KLA Corp

NASDAQ:KLAC

Earnings Call Transcript 2019-Q1

[Operator]

Good afternoon. My name is Chantal, and I will be your conference operator today. At this time, I would like to welcome everyone to the KLA-Tencor First Quarter Fiscal Year 2019 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. [Operator Instructions]

Thank you. Ed Lockwood with KLA-Tencor Investor Relations. You may begin you conference.

[Ed Lockwood, Investor Relations]

Thank you, Chantal. Good afternoon, everyone, and welcome to our conference call. Joining me on our call today are Rick Wallace, our President and Chief Executive Officer; and Bren Higgins, our Chief Financial Officer.

We are here today to discuss quarterly results for the period ended September 30, 2018. We released these results this afternoon at 1:15 Pacific Time. If you haven’t seen the release, you can find it in our website.

Today’s discussion of our financial results will be presented on a non-GAAP financial basis, unless otherwise specified. A detailed reconciliation of GAAP to non-GAAP results can be found in today’s earnings press release and in the Investor Presentation on KLA-Tencor’s Investor Relations website.

There you will also find a calendar of future investor events, presentations and conferences as well as links to KLA-Tencor’s SEC filings, including our annual report on Form 10-K for the year ended June 30, 2018. In those filings, you will find descriptions of risk factors that could impact our future results.

As you know, our future results are subject to risks. Any forward-looking statements, including those we make on the call today are subject to those risks and KLA-Tencor cannot guarantee those forward-looking statements will come true. Our actual results may differ significantly from those projected in our forward-looking statements.

With that, I will turn the call over to Rick.

[Rick Wallace, President and CEO]

Thank you, Ed, and thank you all for joining us today. KLA-Tencor delivered another outstanding result in the September quarter, driven by the company’s technology and market leadership, and the compelling value of our diversified product and service portfolio in enabling customer success.

The September quarter results also show the company is benefiting from our strategies for market leadership and revenue diversification. Furthermore, they demonstrate their critical nature of process control and enabling technology inflections in the semiconductor industry, including growth markets such as vertical NAND, EUV adoption and the China semiconductor industry.

And with the expected closing this quarter of the Orbotech acquisition, KLA-Tencor will further extend its market reach in the electronics value chain, enhancing the company’s product and services portfolio beyond our core and WFE to address new growth markets where technological complexity is rising and where KLA can extend its core competencies into exciting new opportunities.

Now for some perspective on the current industry demand environment, first, notwithstanding, the recent adjustments in capacity investment for memory customers and delays in logic spend from the second half of 2018 into 2019, we believe the long-term factors underpinning demand in the wafer fab equipment industry remain sound. This is the result of several key elements, including more diversified end markets for semiconductor.

The ongoing commitment of customers to driving innovation and leading-edge technology roadmaps, disciplined market-driven capacity planning and the high levels of investment required to address increased design complexity and advanced device architectures. We expect these industry drivers will persist in delivering long-term growth and value creation opportunities for the company, the industry and for all our stakeholders.

Moving now to the recent highlights that demonstrate successful execution of the company’s strategic focus on technology and market leadership, first, as the market leader in process control, KLA-Tencor is helping to enable growth of the semiconductor industry in China.

Memory and foundry manufacturers in this region are investing in a high level to accelerate process development and yield learning. We expect momentum in China to continue in 2019 and beyond with customers progressing their technology roadmaps and ramping new production capacity in the initial phase of a multiyear investment cycle.

Additionally, over the past several quarters, we have seen exceptional demand for bare waver and mask inspection products. Growth in our mask inspection business is consistent with planned increases in CapEx from the leading foundries as these customers ramp 7-nanometer capacity to support a high number of customer tapeouts at this node and begin aggressive development of 5-nanometer, including EUV development.

In bare wafer, KLA’s market-leading inspection and metrology tools are key enablers of the growth in wafer supply to address capacity expansion in memory. These products are also essential in helping customers in all segments to meet more stringent design specification for wafer flatness and cleanliness.

And finally, KLA-Tencor service business continues to be a highlight. Going forward, it is on a trajectory to deliver high single-digit to low double-digit annual revenue growth with low business volatility consistent with historical trends.

Long-term growth and services is tied to expansion of the installed base, as well as from the increasing uptime requirements from current node production and at the trailing edge. Trailing edge fabs are currently running at near full utilization, creating new opportunities for product enhancements and upgrades.

In summary, before I turn the call over to Bren, KLA-Tencor delivered another outstanding performance in the September quarter, driven by the company’s strong execution and market leadership.

Given our momentum in the marketplace, diversified growth markets and the critical role the company’s products and services play in enabling customer success, we are positioned for a strong finish in 2018.

I’d now like to turn the call over to Bren for his review of the financial results. Bren?

[Bren Higgins, Chief Financial Officer]

Thanks, Rick, and good afternoon, everyone. As Rick highlighted in his opening remarks, the September quarter delivered excellent financial results for the company. Shipments, revenue, gross margin and GAAP and non-GAAP diluted earnings per share, all came in at the upper end of the range of guidance in the quarter.

Revenue was $1.09 billion, GAAP diluted earnings per share were $2.54 and non-GAAP diluted earnings per share were $2.46. The primary difference between GAAP and non-GAAP earnings was a discrete tax benefit taken in the quarter related to new guidance affecting our adoption of the new tax law in the United States.

As a reminder, since this is the first quarter of our new fiscal year 2019, our results reflect the adoption of ASC 606 for revenue recognition. We have adopted the new standard using the modified retrospective approach. Therefore, all revenue commentary in our results and guidance exclusively reflect our adoption of the new standard and we do not plan to provide any color related to the financial results under the previous standard.

In today’s press release, you will find a reconciliation of GAAP to non-GAAP diluted earnings per share. As a reminder, unless I explicitly refer to GAAP results, my commentary will be solely focused on the non-GAAP results, which exclude the adjustments covered in the press release.

Now for highlights for the -- of the September demand environment in terms of shipments, total shipments were $1.007 billion, above the $975 million midpoint and at the top-end of guidance for the quarter, driven by strength in memory and an expected sequential increase in shipments to foundry customers. Looking forward, we are modeling December quarter shipments to be in a range of $985 million to $1.065 billion, consistent with the update we provided in early September.

Our current outlook is for shipments in the first half of calendar 2019 to be modestly higher compared with the second half of 2018. The shipment profile in the first half of 2019 is expected to show accelerating momentum from foundry customers driven by 7-nanometer design starts and 5-nanometer development activity, consistent investment from logic customers and a balanced mix in memory.

Memory was 57% of shipments in September. DRAM accounted for 26% of total system shipments in the period. We expect memory to be strong again in this quarter and approximately 64% of total shipments.

Foundry was 38% of shipments in the September quarter and is forecasted to be about 22% of the total in December. Logic shipments were 5% of the total in Q3 and the current outlook is for logic to be 14% in December.

The approximate distribution of shipments by product group was, wafer inspection was 48% of shipments, patterning was 27%, patterning includes shipments reticle inspection, service 22% and non-semi and component inspection was approximately 3%.

I will turn now to the income statement. Revenue was $1.09 billion in September and finishing at the top-end of the range of guidance. We expect December revenue to be in the range of $1.03 billion to $1.11 billion for the quarter.

Gross margin was 65.2% and also at the top-end of guidance for the quarter. The factors driving the strong gross margin performance in September were consistent with recent margin trends, with the upside largely driven by product mix. In December, we expect gross margin to be in the range of 63.5% to 64.5% as a slightly weaker product mix is offset by higher service and manufacturing efficiencies.

Total operating expenses were $263 million in September, as non-headcount engineering program investments were lower than expected in the quarter due to timing issues related to prototype materials.

We expect to incur those expenses in the December quarter, as we are modeling operating expenses to be approximately $275 million at the midpoint, with variability around this operating expense level driven principally by the timing of these types of program development costs.

Looking forward for the next several quarters, we are modeling quarterly operating expenses in the $270 million to $275 million range, based on planned program -- product development requirements and our current topline expectations. Operating margin in September was 41.1%.

The effective tax rate was an 11.3% in the quarter and below the 15% long-term tax planning rate as business mix and further implementation of provisions of the Tax Cuts and Jobs Act legislation in the U.S. impacted our rate. We will provide an update to the planning rate for the company inclusive of the Orbotech acquisition when we report results for the December quarter.

Finally, net income for the quarter was $384 million and we ended the quarter with 156.1 million fully diluted shares outstanding. For the December quarter, you should model share count at approximately 153 million.

I will turn now to highlight for the balance sheet and cash flow statement. Cash and investments were $2.8 billion. Cash from operations was $381 million and free cash flow was $359 million. In September, we paid an aggregate of $123 million in regular quarterly dividends and dividend equivalents for fully-vested restricted stock units and repurchased 300 million of common stock pursuant to our share repurchase program.

We are currently repurchasing shares under an existing $1 billion buyback authorization and expect to complete this program over the next few quarters, consistent with the previously articulated approach and subject to market conditions. We have authorization for an additional 1 billion share repurchase upon completion of the Orbotech acquisition.

Finally, in regards to the adoption of ASC 606, please refer to our 10-Q filing for a detailed reconciliation of differences in revenue recognition under the new and legacy standards. These differences are largely driven by timing of revenue recognition, principally due to and control the products’ transfers to the customer.

Under ASC 606, we see reduction in the time period between shipment and revenue recognition compared to the previous standard. Based on the product and customer mix in our current shipment and revenue forecasts, we expect reported revenue under the new standard to be favorable for calendar ‘18 and in the range of 2.5% plus or minus 50 basis points. The difference in revenue recognition between ASC 606 and the legacy standard could fluctuate from quarter-to-quarter but will narrow over a multiple quarter time horizon.

In conclusion, the results demonstrated by KLA-Tencor in the September quarter reflect the company’s technology leadership, the critical nature of process control in our customer’s growth strategies and the value generated by our industry-leading business model.

As the market leader in process control coupled with the new opportunities for market expansion represented by the pending Orbotech acquisition, we believe KLA-Tencor is uniquely positioned to deliver long-term value to stockholders.

With that to summarize guidance for the December quarter is, shipments in the range of $985 million to $1.065 billion, revenue between $1.03 billion and $1.11 billion and GAAP diluted EPS of $1.88 per share to $2.20 per share, as well as non-GAAP diluted EPS at $2.02 per share to $2.34 per share.

Before turning the call over for your questions, I’d like to announce we have scheduled an Investor Day for March 6, 2019 in New York City. Please circle that date on your calendars and keep an eye out for further details and a formal invite in the coming weeks. We look forward to seeing you all in New York.

With that, I will now turn the call back over to Ed to begin the Q&A.

[Ed Lockwood, Investor Relations]

Okay. Thank you, Bren. At this point, we’d like to open the call up to your questions. We once again request you limit yourself to one question and one follow up, given the limited time we have for today’s call. Please feel free to requeue and we will do our best to give everyone a chance to rejoin today’s call as time permits.

All right, Chantal, we are ready for the first question.

[Operator]

[Operator Instructions] Your first question comes from Timothy Arcuri with UBS. Your line is open.

[Timothy Arcuri, UBS]

Thank you much. Hi, guys. I had two. First of all, I am sure you saw the news today about the export restrictions to Jinhua, which is one of the three big memory fabs of course being built this was shipping to this year. So my first question is, does this sort of change how you think about your business next year, it seems to be a little more surgical than sort of likely to spread to be a big broad export restriction, but I am curious of your thoughts? Thanks.

[Rick Wallace, President and CEO]

Hey, Tim. This is Rick and then Bren will follow. It does not change our view for the rest of 19 -- ‘18 or what we are looking at a ‘19 based on the expectation we had from that customer. To your point, it was a strategical export control, obviously, other things would change if that were broadened, but as it stands today it does not change our view.

[Bren Higgins, Chief Financial Officer]

Yeah. Tim, I think, as we look at this year, we feel pretty good about the tools that we have shipped there and closing on that business. There’s some de minimis levels of business in our ship plans over the next several quarters and into our forecast for next year for that side. But I don’t think it changes in a material way anyway of how we are really thinking about the business going forward.

[Timothy Arcuri, UBS]

Okay. Awesome. Thank you. And then, Bren, service was up a lot, it was up 26% year-over-year, a big inflection. I guess, my question is, are you doing something different in service that caused a big inflection and can service grow that much year-over-year in December and then as you get in the first half of next year? Thank you.

[Bren Higgins, Chief Financial Officer]

No. Tim, that’s a result of our adoption of 606 and what is happening there and I provided some color in the last call on this topic for -- to provide a little bit of clarity and there will be more in the -- in our SEC disclosures that we will file in the next couple of days.

But what we are doing here is that given the experience of our customers around our obligations in the first year warranty, is very similar to second year and third year contracts, as we are having to carve out of the tool purchase and defer the revenue associated with that first year obligation.

Historically, with the cost accrual, so what happened is, we have reversed the cost accrual and then for the tools under warranty, we have added the deferred revenue, which we will take over the next 12 months effectively for all tools that were under warranty effective the transition date to 606 on June 30th.

So it’s a unique dynamic that you saw with a pretty big inflection. I think the dynamics around our service business are consistent Rick talked about in terms of our views of growth rate going forward.

But you will see this, this step up that will happen here and we will see it probably play out over the next couple of quarters and then it will level back out something consistent with what we saw historically.

So, no changes in cash flow or business operations, but given the experience is fundamentally consistent with second year and third year contracts, the literature guides us this direction in terms of how we treat those obligations.

[Timothy Arcuri, UBS]

Awesome, guys. Thank you so much.

[Bren Higgins, Chief Financial Officer]

Thank you.

[Operator]

Your next question comes from John Pitzer with Credit Suisse. Your line is open.

[John Pitzer, Credit Suisse]

Yeah. Good afternoon, guys. Thanks for letting me ask the questions. Congratulations on the solid results. Bren, maybe to follow-up just on Tim’s question there, relative to your view that first half of ‘19 should be higher than second half of ‘18. If you could elaborate a little bit about what’s driving that views. How much of a benefit is 606. Is the expectation that the memory adjustments are now behind you or is -- are you still seeing memory uncertainty but logic and foundry has really given you that confidence, any color there would be helpful?

[Bren Higgins, Chief Financial Officer]

Hey. John, it’s Bren. So those were shipments’ statements, not revenue and I think it’s an important distinction here, because as we go through this transition, one anchor of continuity is the shipment metric, which is why we are continuing to provide not only actual results and context, but also guidance. So to be consistent with what we had said previously and to be consistent with this metric that is unchanging, our commentary reflects that.

So as we move into this first half, I think, that the way the second half of this year has played out is very similar to the way we described in an update that we did back in September, where the September quarter came in a little bit stronger, December quarter sequential growth weaker and consistent with that guidance.

So as we look at the first half of next year, we see an increase in the foundry and logic investment and we see memory in a relatively balanced profile as we move into the first half of the year. I would say that it is modest growth in terms of our expectations and we look at the build plan. But -- and I am not going to comment at this point of whether given where we are whether it’s March or June, but as we look at the first half given the timing and our conversations with customers, that’s how we are seeing the first half play out at least at this point in terms of shipments.

[John Pitzer, Credit Suisse]

That’s helpful. And maybe as my follow up just relative to all the consternation and concern about memory. It was interesting to hear you say that you believe memory shipments as a percent of overall shipments will grow sequentially in the December quarter. Rick, I wondering you just talk to what extent that that’s rising sort of intensity of what you do in the memory market versus just timing of projects, any help on sort of the rising intensity would be helpful?

[Rick Wallace, President and CEO]

It’s the intensity has stepped up but it’s more consistent with what we have seen over the last year. Remember we have other products that contribute to that too such as the bare wafer inspection products, which are leveraged to the memory overall wafer shipment.

So those products have been extremely strong as the wafer demand around the world continues to get stretched and because of flatness requirements, we have seen an uptick in our business for flatness measurement.

So I think it’s more related to those functions and that really has been playing out throughout this memory cycle where intensity has grown partly because of the strength of the wafer houses themselves.

[John Pitzer, Credit Suisse]

Perfect. Thanks, guys.

[Operator]

Your next question comes from Krish Sankar with Cowen. Your line is open.

[Krish Sankar, Cowen]

Yeah. Hi. Thanks for taking my question. I had two of them, first one, just to follow up on China. It looks like you guys are not worried too much about the export control impacting your customer or at least your shipments to China so that’s kind of good to know. Is there a way to quantify either, I think, you had said in the past how indigenous China bookings are in the $600 million range for this year or as a percentage of sales like 25% of system sales was China. Is there a way to quantify what it was for the September quarter and then I had a follow up?

[Rick Wallace, President and CEO]

Yeah. Krish, let me take the first part, and then, let Bren answer. We are not concerned about this particular movement in the market. So this one was a very strategic export control that that let’s just be clear on that.

[Krish Sankar, Cowen]

Thanks.

[Bren Higgins, Chief Financial Officer]

Yeah. Krish, so shipments, 27% of shipments in the September quarter were China and that, I would say that most of that is indigenous China. There wasn’t a lot of activity with the multinationals there, probably, a little bit, but not a lot.

And consistently, as we have looked at that indigenous business into this year and into next year, the range you talked about is about how we are seen it in terms of shipment at revenue levels $500 million to $600 million is more foundry centric, a little bit more foundry centric and material centric in 2018, it looks to be that way in 2019 as well, at least from an order perspective, but generally, we expect a continuation of momentum from those customers.

And to the earlier point, I think, we feel, okay, I mean, strategically that this situation around export control tend to be confined to that one particular situation, and as we said earlier, we don’t think it has much effect on how we are running the business or planning for it into next year.

[Krish Sankar, Cowen]

Got it. Got it. Thank you very much. That’s very helpful. And then just as a follow up, your commentary on first half shipments and the fact that next year it would be more weighted towards foundry and logic. Is it fair to assume that, I mean, without any guidance like calendar ‘19 revenue should grow over calendar ‘18 and given it’s more weighted to foundry/logic. The margin profile or EPS should be better than sales. Is that a fair enough assumption?

[Bren Higgins, Chief Financial Officer]

So, I will make a couple of comments around ‘19 and the first is, we do expect foundry/logic to be up in ‘19 versus ‘18 and that we expect the first half to be modestly up from a shipment perspective versus ‘18 -- the second half of ‘18. So we will have more to say as we get to the end of this quarter and report results for the December quarter on the total year view. But at least that’s how we see it right now.

You are right. Those segments are good segments for KLA in terms of process control intensity. Our margins are very consistent across our customer base. I don’t think it affects the margin profile or expectations from that business.

But, certainly, that business were more exposed to in terms of the process control intensity of those wafer fab dollars. So we are encouraged by that. We will see how the broader industry plays out and have more to say about that as we move into December and in the first part of next year.

[Krish Sankar, Cowen]

Thanks, Bren. Thanks, Rick.

[Rick Wallace, President and CEO]

Thanks.

[Operator]

Your next question comes from Harlan Sur with J.P. Morgan. Your line is open.

[Harlan Sur, J.P. Morgan]

Good Afternoon. Good job on the quarterly execution guys and strong free cash flow. Yes or no, talked about shipping 30 EUV systems next year, that’s up from about 18 this year. So the EUV adoption curve is here and it look like it’s a pretty aggressive ramp. You guys are supporting that with your mask inspection, blank inspection, CD overlay Gen 5, print check portfolios. So outside of yes or no, you guys are probably one of the bigger beneficiary, there is EUV ramps and given that ramp adoption next year, can you guys just quantify your EUV related opportunity next year and does this help the team sort of sustain that sort of 64% or 65% gross margin profile maybe into next year?

[Rick Wallace, President and CEO]

Hi, Harlan. It’s Rick. I will take the first part and then Bren will follow up. Let me start with -- we don’t break out our business by EUV in particular, but to your point there are a lot of drivers about EUV that are frankly good for KLA-Tencor and for helping our customers solve the related problems that they have with it.

And as you mentioned, we are seeing good business and as we mentioned in the prepared remarks in our mask business due to the number of advanced starts that are going through fabs and there’s also support for print check as you mentioned with Gen 5 and also the overlay challenges that our customers face.

So, it is a catalyst and a driver for us as we go forward, but we don’t break it out in particular and we are a little bit agnostic into how many tools there are per se next year. So our demand won’t really change if it’s the 30 tools they talked about or 20 tools. It’s really the driving of the new capability nodes that are driving our business. And, Bren, you can break up the second part.

[Bren Higgins, Chief Financial Officer]

So on gross margins, Harlan, I think, as we look at next year this and in my comments in the script, we see things operating generally around this level, product mix will drive us directionally here and there from quarter-to-quarter. But in and around this 64%-ish plus or minus 50 basis points looks like that’s how things are trending right now.

Obviously, if we see expansion in the business, we should get leverage and that would work probably both directions if it turns out that the revenue were to come down. So, but in terms of the fundamental structural dynamics around margins that’s generally the right place to be.

[Harlan Sur, J.P. Morgan]

Great. Thanks for the insights there. And then on your Gen 5 pattern wafer inspection system, I think, you guys have said, anticipated 17 systems, 18 systems in the field by the end of this year, did you guys hit that target and how do you guys see the momentum of Gen 5 going into next year, just given the sharp ramp of EUV, the start of 5-nanometer EUV foundry and 7-nanometer EUV logic development activities?

[Bren Higgins, Chief Financial Officer]

Yes. Harlan, we did hit our target. So we are consistent with the numbers that we provided earlier and we would expect an increase into next year. I would expect revenue from Gen 5 into next year given the drivers that you mentioned that Rick elaborated on, we would expect an increase in Gen 5 revenue in ‘19 versus what we saw in ‘18.

[Rick Wallace, President and CEO]

And in terms of momentum, it’s playing out very much the same as prior generations when we got the new generations of inspection products or you have a couple of early adopters maybe one big early adopter that will drive it. Then you have customers that are maybe more evaluative of it and they will spend a lot of time trying to figure it out and then the momentum gets going when the customers who have not adopted realize the advantage that the leaders are having and then we see it kind of flow out.

So when we model those, it’s not just the number of systems, it’s where they are located and the use cases. So we have -- some that are being utilized in the early stages of manufacturing support where others are in development.

So we like the momentum of the product, we are finding unique capabilities. It is true that EUV creates more opportunities for that product to differentiate and for customers to rely on it. So we are feeling very good about how we are positioned as we go forward in 2019.

[Harlan Sur, J.P. Morgan]

Great. Thank you.

[Operator]

Your next question comes from Vivek Arya from Bank of America Merrill Lynch. Your line is open.

[Vivek Arya, Bank of America Merrill Lynch]

Thanks for taking my question. For the first one, you have mentioned the potential for first half ‘19 orders to slightly grow half over half. How sensitive is that to assumption of where memory prices will trend?

[Bren Higgins, Chief Financial Officer]

So my statement was around shipments, and not about orders, and I think, right now that the plans our customers have put in front of us given what we are seeing is it doesn’t seem to necessarily be pricing dependent, obviously, that does influence how they think about overall supply.

But we have seen a number of adjustments already and how those have played out through ‘18 and those pushes into ‘19. So based on what we know today, our expectation is to see some balanced investment into the first half of ‘19 from a shipment perspective, and as I said, modestly up versus the second half of ‘18.

[Vivek Arya, Bank of America Merrill Lynch]

Got it. And for my follow up, just a question on inventories, they are higher than what we have seen historically. Can you give us some sense of what the range should for whether it’s days or dollars or what have you over the next several quarters? Thank you.

[Bren Higgins, Chief Financial Officer]

You are right. It’s a good question and they are higher. We have seen some increases related to some of our long lead time products that are in the queue, namely the reticle inspection products and we talked about some of the incremental demand that we are seeing for that tool and those are long lead times so we have to get in the queue to buy that those materials early.

We have a number of new products that are coming out and so we are spinning up supply chain to support that in some cases you work -- we are working with newer suppliers and so, we are buying early to qualify parts to support a ramp. We have a new product launch in laser scanning, in E-beam. We talked about Gen 5 and the increments for Gen 5 into next year.

So, all those things are driving the inventory levels higher. As we move over then that I would expect based on what we are seeing in terms of output expectations into next year that we will see that number flatten out and that will be -- that’s a -- as we start to put that material into tools and ship those tools out.

So we are committing earlier and in those cases to make sure we have got the products in position so we can ramp them and that’s where we see in our financials is in the inventory build.

[Vivek Arya, Bank of America Merrill Lynch]

Thank you.

[Operator]

Your next question comes from the CJ Muse with Evercore. Your line is open.

[CJ Muse, Evercore]

Yeah. Good afternoon. Thank you for taking my question. I guess, first question, back on deferred revenues. It looks like that ticked up from June to September by $300 plus million. So is that the kind of number we should be thinking about in terms of an increase for deferred in fiscal ‘19 versus fiscal ‘18?

And as a second part to that, should we be thinking about deferred being isolated to certain long lead time or newer products and are there certain gross margins associated with those products vis-à-vis the rest of your mix?

[Bren Higgins, Chief Financial Officer]

Yeah. CJ, maybe this is something we need to reconcile with you, but deferred revenue, revenue backlog should come down. One thing about the 606 is, given the timing issues and given our implementation of 605, which was rules based and as a result took us longer to meet the conditions of transfer and customer acceptance, under 606 we get there much faster. So from the time we ship a tool till the time we revenue, it should only be about a month. So we should see deferred revenue related to that to come down.

I talked a little bit about the warranty dynamic earlier, which will play out over the next few quarters. But there isn’t anything in particular that’s -- that special or unique about certain products is more really based on, if you ship a new product and it’s first of a kind of matching requirement things like that, that we have to go all the way to an acceptance on.

But under 606 you go to that acceptance level and in a much faster way, and then all the follow-on tools are generally, you see revenue at shipment. As you know the installation acceptance process becomes or is considered more perfunctory from an accounting perspective. So that’s what’s happening and I would expect the deferred revenues to come down over time given those dynamics.

[CJ Muse, Evercore]

Very helpful. And as a follow-up, as you think about just the Jinhua ruling from the Department of Commerce. How are you thinking if at all that could impact MOFCOM and their willingness to sign off on your acquisition of Orbotech?

[Rick Wallace, President and CEO]

We have not -- we have had dialog and discussions and we are proceeding along the path that we had modeled where we were in terms of regulatory in China. We feel very good about the exchange that we are having and we believe we are on track to close that out this calendar year, so as we have said at this quarter. So we feel good about that we have seen no indication of any change in their posture based on any of the other things that are going on relative to trade.

[CJ Muse, Evercore]

Good to hear. Thank you.

[Operator]

Your next question comes from Toshiya Hari with Goldman Sachs. Your line is open.

[Toshiya Hari, Goldman Sachs]

Great. Thank you very much for taking my questions. Rick, you called out at Foundry 5-nanometer as one of the potential drivers heading into first half of ‘19 and I realize it’s really early. But how do you think about that node in terms of contribution to your business over the next couple of years?

[Rick Wallace, President and CEO]

Well, I mean, I think, it will be a continuation of the expansion we have seen in terms of the newer products that we have are going to be targeted at 5-nanometer. We see the process control intensity challenges are very significant for our customers because that that’s the node in which EUV is going to be adopted in a greater percentage. Some people are looking at some level of EUV at 7, but 5 is really where it increases an adoption then will drive a lot of use.

So we are well positioned for now. We are working closely with the customers that are pushing their technology and this is part of the Gen 5 discussion that we have had in the past where a Gen 5 is really more of a development tool, if you go back a year ago and now it’s becoming more of a pilot tool an early production in 5-nanometer becomes more biased toward production. So we feel great about where we are with that tool but also the supporting metrology tools as well.

[Bren Higgins, Chief Financial Officer]

In the first part of next year we will see the 7-nanometer tapeouts that are currently -- customers currently talking about we will see that drive up some activity, we are seeing in the mask shop, we will see it in the wafer fab as well and we will start to see more the n5 investments in early development as we move towards the second half of the year.

As Rick said, it’s a challenging node, it’s a bigger node for EUV and we have got a number of products that are targeted for it. And I think, it will be interesting and intriguing business for us as we move into the second half of the year.

[Toshiya Hari, Goldman Sachs]

Great. And then as a quick follow up, on bare wafer inspection, I think, this is another segment or product group rather that you guys have called out over the past couple, if not several quarters. I realize it’s a high margin business for you guys. I think some of your customers or all of your customers remain pretty constructive in the 2018, I am sorry, 2019 in terms of their outlook in terms of pricing, but some of them have toned it down a little bit, just given the weakness in memory and in certain parts of logic. How sustainable do you think this business is for you? I ask, because, in the past, I think, it’s been pretty volatile for you guys? Thank you.

[Rick Wallace, President and CEO]

We are certainly in a period where there’s both there’s kind of three things working at once in favor of this business, which is there’s capacity expansion, there’s technological challenges associated with these activity and there’s increased flatness requirements.

So it is true that that has stepped up the level of business. So we are modeling as we go forward is, we don’t see that level of growth going forward again where we have essentially over the last few years that business has grown quite a bit. But the sustainability of the current levels is what we are modeling in terms of when we talk with our customers as they continue to bring on capability.

And remember, the percent of their wafers that are going to leading-edge right now is relatively small and so over time they have to convert more of that to leading edge and so we will be feathering in our products and support of that.

So we feel pretty good about the current level of business that we have in the bare wafer and its sustainability. We don’t see another leg up though as we saw in the last few years as we went to this node.

[Toshiya Hari, Goldman Sachs]

Thanks so much.

[Operator]

Your next question comes from Patrick Ho with Stifel. Your line is open.

[Patrick Ho, Stifel]

Thank you very much. Maybe just as a follow up to your comments on the memory market lease in the near-term, when you are discussing about a balanced memory market, does that include the combination of DRAM and NAND or are you seeing one or the other potentially driving the first half of ‘19 outlook that you detailed?

[Bren Higgins, Chief Financial Officer]

So that’s the statement on our expectations for shipments into the first half. That it’s a relatively balanced shipment profile across the two segments. So I don’t really have much more to say than that.

I think we feel pretty good. We have to remember one thing about KLA is that we tend to be more about enabling technology and less about just raw capacity expansion and so as long as our customers are continuing to push their roadmaps and they are in DRAM and they are pursuing you know incremental layers in NAND that we see and expect to see a continued level of business from those customers irrespective of the capacity adjustments that could happen.

[Rick Wallace, President and CEO]

Yeah. And we don’t just agree with the industry perspective that DRAM Investment in ‘19 will be coming down, we did see foundry up and so. But as Bren said it’s -- that’s not as much of the driver for us as the other factors he mentioned.

[Patrick Ho, Stifel]

Great. That’s helpful. And maybe, Rick, as a follow up in terms of China and the indigenous market, particularly on the trailing edge foundry logic segment that’s been a surprising strength for the entire industry in 2018. From a process control intensity standpoint, do you believe the local semiconductor manufacturers on the foundry logic side are seeing the value and this will then continue as they continue to migrate down nodes in the future or I guess, I am a little surprised that there has been so much strength coming out of there given that they can reuse tool or buy used tools in the marketplace?

[Rick Wallace, President and CEO]

They have a -- there’s another process challenges I think that they are facing even though they have as you say that there -- they have the options that some of the bigger players might have tried to leverage.

But it’s harder when you are relatively new and your scale isn’t as big to be able to do the reuse and some of the things that you have seen in the other places. So they are also tackling a number of technology challenges at once.

We have excellent relationships there and we feel very good about the sustainability of that business. On a relative basis too, when you look at those fabs in terms of the scale they are significantly smaller, as I said, than what you’d see elsewhere.

So, I think, it continues to be strong, I do think there’s even potential for more in the way of things like mash ups, where you will continuously strength. Ultimately they’d like to have wafer manufacturing, but I think that’s several years away before that would be a significant piece of that.

[Bren Higgins, Chief Financial Officer]

Well, they also are challenged to get used equipment, it’s a pretty tight market out there and we will sell at time you scale the equipment, we don’t really have in any of that in inventory. So what we have done is we have restarted older product lines to support some of that business or you are seeing current revenues or products that are de-configured to meet these trailing edge needs that certainly have the utility to be upgraded over time from those customers. So they are investing that way, and to Rick’s point, I mean, there are markets to ship into and eventually they will be able to get to a place where they can do that.

[Patrick Ho, Stifel]

Great. Thank you.

[Operator]

Your next question comes from Atif Malik with Citigroup. Your line is open.

[Atif Malik, Citigroup]

Hi. Thanks for taking my question. Rick, I want to get your thoughts on the use of EUV for DRAM, when you think it gets implemented on DRAM and how you guys could benefit from that?

[Rick Wallace, President and CEO]

Well, I think, that the, you are going to start seeing some adoption of it very much depends on the economics, I think, and that’s going to be the big challenge. But I think we are going to see some in 2019 beyond what we have seen in pilot in 2018.

It’s really a similar story that to what we see in logic, where EUV presents opportunities both in terms of the mask shop, obviously, with DRAM, you don’t have the number of starts, but you do have very significant concerns about lifetime and contamination and EUV cleanliness overall.

But I think it’s much more about the scalability and scaling of the design role in DRAM and also some of the challenges they are trying to get around in terms of overlay control. So it’s a driver, but not as much as it is, of course, than logic.

[Atif Malik, Citigroup]

Okay. And then on China in a nuclear winter scenario where, let’s say, there are broad restrictions put on equipment suppliers to ship equipment to China. Do you think this spending will just get absorbed elsewhere in Korea or Taiwan or in other fab infrastructure there to take the demand?

[Rick Wallace, President and CEO]

Boy that’s -- it’s hard to speculate on that. But I would think there’s clearly a case that China is investing for strategic reasons, and therefore, it’s more additive in some ways than if they were to not be allowed to invest. So, I think, you’d probably see some impact.

We rate that probability as low and maybe also because of the action that was taken was very targeted and for specific reasons. So we are not modeling that as one of the outcomes. But, yes, I think, that that would have an overall impact on WFE for sure.

[Ed Lockwood, Investor Relations]

Operator, we are ready for next question.

[Operator]

[Operator Instructions] Your next question comes from Sidney Ho with Deutsche Bank. Your line is open.

[Sidney Ho, Deutsche Bank]

Thanks for taking my question. Just a follow-up on the service revenue, want to make sure that, you talk about it takes a few quarters for the revenue recognition to formalize. So should we think about by the end of this fiscal year, you will get back to a longer term trend of, say, 9% to 10% year-over-year?

[Bren Higgins, Chief Financial Officer]

Yes.

[Rick Wallace, President and CEO]

Yeah. No. That’s a good way to think about it, because you are going to have to work through the deferred revenue associated with all the tools that were under warranty at the time of conversion. So there are some tools that are shipped right at the end of that quarter. So it will take a year for that to completely roll-off, although, it’s likely a little bit heavier in the front end than it is in the back half of the fiscal year. That’s a good way to think about it.

[Sidney Ho, Deutsche Bank]

Okay. Great. My second question is that, in the past you have talked about trailing edge is now close to 40% of your revenues. Some of the foundries have you talked about overcapacity of 28 nanometers wafers and utilization may come down. Do you expect that to be a short-term phenomenon and do you expect next year you will see trailing edge going back to 40% of the revenues?

[Rick Wallace, President and CEO]

It looks pretty stable to us as we look at next year around as its more trailing edge that more of a foundry statement than an overall. But given the diversity of end markets around semis, if you look at those customers that are investing in the activity we are seeing. I’d see it being fairly stable. We will have to watch those markets and see. But at least at this point, that’s how it looks to us.

[Bren Higgins, Chief Financial Officer]

Part of what drives those, we have created options for those customers to upgrade their capability and so part of the business that we have for them even in a market where maybe they are not investing in new capacity is to upgrade their existing so they can get more efficient and we are seeing big demand for that and that was the initiative started a couple of years ago to be able to extend the value of the tools that are already in the installed base where we obviously have a home court advantage too.

[Sidney Ho, Deutsche Bank]

Great. Thank you very much.

[Operator]

There are no further questions at this time. I will now turn the call back over to Ed Lockwood.

[Ed Lockwood, Investor Relations]

Thank you, Chantal. No further commentary from us today. Thank you all for joining. This concludes our conference call.

[Operator]

This concludes today’s conference call. You may now disconnect.