2010 and June 30, 2009 were as follows:

 

 

     Asset Derivatives    Liability Derivatives
          March 31,
2010
   June 30,
2009
        March 31,
2010
   June 30,
2009

(In thousands)

   Balance Sheet Location    Fair Value    Balance Sheet Location    Fair Value

Derivatives Designated as Hedging Instruments

                 

Foreign exchange contracts

   Other current assets    $ 704    $ 441    Other current liabilities    $ 862    $ 657
                                 

Total Derivatives Designated as Hedging Instruments

      $ 704    $ 441       $ 862    $ 657
                                 

Derivatives Not Designated as Hedging Instruments

                 

Foreign exchange contracts

   Other current assets    $ 1,421    $ 1,803    Other current liabilities    $ 1,405    $ 2,142

Other(1)

   Other current assets      2,275      2,416         
                                 

Total Derivatives Not Designated as Hedging Instruments

      $ 3,696    $ 4,219       $ 1,405    $ 2,142
                                 

Total Derivatives

      $ 4,400    $ 4,660       $ 2,267    $ 2,799
                                 

 

(1) Includes the Put Option to sell the Company’s auction rate securities at par value to UBS.

The following table provides the balances and changes in the accumulated OCI related to derivative instruments for the three and nine months ended March 31, 2010 and 2009:

 

 

(In thousands)

   Three months ended
March 31,
    Nine months ended
March 31,
 
   2010     2009     2010     2009  

Beginning balance

   $ (457   $ (9,201   $ (1,613   $ (6,779

Amount reclassified to income

     466        4,133        2,024        10,161   

Net change

     (460     3,240        (862     (5,211
                                

Ending balance

   $ (451   $ (1,828   $ (451   $ (1,828
                                

NOTE 17 – IMPAIRMENT OF REAL ESTATE ASSETS

During fiscal year 2009, as part of its long-term business plan, the Company decided to sell certain of its owned real estate properties located in San Jose, California. The real estate properties are non-financial assets classified within Level 3 of the fair value hierarchy. During the three months ended March 31, 2010, no additional asset impairment charge was recorded. During the nine months ended March 31, 2010, the Company recorded an asset impairment charge of approximately $10.4 million based on the valuation of these assets using relevant market indicators such as range of estimated selling prices. This impairment charge was included in selling, general and administrative expenses.

NOTE 18 – RELATED PARTY TRANSACTIONS

During the three and nine months ended March 31, 2010 and 2009, the Company purchased from, or sold to, several entities where one or more members of the Company’s Board of Directors, or their immediate family members, also serves as an executive officer or board member, including JDS Uniphase Corporation, Freescale Semiconductor, Inc. and National Semiconductor Corp. The following table provides the transactions with these parties (for the portion of such period that they were considered related):

 

(In thousands)

   Three months ended
March 31,
   Nine months ended
March 31,
   2010    2009    2010    2009

Total revenues

   $ 2,310    $ 2,232    $ 6,247    $ 6,691

Total purchases

   $ 104    $ 31      2,496    $ 764

 

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The Company had a receivable balance from these parties of approximately $2 million and $1 million at March 31, 2010 and June 30, 2009, respectively. Management believes that such transactions are at arms length and on similar terms as would have been obtained from unaffiliated third parties.

NOTE 19 – SEGMENT REPORTING AND GEOGRAPHIC INFORMATION

KLA-Tencor reports one reportable segment in accordance with the provisions of the authoritative guidance for segment reporting. Operating segments are defined as components of an enterprise about which separate financial information is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. KLA-Tencor’s chief operating decision maker is the Chief Executive Officer.

KLA-Tencor is engaged primarily in designing, manufacturing, and marketing process control and yield management solutions for the semiconductor and related nanoelectronics industries. All operating units 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 KLA-Tencor operates in one segment, all financial segment information can be found in the condensed consolidated financial statements.

KLA-Tencor’s significant operations outside the United States include manufacturing facilities in Israel and Singapore, and sales, marketing and service offices in Western Europe, Japan and the Asia Pacific region. For geographical revenue reporting, revenues are attributed to the geographic location in which the customer is located. Long-lived assets consist primarily of net property and equipment and are attributed to the geographic region in which they are located.

The following is a summary of revenues by geographic region for the three and nine months ended March 31, 2010 and 2009:

 

 

(Dollar amounts in thousands)

   Three months ended
March 31,
    Nine months ended
March 31,
 
   2010     2009     2010     2009  

Revenues:

                 

United States

   $ 102,156    21   $ 127,999    41   $ 282,202    23   $ 287,324    23

Taiwan

     176,329    37     18,664    6     470,395    37     140,803    11

Japan

     51,313    11     76,032    25     166,806    13     363,830    30

Europe & Israel

     28,886    6     29,148    9     79,719    6     126,235    10

Korea

     49,252    10     37,837    12     98,201    8     170,449    14

Rest of Asia Pacific

     70,363    15     19,932    7     164,018    13     150,073    12
                                                    

Total

   $ 478,299    100   $ 309,612    100   $ 1,261,341    100   $ 1,238,714    100
                                                    

Long-lived assets by geographic region as of March 31, 2010 and June 30, 2009 were as follows:

 

(In thousands)

   March 31, 2010    June 30, 2009

Long-lived assets:

     

United States

   $ 215,575    $ 239,863

Taiwan

     839      1,021

Japan

     3,976      4,308

Europe & Israel

     103,195      143,410

Korea

     3,578      3,764

Rest of Asia Pacific

     58,172      64,868
             

Total

   $ 385,335    $ 457,234
             

 

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The following is a summary of revenues by major products for the three and nine months ended March 31, 2010 and 2009 (as a percentage of total revenue):

 

(Dollar amounts in thousands)

   Three months ended
March 31,
    Nine months ended
March 31,
 
   2010     2009     2010     2009  

Revenues:

                 

Defect inspection

   $ 256,863    54   $ 158,998    51   $ 688,977    55   $ 659,594    53

Metrology

     77,370    16     41,922    14     177,242    14     192,555    15

Service

     126,879    27     98,699    32     363,249    29     340,673    28

Other

     17,187    3     9,993    3     31,873    2     45,892    4
                                                    

Total

   $ 478,299    100   $ 309,612    100   $ 1,261,341    100   $ 1,238,714    100
                                                    

For the three and nine months ended March 31, 2010, two customers accounted for greater than 10% of revenues. For the three months ended March 31, 2009, one customer accounted for greater than 10% of revenue. For the nine months ended March 31, 2009, two customers accounted for greater than 10% of revenue. As of March 31, 2010, three customers accounted for greater than 10% of net accounts receivable, and as of June 30, 2009, two customers accounted for greater than 10% of net accounts receivable.

 

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; the percentage of spending that our customers allocate to process control; orders for our products and capital equipment generally; sales of semiconductors; the allocation of capital spending by our customers; 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; the availability of the offer to repurchase our auction rate securities by the securities firm from which we purchased such securities; the future impact of the restatement of our historical financial statements, shareholder litigation and related matters arising from the discovery that we had retroactively priced stock options (primarily from July 1, 1997 to June 30, 2002) and had not accounted for them correctly; our future product offerings and product features; the success and market acceptance of new products; timing of shipment of backlog; the future of our product shipments and our product and service revenues; our future gross margins; our future research and development expenses and selling, general and administrative expenses; our ability to successfully implement our efforts to reduce our operating costs, and the anticipated cost savings to be realized from such efforts; international sales and operations; our ability to maintain or improve our existing competitive position; success of our product offerings; creation and funding of programs for research and development; attraction and retention of employees; results of our investment in leading edge technologies; the effects of hedging transactions; the effect of the sale of trade receivables and promissory notes from customers; our future income tax rate; dividends; the completion of any acquisitions of third parties, or the technology or assets thereof; benefits received from any acquisitions and development of acquired technologies; sufficiency of our existing cash balance, investments and cash generated from operations to meet our operating and working capital requirements; and the adoption of new accounting pronouncements.

Our actual results may differ significantly from those projected in the forward-looking statements in this report. Factors that might cause or contribute to such differences include, but are not limited to, those discussed in Part II, Item 1A, “Risk Factors” in this report as well as in Item 1, “Business” and Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the year ended June 30, 2009, filed with the Securities and Exchange Commission on August 7, 2009. 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 to update the forward-looking statements in this report after the date hereof.

CRITICAL ACCOUNTING ESTIMATES AND POLICIES

The preparation of our condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions in applying our accounting policies that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. Note 1 to the consolidated financial statements in our Annual Report on Form 10-K for the fiscal year ended June 30, 2009 describes the significant accounting policies and methods used in preparation of our consolidated financial statements. We based these estimates and assumptions on historical experience and evaluate them on an on-going basis to ensure that they remain reasonable under current conditions. Actual results could differ from those estimates and assumptions. We discuss the development and selection of the critical accounting estimates with the Audit Committee of our Board of Directors on a quarterly basis, and the Audit Committee has reviewed the Company’s related disclosure in this Quarterly Report on Form 10-Q. The accounting policies that reflect our more significant estimates, judgments and assumptions and which we believe are the most critical to aid in fully understanding and evaluating our reported financial results include the following:

 

   

Revenue Recognition

 

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Inventories

 

   

Warranty

 

   

Allowance for Doubtful Accounts

 

   

Stock-Based Compensation

 

   

Contingencies and Litigation

 

   

Goodwill and Intangible Assets

 

   

Income Taxes

System revenues recognized without a written acceptance from the customer were approximately 25%, 22% and 10% of total revenues for the three months ended March 31, 2010, December 31, 2009 and March 31, 2009, respectively. The percentage of system revenues recognized without a written acceptance from the customer for the three months ended March 31, 2010 has increased compared to the three months ended December 31, 2009 and March 31, 2009 primarily due to higher shipments of tools that have already met the required acceptance criteria at those customer fabs.

During the three months ended December 31, 2009, we adopted two amendments to the authoritative guidance related to revenue recognition for certain arrangements with software elements and for multiple deliverables. The implementation resulted in additional qualitative disclosures but did not have a material impact on our critical accounting estimates and policies. Please refer to Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in Part II, Item 7 of our Annual Report on Form 10-K for our fiscal year ended June 30, 2009 for a more complete discussion of our critical accounting policies and estimates.

Revenue Recognition for Certain Arrangements with Software Elements and/or Multiple Deliverables

In October 2009, the Financial Accounting Standards Board (“FASB”) amended the accounting standards for revenue recognition to remove tangible products containing software components and non-software components that function together to deliver the product’s essential functionality from the scope of industry-specific software revenue recognition guidance. In October 2009, the FASB also amended the accounting standards for multiple deliverable revenue arrangements to:

 

   

provide updated guidance on how the deliverables in an arrangement should be separated, and how the consideration should be allocated;

 

   

eliminate the use of the residual method and require an entity to allocate revenue using the relative selling price method; and

 

   

require an entity to allocate revenue in an arrangement using estimated selling prices (“ESP”) of deliverables if it does not have vendor-specific objective evidence (“VSOE”) or third-party evidence (“TPE”) of selling price. Valuation terms are defined as follows:

 

   

VSOE – the price at which we sell the element in a separate stand-alone transaction.

 

   

TPE – evidence from us or other companies of the value of a largely interchangeable element in a transaction.

 

   

ESP – our best estimate of the selling price of an element in a transaction.

We elected to early adopt this accounting guidance at the beginning of the second quarter of our fiscal year ending June 30, 2010 and have applied the adoption retrospectively to the beginning of the fiscal year to apply the guidance to transactions originating or materially modified after June 30, 2009. The implementation resulted in additional qualitative disclosures that are included below but did not have a material impact on our financial position, results of operations or cash flows.

For transactions entered into through June 30, 2009, we primarily recognized revenue based upon the guidance in Staff Accounting Bulletin No. 104. During the period, for the majority of our arrangements involving multiple deliverables, the entire amount of the sales contract was allocated to each respective element based on its relative selling price, using fair value. In the limited circumstances when we were not able to determine fair value for the deliverables in the arrangement, but were able to obtain fair value for the undelivered elements, revenue was allocated using the residual method. Under the residual method, the amount of revenue allocated to delivered elements equaled the total arrangement consideration less the aggregate selling price of any undelivered elements, and no revenue was recognized until all elements without fair value had been delivered. If fair value of any undelivered elements did not exist, the entire amount of the sales contract was deferred until all elements were accepted by the customer.

This guidance does not generally change the units of accounting for our revenue transactions. We typically recognize revenue for system sales upon acceptance by the customer that the system has been installed and is operating according to predetermined specifications. Under certain circumstances, however, we recognize revenue upon shipment, prior to written acceptance by the customer. The portion of revenue associated with installation is deferred based on relative sales price and recognized upon completion of the installation. Spare parts revenue is recognized when the product has been shipped and risk of loss has passed to the customer, and collectability is reasonably assured. Service and maintenance contract revenue is recognized ratably over the term of the

 

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maintenance contract. Revenue from services performed in the absence of a contract, such as consulting and training revenue, is recognized when the related services are performed, and collectability is reasonably assured. Our arrangements generally do not include any provisions for cancellation, termination or refunds that would significantly impact recognized revenue.

We enter into revenue arrangements that may consist of multiple deliverables of our products and services where certain elements of a sales contract are not delivered and accepted in one reporting period.

In many instances, products are sold in stand-alone arrangements. Services are sold separately through renewals of annual maintenance contracts. As a result, for substantially all of the arrangements with multiple deliverables pertaining to products and services, we use VSOE or TPE to allocate the selling price to each deliverable. We determine TPE based on historical prices charged for products and services when sold on a stand-alone basis.

When we are unable to establish relative selling price using VSOE or TPE, we use ESP in our allocation of arrangement consideration. The objective of ESP is to determine the price at which we would transact a sale if the product or service were sold on a stand-alone basis. ESP could potentially be used for new or customized products.

We regularly review relative selling prices and maintain internal controls over the establishment and updates of these estimates.

In terms of the timing and pattern of revenue recognition, the new accounting guidance for revenue recognition is not expected to have a significant effect on revenues in periods after the initial adoption when applied to multiple element arrangements based on current sales strategies.

Valuation of Goodwill and Intangible Assets

We assess goodwill for impairment annually as well as whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Long-lived intangible assets are tested for recoverability whenever events or changes in circumstances indicate that their carrying amounts may not be recoverable.

We completed our annual evaluation of goodwill by reporting unit during the three months ended December 31, 2009 and concluded that there was no impairment.

During the fiscal year ended June 30, 2009, we completed our annual evaluation of goodwill by reporting unit as of December 31, 2008. As a result of the global economic downturn, reductions to our revenue, operating income, and cash flow forecasts, and a significant reduction in our market capitalization, we determined that the goodwill related to our Metrology reporting unit was impaired as of December 31, 2008. As a result, we recorded an impairment charge of $272.1 million, which represented the entire goodwill amount related to the Metrology reporting unit, during the three months ended December 31, 2008. Our assessment of goodwill impairment indicated that the fair values of our Defect Inspection, Service, and Other reporting units exceeded their estimated carrying values, and therefore goodwill in those reporting units was not impaired.

Adoption of Fair Value Measurement

We adopted authoritative guidance for fair value measurements as of the beginning of fiscal year 2009. In February 2008, the FASB issued a provision that allowed companies to elect a one-year delay in applying the fair value measurements guidance to certain fair value measurements, primarily related to non-financial assets and liabilities. We elected the delayed adoption date for our non-financial assets and liabilities impacted by the guidance. This guidance defines fair value, establishes a framework for measuring fair value under generally accepted accounting principles and enhances disclosures about fair value measurements. Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Valuation techniques used to measure fair value must maximize the use of observable inputs and minimize the use of unobservable inputs. The adoption of the guidance relating to the fair value measurement of non-financial assets and liabilities on July 1, 2009 did not have a material impact on our condensed consolidated results of operations or financial condition. See Note 2, “Fair Value Measurements,” to the condensed consolidated financial statements.

Concurrently with the adoption of the fair value measurement and disclosure provisions, we adopted authoritative guidance that permits entities to elect, at specified election dates, to measure eligible financial instruments at fair value. See Note 2, “Fair Value Measurements,” to the condensed consolidated financial statements.

Recent Accounting Pronouncements In February 2010, the Securities and Exchange Commission (“SEC”) issued a policy statement and staff work plan regarding the potential use by U.S. issuers of financial statements prepared in accordance with International Financial Reporting Standards (“IFRS”). IFRS is a comprehensive series of accounting standards published by the International Accounting Standards Board. Under the proposed timeline set forth by the SEC, we could be required in fiscal year 2015 to prepare financial statements in accordance with IFRS, and the SEC is expected to make a determination in 2011 regarding the mandatory adoption of IFRS. We are currently assessing the impact that this potential change would have on our consolidated financial statements, and we will continue to monitor the development of the potential implementation of IFRS.

 

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In February 2010, the FASB amended its guidance on subsequent events. The amendment states that entities that are required to file or furnish their financial statements with the SEC are no longer required to disclose the date through which the entity has evaluated subsequent events. This amendment is effective for our interim reporting period ended March 31, 2010, and the implementation did not have an impact on our financial position, results of operations or cash flows as it is disclosure-only in nature.

In January 2010, the FASB issued authoritative guidance for fair value measurements. This guidance now requires a reporting entity to disclose separately the amounts of significant transfers in and out of Level 1 and Level 2 fair value measurements and also to describe the reasons for these transfers. This authoritative guidance also requires enhanced disclosure of activity in Level 3 fair value measurements. The guidance for Level 1 and Level 2 fair value measurements is effective for our interim reporting period ended March 31, 2010. The implementation did not have an impact on our financial position, results of operations or cash flows as it is disclosure-only in nature. The guidance for Level 3 fair value measurements disclosures becomes effective for our interim reporting period ending September 30, 2011, and we do not expect that this guidance will have an impact on our financial position, results of operations or cash flows as it is disclosure-only in nature.

In October 2009, the FASB amended its Emerging Issues Task Force (“EITF”) authoritative guidance addressing revenue arrangements with multiple deliverables. The guidance requires revenue to be allocated to multiple elements using relative fair value based on vendor-specific objective evidence, third-party evidence or estimated selling price. The residual method also becomes obsolete under this guidance. This guidance is effective for our interim reporting period ending September 30, 2010, and allows for early adoption. We elected to early adopt the accounting guidance at the beginning of the second quarter of our fiscal year ending June 30, 2010 and have applied the adoption retrospectively to the beginning of the fiscal year to apply the guidance to transactions originating or materially modified after June 30, 2009. The implementation resulted in additional qualitative disclosures but did not have a material impact on our financial position, results of operations or cash flows.

In October 2009, the FASB amended the authoritative guidance addressing certain revenue arrangements that include software elements. This guidance states that tangible products with hardware and software components that work together to deliver the product functionality are considered non-software products, and the accounting guidance for revenue arrangements with multiple deliverables is to be followed with respect to such products. This guidance is effective for our interim reporting period ending September 30, 2010, and allows for early adoption. We elected to early adopt the accounting guidance at the beginning of the second quarter of our fiscal year ending June 30, 2010 and have applied the adoption retrospectively to the beginning of the fiscal year to apply the guidance to transactions originating or materially modified after June 30, 2009. The implementation resulted in additional qualitative disclosures but did not have a material impact on our financial position, results of operations or cash flows.

In August 2009, the FASB issued authoritative guidance for measuring liabilities at fair value that reaffirms the previously existing definition of fair value and reintroduces the concept of entry value into the determination of fair value of liabilities. Entry value is the amount an entity would receive to enter into an identical liability. The guidance was effective for our interim reporting period ended December 31, 2009. The implementation did not have a material impact on our financial position, results of operations or cash flows.

In June 2009, the FASB issued authoritative guidance for consolidations that changes how a company determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. The determination of whether a company is required to consolidate an entity is based on, among other things, an entity’s purpose and design and a company’s ability to direct the activities of the entity that most significantly impact the entity’s economic performance. This guidance is effective for our interim reporting period ending September 30, 2010. We are currently evaluating the impact of the implementation on our financial position, results of operations and cash flows.

In June 2009, the FASB issued authoritative guidance to establish the FASB Accounting Standards Codification as the source of authoritative accounting principles and the framework for selecting the principles used in the preparation of financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting principles in the United States. This guidance was effective for our interim reporting period ended September 30, 2009 and only impacted references for accounting guidance.

In April 2009, the FASB issued authoritative guidance for business combinations that amends the provisions related to the initial recognition and measurement, subsequent measurement and disclosure of assets and liabilities arising from contingencies in a business combination. This guidance will require such contingencies to be recognized at fair value on the acquisition date if fair value can be reasonably estimated during the allocation period. Otherwise, entities would typically account for the acquired contingencies in accordance with authoritative guidance for contingencies. The guidance became effective for our business combinations for which the acquisition date is on or after July 1, 2009. We did not complete any material business combinations during the three or nine months ended March 31, 2010, and the effect of this guidance, if any, on our financial position, results of operations and cash flows in future periods will depend on the nature and significance of business combinations subject to this guidance.

In April 2009, the FASB issued authoritative guidance to increase the frequency of fair value disclosures of financial instruments, thereby enhancing consistency in financial reporting. The guidance relates to fair value disclosures for any financial instruments that are not currently reflected on a company’s balance sheet at fair value. Prior to the effective date of this guidance, fair

 

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values for these types of financial assets and liabilities have only been disclosed once a year. The guidance requires these disclosures on a quarterly basis, providing qualitative and quantitative information about fair value estimates for all those financial instruments not measured on the balance sheet at fair value. The disclosure requirement under this guidance was effective for our interim reporting period ended September 30, 2009. The implementation did not have an impact on our financial position, results of operations or cash flows as it is disclosure-only in nature.

In December 2008, the FASB issued authoritative guidance for an employer’s disclosures about plan assets of a defined benefit pension or other post-retirement plan. The guidance requires annual disclosures surrounding how investment allocation decisions are made, including the factors that are pertinent to an understanding of investment policies and strategies. The annual disclosure requirement under this guidance is effective for our fiscal year ending June 30, 2010. The guidance does not change the accounting treatment for post-retirement benefit plans.

In April 2008, the FASB issued authoritative guidance for general intangibles other than goodwill, amending the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset. This guidance is effective for intangible assets acquired on or after July 1, 2009. The adoption did not have a material impact on our financial position, results of operations or cash flows.

EXECUTIVE SUMMARY

KLA-Tencor Corporation is a leading supplier of process control and yield management solutions for the semiconductor and related nanoelectronics industries. Within our primary area of focus, our comprehensive portfolio of products, services, software and expertise helps integrated circuit (“IC” or “chip”) manufacturers manage yield throughout the entire wafer fabrication process – from research and development to final volume production. In addition to the semiconductor industry, our technologies serve a number of other industries, including light emitting diode (“LED”), data storage, solar process development and control, and general materials research.

Our products and services are used by virtually every major wafer, IC and photomask manufacturer in the world. Our revenues are driven largely by capital spending by our customers who operate in one or more of several key semiconductor markets, including the memory, foundry and logic markets. Our customers purchase our products either in response to the need to drive advances in process technologies or to ramp up production to satisfy demand from industries such as communication, data processing, consumer electronics, automotive and aerospace. 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, as well as reduced cost, which in turn will drive increased adoption of process control to reduce defectivity.

As a supplier to the global semiconductor and semiconductor-related industries, we are subject to business cycles, the timing, length and volatility of which can be difficult to predict. The industries we serve have historically been cyclical due to sudden changes in demand and manufacturing capacity. Our ability to predict future capacity-related capital spending by our customers is extremely limited, as such spending is very closely connected to the unpredictable business cycles within their industries. We expect our customers’ capital spending on process control to increase over the long term, driven by the demand for more precise diagnostics capabilities to address new defects as a result of shrinking of device feature sizes, the transition to new materials, new device and circuit architecture, new lithography challenges and fab process innovation.

The demand for our products is generally affected by the profitability of our customers, which is driven by capacity and market supply for their products, as well as the willingness and ability of our customers to invest in new technologies. While semiconductor content in communication, data processing, consumer electronics, automotive and aerospace products continues to increase, the global economic weakness during the fiscal year ended June 30, 2009 adversely impacted our customers that operate in those industries and consequently impacted the demand for our products. However, over the past four quarters, the outlook for economic growth, end product demand for our customers’ products and factory utilization of our customers has improved, resulting in an increase in the demand for semiconductor capital equipment. As our customers accelerate capital investments, we have started to increase production volumes to support anticipated customer demand. However, we cannot predict the duration and sustainability of the improving business conditions. As we increase production volumes and make commitments to increase our capacity in anticipation of improved business conditions, we remain at risk of incurring inventory-related and other restructuring charges if the recent improved business conditions do not continue.

 

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The following table sets forth some of the key quarterly unaudited financial information that we use to manage our business:

 

(In thousands, except net income (loss) per share)

   Three months ended    Three months ended
   March 31,
2010
   December 31,
2009
   September 30,
2009
   June 30,
2009
    March 31,
2009
    December 31,
2008
    September  30,
2008

Total revenues

   $ 478,299    $ 440,355    $ 342,687    $ 281,502      $ 309,612      $ 396,589      $ 532,513

Total costs and operating expenses

   $ 387,020    $ 393,260    $ 327,737    $ 316,469      $ 381,893      $ 902,220      $ 497,575

Income (loss) from operations

   $ 91,279    $ 47,095    $ 14,950    $ (34,967   $ (72,281   $ (505,631   $ 34,938

Net income (loss)

   $ 57,016    $ 21,794    $ 20,405    $ (25,576   $ (82,827   $ (434,254   $ 19,289

Net income (loss) per share:

                 

Basic (1)

   $ 0.33    $ 0.13    $ 0.12    $ (0.15   $ (0.49   $ (2.57   $ 0.11

Diluted (1)

   $ 0.33    $ 0.13    $ 0.12    $ (0.15   $ (0.49   $ (2.57   $ 0.11

 

(1) Basic and diluted earnings per share are computed independently for each of the quarters presented based on the weighted average basic and fully diluted shares outstanding for each quarter. Therefore, the sum of quarterly basic and diluted per share information may not equal annual basic and diluted earnings per share.

RESULTS OF OPERATIONS

Revenues and Gross Margin

 

     Three months ended                         

(Dollar amounts in thousands)

   March 31,
2010
    December 31,
2009
    March 31,
2009
    Q3 FY10 vs.
Q2 FY10
    Q3 FY10 vs.
Q3 FY09
 

Revenues:

               

Product

   $ 349,787      $ 314,946      $ 207,332      $ 34,841    11   $ 142,455      69

Service

   $ 128,512      $ 125,409      $ 102,280      $ 3,103    2   $ 26,232      26
                                           

Total revenues

   $ 478,299      $ 440,355      $ 309,612      $ 37,944    9   $ 168,687      54
                                           

Costs of revenues

   $ 208,565      $ 207,286      $ 209,223      $ 1,279    1   $ (658   0

Stock-based compensation expense included in costs of revenues

   $ 3,793      $ 3,325      $ 4,706      $ 468    14   $ (913   -19

Gross margin percentage

     56     53     32         

 

(Dollar amounts in thousands)

   Nine months ended              
   March 31,
2010
    March 31,
2009
    Q3 FY10 YTD vs.
Q3  FY09 YTD
 

Revenues:

        

Product

   $ 893,984      $ 885,900      $ 8,084      1

Service

     367,357        352,814        14,543      4
                          

Total revenues

   $ 1,261,341      $ 1,238,714      $ 22,627      2
                          

Costs of revenues

   $ 587,743      $ 700,203      $ (112,460   -16

Gross margin percentage

     53     43    

Stock-based compensation expense included in costs of revenues

   $ 10,406      $ 14,841      $ (4,435   -30

Product revenues

Product revenues increased during the three months ended March 31, 2010 from the three months ended December 31, 2009 and March 31, 2009 as our customers accelerated their capital spending due to improved factory utilization and demand for their products, as well as increased demand from our customers for equipment to support their advanced technology development programs. These factors contributed to an increase in the number of tools that we sold during the three months ended March 31, 2010, as compared to the three months ended December 31, 2009 and March 31, 2009. The increase in tool sales over our prior quarter was primarily driven by an increase in our sales of metrology equipment. Compared to the three months ended March 31, 2009, our sales of both defect inspection and metrology equipment during the three months ended March 31, 2010 increased significantly. The slight increase in product revenues for the nine months ended March 31, 2010, compared to the nine months ended March 31, 2009, is primarily attributable to an increase in our sales of defect inspection equipment, partially offset by a decrease in our sales of metrology equipment between those two periods.

 

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For the three and nine months ended March 31, 2010, two customers accounted for greater than 10% of total revenues. For the three months ended March 31, 2009, one customer accounted for greater than 10% of total revenues. For the nine months ended March 31, 2009, two customers accounted for greater than 10% of total revenues.

Service revenues

Service revenues are generated from maintenance service contracts, as well as time and material billable service calls made to our customers after the expiration of the warranty period. The amount of service revenues generated is generally a function of the number of post-warranty systems installed at our customers’ sites and the utilization of those systems. Service revenues increased in the three months ended March 31, 2010 compared to the three months ended December 31, 2009 and March 31, 2009 as a result of increased factory utilization by our customers and increased demand for our customers’ products.

Revenues by region

Revenues by region for the periods indicated were as follows:

 

(Dollar amounts in thousands)

   Three months ended  
   March 31, 2010     December 31, 2009     March 31, 2009  

United States

   $ 102,156    21   $ 105,489    24   $ 127,999    41

Taiwan

     176,329    37     171,947    39     18,664    6

Japan

     51,313    11     56,140    13     76,032    25

Europe & Israel

     28,886    6     26,908    6     29,148    9

Korea

     49,252    10     19,437    4     37,837    12

Rest of Asia Pacific

     70,363    15     60,434    14     19,932    7
                                       

Total

   $ 478,299    100   $ 440,355    100   $ 309,612    100
                                       

A significant portion of our revenues continues to be generated in Asia, where a substantial portion of the world’s semiconductor manufacturing capacity is located, and we expect that will continue to be the case.

Gross margin

Our gross margin fluctuates with revenue levels and product mix, and is affected by variations in costs related to manufacturing and servicing our products. Our gross margin percentage increased to 56% during the three months ended March 31, 2010 from 53% during the three months ended December 31, 2009 primarily due to higher product and service revenues and increased manufacturing capacity utilization.

Our gross margin percentage increased to 56% during the three months ended March 31, 2010 from 32% during the three months ended March 31, 2009 primarily due to higher product and service revenues and increased manufacturing capacity utilization (which in aggregate contributed approximately ten percentage points of the difference in gross margin percentage) and lower inventory costs attributable to obsolescence (which also accounted for approximately ten percentage points of the difference). The remaining four percentage point increase was mainly due to lower intangible assets amortization expense and severance related charges, which each accounted for two percentage points of the difference.

Our gross margin percentage increased to 53% during the nine months ended March 31, 2010 from 43% during the corresponding period of fiscal year 2009 primarily due to lower inventory costs attributable to obsolescence (which contributed approximately six percentage points of the difference). The remaining four percentage point increase was mainly due to lower intangible assets amortization expense and severance related charges, which accounted for two percentage points and one percentage point of the difference, respectively.

Engineering, Research and Development (“R&D”)

 

(Dollar amounts in thousands)

   Three months ended                         
   March 31,
2010
    December 31,
2009
    March 31,
2009
    Q3 FY10 vs.
Q2 FY10
    Q3 FY10 vs.
Q3 FY09
 

R&D expenses

   $ 84,741      $ 83,301      $ 82,609      $ 1,440    2   $ 2,132      3

Stock-based compensation expense included in R&D expenses

   $ 6,843      $ 6,667      $ 7,524      $ 176    3   $ (681   -9

R&D expenses as a percentage of total revenues

     18     19     27         

 

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     Nine months ended              

(Dollar amounts in thousands)

   March 31,
2010
    March 31,
2009
    Q3 FY10 YTD vs.
Q3 FY09 YTD
 

R&D expenses

   $ 246,251      $ 292,236      $ (45,985   -16

Stock-based compensation expense included in R&D expenses

   $ 20,113      $ 24,477      $ (4,364   -18

R&D expenses as a percentage of total revenues

     20     24    

R&D expenses during the three months ended March 31, 2010 increased compared to the three months ended December 31, 2009. The increase is primarily attributable to increased employee-related expenses.

The following are expenses that were recorded in R&D expenses in the three months ended March 31, 2010 compared to the three months ended December 31, 2009:

 

   

$55.3 million for employee-related expenses, compared to $52.8 million during the three months ended December 31, 2009,

 

   

$6.8 million for outside services such as consulting and legal, compared to $6.3 million during the three months ended December 31, 2009, and

 

   

$4.5 million of benefit to R&D expense from external funding, compared to $1.8 million during the three months ended December 31, 2009.

The increase in R&D expenses during the three months ended March 31, 2010 compared to the three months ended March 31, 2009 is primarily due to increased employee-related expenses.

The following are expenses that were recorded in R&D expenses in the three months ended March 31, 2010 compared to the three months ended March 31, 2009:

 

   

$55.3 million for employee-related expenses, compared to $54.9 million during the three months ended March 31, 2009,

 

   

$12.7 million for engineering material costs, compared to $11.3 million in the three months ended March 31, 2009, and

 

   

$6.8 million for outside services such as consulting and legal, compared to $7.1 million during the three months ended March 31, 2009.

The decrease in R&D expenses during the nine months ended March 31, 2010 compared to the nine months ended March 31, 2009 was primarily due to reduced employee-related expenses, lower amortization of purchased intangibles, reduced engineering material costs and lower fees for outside service providers during the nine months ended March 31, 2010.

The following are expenses that were recorded in R&D expenses in the nine months ended March 31, 2010 compared to the nine months ended March 31, 2009:

 

   

$155.7 million for employee-related expenses, compared to $179.4 million during the nine months ended March 31, 2009,

 

   

$36.0 million for engineering material costs, compared to $43.5 million in the nine months ended March 31, 2009,

 

   

$18.7 million for outside services such as consulting and legal, compared to $25.3 million during the nine months ended March 31, 2009, and

 

   

$2.7 million for amortization of purchased intangibles, compared to $12.7 million, which includes $8.6 million of expensed in-process R&D related to the MIE business unit, during the nine months ended March 31, 2009.

 

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R&D expenses include the benefit of $4.5 million, $1.8 million and $6.1 million of external funding received during the three months ended March 31, 2010, December 31, 2009 and March 31, 2009, respectively, for certain strategic development programs from government grants.

Our future operating results will depend significantly on our ability to produce products and provide services that have a competitive advantage in our marketplace. To do this, we believe that we must continue to make substantial investments in our research and development. We remain committed to product development in new and emerging technologies as we address the yield challenges our customers face at future technology nodes.

Selling, General and Administrative (“SG&A”)

 

(Dollar amounts in thousands)

   Three months ended                         
   March 31,
2010
    December 31,
2009
    March 31,
2009
    Q3 FY10 vs.
Q2 FY10
    Q3 FY10 vs.
Q3 FY09
 

SG&A expenses

   $ 93,714      $ 102,673      $ 90,061      $ (8,959   -9   $ 3,653    4

Stock-based compensation expense included in SG&A expenses

   $ 10,833      $ 10,863      $ 10,528      $ (30   0   $ 304    3

SG&A expenses as a percentage of total revenues

     20     23     29         

 

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(Dollar amounts in thousands)

   Nine months ended              
   March 31,
2010
    March 31,
2009
    Q3 FY10 YTD vs.
Q3 FY09 YTD
 

SG&A expenses

   $ 274,023      $ 342,505      $ (68,482   -20

Stock-based compensation expense included in SG&A expenses

   $ 32,004      $ 40,125      $ (8,122   -20

SG&A expenses as a percentage of total revenues

     22     28    

SG&A expenses during the three months ended March 31, 2010 were lower compared to the three months ended December 31, 2009 primarily due to lower charges related to facility usage and impairment as a result of the recent facilities consolidation efforts by our management.

The following are expenses that were recorded in SG&A expenses in the three months ended March 31, 2010 compared to the three months ended December 31, 2009:

 

   

$84.8 million for employee-related expenses, compared to $77.1 million in the three months ended December 31, 2009,

 

   

$18.3 million for facilities-related expenses, fixed asset depreciation and intangibles amortization expenses, compared to $27.4 million in the three months ended December 31, 2009,

 

   

$7.0 million for expenses primarily due to facility lease reserve, compared to $11.3 million for expenses related to building impairment recorded during the three months ended December 31, 2009, and

 

   

$5.4 million for expenses related to the shareholder litigation relating to our historical stock option practices, compared to $7.1 million recorded during the three months ended December 31, 2009.

SG&A expenses during the three months ended March 31, 2010 were higher compared to the three months ended March 31, 2009 primarily due to higher employee-related expenses, as well as higher building impairment charges.

The following are expenses that were recorded in SG&A expenses in the three months ended March 31, 2010 compared to the three months ended March 31, 2009:

 

   

$84.8 million for employee-related expenses, compared to $77.7 million in the three months ended March 31, 2009, and

 

   

$7.0 million for expenses primarily due to facility lease reserve, compared to $2.4 million for expenses related to building impairment recorded during the three months ended March 31, 2009.

SG&A expenses during the nine months ended March 31, 2010 were lower compared to the nine months ended March 31, 2009 primarily due to lower employee-related expenses as a result of a number of cost reduction activities that we undertook during the fiscal year ended June 30, 2009, as well as bad debt expense recorded in the nine months ended March 31, 2009.

The following are expenses that were recorded in SG&A expenses in the nine months ended March 31, 2010 compared to the nine months ended March 31, 2009:

 

   

$228.5 million for employee-related expenses, compared to $272.4 million in the nine months ended March 31, 2009, and

 

   

No bad debt expense, compared to $23.9 million during the nine months ended March 31, 2009 for potential losses relating to heightened risk of non-payment of accounts receivable by customers facing financial difficulty.

Impairment of Goodwill and Purchased Intangible Assets

For the three months ended December 31, 2009, we performed our annual evaluation of goodwill by reporting unit and concluded that there was no impairment as of December 31, 2009. As of December 31, 2009, our assessment indicated that the fair value of our reporting units was substantially in excess of their estimated carrying values, and therefore goodwill in the reporting units was not impaired.

For the three months ended December 31, 2008, we performed our annual evaluation of goodwill by reporting unit, and concluded that, as of December 31, 2008, the carrying value of our Metrology reporting unit exceeded its estimated fair value. As a result of the global economic downturn, reductions to our revenue and operating forecasts and a significant reduction in our market capitalization, we determined that the goodwill related to our Metrology reporting unit was fully impaired. As a result, we recorded a goodwill impairment charge of $272.1 million during the three months ended December 31, 2008.

As a result of the aforementioned impairment indicators for the three months ended December 31, 2008 and in accordance with the authoritative guidance on impairment of long-lived assets, we performed an analysis utilizing discounted future cash flows related to the long-lived and intangible assets to determine the fair value of each of our asset groups. Based on the assessment, we recorded an

 

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intangible asset impairment charge of $162.8 million related to existing technology, patents, customer relationships and trademarks, as well as an additional $2.0 million impairment charge related to long-lived assets during the three months ended December 31, 2008.

Restructuring Charges

In March 2009, we announced a plan to further reduce our global workforce by approximately 10%, which followed our announcement in November 2008 of a global workforce reduction of approximately 15%. We have undertaken a number of cost reduction activities, including these workforce reductions, in an effort to lower our quarterly operating expense run rate. The program in the United States is accounted for in accordance with the authoritative guidance related to compensation for nonretirement post-employment benefits, whereas the programs in the international locations are accounted for in accordance with the authoritative guidance for contingencies. During the three months ended March 31, 2010, we recorded a $1.2 million net restructuring charge, of which $0.3 million was recorded to costs of revenues and $0.9 million was recorded to selling, general and administrative expense. This charge represents the estimated minimum liability associated with expected termination benefits to be provided to employees after employment.

The following table shows the activity primarily related to severance and benefits expense for the three and nine months ended March 31, 2010 and 2009:

 

(In thousands)

   Three months ended
March 31,
    Nine months ended
March 31,
 
   2010     2009     2010     2009  

Beginning balance

   $ 4,578      $ 18,707      $ 8,086      $ 1,333   

Restructuring costs

     1,398        16,788        5,242        39,930   

Adjustments

     (202     (222     (887     (1,555

Cash payments

     (5,038     (13,024     (11,705     (17,459
                                

Ending balance

   $ 736      $ 22,249      $ 736      $ 22,249   
                                

Substantially all of the remaining accrued restructuring balance as of March 31, 2010 related to our workforce reductions is expected to be paid out by the end of calendar year 2010.

Interest Income and Other, Net and Interest Expense

 

(Dollar amounts in thousands)

   Three months ended  
   March 31, 2010     December 31, 2009     March 31, 2009  

Interest income and other, net

   $ 3,084      $ 4,463      $ 8,723   

Interest expense

   $ 14,092      $ 13,542      $ 13,609   

Interest income and other, net as a percentage of total revenues

     1     1     3

Interest expense as a percentage of total revenues

     3     3     4

 

(Dollar amounts in thousands)

   Nine months ended  
   March 31, 2010     March 31, 2009  

Interest income and other, net

   $ 28,846      $ 28,154   

Interest expense

   $ 41,091      $ 41,335   

Interest income and other, net as a percentage of total revenues

     2     2

Interest expense as a percentage of total revenues

     3     3

Interest income and other, net is comprised primarily of interest income earned on our investment and cash portfolio, realized gains or losses on sales of marketable securities, as well as gains or losses recorded upon settlement of certain foreign currency contracts. The decrease in interest income and other, net during the three months ended March 31, 2010 compared to the three months ended December 31, 2009 was primarily attributable to an increase in foreign exchange loss due to revaluation of certain foreign currency denominated assets during the three months ended March 31, 2010. The decrease in interest income and other, net during the three months ended March 31, 2010 compared to the three months ended March 31, 2009 was primarily due to $5.0 million foreign currency gain recorded in the three months ended March 31, 2009. Interest income and other, net remained relatively unchanged in the nine months ended March 31, 2010 compared to the nine months ended March 31, 2009.

 

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Interest expense, which is primarily attributable to fixed interest payments to holders of our senior notes, remained relatively unchanged in the three months ended March 31, 2010 compared to the three months ended December 31, 2009 and March 31, 2009, as well as in the nine months ended March 31, 2010 compared to the nine months ended March 31, 2009.

Provision for Income Taxes

The following table provides details of income taxes:

 

(Dollar amounts in thousands)

   Three months ended
March  31,
    Nine months ended
March  31,
 
   2010     2009     2010     2009  

Income (loss) before income taxes

   $ 80,271      $ (77,167   $ 141,079      $ (556,155

Provision for (benefit from) taxes

     23,255        5,660        41,864        (58,363

Effective tax rate

     29.0     (7.3 %)      29.7     10.5

Tax expense was positively impacted during the three months and nine months ended March 31, 2010 by a non-taxable increase in the assets held within our Executive Deferred Savings Plan and a reduction of the gross unrecognized tax benefits from a lapsing of the statute of limitations based on authoritative tax guidance.

Tax expense was negatively impacted during the three months and nine months ended March 31, 2010 due to shortfalls from employee stock activity and the tax effect of inter-company dividends.

Windfall tax benefits arise when a company’s tax deduction for employee stock activity exceeds book compensation for the same activity. A shortfall arises when the tax deduction is less than book compensation. Windfalls are recorded as increases to capital in excess of par value. Shortfalls are recorded as decreases to capital in excess of par value to the extent that cumulative windfalls exceed cumulative shortfalls. Shortfalls in excess of cumulative windfalls are recorded as provision for income taxes.

Tax expense was negatively impacted during the three months ended March 31, 2009 by the adoption of California budget legislation, signed on February 20, 2009, which will allow a taxpayer to elect an alternative method to attribute taxable income to California for tax years beginning on or after January 1, 2011. The enactment of this legislation resulted in an expense to reduce non-current deferred tax assets.

Tax expense was negatively impacted during the nine months ended March 31, 2009 by the adoption of the California budget legislation described in the preceding paragraph, as well as a goodwill impairment charge related to certain business units recorded during the nine months ended March 31, 2009, which was non-deductible for tax purposes.

Our future effective income tax rate depends on various factors, such as tax legislation, the geographic composition of our pre-tax income, non-deductible expenses incurred in connection with acquisitions, research and development credits as a percentage of aggregate pre-tax income, non-taxable or non-deductible increases or decreases in the assets held within our Executive Deferred Savings Plan, the tax effects of employee stock activity and the effectiveness of our tax planning strategies.

Cumulative shortfalls in excess of windfalls resulted in additional provision for income taxes of $3.1 million and $11.8 million for the three and nine months ended March 31, 2010, respectively. For the three months ending June 30, 2010, cumulative shortfalls may continue to exceed cumulative windfalls, and we may therefore report higher provision for income taxes as a result. Because we can not determine all of the factors that will enter into our income tax expense computation, we cannot currently estimate this impact on our tax rate for the three months ending June 30, 2010.

In the normal course of business, we are subject to examination by taxing authorities throughout the world. We have been notified of a pending United States federal income tax examination for the fiscal years ended June 30, 2007 through June 30, 2009, which represents all completed years for which the statute of limitation has not expired. We are subject to state income tax examinations for all years beginning from the fiscal year ended June 30, 2005. We are also subject to examinations in major foreign jurisdictions, including Japan, Israel and Singapore, for all years beginning from the fiscal year ended June 30, 2004 and are currently under tax examinations in various other foreign tax jurisdictions. It is possible that certain examinations may be concluded in the next twelve months. We believe it is possible that we may recognize up to $9.6 million of our existing unrecognized tax benefits within the next twelve months as a result of the lapse of statutes of limitations and the resolution of agreements with various foreign tax authorities.

LIQUIDITY AND CAPITAL RESOURCES

 

(Dollar amounts in thousands)

   March 31, 2010     June 30, 2009  

Cash and cash equivalents

   $ 543,505      $ 524,967   

Marketable securities

     1,010,019        804,917   
                

Total cash, cash equivalents and marketable securities

   $ 1,553,524      $ 1,329,884   
                

Percentage of total assets

     41     37

 

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     Nine months ended  

(In thousands)

   March 31, 2010     March 31, 2009  

Cash flow:

    

Net cash provided by operating activities

   $ 364,522      $ 122,246   

Net cash used in investing activities

     (228,940     (277,812

Net cash used in financing activities

     (120,753     (286,049

Effect of exchange rate changes on cash and cash equivalents

     3,709        (21,562
                

Net increase/(decrease) in cash and cash equivalents

   $ 18,538      $ (463,177
                

At March 31, 2010, our cash, cash equivalents and marketable securities totaled $1.6 billion, an increase of $224 million from June 30, 2009. We have historically financed our operations through cash generated from operations. Cash provided by operating activities was $365 million and $122 million for the nine months ended March 31, 2010 and 2009, respectively.

Cash provided by operating activities during the nine months ended March 31, 2010 increased compared to the nine months ended March 31, 2009 from $122 million to $365 million primarily as a result of the following key factors:

 

   

Lower operating expenses during the nine months ended March 31, 2010, reduced by $266 million as compared to the nine months ended March 31, 2009, resulting primarily from our recent cost cutting measures, and

 

   

No material cash payments in the settlement of litigation during the nine months ended March 31, 2010, as compared to a cash payment of $65 million during the nine months ended March 31, 2009 in connection with the settlement of the shareholder class action litigation related to our historical stock option practices, offset by

 

   

Decrease in cash collections by approximately $91 million during the nine months ended March 31, 2010 as compared to the nine months ended March 31, 2009, due to lower account receivable balances.

Cash used in investing activities during the nine months ended March 31, 2010 declined compared to the nine months ended March 31, 2009 from $278 million to $229 million primarily as a result of the following key factors:

 

   

Decrease of $140 million in acquisitions, primarily driven by the acquisition of the MIE business unit during the nine months ended March 31, 2009, offset by

 

   

Decrease in cash collections by approximately $16 million from sale of assets, and

 

   

Increase in the use of cash for purchases of available-for-sale and trading securities, net of sales and maturities, of approximately $71 million.

Cash used in financing activities during the nine months ended March 31, 2010 declined compared to the nine months ended March 31, 2009 from $286 million to $121 million as a result of lower common stock repurchases. We repurchased $55 million of our common stock during the nine months ended March 31, 2010, as compared to $227 million in stock repurchases during the nine months ended March 31, 2009.

During the three months ended March 31, 2010, our Board of Directors declared a dividend of $0.15 per share of our outstanding common stock, which was paid on March 1, 2010 to our stockholders of record as of February 16, 2010. During the same period in fiscal year 2009, our Board of Directors also declared and paid a quarterly cash dividend of $0.15 per share. The total amount of dividends paid during the three months ended March 31, 2010 and 2009 was $25.7 million and $25.5 million, respectively. The total amount of dividends paid during the nine months ended March 31, 2010 and 2009 was $77.0 million and $76.7 million, respectively.

The following is a schedule summarizing our significant obligations to make future payments under contractual obligations as of March 31, 2010:

 

     Fiscal year ending June 30,

(In thousands)

   Total    2010(2)    2011    2012    2013    2014    Thereafter    Other

Long-term debt obligations(1)

   $ 750,000    $ —      $ —      $ —      $ —      $ —      $ 750,000    —  

Interest expense associated with long-term debt obligations

     431,250      25,875      51,750      51,750      51,750      51,750      198,375    —  

Purchase commitments

     199,527      134,138      62,568      1,522      583      534      182    —  

Non-current income tax payable(3)

     46,323      —        —        —        —        —        —      46,323

Operating leases

     28,358      2,474      7,981      5,294      3,632      2,564      6,413    —  

 

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     Fiscal year ending June 30,

(In thousands)

   Total    2010(2)    2011    2012    2013    2014    Thereafter    Other

Pension obligations

     16,622      315      1,549      1,489      1,455      1,765      10,049      —  
                                                       

Total contractual cash obligations

   $ 1,472,080    $ 162,802    $ 123,848    $ 60,055    $ 57,420    $ 56,613    $ 965,019    $ 46,323
                                                       

 

(1) In April 2008, we issued $750 million aggregate principal amount of senior notes due in 2018.
(2) Remaining 3 months.
(3) Represents the non-current tax payable obligation. We are unable to make a reasonably reliable estimate of the timing of payments in individual years beyond 12 months due to uncertainties in the timing of tax audit outcomes.

We have agreements with financial institutions to sell certain of our trade receivables and promissory notes from customers without recourse. In addition, from time to time we will discount, without recourse, Letters of Credit (“LCs”) received from customers in payment of goods.

The following table shows total receivables sold under factoring agreements and proceeds from sales of LCs and related discounting fees paid for the three and nine months ended March 31, 2010 and 2009:

 

     Three months ended    Nine months ended

(In thousands)

   March 31,
2010
   March 31,
2009
   March 31,
2010
   March 31,
2009

Receivables sold under factoring agreements

   $ 16,968    $ 50,143    $ 86,987    $ 208,782

Proceeds from sales of LCs

   $ 13,384    $ —      $ 23,891    $ 10,666

Discounting fees paid on sales of LCs (1)

   $ 26    $ —      $ 149    $ 44

 

(1) Discounting fees were equivalent to interest expense and were recorded in interest income and other, net.

We maintain guarantee arrangements of $16.7 million in various locations to fund customs guarantees for VAT and LC needs of our subsidiaries in Europe and Asia. Approximately $11.9 million was outstanding under these arrangements as of March 31, 2010.

We maintain certain open inventory purchase commitments with our suppliers to ensure a smooth and continuous supply chain for key components. Our liability under these purchase commitments is generally restricted to a forecasted time-horizon as mutually agreed upon between the parties. This forecast time-horizon can vary among different suppliers. Our open inventory purchase commitments were approximately $199.5 million as of March 31, 2010 and are primarily due within the next 12 months. Actual expenditures will vary based upon the volume of the transactions and length of contractual service provided. In addition, the amounts paid under these arrangements may change in the event that the arrangements are renegotiated or canceled. Certain agreements provide for potential cancellation penalties.

We provide standard warranty coverage on our systems for 40 hours per week for twelve months, providing labor and parts necessary to repair the systems during the warranty period. We account 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. The actual product performance and/or field expense profiles may differ, and in those cases we adjust our warranty accruals accordingly. The difference between the estimated and actual warranty costs tends to be larger for new product introductions as there is limited historical product performance to estimate warranty expense; more mature products with longer product performance histories tend to be more stable in our warranty charge estimates. Non-standard warranty coverage generally includes services incremental to the standard 40-hour per week coverage for twelve months. See Note 14, “Commitments and Contingencies,” to the condensed consolidated financial statements for a detailed description.

Working capital increased to $2.0 billion as of March 31, 2010, compared to $1.9 billion as of June 30, 2009. As of March 31, 2010, our principal sources of liquidity consisted of $1.6 billion of cash, cash equivalents and marketable securities. Our liquidity is affected by many factors, some of which are based on the normal ongoing operations of the business, and others of which relate to the uncertainties of global economies and the semiconductor and the semiconductor equipment industries. Although cash requirements will fluctuate based on the timing and extent of these factors, we believe that cash generated from operations, together with the liquidity provided by existing cash balances, will be sufficient to satisfy our liquidity requirements for at least the next twelve months.

Our investment portfolio includes auction rate securities, which are investments with contractual maturities generally between 20 to 30 years. They are usually found in the form of municipal bonds, preferred stock, a pool of student loans, or collateralized debt obligations whose interest rates are reset. The reset typically occurs every seven to forty-nine days, through an auction process. At the end of each reset period, investors can sell or continue to hold the securities at par. The auction rate securities held by us are backed by student loans and are collateralized, insured and guaranteed by the United States Federal Department of Education. In addition, all auction rate securities held by us are rated by the major independent rating agencies as either AAA or Aaa. In February 2008, auctions failed for approximately $48.2 million in par value of municipal auction rate securities that we held because sell orders exceeded buy orders. These failures are not believed to be a credit issue, but rather caused by a lack of liquidity. The funds associated with these

 

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failed auctions may not be accessible until the issuer calls the security, a successful auction occurs, a buyer is found outside of the auction process, or the security matures. Prior to June 30, 2009, a total of $7.6 million of the auction rate securities were called at par value by the issuer (therefore, no losses were recognized on these securities). During the three and nine months ended March 31, 2010, an additional $4.0 million and $12.2 million, respectively, of the auction rate securities were called at par value by the issuer. The fair value of our auction rate securities at March 31, 2010 was $26.1 million, which is included in marketable securities under current assets.

By letter dated August 8, 2008, we received notification from UBS AG (“UBS”), in connection with a settlement entered into between UBS and certain regulatory agencies, offering to repurchase all of our auction rate security holdings at par value. We formally accepted the settlement offer and entered into a repurchase agreement (“Agreement”) with UBS on November 11, 2008 (“Acceptance Date”). By accepting the Agreement, we (1) received the right (“Put Option”) to sell our auction rate securities at par value to UBS between June 30, 2010 and June 30, 2012 and (2) gave UBS the right to purchase the auction rate securities from us any time after the Acceptance Date as long as we receive the par value. Our intention is to exercise our right with UBS to sell these auction rate securities at par value at the earliest date possible, which is June 30, 2010. However, if the Put Option is not exercised before June 30, 2012, it will expire and UBS will have no further rights or obligation to buy the auction rate securities.

The Agreement covers $28.4 million par value (fair value of $26.1 million) of the auction rate securities held by us as of March 31, 2010. We are accounting for the Put Option as a freestanding financial instrument and elected to record the value under the fair value option during the three months ended March 31, 2010. The fair value of the Put Option was $2.3 million and $2.4 million as of March 31, 2010 and June 30, 2009, respectively.

During the three months ended December 31, 2008, we made an election pursuant to the authoritative guidance for debt and equity investments to transfer these auction rate securities from available-for-sale to trading securities. The transfer to trading securities reflects our intent to exercise the Put Option during the period June 30, 2010 to June 30, 2012. During the three months ended March 31, 2010, we recognized an increase in the fair value of the auction rate securities of $0.7 million, which is included in interest income and other, net. There was no change in the fair value of the auction rate securities during the nine months ended March 31, 2010.

We expect that the future changes in the fair value of the Put Option will continue to be largely offset by the fair value movements in the auction rate securities. We estimated the fair value of the auction rate securities using a discounted cash flow model incorporating assumptions that market participants would use in their estimates of fair value. Some of these assumptions include estimates for interest rates, timing and amount of cash flows and expected holding periods of the auction rate securities. We estimated the fair value of the Put Option using the expected value that we will receive from UBS which was calculated as the difference between the anticipated recognized losses and par value of the auction rate securities as of the option exercise date. This value was discounted by using UBS’s credit default swap rate to account for the credit considerations of the counterparty risk. We do not believe that the lack of liquidity of our auction rate securities will have a material impact on our overall ability to meet our cash requirements for the foreseeable future.

In April 2008, we issued $750 million aggregate principal amount of 6.90% senior, unsecured long-term debt due in 2018 with an effective interest rate of 7.00%. The discount on the debt amounted to $5.4 million and is being amortized over the life of the debt using the straight-line method as opposed to the interest method due to immateriality. Interest is payable semi-annually on November 1 and May 1. The debt indenture includes covenants that limit our ability to grant liens on our facilities and to enter into sale and leaseback transactions, subject to significant allowances under which certain sale and leaseback transactions are not restricted. We are in compliance with all of our covenants as at March 31, 2010.

Our credit ratings and outlooks as of April 15, 2010 are summarized below.

 

Rating Agency

   Rating    Outlook

Fitch

   BBB    Stable

Moody’s

   Baa1    Stable

Standard & Poor’s

   BBB    Negative

Factors that can affect our credit ratings include changes in our operating performance, the economic environment, conditions in the semiconductor and semiconductor equipment industries, our financial position, and changes in our business strategy.

Off-Balance Sheet Arrangements

Under our foreign currency risk management strategy, we utilize derivative instruments to protect our interests from unanticipated fluctuations in earnings and cash flows caused by volatility in currency exchange rates. This financial exposure is monitored and managed as an integral part of our overall risk management program which focuses on the unpredictability of financial markets and seeks to reduce the potentially adverse effects that the volatility of these markets may have on our operating results. We continue our policy of hedging our current and forecasted foreign currency exposures with hedging instruments having tenors of up to 18 months. The outstanding hedge contracts, with maximum maturity of 18 months, were as follows:

 

(In thousands)

   As of
March 31, 2010
    As of
June 30, 2009
 

Cash flow hedge contracts

    

Purchase

   $ 10,384      $ —     

Sell

     (32,434     (36,938

Other foreign currency hedge contracts

    

Purchase

     102,481        73,914   

Sell

     (56,447     (106,080
                

Net

   $ 23,984      $ (69,104
                

 

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to financial market risks, including changes in interest rates, foreign currency exchange rates and marketable equity security prices. To mitigate these risks, we utilize derivative financial instruments, such as foreign currency hedges. We do not use derivative financial instruments for speculative or trading purposes. All of the potential changes noted below are based on sensitivity analyses performed on our financial position as of March 31, 2010. Actual results may differ materially.

As of March 31, 2010, we had an investment portfolio of fixed income securities of approximately $1,010.0 million, excluding those classified as cash and cash equivalents. These securities, as with all fixed income instruments, are subject to interest rate risk and will fall in value if market interest rates increase. If market interest rates were to increase immediately and uniformly by 10% from levels as of March 31, 2010, the fair value of the portfolio would have declined by $1.3 million.

As of March 31, 2010, we had net forward contracts to purchase $24.0 million in foreign currency in order to hedge currency exposures (see Note 16, “Derivative Instruments and Hedging Activities,” to the condensed consolidated financial statements for a detailed description). If we had entered into these contracts on March 31, 2010, the U.S. dollar equivalent would have been $23.8 million. A 10% adverse move in all currency exchange rates affecting the contracts would decrease the fair value of the contracts by $17.1 million. However, if this occurred, the fair value of the underlying exposures hedged by the contracts would increase by a similar amount. Accordingly, we believe that the hedging of our foreign currency exposure should have no material impact on our net income or cash flows.

See Note 4, “Marketable Securities,” to the condensed consolidated financial statements in Part I, Item 1; Management’s Discussion and Analysis of Financial Condition and Results of Operations, “Liquidity and Capital Resources,” in Part I, Item 2; and Risk Factors in Part II, Item 1A of this Quarterly Report on Form 10-Q for a description of recent market events that may affect the value of the investments in our portfolio and the liquidity of certain auction rate securities that we held at March 31, 2010.

 

ITEM 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures and Related CEO and CFO Certifications

Evaluation of Disclosure Controls and Procedures

The Company conducted an evaluation of the effectiveness of the design and operation of its disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) (“Disclosure Controls”) as of the end of the period covered by this Quarterly Report on Form 10-Q (this “Report”) required by Exchange Act Rules 13a-15(b) or 15d-15(b). The controls evaluation was conducted under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”). Based on this evaluation, the CEO and CFO have concluded that as of the end of the period covered by this Report the Company’s disclosure controls and procedures were effective at a reasonable assurance level.

Attached as exhibits to this Report are certifications of the CEO and CFO, which are required in accordance with Rule 13a-14 of the Exchange Act. This Controls and Procedures section includes the information concerning the controls evaluation referred to in the certifications, and it should be read in conjunction with the certifications for a more complete understanding of the topics presented.

Definition of Disclosure Controls

Disclosure Controls are controls and procedures designed to reasonably assure that information required to be disclosed in the Company’s reports filed under the Exchange Act, such as this Report, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure Controls are also designed to reasonably assure that such information is accumulated and communicated to the Company’s management, including the CEO and CFO, as appropriate to allow timely decisions regarding required disclosure. The Company’s Disclosure Controls include components of its internal control over financial reporting, which consists of control processes designed to provide reasonable assurance regarding the reliability of its financial reporting and the preparation of financial statements in accordance with generally accepted accounting principles in the United States. To the extent that components of the Company’s internal control over financial reporting are included within its Disclosure Controls, they are included in the scope of the Company’s annual controls evaluation.

 

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Limitations on the Effectiveness of Controls

The Company’s management, including the CEO and CFO, does not expect that the Company’s disclosure controls or internal control over financial reporting will prevent all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision making can be faulty and that breakdowns can occur because of simple error or mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

There have been no changes in our internal control over financial reporting during the three months ended March 31, 2010 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

 

ITEM 1. LEGAL PROCEEDINGS

The information set forth above under Note 13, “Litigation and Other Legal Matters,” to the condensed consolidated financial statements in Item 1 of Part 1 is incorporated herein by reference.

 

ITEM 1A. RISK FACTORS

Risks Associated with Our Industry and Market Conditions

The semiconductor equipment industry is highly cyclical. The purchasing decisions of our customers are highly dependent on the economies of both the local markets in which they are located and the semiconductor industry worldwide. If we fail to respond to industry cycles, our business could be seriously harmed.

The timing, length and severity of the up-and-down cycles in the semiconductor equipment industry are difficult to predict. The cyclical nature of the primary industry in which we operate is largely a function of our customers’ capital spending patterns and need for expanded manufacturing capacity, which in turn are affected by factors such as capacity utilization, consumer demand for products, inventory levels and our customers’ access to capital. This cyclicality affects our ability to accurately predict future revenue and, in some cases, future expense levels. In the current environment, our ability to accurately predict our future operating results is particularly limited. During down cycles in our industry, the financial results of our customers may be negatively impacted, which could result not only in a decrease in, or cancellation or delay of, orders (which are generally subject to cancellation or delay by the customer with limited or no penalty) but also a weakening of their financial condition that could impair their ability to pay for our products or our ability to recognize revenue from certain customers. When cyclical fluctuations result in lower than expected revenue levels, operating results may be adversely affected and cost reduction measures may be necessary in order for us to remain competitive and financially sound. During periods of declining revenues, as was experienced during fiscal year 2009, we must be in a position to adjust our cost and expense structure to prevailing market conditions and to continue to motivate and retain our key employees. If we fail to respond, or if our attempts to respond fail to accomplish our intended results, then our business could be seriously harmed. Furthermore, any workforce reductions and cost reduction actions that we adopt in response to down cycles may result in additional restructuring charges, disruptions in our operations and loss of key personnel. In addition, during periods of rapid growth, we must be able to increase manufacturing capacity and personnel to meet customer demand. We can provide no assurance that these objectives can be met in a timely manner in response to industry cycles. Each of these factors could adversely impact our operating results and financial condition.

In addition, the semiconductor equipment industry and other industries that we serve are constantly developing and changing over time. These changes currently, or in the future may, include the increasing cost of building and operating fabrication facilities and the impact of such increases on our customers’ investment decisions; the variability of future growth rates in the semiconductor and related industries; the ever-increasing cost and complexity involved in the adoption by our customers of technology advances and the potential impact that may have on their rate of adoption; pricing trends in the end-markets for consumer electronics and other products, which places a growing emphasis on our customers’ cost of ownership; overall changes in capital spending patterns by our customers; and demand by semiconductor manufacturers for shorter cycle times for developing, manufacturing and installing capital equipment. Further, many semiconductor manufacturers have recently experienced decreased profitability, causing them to enter into collaboration or sharing arrangements for capacity, cost or risk with other manufacturers, outsource manufacturing activities, focus only on specific markets or applications, or purchase less manufacturing equipment. Any of the changes described in this paragraph may, particularly during periods of challenging macroeconomic conditions, negatively affect our customers’ rate of investment in

 

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capital equipment, which could result in downward pressure on our prices, customer orders, revenues and gross margins. If we do not successfully manage the risks resulting from any of these or other potential changes in our industries, our business, financial condition and operating results could be adversely impacted.

We are exposed to risks associated with a weakening in the condition of the financial markets and the global economy.

The severe tightening of the credit markets, turmoil in the financial markets and weakening of the global economy that were experienced during the fiscal year ended June 30, 2009 contributed to slowdowns in the industries in which we operate, which slowdowns could recur or worsen if economic conditions were to deteriorate again.

The markets for semiconductors, and therefore our business, are ultimately driven by the global demand for electronic devices by consumers and businesses. Economic uncertainty frequently leads to reduced consumer and business spending, which, in the recent economic slowdown, caused our customers to decrease, cancel or delay their equipment and service orders from us. In addition, the tightening of credit markets and concerns regarding the availability of credit that accompanied that slowdown made it more difficult for our customers to raise capital, whether debt or equity, to finance their purchases of capital equipment, including the products we sell. Reduced demand, combined with delays in our customers’ ability to obtain financing (or the unavailability of such financing), has in recent periods adversely affected our product and service sales and revenues and therefore has harmed our business and operating results, and our operating results and financial condition may again be adversely impacted if economic conditions decline from their current levels.

In addition, a decline in the condition of the global financial markets could adversely impact the market values or liquidity of our investments. Our investment portfolio includes corporate and government securities, auction rate securities, money market funds and other types of debt and equity investments. Although we believe our portfolio continues to be comprised of sound investments due to the quality and (where applicable) credit ratings and government guarantees of the underlying investments, a decline in the capital and financial markets would adversely impact the market values of our investments and their liquidity. If the market value of such investments were to decline, or if we were to have to sell some of our investments under illiquid market conditions, we may be required to recognize an impairment charge on such investments or a loss on such sales, either of which could have an adverse effect on our financial condition and operating results.

If we are unable to timely and appropriately adapt to changes resulting from difficult macroeconomic conditions, our business, financial condition or results of operations may be materially and adversely affected.

Our future performance depends, in part, upon our ability to continue to compete successfully worldwide.

Our industry includes large manufacturers with substantial resources to support customers worldwide. Some of our competitors are diversified companies with greater financial resources and more extensive research, engineering, manufacturing, marketing, and customer service and support capabilities than we possess. We face competition from companies whose strategy is to provide a broad array of products and services, some of which compete with the products and services that we offer. These competitors may bundle their products in a manner that may discourage customers from purchasing our products, including pricing such competitive tools significantly below our product offerings. In addition, we face competition from smaller emerging semiconductor equipment companies whose strategy is to provide a portion of the products and services that we offer, using innovative technology to sell products into specialized markets. The strength of our competitive positions in many of our existing markets is largely due to our leading technology, which is the result of continuing significant investments in product research and development. However, we may enter new markets, whether through acquisitions or new internal product development, in which competition is based primarily on product pricing, not technological superiority. Further, some new growth markets that emerge may not require leading technologies. Loss of competitive position in any of the markets we serve, or an inability to sell our products on favorable commercial terms in new markets we may enter, could negatively affect our prices, customer orders, revenues, gross margins and market share, any of which would negatively affect our operating results and financial condition.

We are exposed to risks associated with a highly concentrated customer base.

Our customer base, particularly in the semiconductor industry, historically has been, and is becoming increasingly, highly concentrated. In this environment, orders from a relatively limited number of manufacturers have accounted for, and are expected to continue to account for, a substantial portion of our sales. In addition, the mix and type of customers, and sales to any single customer, may vary significantly from quarter to quarter and from year to year. If customers do not place orders, or they delay or cancel orders, we may not be able to replace the business. Furthermore, because our products are configured to customer specifications, any changes, delays or cancellations of orders may result in significant, non-recoverable costs. As a result of the consolidation within our customer base, the customers that survive that consolidation represent a greater portion of our sales. Those surviving customers may have more aggressive policies regarding engaging alternative, second-source suppliers for the products we serve and, in addition, may seek, and on occasion receive, pricing, payment, intellectual property-related, or other commercial terms that are less favorable to us. Any of these changes could negatively impact our prices, customer orders, revenues and gross margins. Also, certain customers have undergone significant ownership changes, experienced management changes or have outsourced manufacturing activities, any of which may result in additional complexities in managing customer relationships and transactions. As a result of the recent challenging economic environment, we have been exposed to additional risks related to the continued financial viability of certain of our

 

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customers. To the extent our customers experience liquidity issues, we may be required to incur additional bad debt expense with respect to receivables owed to us by those customers. In addition, customers with liquidity issues may be forced to discontinue operations or may be acquired by one of our customers, and in either case such event would have the effect of further consolidating our customer base. Any of these factors could have a material adverse effect on our business, financial condition and operating results.

A majority of our annual revenues are derived from outside the United States, and we expect that international revenues will continue to represent a substantial percentage of our revenues. A protracted economic slowdown in any of the countries in which we do business may adversely affect our business and results of operations.

A majority of our annual revenues are derived from outside the United States, and we expect that international revenues will continue to represent a substantial percentage of our revenues. Our international revenues and operations are affected by economic conditions specific to each country and region. Because of our significant dependence on international revenues, a decline in the economies of any of the countries or regions in which we do business could negatively affect our operating results. Managing global operations and sites located throughout the world presents challenges associated with, among other things, cultural diversity and organizational alignment. Moreover, each region in the global semiconductor equipment market exhibits unique characteristics that can cause capital equipment investment patterns to vary significantly from period to period. Periodic local or international economic downturns, trade balance issues, tariffs or other trade barriers, political instability, legal or regulatory changes or terrorism in regions where we have operations or where we do business, along with fluctuations in interest and currency exchange rates, could negatively affect our business and results of operations. Although we attempt to manage near-term currency risks through the use of hedging instruments, there can be no assurance that such efforts will be adequate.

Risks Related to Our Business

If we do not develop and introduce new products and technologies in a timely manner in response to changing market conditions or customer requirements, our business could be seriously harmed.

Success in the semiconductor equipment industry depends, in part, on continual improvement of existing technologies and rapid innovation of new solutions. For example, the size of semiconductor devices continues to shrink, and the industry is currently transitioning to the use of new materials and innovative fab processes. While we expect these trends will increase our customers’ reliance on diagnostic products such as ours, we cannot be sure that these trends will directly improve our business. These and other evolving customer needs require us to respond with continued development programs and to cut back or discontinue older programs, which may no longer have industry-wide support. Technical innovations are inherently complex and require long development cycles and appropriate staffing of highly qualified employees. Our competitive advantage and future business success depend on our ability to accurately predict evolving industry standards, to develop and introduce new products that successfully address changing customer needs, to win market acceptance of these new products and to manufacture these new products in a timely and cost-effective manner.

In this environment, we must continue to make significant investments in research and development in order to enhance the performance, features and functionality of our products, to keep pace with competitive products and to satisfy customer demands. Substantial research and development costs typically are incurred before we confirm the technical feasibility and commercial viability of a new product, and not all development activities result in commercially viable products. There can be no assurance that revenues from future products or product enhancements will be sufficient to recover the development costs associated with such products or enhancements. In addition, we cannot be sure that these products or enhancements will receive market acceptance or that we will be able to sell these products at prices that are favorable to us. Our business will be seriously harmed if we are unable to sell our products at favorable prices or if the market in which we operate does not accept our products.

Our business would be harmed if we do not receive sufficient parts to meet our production requirements in a timely and cost-effective manner.

We use a wide range of materials in the production of our products, including custom electronic and mechanical components, and we use numerous suppliers to supply these materials. We generally do not have guaranteed supply arrangements with our suppliers. Because of the variability and uniqueness of customers’ orders, we do not maintain an extensive inventory of materials for manufacturing. We seek to minimize the risk of production and service interruptions and/or shortages of key parts by selecting and qualifying alternative