KLAC 10Q 12/31/13
Table of Contents

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

FORM 10-Q


(Mark one)
T
QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended December 31, 2013
or
£
TRANSITION REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from              to             
Commission File Number 000-09992
KLA-Tencor Corporation
(Exact name of registrant as specified in its charter)
  
Delaware
 
04-2564110
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification No.)
 
 
 
One Technology Drive, Milpitas, California
 
95035
(Address of Principal Executive Offices)
 
(Zip Code)
(408) 875-3000
(Registrant’s telephone number, including area code)
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  £
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  £
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer x
 
Accelerated filer £
 
Non-accelerated filer £
 
Smaller reporting company £
 
 
 
 
(Do not check if a smaller reporting company)
 
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes £    No  x
As of January 10, 2014, there were 166,577,223 shares of the registrant’s Common Stock, $0.001 par value, outstanding.

Table of Contents

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


 

2
Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1.
FINANCIAL STATEMENTS
KLA-TENCOR CORPORATION
Condensed Consolidated Balance Sheets
(Unaudited)
 
(In thousands)
December 31,
2013
 
June 30,
2013
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
793,382

 
$
985,390

Marketable securities
2,157,279

 
1,933,491

Accounts receivable, net
573,077

 
524,610

Inventories
663,040

 
634,448

Deferred income taxes
200,614

 
198,525

Other current assets
120,142

 
75,039

Total current assets
4,507,534

 
4,351,503

Land, property and equipment, net
325,856

 
305,281

Goodwill
326,578

 
326,635

Purchased intangibles, net
26,098

 
34,515

Other non-current assets
254,668

 
269,423

Total assets
$
5,440,734

 
$
5,287,357

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
141,545

 
$
115,680

Deferred system profit
243,603

 
157,965

Unearned revenue
47,629

 
60,838

Other current liabilities
495,222

 
527,049

Total current liabilities
927,999

 
861,532

Non-current liabilities:
 
 
 
Long-term debt
747,647

 
747,376

Pension liabilities
57,621

 
57,959

Income tax payable
62,777

 
59,494

Unearned revenue
58,653

 
42,228

Other non-current liabilities
35,830

 
36,616

Total liabilities
1,890,527

 
1,805,205

Commitments and contingencies (Note 11 and Note 12)

 

Stockholders’ equity:
 
 
 
Common stock and capital in excess of par value
1,193,654

 
1,159,565

Retained earnings
2,386,801

 
2,359,233

Accumulated other comprehensive income (loss)
(30,248
)
 
(36,646
)
Total stockholders’ equity
3,550,207

 
3,482,152

Total liabilities and stockholders’ equity
$
5,440,734

 
$
5,287,357

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

3
Table of Contents

KLA-TENCOR CORPORATION
Condensed Consolidated Statements of Operations
(Unaudited)
 
 
Three months ended
 
Six months ended
 
December 31,
 
December 31,
(In thousands, except per share data)
2013
 
2012
 
2013
 
2012
Revenues:
 
 
 
 
 
 
 
Product
$
544,183

 
$
523,023

 
$
1,045,923

 
$
1,097,101

Service
160,946

 
149,988

 
317,543

 
296,619

Total revenues
705,129

 
673,011

 
1,363,466

 
1,393,720

Costs and operating expenses:
 
 
 
 
 
 
 
Costs of revenues
285,814

 
303,915

 
563,471

 
621,140

Engineering, research and development
134,587

 
121,608

 
266,860

 
241,350

Selling, general and administrative
96,746

 
94,241

 
195,242

 
191,426

Total costs and operating expenses
517,147

 
519,764

 
1,025,573

 
1,053,916

Income from operations
187,982

 
153,247

 
337,893

 
339,804

Interest income and other, net
2,074

 
5,058

 
5,689

 
8,546

Interest expense
13,311

 
13,431

 
26,973

 
26,934

Income before income taxes
176,745

 
144,874

 
316,609

 
321,416

Provision for income taxes
37,499

 
38,244

 
66,166

 
79,419

Net income
$
139,246

 
$
106,630

 
$
250,443

 
$
241,997

Net income per share:
 
 
 
 
 
 
 
Basic
$
0.84

 
$
0.64

 
$
1.51

 
$
1.45

Diluted
$
0.83

 
$
0.63

 
$
1.49

 
$
1.43

Cash dividends declared per share
$
0.45

 
$
0.40

 
$
0.90

 
$
0.80

Weighted-average number of shares:
 
 
 
 
 
 
 
Basic
166,414

 
166,268

 
166,150

 
166,632

Diluted
168,206

 
169,076

 
168,478

 
169,702

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

4
Table of Contents

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

 
Three months ended
 
Six months ended
 
December 31,
 
December 31,
(In thousands)
2013
 
2012
 
2013
 
2012
Net income
$
139,246

 
$
106,630

 
$
250,443

 
$
241,997

Other comprehensive income:
 
 
 
 
 
 
 
Currency translation adjustments:
 
 
 
 
 
 
 
Change in currency translation adjustments
(1,189
)
 
(1,126
)
 
3,921

 
5,496

Change in income tax benefit or expense
541

 
(1,035
)
 
(774
)
 
(2,712
)
Net change related to currency translation adjustments
(648
)
 
(2,161
)
 
3,147

 
2,784

Cash flow hedges:
 
 
 
 
 
 
 
Change in net unrealized gains or losses
3,864

 
2,242

 
3,573

 
2,001

Reclassification adjustments for gains or losses included in net income
(22
)
 
(128
)
 
(2,538
)
 
964

Change in income tax benefit or expense
(1,377
)
 
(753
)
 
(371
)
 
(1,056
)
Net change related to cash flow hedges
2,465

 
1,361

 
664

 
1,909

Net change related to unrecognized losses and transition obligations in connection with defined benefit plans
200

 
160

 
400

 
317

Available-for-sale investments:
 
 
 
 
 
 
 
Change in net unrealized gains or losses
659

 
(968
)
 
4,797

 
2,949

Reclassification adjustments for gains or losses included in net income
(1,213
)
 
(1,048
)
 
(1,447
)
 
(1,356
)
Change in income tax benefit or expense
180

 
709

 
(1,163
)
 
(518
)
Net change related to available-for-sale securities
(374
)
 
(1,307
)
 
2,187

 
1,075

Other comprehensive income (loss)
1,643

 
(1,947
)
 
6,398

 
6,085

Total comprehensive income
$
140,889

 
$
104,683

 
$
256,841

 
$
248,082


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

5
Table of Contents

KLA-TENCOR CORPORATION
Condensed Consolidated Statements of Cash Flows
(Unaudited)
 
Six months ended
December 31,
(In thousands)
2013
 
2012
Cash flows from operating activities:
 
 
 
Net income
$
250,443

 
$
241,997

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation and amortization
40,448

 
45,941

Asset impairment charges
1,374

 
1,327

Net gain on sale of assets
—

 
(1,160
)
Non-cash stock-based compensation expense
34,089

 
33,942

Excess tax benefit from equity awards
(19,530
)
 
(13,093
)
Net gain on sale of marketable securities and other investments
(1,447
)
 
(1,357
)
Changes in assets and liabilities:
 
 
 
Decrease (increase) in accounts receivable, net
(50,791
)
 
89,583

Increase in inventories
(32,743
)
 
(10,467
)
Decrease (increase) in other assets
(39,993
)
 
615

Increase (decrease) in accounts payable
25,939

 
(35,418
)
Increase in deferred system profit
85,638

 
9,557

Decrease in other liabilities
(908
)
 
(38,631
)
Net cash provided by operating activities
292,519

 
322,836

Cash flows from investing activities:
 
 
 
Capital expenditures, net
(36,216
)
 
(37,363
)
Proceeds from sale of assets
—

 
1,838

Purchase of available-for-sale securities
(796,808
)
 
(823,053
)
Proceeds from sale of available-for-sale securities
520,575

 
652,468

Proceeds from maturity of available-for-sale securities
50,889

 
137,182

Purchase of trading securities
(32,107
)
 
(19,912
)
Proceeds from sale of trading securities
30,879

 
19,438

Net cash used in investing activities
(262,788
)
 
(69,402
)
Cash flows from financing activities:
 
 
 
Issuance of common stock
78,766

 
46,857

Tax withholding payments related to vested and released restricted stock units
(49,209
)
 
(28,432
)
Common stock repurchases
(120,806
)
 
(136,600
)
Payment of dividends to stockholders
(149,600
)
 
(133,151
)
Excess tax benefit from equity awards
19,530

 
13,093

Net cash used in financing activities
(221,319
)
 
(238,233
)
Effect of exchange rate changes on cash and cash equivalents
(420
)
 
818

Net increase (decrease) in cash and cash equivalents
(192,008
)
 
16,019

Cash and cash equivalents at beginning of period
985,390

 
751,294

Cash and cash equivalents at end of period
$
793,382

 
$
767,313

Supplemental cash flow disclosures:
 
 
 
Income taxes paid, net
$
67,241

 
$
76,204

Interest paid
$
26,301

 
$
26,915

Non-cash investing activities:
 
 
 
Purchase of land, property and equipment
$
5,923

 
$
—

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

6
Table of Contents

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

NOTE 1 – BASIS OF PRESENTATION
Basis of Presentation. The condensed consolidated financial statements have been prepared by KLA-Tencor Corporation (“KLA-Tencor” or the “Company”) pursuant to the rules and regulations of the U.S. Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations. In the opinion of management, the unaudited interim financial statements reflect all adjustments (consisting only of normal, recurring adjustments) necessary for a fair statement of the financial position, results of operations, comprehensive income, and cash flows for the periods indicated. These financial statements and notes, however, should be read in conjunction with Item 8, “Financial Statements and Supplementary Data” included in the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2013, filed with the SEC on August 8, 2013.
The condensed consolidated financial statements include the accounts of KLA-Tencor and its majority-owned subsidiaries. All significant intercompany balances and transactions have been eliminated.
The results of operations for the six months ended December 31, 2013 are not necessarily indicative of the results that may be expected for any other interim period or for the full fiscal year ending June 30, 2014.
Certain reclassifications have been made to the prior year’s Condensed Consolidated Balance Sheet and notes to conform to the current year presentation. The reclassifications had no effect on the Condensed Consolidated Statements of Operations or Cash Flows.
Management Estimates. The preparation of the condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions in applying the Company's accounting policies that affect the reported amounts of assets and liabilities (and related disclosure of contingent assets and liabilities) at the date of the condensed consolidated financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates.
Revenue Recognition. KLA-Tencor recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the selling price is fixed or determinable, and collectibility is reasonably assured. The Company derives revenue from three sources—sales of systems, spare parts and services. In general, the Company recognizes revenue for systems when the system has been installed, is operating according to predetermined specifications and is accepted by the customer. When a customer delays installation for delivered products for which the Company has demonstrated a history of successful installation and acceptance, the Company recognizes revenue upon customer acceptance. Under certain circumstances, however, the Company recognizes revenue upon shipment, prior to acceptance from the customer, as follows:
•
When the customer fab has previously accepted the same tool, with the same specifications, and when the Company can objectively demonstrate that the tool meets all of the required acceptance criteria.
•
When system sales to independent distributors have no installation requirement, contain no acceptance agreement, and 100% payment is due based upon shipment.
•
When the installation of the system is deemed perfunctory.
•
When the customer withholds acceptance due to issues unrelated to product performance, in which case revenue is recognized when the system is performing as intended and meets predetermined specifications.
In circumstances in which the Company recognizes revenue prior to installation, the portion of revenue associated with installation is deferred based on estimated fair value, and that revenue is recognized upon completion of the installation.

7
Table of Contents

In many instances, products are sold in stand-alone arrangements. Services are sold separately through renewals of annual maintenance contracts. The Company also allows for multiple element revenue arrangements in cases where certain elements of a sales arrangement are not delivered and accepted in one reporting period. To determine the relative fair value of each element in a revenue arrangement, the Company allocates arrangement consideration based on the selling price hierarchy. For substantially all of the arrangements with multiple deliverables pertaining to products and services, the Company uses vendor-specific objective evidence (“VSOE”) or third-party evidence (“TPE”) to allocate the selling price to each deliverable. The Company determines TPE based on historical prices charged for products and services when sold on a stand-alone basis. When the Company is unable to establish relative selling price using VSOE or TPE, the Company uses estimated selling price (“ESP”) in its allocation of arrangement consideration. The objective of ESP is to determine the price at which the Company would transact a sale if the product or service were sold on a stand-alone basis. ESP could potentially be used for new or customized products. The Company regularly reviews relative selling prices and maintains internal controls over the establishment and updates of these estimates. In a multiple element revenue arrangement, the Company defers revenue recognition associated with the relative fair value of the undelivered elements until that element is delivered to the customer. To be considered a separate element, the product or service in question must represent a separate unit of accounting, which means that such product or service must fulfill the following criteria: (a) the delivered item(s) has value to the customer on a stand-alone basis; and (b) if the arrangement includes a general right of return relative to the delivered item(s), delivery or performance of the undelivered item(s) is considered probable and substantially in the control of the Company. If the arrangement does not meet all the above criteria, the entire amount of the sales contract is deferred until all elements are accepted by the customer.
Trade-in rights are occasionally granted to customers to trade in tools in connection with subsequent purchases. The Company estimates the value of the trade-in right and reduces the revenue recognized on the initial sale. This amount is recognized at the earlier of the exercise of the trade-in right or the expiration of the trade-in right.
 Spare parts revenue is recognized when the product has been shipped, risk of loss has passed to the customer and collection of the resulting receivable is probable.
Service and maintenance contract revenue is recognized ratably over the term of the maintenance contract. Revenue from services performed in the absence of a maintenance contract, including consulting and training revenue, is recognized when the related services are performed and collectibility is reasonably assured.
The Company sells stand-alone software that is subject to the software revenue recognition guidance. The Company periodically reviews selling prices to determine whether VSOE exists, and in some situations where the Company is unable to establish VSOE for undelivered elements such as post-contract service, revenue is recognized ratably over the term of the service contract.
The Company also defers the fair value of non-standard warranty bundled with equipment sales as unearned revenue. Non-standard warranty includes services incremental to the standard 40-hour per week coverage for 12 months. Non-standard warranty is recognized ratably as revenue when the applicable warranty term period commences.
The deferred system profit balance equals the amount of deferred system revenue that was invoiced and due on shipment, less applicable product and warranty costs. Deferred system revenue represents the value of products that have been shipped and billed to customers which have not met the Company's revenue recognition criteria. Deferred system profit does not include the profit associated with product shipments to customers in Japan, to whom title does not transfer until customer acceptance. Shipments to customers in Japan are classified as inventory at cost until the time of acceptance.

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Recent Accounting Pronouncements. In July 2013, the Financial Accounting Standards Board (“FASB”) issued an accounting standard update that provides explicit guidance on the financial statement presentation of an unrecognized tax benefit when a net operating loss carryforward, a similar tax loss or a tax credit carryforward exists. Under the new standard update, in most circumstances, an unrecognized tax benefit, or a portion of an unrecognized tax benefit, should be presented in the Company's financial statements as a reduction to a deferred tax asset for a net operating loss carryforward, a similar tax loss or a tax credit carryforward. This accounting standard update will be effective for the Company's interim period ending September 30, 2014 and applied prospectively with early adoption permitted. The Company is currently evaluating the impact of this accounting standard update on its consolidated financial statements.
NOTE 2 – FAIR VALUE MEASUREMENTS
The Company’s financial assets and liabilities are measured and recorded at fair value, except for equity investments in privately-held companies. These equity investments are generally accounted for under the cost method of accounting and are periodically assessed for other-than-temporary impairment when an event or circumstance indicates that an other-than-temporary decline in value may have occurred. The Company’s non-financial assets, such as goodwill, intangible assets, and land, property and equipment, are recorded at cost and are assessed for impairment when an event or circumstance indicates that an other-than-temporary decline in value may have occurred.
Fair Value of Financial Instruments. KLA-Tencor has evaluated the estimated fair value of financial instruments using available market information and valuations as provided by third-party sources. The use of different market assumptions and/or estimation methodologies could have a significant effect on the estimated fair value amounts. The fair value of the Company's cash equivalents, accounts receivable, accounts payable and other current liabilities approximate their carrying amounts due to the relatively short maturity of these items.
Fair Value Hierarchy. The authoritative guidance for fair value measurements establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy are described below:
Level 1
  
Valuations based on quoted prices in active markets for identical assets or liabilities that the entity has the ability to access.
 
 
 
Level 2
  
Valuations based on quoted prices for similar assets or liabilities, quoted prices in markets that are not active, or other inputs that are observable or can be corroborated by observable data for substantially the full term of the assets or liabilities.
 
 
 
Level 3
  
Valuations based on inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.
A financial instrument’s level within the fair value hierarchy is based on the lowest level of any input that is significant to the fair value measurement.
All of the Company’s financial instruments were classified within Level 1 or Level 2 of the fair value hierarchy as of December 31, 2013, because they were valued using quoted market prices, broker/dealer quotes or alternative pricing sources with reasonable levels of price transparency. As of December 31, 2013, the types of instruments valued based on quoted market prices in active markets included money market funds, U.S. Treasury securities and certain U.S. Government agency securities and sovereign securities. Such instruments are generally classified within Level 1 of the fair value hierarchy.
As of December 31, 2013, the types of instruments valued based on other observable inputs included corporate debt securities, municipal securities and certain U.S. Government agency securities and sovereign securities. The market inputs used to value these instruments generally consist of market yields, reported trades and broker/dealer quotes. Such instruments are generally classified within Level 2 of the fair value hierarchy.
The principal market in which the Company executes its foreign currency contracts is the institutional market in an over-the-counter environment with a relatively high level of price transparency. The market participants usually are large commercial banks. The Company’s foreign currency contracts’ valuation inputs are based on quoted prices and quoted pricing intervals from public data sources and do not involve management judgment. These contracts are typically classified within Level 2 of the fair value hierarchy.

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Financial assets (excluding cash held in operating accounts and time deposits) and liabilities measured at fair value on a recurring basis as of the date indicated below were presented on the Company’s Condensed Consolidated Balance Sheet as follows:
As of December 31, 2013 (In thousands)
Total
 
Quoted Prices in
Active Markets
for Identical
Assets (Level 1)
 
Significant Other
Observable Inputs
(Level 2)
Assets
 
 
 
 
 
Cash equivalents:
 
 
 
 
 
U.S. Government agency securities
$
19,997

 
$
5,000

 
$
14,997

Corporate debt securities
61,797

 
—

 
61,797

Money market and other
574,904

 
574,904

 
—

Marketable securities:
 
 
 
 
 
U.S. Treasury securities
168,313

 
168,313

 
—

U.S. Government agency securities
731,636

 
709,647

 
21,989

Municipal securities
107,587

 
—

 
107,587

Corporate debt securities
1,107,255

 
—

 
1,107,255

Sovereign securities
36,439

 
8,498

 
27,941

Total cash equivalents and marketable securities(1)
2,807,928

 
1,466,362

 
1,341,566

Other current assets:
 
 
 
 
 
Derivative assets
5,584

 
—

 
5,584

Other non-current assets:
 
 
 
 
 
Executive Deferred Savings Plan
155,277

 
103,374

 
51,903

Total financial assets(1)
$
2,968,789

 
$
1,569,736

 
$
1,399,053

Liabilities
 
 
 
 
 
Other current liabilities:
 
 
 
 
 
Derivative liabilities
$
(708
)
 
$
—

 
$
(708
)
Executive Deferred Savings Plan
(155,433
)
 
(102,554
)
 
(52,879
)
Total financial liabilities
$
(156,141
)
 
$
(102,554
)
 
$
(53,587
)
________________
(1) Excludes cash of $122.8 million held in operating accounts and time deposits of $19.9 million as of December 31, 2013.


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

 
$
—

 
$
3,800

Money market and other
817,608

 
817,608

 
—

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

 
93,787

 
—

U.S. Government agency securities
598,031

 
598,031

 
—

Municipal securities
103,455

 
—

 
103,455

Corporate debt securities
1,099,525

 
—

 
1,099,525

Sovereign securities
33,805

 
13,559

 
20,246

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

 
1,522,985

 
1,227,026

Other current assets:
 
 
 
 
 
Derivative assets
4,016

 
—

 
4,016

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

 
96,180

 
40,281

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

 
$
1,619,165

 
$
1,271,323

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

 
$
(2,173
)
Executive Deferred Savings Plan
(137,849
)
 
(97,570
)
 
(40,279
)
Total financial liabilities
$
(140,022
)
 
$
(97,570
)
 
$
(42,452
)
________________
(1) Excludes cash of $125.5 million held in operating accounts and time deposits of $43.4 million as of June 30, 2013.
There were no transfers in and out of Level 1 and Level 2 fair value measurements during the three and six months ended December 31, 2013. The Company did not have any assets or liabilities measured at fair value on a recurring basis within Level 3 fair value measurements as of December 31, 2013 or June 30, 2013.



11
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NOTE 3 – FINANCIAL STATEMENT COMPONENTS
Balance Sheet Components
(In thousands)
As of
December 31, 2013
 
As of
June 30, 2013
Accounts receivable, net:
 
 
 
Accounts receivable, gross
$
595,048

 
$
546,745

Allowance for doubtful accounts
(21,971
)
 
(22,135
)
 
$
573,077

 
$
524,610

Inventories:
 
 
 
Customer service parts
$
193,371

 
$
180,749

Raw materials
229,186

 
229,233

Work-in-process
176,432

 
176,704

Finished goods
64,051

 
47,762

 
$
663,040

 
$
634,448

Other current assets:
 
 
 
Prepaid expenses
$
33,023

 
$
31,997

Prepaid income taxes
66,403

 
25,825

Other current assets
20,716

 
17,217

 
$
120,142

 
$
75,039

Land, property and equipment, net:
 
 
 
Land
$
41,838

 
$
41,850

Buildings and leasehold improvements
281,119

 
272,920

Machinery and equipment
496,203

 
476,747

Office furniture and fixtures
20,787

 
20,701

Construction-in-process
25,488

 
16,604

 
865,435

 
828,822

Less: accumulated depreciation and amortization
(539,579
)
 
(523,541
)
 
$
325,856

 
$
305,281

Other non-current assets:
 
 
 
Executive Deferred Savings Plan(1)
$
155,277

 
$
136,461

Deferred tax assets – long-term
83,727

 
114,833

Other
15,664

 
18,129

 
$
254,668

 
$
269,423

Other current liabilities:
 
 
 
Warranty
$
41,599

 
$
42,603

Executive Deferred Savings Plan(1)
155,433

 
137,849

Compensation and benefits
154,092

 
195,793

Income taxes payable
13,565

 
11,076

Interest payable
8,769

 
8,769

Other accrued expenses
121,764

 
130,959

 
$
495,222

 
$
527,049


12
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________________
(1)
KLA-Tencor has a non-qualified deferred compensation plan whereby certain executives and non-employee directors may defer a portion of their compensation. Participants are credited with returns based on their allocation of their account balances among measurement funds. The Company controls the investment of these funds, and the participants remain general creditors of KLA-Tencor. Distributions from the plan commence the quarter following a participant’s retirement or termination of employment, except in cases where such distributions are required to be delayed in order to avoid a prohibited distribution under Internal Revenue Code Section 409A. As of December 31, 2013, the Company had a deferred compensation plan related asset and liability included as a component of other non-current assets and other current liabilities on the Condensed Consolidated Balance Sheet.
Accumulated Other Comprehensive Income (Loss)
The components of accumulated other comprehensive income (loss) (“AOCI”) as of the dates indicated below were as follows:
(In thousands)
Currency Translation Adjustments
 
Unrealized Gains (Losses) on Available-for-Sale Investments
 
Unrealized Gains (Losses) on Cash Flow Hedges
 
Unrealized Gains (Losses) on Defined Benefit Plans
 
Total
Balance as of June 30, 2013
$
(22,467
)
 
$
(602
)
 
$
1,594

 
$
(15,171
)
 
$
(36,646
)
Other comprehensive income before reclassifications
3,921

 
4,797

 
3,573

 
—

 
12,291

Amounts reclassified from AOCI
—

 
(1,447
)
 
(2,538
)
 
628

 
(3,357
)
Tax benefits
(774
)
 
(1,163
)
 
(371
)
 
(228
)
 
(2,536
)
Other comprehensive income
3,147

 
2,187

 
664

 
400

 
6,398

Balance as of December 31, 2013
$
(19,320
)
 
$
1,585

 
$
2,258

 
$
(14,771
)
 
$
(30,248
)
The effects on net income of amounts reclassified from AOCI to the consolidated statement of operations for the indicated periods were as follows (in thousands):
 
 
 
 
Three months ended
December 31,
 
Six months ended
December 31,
AOCI Components
 
Location
 
2013
 
2013
Gains (losses) on cash flow hedges from foreign exchange contracts
 
Revenues
 
$
(128
)
 
$
2,322

 
 
Costs of revenues
 
150

 
216

 
 
Total before tax
 
22

 
2,538

Unrealized gains on available-for-sale investments
 
Interest income and other, net
 
1,213

 
1,447

Unrealized losses on defined benefit plans
 
Total before tax
 
$
(313
)
 
$
(628
)
Total amount reclassified from AOCI
 
 
 
$
922

 
$
3,357


13
Table of Contents


NOTE 4 – MARKETABLE SECURITIES
The amortized cost and fair value of marketable securities as of the dates indicated below were as follows:
As of December 31, 2013 (In thousands)
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
U.S. Treasury securities
$
168,354

 
$
70

 
$
(111
)
 
$
168,313

U.S. Government agency securities
751,314

 
614

 
(295
)
 
751,633

Municipal securities
107,740

 
92

 
(245
)
 
107,587

Corporate debt securities
1,166,754

 
2,967

 
(669
)
 
1,169,052

Money market and other
574,904

 
—

 
—

 
574,904

Sovereign securities
36,442

 
15

 
(18
)
 
36,439

Subtotal
2,805,508

 
3,758

 
(1,338
)
 
2,807,928

Add: Time deposits(1)
19,942

 
—

 
—

 
19,942

Less: Cash equivalents
670,591

 
—

 
—

 
670,591

Marketable securities
$
2,154,859

 
$
3,758

 
$
(1,338
)
 
$
2,157,279

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

 
$
53

 
$
(206
)
 
$
93,787

U.S. Government agency securities
598,471

 
569

 
(1,009
)
 
598,031

Municipal securities
103,686

 
71

 
(302
)
 
103,455

Corporate debt securities
1,103,438

 
2,353

 
(2,466
)
 
1,103,325

Money market and other
817,608

 
—

 
—

 
817,608

Sovereign securities
33,799

 
25

 
(19
)
 
33,805

Subtotal
2,750,942

 
3,071

 
(4,002
)
 
2,750,011

Add: Time deposits(1)
43,413

 
—

 
—

 
43,413

Less: Cash equivalents
859,933

 
—

 
—

 
859,933

Marketable securities
$
1,934,422

 
$
3,071

 
$
(4,002
)
 
$
1,933,491

________________
(1)
Time deposits excluded from fair value measurements.
KLA-Tencor’s investment portfolio consists of both corporate and government securities that have a maximum maturity of three years. The longer the duration of these securities, the more susceptible they are to changes in market interest rates and bond yields. As yields increase, those securities with a lower yield-at-cost show a mark-to-market unrealized loss. All unrealized losses are due to changes in market interest rates, bond yields and/or credit ratings. The Company has the ability to realize the full value of all of these investments upon maturity. The following table summarizes the fair value and gross unrealized losses of the Company’s investments that were in an unrealized loss position as of the date indicated below:
 
As of December 31, 2013 (In thousands)
Fair Value
 
Gross
Unrealized
Losses(1)
U.S. Treasury securities
$
68,423

 
$
(111
)
U.S. Government agency securities
249,078

 
(295
)
Municipal securities
55,784

 
(245
)
Corporate debt securities
310,332

 
(669
)
Sovereign securities
21,238

 
(18
)
Total
$
704,855

 
$
(1,338
)
__________________ 
(1)
Of the total gross unrealized losses, the amount of total gross unrealized losses related to investments that had been in a continuous loss position for 12 months or more was immaterial.

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The contractual maturities of securities classified as available-for-sale, regardless of their classification on the Company's Condensed Consolidated Balance Sheet, as of the date indicated below were as follows:
As of December 31, 2013 (In thousands)
Amortized Cost
 
Fair Value
Due within one year
$
532,278

 
$
533,124

Due after one year through three years
1,622,581

 
1,624,155

 
$
2,154,859

 
$
2,157,279

Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Realized gains on available-for-sale securities for the three months ended December 31, 2013 and December 31, 2012 were $1.2 million and $1.1 million, respectively. Realized gains on available-for-sale securities for the six months ended December 31, 2013 and December 31, 2012 were $1.5 million and $1.4 million, respectively. Realized losses on available-for-sale securities for the three and six months ended December 31, 2013 and December 31, 2012 were immaterial.
NOTE 5 – GOODWILL AND PURCHASED INTANGIBLE ASSETS
Goodwill
The following table presents goodwill balances as of the dates indicated below:
(In thousands)
As of
December 31, 2013
 
As of
June 30, 2013
Gross goodwill balance
$
604,148

 
$
604,205

Accumulated impairment losses
(277,570
)
 
(277,570
)
Net goodwill balance
$
326,578

 
$
326,635

The changes in the gross goodwill balance since June 30, 2013 resulted from foreign currency translation adjustments.
Goodwill represents the excess of the purchase price over the fair value of the net tangible and identifiable intangible assets acquired in each business combination.
The Company has four reporting units: Defect Inspection, Metrology, Service and Other. As of December 31, 2013, substantially all of the goodwill balance resided in the Defect Inspection reporting unit.
The fair value of each of the Company's reporting units was substantially in excess of its estimated carrying amount as of the most recent quantitative analysis of goodwill impairment performed in the three months ended December 31, 2010. There have been no triggering events or changes in circumstances since that quantitative analysis to indicate that the fair value of any of the Company's reporting units would be less than its carrying amount.
The Company performed a qualitative assessment of the goodwill by reporting unit as of November 30, 2013 during the three months ended December 31, 2013 and concluded that it was more likely than not that the fair value of each of the reporting units exceeded its carrying amount. As a result of the Company's determination following its qualitative assessment, it was not necessary to perform the two-step quantitative goodwill impairment test at this time. In assessing the qualitative factors, the Company considered the impact of these key factors: change in industry and competitive environment, market capitalization, stock price, earnings multiples, budgeted-to-actual revenue performance from prior year, gross margin and cash flow from operating activities.
Based on the Company's assessment, goodwill in the reporting units was not impaired as of December 31, 2013 or 2012.

15
Table of Contents

Purchased Intangible Assets
The components of purchased intangible assets as of the dates indicated below were as follows:
(In thousands)
 
 
As of
December 31, 2013
 
As of
June 30, 2013
Category
Range of
Useful Lives
 
Gross
Carrying
Amount
 
Accumulated
Amortization
and
Impairment
 
Net
Amount
 
Gross
Carrying
Amount
 
Accumulated
Amortization
and
Impairment
 
Net
Amount
Existing technology
4-7 years
 
$
133,659

 
$
122,848

 
$
10,811

 
$
133,659

 
$
119,106

 
$
14,553

Patents
6-13 years
 
57,648

 
52,740

 
4,908

 
57,648

 
51,068

 
6,580

Trade name/Trademark
4-10 years
 
19,893

 
16,677

 
3,216

 
19,893

 
15,928

 
3,965

Customer relationships
6-7 years
 
54,680

 
47,517

 
7,163

 
54,680

 
45,263

 
9,417

Other
0-1 year
 
16,200

 
16,200

 
—

 
16,200

 
16,200

 
—

Total
 
 
$
282,080

 
$
255,982

 
$
26,098

 
$
282,080

 
$
247,565

 
$
34,515

Intangible assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset or asset group may not be recoverable.
For the three months ended December 31, 2013 and 2012, amortization expense for intangible assets was $3.9 million and $4.6 million, respectively. For the six months ended December 31, 2013 and 2012, amortization expense for intangible assets was $8.4 million and $11.8 million, respectively. Based on the intangible assets recorded as of December 31, 2013, and assuming no subsequent additions to, or impairment of, the underlying assets, the remaining estimated amortization expense is expected to be as follows:
Fiscal year ending June 30:
Amortization
(In thousands)
2014 (remaining 6 months)
$
6,950

2015
12,752

2016
5,564

2017
806

2018
26

Total
$
26,098


NOTE 6 – LONG-TERM DEBT
In April 2008, the Company issued $750 million aggregate principal amount of 6.90% senior, unsecured long-term debt due in 2018 with an effective interest rate of 7.00%. The discount on the debt amounted to $5.4 million and is being amortized over the life of the debt using the straight-line method as opposed to the interest method due to immateriality. Interest is payable semi-annually on November 1 and May 1. The debt indenture includes covenants that limit the Company’s ability to grant liens on its facilities and to enter into sale and leaseback transactions, subject to significant allowances under which certain sale and leaseback transactions are not restricted. The Company was in compliance with all of its covenants as of December 31, 2013.
In certain circumstances involving a change of control followed by a downgrade of the rating of the Company’s senior notes, the Company will be required to make an offer to repurchase the senior notes at a purchase price equal to 101% of the aggregate principal amount of the notes, plus accrued and unpaid interest. The Company’s ability to repurchase the senior notes in such event may be limited by law, by the indenture associated with the senior notes, by the Company’s then-available financial resources or by the terms of other agreements to which the Company may be party at such time. If the Company fails to repurchase the senior notes as required by the indenture, it would constitute an event of default under the indenture governing the senior notes which, in turn, may also constitute an event of default under other obligations.
Based on the trading prices of the debt on the applicable dates, the fair value of the debt as of December 31, 2013 and June 30, 2013 was $874.9 million and $872.3 million, respectively. While the debt is recorded at cost, the fair value of the long-term debt was determined based on quoted prices in markets that are not active; accordingly, the long-term debt is categorized as Level 2 for purposes of the fair value measurement hierarchy.

16
Table of Contents


NOTE 7 – EQUITY AND LONG-TERM INCENTIVE COMPENSATION PLANS
Equity Incentive Program
Under the Company’s current equity incentive program, the Company issues equity awards from its 2004 Equity Incentive Plan (the “2004 Plan”), which provides for the grant of options to purchase shares of its common stock, stock appreciation rights, restricted stock units, performance shares, performance units and deferred stock units to its employees, consultants and members of its Board of Directors. The 2004 Plan currently permits the issuance of up to 34.9 million shares of common stock, including 2.9 million additional shares approved by the Company's stockholders on November 6, 2013. Any 2004 Plan awards of restricted stock units, performance shares, performance units or deferred stock units with a per share or unit purchase price lower than 100% of fair market value on the grant date are counted against the total number of shares issuable under the 2004 Plan as follows, based on the grant date of the applicable award: (a) for any such awards granted before November 6, 2013, the awards counted against the 2004 Plan share reserve as 1.8 shares for every one share subject thereto; and (b) for any such awards granted on or after November 6, 2013, the awards count against the 2004 Plan share reserve as 2.0 shares for every one share subject thereto.
The following table summarizes the combined activity under the Company's equity incentive plans for the indicated period:
(In thousands)
Available
For Grant
Balances as of June 30, 2013(1)
6,696

Plan shares increased
2,900

Restricted stock units granted(2)(3)
(1,259
)
Restricted stock units canceled(2)
221

Options canceled/expired/forfeited
44

Plan shares expired(4)
(35
)
Balances as of December 31, 2013(1)
8,567

__________________ 
(1)
Includes shares available for issuance under the 2004 Plan, as well as under the Company’s 1998 Outside Director Option Plan (the “Outside Director Plan”), which only permits the issuance of stock options to the Company’s non-employee members of the Board of Directors. As of December 31, 2013, 1.7 million shares were available for grant under the Outside Director Plan.
(2)
The number of restricted stock units provided in this row reflects the application of the full value award multiplier described above (1.8x or 2.0x depending on the grant date of the applicable award).
(3)
Includes 0.3 million (reflected as 0.6 million shares in this table due to the application of the 1.8x multiple described above, as all of these awards were granted before November 6, 2013) restricted stock units granted to senior management during the six months ended December 31, 2013 with performance-based vesting criteria (in addition to service-based vesting criteria for any of such restricted stock units that are deemed to have been earned). As of December 31, 2013, it had not yet been determined the extent to which (if at all) the performance-based vesting criteria of such restricted stock units had been satisfied. Therefore, this line item includes all such performance-based restricted stock units granted during the six months ended December 31, 2013, reported at the maximum possible number of shares that may ultimately be issuable under such restricted stock units if all applicable performance-based criteria are achieved at their maximum and all applicable service-based criteria are fully satisfied.
(4)
Represents the portion of shares listed as “Options canceled/expired/forfeited” above that were issued under the Company’s equity incentive plans other than the 2004 Plan or the Outside Director Plan. Because the Company is only currently authorized to issue equity awards under the 2004 Plan and the Outside Director Plan, any equity awards that are canceled, expire or are forfeited under any other Company equity incentive plans do not result in additional shares being available to the Company for future grant.

17
Table of Contents

Except for stock options granted to non-employee Board members as part of their regular compensation package for service through the end of the first quarter of fiscal year 2008, the Company has granted only restricted stock units under its equity incentive program since September 2006. For the preceding several years until September 30, 2006, stock options were granted at the market price of the Company’s common stock on the date of grant (except for the previously disclosed retroactively priced options which were granted primarily prior to the fiscal year ended June 30, 2002), generally with a vesting period of five years and an exercise period not to exceed seven years (ten years for options granted prior to July 1, 2005) from the date of issuance. Restricted stock units may be granted with varying criteria such as service-based and/or performance-based vesting.
The fair value of stock-based awards is measured at the grant date and is recognized as an expense over the employee’s requisite service period. The fair value is determined using a Black-Scholes valuation model for purchase rights under the Company’s Employee Stock Purchase Plan and using the closing price of the Company’s common stock on the grant date for restricted stock units, adjusted to exclude the present value of dividends which do not accrue on restricted stock units granted by the Company to date. In November 2013, the Company's stockholders approved amendments to the 2004 Plan that included, among other things, giving the plan administrator the ability to grant "dividend equivalent" rights in connection with awards of restricted stock units, performance shares, performance units and deferred stock units, which represent the right to receive accrued dividends on such awards once the underlying awards vest. As of December 31, 2013, the Company had not granted dividend equivalent rights in connection with any such awards.
The following table shows pre-tax stock-based compensation expense for the indicated periods: 
 
Three months ended
December 31,
 
Six months ended
December 31,
(In thousands)
2013
 
2012
 
2013
 
2012
Stock-based compensation expense by:
 
 
 
 
 
 
 
Costs of revenues
$
2,321

 
$
2,624

 
$
5,498

 
$
5,899

Engineering, research and development
3,877

 
4,270

 
9,285

 
9,733

Selling, general and administrative
8,672

 
8,064

 
19,306

 
18,310

Total stock-based compensation expense
$
14,870

 
$
14,958

 
$
34,089

 
$
33,942

The following table shows stock-based compensation capitalized as inventory as of the dates indicated below: 
(In thousands)
As of
December 31, 2013
 
As of
June 30, 2013
Inventory
$
8,338

 
$
8,098

Stock Options
The following table summarizes the activity and weighted-average exercise price for stock options under all plans during the six months ended December 31, 2013: 
Stock Options
Shares
(In thousands)
 
Weighted-Average
Exercise Price
Outstanding stock options as of June 30, 2013
1,663

 
$
48.97

Granted
—

 
$
—

Exercised
(1,147
)
 
$
50.94

Canceled/expired/forfeited
(44
)
 
$
51.76

Outstanding stock options as of December 31, 2013 (all outstanding and all vested and exercisable)
472

 
$
43.94

The Company has not issued any stock options since November 1, 2007. The weighted-average remaining contractual terms for total options outstanding under all plans, and for total options vested and exercisable under all plans, as of December 31, 2013 were each 0.6 years. The aggregate intrinsic values for total options outstanding under all plans, and for total options vested and exercisable under all plans, as of December 31, 2013 were each $9.7 million.

18
Table of Contents

The authoritative guidance on stock-based compensation permits companies to select the option-pricing model used to estimate the fair value of their stock-based compensation awards. The Black-Scholes option-pricing model requires the input of assumptions, including the option’s expected term and the expected price volatility of the underlying stock. For purposes of the fair value estimates presented in this report, the Company has based its expected stock price volatility assumption on the market-based implied volatility from traded options of the Company’s common stock. As of December 31, 2013, the Company had no unrecognized stock-based compensation balance related to stock options.
The following table shows the total intrinsic value of options exercised, total cash received from employees and non-employee Board members as a result of stock option exercises and tax benefits realized by the Company in connection with these stock option exercises for the indicated periods: 
 
Three months ended
December 31,
 
Six months ended
December 31,
(In thousands)
2013
 
2012
 
2013
 
2012
Total intrinsic value of options exercised
$
3,431

 
$
847

 
$
11,314

 
$
4,774

Total cash received from employees and non-employee Board members as a result of stock option exercises
$
15,684

 
$
3,467

 
$
56,731

 
$
26,718

Tax benefits realized by the Company in connection with these exercises
$
1,061

 
$
285

 
$
3,678

 
$
1,579

The Company generally settles employee stock option exercises with newly issued common shares, except in certain tax jurisdictions where settling such exercises with treasury shares provides the Company or one of its subsidiaries with a tax benefit.
Restricted Stock Units
The following table shows the applicable number of restricted stock units and weighted-average grant date fair value for restricted stock units granted, vested and released, withheld for taxes, and forfeited during the six months ended December 31, 2013 and restricted stock units outstanding as of December 31, 2013 and June 30, 2013: 
Restricted Stock Units
Shares
(In thousands) (1)
 
Weighted-Average
Grant Date
Fair Value
Outstanding restricted stock units as of June 30, 2013(2)
5,374

 
$
34.39

Granted(3)
698

 
$
53.27

Vested and released
(1,508
)
 
$
32.60

Withheld for taxes
(827
)
 
$
32.60

Forfeited
(124
)
 
$
35.23

Outstanding restricted stock units as of December 31, 2013(2) (3)
3,613

 
$
39.17

__________________ 
(1)
Share numbers reflect actual shares subject to awarded restricted stock units. As described above, under the terms of the 2004 Plan, the number of shares subject to each award reflected in this number is multiplied by either 1.8 or 2.0 (depending on the grant date of the award) to calculate the impact of the award on the share reserve under the 2004 Plan.
(2)
Includes 0.3 million restricted stock units granted to senior management during the six months ended December 31, 2012 with performance-based vesting criteria (in addition to service-based vesting criteria for any of such restricted stock units that are deemed to have been earned). As of December 31, 2013, it had not yet been determined the extent to which (if at all) the performance-based vesting criteria of such restricted stock units had been satisfied. Therefore, this line item includes all such performance-based restricted stock units, reported at the maximum possible number of shares that may ultimately be issuable under such restricted stock units if all applicable performance-based criteria are achieved at their maximum and all applicable service-based criteria are fully satisfied.
(3)
Includes 0.3 million restricted stock units granted to senior management during the six months ended December 31, 2013 with performance-based vesting criteria (in addition to service-based vesting criteria for any of such restricted stock units that are deemed to have been earned). As of December 31, 2013, it had not yet been determined the extent to which (if at all) the performance-based vesting criteria of such restricted stock units had been satisfied. Therefore, this line item includes all such performance-based restricted stock units, reported at the maximum possible number of shares that may ultimately be issuable under such restricted stock units if all applicable performance-based criteria are achieved at their maximum and all applicable service-based criteria are fully satisfied.

19
Table of Contents

The restricted stock units granted by the Company since the beginning of the fiscal year ended June 30, 2013 generally vest (a) with respect to awards with only service-based vesting criteria, in four equal installments on the first, second, third and fourth anniversaries of the grant date and (b) with respect to awards with both performance-based and service-based vesting criteria, in two equal installments on the third and fourth anniversaries of the grant date, in each case subject to the recipient remaining employed by the Company as of the applicable vesting date. The restricted stock units granted by the Company from the beginning of the fiscal year ended June 30, 2007 through the fiscal year ended June 30, 2012 generally vest in two equal installments on the second and fourth anniversaries of the grant date, subject to the recipient remaining employed by the Company as of the applicable vesting date. The fair value is determined using the closing price of the Company’s common stock on the grant date for restricted stock units, adjusted to exclude the present value of dividends which do not accrue on restricted stock units granted by the Company to date. In November 2013, the Company's stockholders approved amendments to the 2004 Plan that included, among other things, giving the plan administrator the ability to grant "dividend equivalent" rights in connection with awards of restricted stock units, performance shares, performance units and deferred stock units, which represent the right to receive accrued dividends on such awards once the underlying awards vest. As of December 31, 2013, the Company had not granted dividend equivalent rights in connection with any such awards.
The restricted stock units have been awarded under the 2004 Plan, and each unit will entitle the recipient to one share of common stock when the applicable vesting requirements for that unit are satisfied. However, for each share actually issued under the awarded restricted stock units, the share reserve under the 2004 Plan will be reduced by 1.8 shares (for awards granted before November 6, 2013) or 2.0 shares (for awards granted on or after November 6, 2013), as provided under the terms of the 2004 Plan.
The following table shows the weighted-average grant date fair value per unit for the restricted stock units granted and tax benefits realized by the Company in connection with vested and released restricted stock units for the indicated periods: 
 
Three months ended
December 31,
 
Six months ended
December 31,
(In thousands, except for weighted-average grant date fair value)
2013
 
2012
 
2013
 
2012
Weighted-average grant date fair value per unit
$
62.85

 
$
41.85

 
$
53.27

 
$
46.41

Tax benefits realized by the Company in connection with vested and released restricted stock units
$
1,485

 
$
10,153

 
$
42,091

 
$
28,024

As of December 31, 2013, the unrecognized stock-based compensation expense balance related to restricted stock units was $103.2 million, excluding the impact of estimated forfeitures, and will be recognized over a weighted-average remaining contractual term and an estimated weighted-average amortization period of 1.6 years. The intrinsic value of outstanding restricted stock units as of December 31, 2013 was $232.9 million.
Cash-Based Long-Term Incentive Compensation
Starting in fiscal year 2013, the Company adopted a cash-based long-term incentive program for many of its employees as part of the Company's employee compensation program. During the six months ended December 31, 2013, the Company approved cash-based long-term incentive (“Cash LTI”) awards of $63.4 million under the Company's Cash Long-Term Incentive Plan (“Cash LTI Plan”). Cash LTI awards issued to employees under the Cash LTI Plan will vest in four equal installments, with 25% of the aggregate amount of the Cash LTI award vesting on each yearly anniversary of the grant date over a four-year period. In order to receive payments under a Cash LTI award, participants must remain employed by the Company as of the applicable award vesting date. Executives and non-employee Board members are not participating in this program. During the three months ended December 31, 2013 and 2012, the Company recognized $7.3 million and $3.5 million, respectively, in compensation expense under the Cash LTI Plan. During the six months ended December 31, 2013 and 2012, the Company recognized $11.4 million and $3.5 million, respectively, in compensation expense under the Cash LTI Plan. As of December 31, 2013, the unrecognized compensation balance related to the Cash LTI Plan was $101.0 million, excluding the impact of estimated forfeitures.
Employee Stock Purchase Plan
KLA-Tencor’s Employee Stock Purchase Plan (“ESPP”) provides that eligible employees may contribute up to 10% of their eligible earnings toward the semi-annual purchase of KLA-Tencor’s common stock. The ESPP is qualified under Section 423 of the Internal Revenue Code. The employee’s purchase price is derived from a formula based on the closing price of the common stock on the first day of the offering period versus the closing price on the date of purchase (or, if not a trading day, on the immediately preceding trading day).

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Table of Contents

Effective January 1, 2010, the offering period (or length of the look-back period) under the ESPP has a duration of six months, and the purchase price with respect to each offering period beginning on or after such date is, until otherwise amended, equal to 85% of the lesser of (i) the fair market value of the Company’s common stock at the commencement of the applicable six-month offering period or (ii) the fair market value of the Company’s common stock on the purchase date.
The Company estimates the fair value of purchase rights under the ESPP using a Black-Scholes valuation model. The fair value of each purchase right under the ESPP was estimated on the date of grant using the Black-Scholes option valuation model and the straight-line attribution approach with the following weighted-average assumptions: 
 
Three months ended
December 31,
 
Six months ended
December 31,
 
2013
 
2012
 
2013
 
2012
Stock purchase plan:
 
 
 
 
 
 
 
Expected stock price volatility
29.1
%
 
30.2
%
 
29.1
%
 
30.2
%
Risk-free interest rate
0.1
%
 
0.1
%
 
0.1
%
 
0.1
%
Dividend yield
2.9
%
 
3.3
%
 
2.9
%
 
3.3
%
Expected life of options (in years)
0.5

 
0.5

 
0.5

 
0.5

 The following table shows total cash received from employees for the issuance of shares under the ESPP, the number of shares purchased by employees through the ESPP, the tax benefits realized by the Company in connection with the disqualifying dispositions of shares purchased under the ESPP and the weighted-average fair value per share for the indicated periods: 
(In thousands, except for weighted-average fair value per share)
Three months ended
December 31,
 
Six months ended
December 31,
2013
 
2012
 
2013
 
2012
Total cash received from employees for the issuance of shares under the ESPP
$
22,035

 
$
20,139

 
$
22,035

 
$
20,139

Number of shares purchased by employees through the ESPP
469

 
496

 
469

 
496

Tax benefits realized by the Company in connection with the disqualifying dispositions of shares purchased under the ESPP
$
87

 
$
68

 
$
873

 
$
674

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

 
$
10.54

 
$
11.80

 
$
10.54

The ESPP shares are replenished annually on the first day of each fiscal year by virtue of an evergreen provision. The provision allows for share replenishment equal to the lesser of 2.0 million shares or the number of shares which KLA-Tencor estimates will be required to be issued under the ESPP during the forthcoming fiscal year. As of December 31, 2013, after giving effect to the ESPP purchase that occurred on such date, a total of 1.2 million shares were reserved and available for issuance under the ESPP. As of the date of this report, no additional shares have been added to the ESPP with respect to the fiscal year ending June 30, 2014.
NOTE 8 – STOCK REPURCHASE PROGRAM
Since July 1997, the Board of Directors has authorized the Company to systematically repurchase in the open market up to 80.8 million shares of its common stock under a repurchase program, including 8.0 million shares authorized in November 2012. The intent of this program is to offset the dilution from KLA-Tencor’s equity incentive plans and employee stock purchase plan, as well as to return excess cash to the Company’s stockholders. Subject to market conditions, applicable legal requirements and other factors, the repurchases will be made from time to time in the open market in compliance with applicable securities laws, including the Securities Exchange Act of 1934 and the rules promulgated thereunder, such as Rule 10b-18. As of December 31, 2013, 3.9 million shares were available for repurchase under the Company’s repurchase program.
Share repurchases for the indicated periods (based on the settlement date of the applicable repurchase) were as follows:
 
Three months ended
December 31,
 
Six months ended
December 31,
(In thousands)
2013
 
2012
 
2013
 
2012
Number of shares of common stock repurchased
959

 
1,465

 
1,997

 
2,826

Total cost of repurchases
$
60,302

 
$
68,283

 
$
120,806

 
$
136,600



21
Table of Contents

NOTE 9 – NET INCOME PER SHARE
Basic net income per share is calculated by dividing net income available to common stockholders by the weighted-average number of common shares outstanding during the period. Diluted net income per share is calculated by using the weighted-average number of common shares outstanding during the period, increased to include the number of additional shares of common stock that would have been outstanding if the shares of common stock underlying the Company’s outstanding dilutive stock options and restricted stock units had been issued. The dilutive effect of outstanding options and restricted stock units is reflected in diluted net income per share by application of the treasury stock method. Under the treasury stock method, the amount the employee must pay for exercising stock options, the amount of compensation cost for future service that the Company has not yet recognized, and the amount of tax benefits that is to be recorded in additional paid-in capital when the award becomes deductible are assumed to be used to repurchase shares. The following table sets forth the computation of basic and diluted net income per share:
(In thousands, except per share amounts)
Three months ended
December 31,
 
Six months ended
December 31,
2013
 
2012
 
2013
 
2012
Numerator:
 
 
 
 
 
 
 
Net income
$
139,246

 
$
106,630

 
$
250,443

 
$
241,997

Denominator:
 
 
 
 
 
 
 
Weighted-average shares-basic, excluding unvested restricted stock units
166,414

 
166,268

 
166,150

 
166,632

Effect of dilutive options and restricted stock units
1,792

 
2,808

 
2,328

 
3,070

Weighted-average shares-diluted
168,206

 
169,076

 
168,478

 
169,702

Basic net income per share
$
0.84

 
$
0.64

 
$
1.51

 
$
1.45

Diluted net income per share
$
0.83

 
$
0.63

 
$
1.49

 
$
1.43

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

 
1,618

 
200

 
1,830

The total amount of dividends paid by the Company during the three months ended December 31, 2013 and 2012 was $75.0 million and $66.5 million, respectively. The total amount of dividends paid by the Company during the six months ended December 31, 2013 and 2012 was $149.6 million and $133.2 million, respectively.
NOTE 10 – INCOME TAXES
The following table provides details of income taxes:
(Dollar amounts in thousands)
Three months ended December 31,
 
Six months ended December 31,
 
2013
 
2012
 
2013
 
2012
Income before income taxes
$
176,745

 
$
144,874

 
$
316,609

 
$
321,416

Provision for income taxes
$
37,499

 
$
38,244

 
$
66,166

 
$
79,419

Effective tax rate
21.2
%
 
26.4
%
 
20.9
%
 
24.7
%
The Company’s estimated annual effective tax rate for the fiscal year ending June 30, 2014 is approximately 21.4%.
There is no material difference between the tax expense as a percentage of income during the three months ended December 31, 2013 and the estimated annual effective tax rate.
Tax expense was lower as a percentage of income before taxes during the three months ended December 31, 2013 compared to the three months ended December 31, 2012 primarily due to the impact of the following items:
•
Tax expense was decreased by $4.7 million during the three months ended December 31, 2013 due to an increase in the proportion of the Company's earnings generated in jurisdictions with tax rates lower than the U.S. statutory tax rate;
•
Tax expense was decreased by $1.7 million during the three months ended December 31, 2013 related to the U.S. federal research credit. The research credit was not available during the three months ended December 31, 2012, because the credit expired on December 31, 2011. On January 2, 2013, the American Taxpayer Relief Act of 2012 reinstated the research credit and extended the credit through December 31, 2013; and

22
Table of Contents

•
Tax expense was decreased by $2.6 million during the three months ended December 31, 2013 related to a non-taxable increase in the value of the assets held within the Company's Executive Deferred Savings Plan.
Tax expense was lower as a percentage of income before taxes during the six months ended December 31, 2013 compared to the six months ended December 31, 2012 primarily due to the impact of the following items:
•
Tax expense was decreased by $7.4 million during the six months ended December 31, 2013 due to an increase in the proportion of the Company's earnings generated in jurisdictions with tax rates lower than the U.S. statutory tax rate;
•
Tax expense was decreased by $3.1 million during the six months ended December 31, 2013 related to the U.S. federal research credit. The research credit was not available during the six months ended December 31, 2012, because the credit expired on December 31, 2011. On January 2, 2013, the American Taxpayer Relief Act of 2012 reinstated the research credit and extended the credit through December 31, 2013; and
•
Tax expense was decreased by $3.6 million during the six months ended December 31, 2013 related to a non-taxable increase in the value of the assets held within the Company's Executive Deferred Savings Plan.
In the normal course of business, the Company is subject to examination by tax authorities throughout the world. The Company is subject to U.S. federal income tax examination for all years beginning from the fiscal year ended June 30, 2010.  The Company is subject to state income tax examinations for all years beginning from the fiscal year ended June 30, 2009. The Company is also subject to examinations in other major foreign jurisdictions, including Singapore, for all years beginning from the fiscal year ended June 30, 2009. It is possible that certain examinations may be concluded in the next twelve months. The Company believes it is possible that it may recognize up to $7.2 million of its existing unrecognized tax benefits within the next twelve months as a result of the lapse of statutes of limitations and the resolution of examinations with various tax authorities.
NOTE 11 – LITIGATION AND OTHER LEGAL MATTERS
The Company is named from time to time as a party to lawsuits and other types of legal proceedings and claims in the normal course of its business. Actions filed against the Company include commercial, intellectual property, customer, and labor and employment related claims, including complaints of alleged wrongful termination and potential class action lawsuits regarding alleged violations of federal and state wage and hour and other laws. In general, legal proceedings and claims regardless of their merit, and associated internal investigations (especially those relating to intellectual property or confidential information disputes) are often expensive to prosecute, defend or conduct and may divert management's attention and other company resources. Moreover, the results of legal proceedings are difficult to predict, and the costs incurred in litigation can be substantial, regardless of outcome. The Company believes the amounts provided in its condensed consolidated financial statements are adequate in light of the probable and estimated liabilities. However, because such matters are subject to many uncertainties, the ultimate outcomes are not predictable, and there can be no assurances that the actual amounts required to satisfy alleged liabilities from the matters described above will not exceed the amounts reflected in the Company's condensed consolidated financial statements or will not have a material adverse effect on its financial condition, results of operations, comprehensive income or cash flows.
NOTE 12 – COMMITMENTS AND CONTINGENCIES
Factoring. KLA-Tencor has agreements (referred to as “factoring agreements”) with financial institutions to sell certain of its trade receivables and promissory notes from customers without recourse. The Company does not believe it is at risk for any material losses as a result of these agreements. In addition, the Company periodically sells certain letters of credit (“LCs”), without recourse, received from customers in payment for goods.
The following table shows total receivables sold under factoring agreements for the indicated periods:
 
Three months ended December 31,
 
Six months ended December 31,
(In thousands)
2013
 
2012
 
2013
 
2012
Receivables sold under factoring agreements
$
10,412

 
$
37,026

 
$
56,294

 
$
85,560

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

23
Table of Contents


Facilities. KLA-Tencor leases certain of its facilities under arrangements that are accounted for as operating leases. Rent expense was $2.3 million and $2.4 million for the three months ended December 31, 2013 and 2012, respectively. Rent expense was $4.4 million and $4.6 million for the six months ended December 31, 2013 and 2012, respectively.
The following is a schedule of expected operating lease payments:
Fiscal year ending June 30,
Amount
(In thousands)
2014 (remaining 6 months)
$
4,093

2015
7,084

2016
5,667

2017
4,521

2018
3,261

2019 and thereafter
3,070

Total minimum lease payments
$
27,696

Purchase Commitments. KLA-Tencor maintains certain open inventory purchase commitments with its suppliers to ensure a smooth and continuous supply for key components. The Company’s liability under these purchase commitments is generally restricted to a forecasted time-horizon as mutually agreed upon between the parties. This forecasted time-horizon can vary among different suppliers. The Company’s open inventory purchase commitments were approximately $262.9 million as of December 31, 2013 and are primarily due within the next 12 months. Actual expenditures will vary based upon the volume of the transactions and length of contractual service provided. In addition, the amounts paid under these arrangements may be less in the event that the arrangements are renegotiated or canceled. Certain agreements provide for potential cancellation penalties.
Cash Long-Term Incentive Plan. As of December 31, 2013, the Company had committed $108.7 million to future payment obligations under its Cash LTI Plan. The calculation of compensation expense related to the Cash LTI Plan includes estimated forfeiture rate assumptions. Cash LTI awards issued to employees under the Cash LTI Plan vest in four equal installments, with 25% of the aggregate amount of the Cash LTI award vesting on each yearly anniversary of the grant date over a four-year period. In order to receive payments under a Cash LTI award, participants must remain employed by the Company as of the applicable award vesting date.
Warranties, Guarantees and Contingencies. KLA-Tencor provides standard warranty coverage on its systems for 40 hours per week for 12 months, providing labor and parts necessary to repair the systems during the warranty period. The Company accounts for the estimated warranty cost as a charge to costs of revenues when revenue is recognized. The estimated warranty cost is based on historical product performance and field expenses. Utilizing actual service records, the Company calculates the average service hours and parts expense per system and applies the actual labor and overhead rates to determine the estimated warranty charge. The Company updates these estimated charges on a quarterly basis. The actual product performance and/or field expense profiles may differ, and in those cases the Company adjusts its warranty accruals accordingly.
The following table provides the changes in the product warranty accrual for the indicated periods:
 
Three months ended December 31,
 
Six months ended December 31,
(In thousands)
2013
 
2012
 
2013
 
2012
Beginning balance
$
37,314

 
$
46,192

 
$
42,603

 
$
46,496

Accruals for warranties issued during the period
15,988

 
9,862

 
25,296

 
20,508

Changes in liability related to pre-existing warranties
(2,424
)
 
(620
)
 
(5,808
)
 
1,732

Settlements made during the period
(9,279
)
 
(13,516
)
 
(20,492
)
 
(26,818
)
Ending balance
$
41,599

 
$
41,918

 
$
41,599

 
$
41,918

The Company maintains guarantee arrangements available through various financial institutions for up to $26.5 million, of which $24.6 million had been issued as of December 31, 2013, primarily to fund guarantees to customs authorities for value-added tax (“VAT”) and other operating requirements of the Company’s subsidiaries in Europe and Asia.

24
Table of Contents

KLA-Tencor is a party to a variety of agreements pursuant to which it may be obligated to indemnify the other party with respect to certain matters. Typically, these obligations arise in connection with contracts and license agreements or the sale of assets, under which the Company customarily agrees to hold the other party harmless against losses arising from, or provides customers with other remedies to protect against, bodily injury or damage to personal property caused by the Company's products, non-compliance with the Company's product performance specifications, infringement by the Company's products of third-party intellectual property rights and a breach of warranties, representations and covenants related to matters such as title to assets sold, validity of certain intellectual property rights, non-infringement of third-party rights, and certain income tax-related matters. In each of these circumstances, payment by the Company is typically subject to the other party making a claim to and cooperating with the Company pursuant to the procedures specified in the particular contract. This usually allows the Company to challenge the other party's claims or, in case of breach of intellectual property representations or covenants, to control the defense or settlement of any third-party claims brought against the other party. Further, the Company's obligations under these agreements may be limited in terms of amounts, activity (typically at the Company's option to replace or correct the products or terminate the agreement with a refund to the other party), and duration. In some instances, the Company may have recourse against third parties and/or insurance covering certain payments made by the Company.
Subject to certain limitations, the Company is obligated to indemnify its current and former directors, officers and employees with respect to certain litigation matters and investigations that arise in connection with their service to the Company. These obligations arise under the terms of the Company's certificate of incorporation, its bylaws, applicable contracts, and Delaware and California law. The obligation to indemnify generally means that the Company is required to pay or reimburse the individuals' reasonable legal expenses and possibly damages and other liabilities incurred in connection with these matters.
In addition, the Company may in limited circumstances enter into agreements that contain customer-specific pricing, discount, rebate or credit commitments offered by the Company. Furthermore, the Company may give these customers limited audit or inspection rights to enable them to confirm that the Company is complying with these commitments. If a customer elects to exercise its audit or inspection rights, the Company may be required to expend significant resources to support the audit or inspection, as well as to defend or settle any dispute with a customer that could potentially arise out of such audit or inspection. To date, the Company has made no accruals in its condensed consolidated financial statements for this contingency. While the Company has not in the past incurred significant expenses for resolving disputes regarding these types of commitments, the Company cannot make any assurance that it will not incur any such liabilities in the future.
It is not possible to predict the maximum potential amount of future payments under these or similar agreements due to the conditional nature of the Company's obligations and the unique facts and circumstances involved in each particular agreement. Historically, payments made by the Company under these agreements have not had a material effect on its business, financial condition, results of operations or cash flows.
NOTE 13 – DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
The authoritative guidance requires companies to recognize all derivative instruments and hedging activities, including foreign currency exchange contracts, as either assets or liabilities at fair value on the balance sheet. Changes in the fair value of derivatives that do not qualify for hedge treatment, as well as the ineffective portion of any hedges, are reflected in the Condensed Consolidated Statement of Operations. In accordance with the guidance, the Company designates foreign currency forward exchange and option contracts as cash flow hedges of certain forecasted foreign currency denominated sales and purchase transactions.
KLA-Tencor’s foreign subsidiaries operate and sell KLA-Tencor’s products in various global markets. As a result, KLA-Tencor is exposed to risks relating to changes in foreign currency exchange rates. KLA-Tencor utilizes foreign currency forward exchange contracts and option contracts to hedge against future movements in foreign exchange rates that affect certain existing and forecasted foreign currency denominated sales and purchase transactions, such as the Japanese yen, the euro, Taiwan dollar and the Israeli new shekel. The Company routinely hedges its exposures to certain foreign currencies with various financial institutions in an effort to minimize the impact of certain currency exchange rate fluctuations. These currency forward exchange contracts and options, designated as cash flow hedges, generally have maturities of less than 18 months. Cash flow hedges are evaluated for effectiveness monthly, based on changes in total fair value of the derivatives. If a financial counterparty to any of the Company’s hedging arrangements experiences financial difficulties or is otherwise unable to honor the terms of the foreign currency hedge, the Company may experience material losses.

25
Table of Contents

For derivative instruments that are designated and qualify as cash flow hedges, the effective portion of the gains or losses on the derivative is reported as a component of accumulated other comprehensive income (loss) (“OCI”) and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. Changes in the fair value of currency forward exchange and option contracts due to changes in time value are excluded from the assessment of effectiveness. Gains and losses on the derivative representing either hedge ineffectiveness or hedge components excluded from the assessment of effectiveness are recognized in current earnings.
For derivative instruments that are not designated as accounting hedges, gains and losses are recognized in interest income and other, net. The Company uses foreign currency forward contracts to hedge certain foreign currency denominated assets or liabilities. The gains and losses on these derivatives are largely offset by the changes in the fair value of the assets or liabilities being hedged.
Derivatives in Cash Flow Hedging Relationships: Foreign Exchange Contracts
The locations and amounts of designated and non-designated derivative instruments’ gains and losses reported in the condensed consolidated financial statements for the indicated periods were as follows:
 
 
Three months ended
December 31,
 
Six months ended
December 31,
(In thousands)
Location in Financial Statements
2013
 
2012
 
2013
 
2012
Derivatives Designated as Hedging Instruments
 
 
 
 
 
 
 
 
Gains in accumulated OCI on derivatives (effective portion)
Accumulated OCI
$
3,864

 
$
2,242

 
$
3,573

 
$
2,001

Gains (losses) reclassified from accumulated OCI into income (effective portion):
Revenues
$
(128
)
 
$
(82
)
 
$
2,322

 
$
(574
)
 
Costs of revenues
150

 
210

 
216

 
(390
)
 
Total gains (losses) reclassified from accumulated OCI into income (effective portion)
$
22

 
$
128

 
$
2,538

 
$
(964
)
Gains (losses) recognized in income on derivatives (ineffective portion and amount excluded from effectiveness testing)
Interest income and other, net
$
44

 
$
(40
)
 
$
26

 
$
11

Derivatives Not Designated as Hedging Instruments
 
 
 
 
 
 
 
 
Gains recognized in income
Interest income and other, net
$
2,722

 
$
9,220

 
$
5,348

 
$
9,894

The U.S. dollar equivalent of all outstanding notional amounts of hedge contracts, with maximum maturity of 13 months, as of the dates indicated below was as follows: 
(In thousands)
As of
December 31, 2013
 
As of
June 30, 2013
Cash flow hedge contracts
 
 
 
Purchase
$
20,288

 
$
14,641

Sell
$
69,197

 
$
35,178

Other foreign currency hedge contracts
 
 
 
Purchase
$
101,064

 
$
99,175

Sell
$
68,876

 
$
97,901


26
Table of Contents

The locations and fair value amounts of the Company’s derivative instruments reported in its Condensed Consolidated Balance Sheets as of the dates indicated below were as follows: 
 
Asset Derivatives
 
Liability Derivatives
 
Balance Sheet Location
 
As of
December 31, 2013
 
As of
June 30, 2013
 
Balance Sheet Location
 
As of
December 31, 2013
 
As of
June 30, 2013
(In thousands)
 
Fair Value
 
 
 
Fair Value
Derivatives designated as hedging instruments
 
 
 
 
 
 
 
 
 
 
 
Foreign exchange contracts
Other current assets
 
$
3,199

 
$
362

 
Other current liabilities
 
$
3

 
$
384

Total derivatives designated as hedging instruments
 
 
$
3,199

 
$
362

 
 
 
$
3

 
$
384

Derivatives not designated as hedging instruments
 
 
 
 
 
 
 
 
 
 
 
Foreign exchange contracts
Other current assets
 
$
2,385

 
$
3,654

 
Other current liabilities
 
$
705

 
$
1,789

Total derivatives not designated as hedging instruments
 
 
$
2,385

 
$
3,654

 
 
 
$
705

 
$
1,789

Total derivatives
 
 
$
5,584

 
$
4,016

 
 
 
$
708

 
$
2,173

The following table provides the balances and changes in accumulated other comprehensive income (loss), before taxes, related to derivative instruments for the indicated periods:
 
Three months ended
December 31,
 
Six months ended
December 31,
(In thousands)
2013
 
2012
 
2013
 
2012
Beginning balance
$
(323
)
 
$
(111
)
 
$
2,484

 
$
(962
)
Amount reclassified to income
(22
)
 
(128
)
 
(2,538
)
 
964

Net change
3,864

 
2,242

 
3,573

 
2,001

Ending balance
$
3,519

 
$
2,003

 
$
3,519

 
$
2,003


27
Table of Contents

Offsetting of Derivative Assets and Liabilities
KLA-Tencor presents derivatives at gross fair values in the Condensed Consolidated Balance Sheets. The Company has entered into arrangements with each of its counterparties, which reduce credit risk by permitting net settlement of transactions with the same counterparty under certain conditions. As of December 31, 2013 and June 30, 2013, information related to the offsetting arrangements was as follows (in thousands):
As of December 31, 2013
 
 
 
 
 
Gross Amounts of Derivatives Not Offset in the Consolidated Balance Sheets
 
 
Description
 
Gross Amounts of Derivatives
 
Gross Amounts of Derivatives Offset in the Consolidated Balance Sheets
 
Net Amount of Derivatives Presented in the Consolidated Balance Sheets
 
Financial Instruments
 
Cash Collateral Received
 
Net Amount
Derivatives - Assets
 
$
5,584

 
$
—

 
$
5,584

 
$
(708
)
 
$
—

 
$
4,876

Derivatives - Liabilities
 
$
(708
)
 
$
—

 
$
(708
)
 
$
708

 
$
—

 
$
—

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

 
$
—

 
$
4,016

 
$
(1,520
)
 
$
—

 
$
2,496

Derivatives - Liabilities
 
$
(2,173
)
 
$
—

 
$
(2,173
)
 
$
1,520

 
$
—

 
$
(653
)
NOTE 14 – RELATED PARTY TRANSACTIONS
During the three and six months ended December 31, 2013 and 2012, the Company purchased from, or sold to, several entities, where one or more executive officers of the Company or members of the Company’s Board of Directors, or their immediate family members, also serves as an executive officer or board member, including Cisco Systems, Inc., Freescale Semiconductor, Inc., Avago Technologies Ltd., NetApp, Inc. and SAP AG. The following table provides the transactions with these parties for the indicated periods (for the portion of such period that they were considered related):
 
Three months ended
December 31,
 
Six months ended
December 31,
(In thousands)
2013
 
2012
 
2013
 
2012
Total revenues
$
178

 
$
1,899

 
$
563

 
$
4,771

Total purchases
$
332

 
$
69

 
$
788

 
$
2,452

The receivable balance from these parties as of December 31, 2013 was immaterial. The Company had a receivable balance from these parties of $0.9 million as of June 30, 2013. Management believes that such transactions are at arm’s length and on similar terms as would have been obtained from unaffiliated third parties.
NOTE 15 – SEGMENT REPORTING AND GEOGRAPHIC INFORMATION
KLA-Tencor reports one reportable segment in accordance with the provisions of the authoritative guidance for segment reporting. Operating segments are defined as components of an enterprise about which separate financial information is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. KLA-Tencor’s chief operating decision maker is the Chief Executive Officer.
The Company is engaged primarily in designing, manufacturing, and marketing process control and yield management solutions for the semiconductor and related nanoelectronics industries. All operating segments have been aggregated due to their inter-dependencies, commonality of long-term economic characteristics, products and services, the production processes, class of customer and distribution processes. The Company’s service products are an extension of the system product portfolio and provide customers with spare parts and fab management services (including system preventive maintenance and optimization services) to improve yield, increase production uptime and throughput, and lower the cost of ownership. Since the Company operates in one reportable segment, all financial segment information required by the authoritative guidance can be found in the condensed consolidated financial statements.

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The Company’s significant operations outside the United States include manufacturing facilities in Singapore, Israel, Belgium, Germany and China and sales, marketing and service offices in Western Europe, Japan and the Asia Pacific regions. For geographical revenue reporting, revenues are attributed to the geographic location in which the customer is located. Long-lived assets consist primarily of land, property and equipment, net and are attributed to the geographic region in which they are located.
The following is a summary of revenues by geographic region, based on ship-to location, for the indicated periods (as a percentage of total revenues):
  
Three months ended December 31,
 
Six months ended December 31,
(Dollar amounts in thousands)
2013
 
2012
 
2013
 
2012
Revenues:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
North America
$
148,233

 
21
%
 
$
169,629

 
25
%
 
$
327,628

 
24
%
 
$
319,617

 
23
%
Taiwan
148,825

 
21
%
 
223,493

 
33
%
 
266,116

 
20
%
 
499,792

 
36
%
Japan
64,223

 
9
%
 
92,849

 
14
%
 
145,635

 
11
%
 
181,564

 
13
%
Europe & Israel
70,295

 
10
%
 
59,753

 
9
%
 
191,782

 
14
%
 
118,913

 
9
%
Korea
152,750

 
22
%
 
57,259

 
9
%
 
230,027

 
17
%
 
127,506

 
9
%
Rest of Asia
120,803

 
17
%
 
70,028

 
10
%
 
202,278

 
14
%
 
146,328

 
10
%
Total
$
705,129

 
100
%
 
$
673,011

 
100
%
 
$
1,363,466

 
100
%
 
$
1,393,720

 
100
%
The following is a summary of revenues by major products for the indicated periods (as a percentage of total revenues):
  
Three months ended December 31,
 
Six months ended December 31,
(Dollar amounts in thousands)
2013
 
2012
 
2013
 
2012
Revenues:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Defect inspection
$
394,702

 
56
%
 
$
367,696

 
55
%
 
$
737,865

 
55
%
 
$
756,184

 
54
%
Metrology
130,012

 
18
%
 
116,600

 
17
%
 
262,994

 
19
%
 
259,083

 
19
%
Service
160,946

 
23
%
 
149,988

 
22
%
 
317,543

 
23
%
 
296,619

 
21
%
Other
19,469

 
3
%
 
38,727

 
6
%
 
45,064

 
3
%
 
81,834

 
6
%
Total
$
705,129

 
100
%
 
$
673,011

 
100
%
 
$
1,363,466

 
100
%
 
$
1,393,720

 
100
%
Four customers each accounted for greater than 10% of total revenues for the three months ended December 31, 2013. One customer accounted for greater than 10% of total revenues for the three months ended December 31, 2012. Three customers each accounted for greater than 10% of total revenues for the six months ended December 31, 2013. Two customers each accounted for greater than 10% of total revenues for the six months ended December 31, 2012. Three customers each accounted for greater than 10% of net accounts receivable as of December 31, 2013. Two customers each accounted for greater than 10% of net accounts receivable as of June 30, 2013.
Long-lived assets by geographic region as of the dates indicated below were as follows: 
(In thousands)
As of
December 31, 2013
 
As of
June 30, 2013
Long-lived assets:
 
 
 
United States
$
223,603

 
$
215,136

Europe
44,100

 
49,556

Israel
32,036

 
28,374

Singapore
48,769

 
44,957

Rest of Asia
11,351

 
9,736

Total
$
359,859

 
$
347,759


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

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As a supplier to the global semiconductor and semiconductor-related industries, we are subject to the cyclical capital spending that characterizes these industries. The timing, length, intensity and volatility of the capacity-oriented capital spending cycles of our customers are unpredictable. In addition, our customer base continues to become more highly concentrated over time, thereby increasing the potential impact of a sudden change in capital spending by a major customer on our revenues and profitability. As our customer base becomes increasingly more concentrated, large orders from a relatively limited number of customers account for a substantial portion of our sales, which potentially exposes us to more volatility for revenues and earnings.
However, in addition to these trends of cyclicality and consolidation, the semiconductor industry has also been significantly impacted by constant technological innovation. The growing use of increasingly sophisticated semiconductor devices has caused many of our customers to invest in additional semiconductor manufacturing capabilities and capacity. These investments have included process control and yield management equipment and services and have had a significant favorable impact on our revenues over the long term.
Our revenues during the three months ended December 31, 2013 increased compared to the three months ended September 30, 2013 and December 31, 2012, primarily due to higher levels of shipments during the period resulting from higher shipment backlog at the beginning of the period, relative to the three months ended September 30, 2013 and December 31, 2012. In the near term, we continue to expect a robust level of new orders for process control and yield management equipment spanning all of our three primary markets -- memory, foundry and logic. We believe that, over the long term, our customers will continue to invest in advanced technologies and new materials to enable smaller design rules and higher density application, as well as to reduce cost. We anticipate that this in turn will drive long-term increased adoption of process control equipment and services that reduce semiconductor defectivity and improve manufacturing yields, reinforcing the longer-term growth drivers in our industry.
The following table sets forth some of our key quarterly unaudited financial information that we use to manage our business: 
(In thousands, except net income per share)
Three months ended
December 31,
2013
 
September 30,
2013
 
June 30,
2013
 
March 31,
2013
 
December 31,
2012
 
September 30,
2012
Total revenues
$
705,129

 
$
658,337

 
$
720,032

 
$
729,029

 
$
673,011

 
$
720,709

Total costs and operating expenses
$
517,147

 
$
508,426

 
$
532,397

 
$
526,783

 
$
519,764

 
$
534,152

Gross margin
$
419,315

 
$
380,680

 
$
413,228

 
$
419,521

 
$
369,096

 
$
403,484

Income from operations
$
187,982

 
$
149,911

 
$
187,635

 
$
202,246

 
$
153,247

 
$
186,557

Net income
$
139,246

 
$
111,197

 
$
134,770

 
$
166,382

 
$
106,630

 
$
135,367

Net income per share:
 
 
 
 
 
 
 
 
 
 
 
Basic (1)
$
0.84

 
$
0.67

 
$
0.81

 
$
1.00

 
$
0.64

 
$
0.81

Diluted (1)
$
0.83

 
$
0.66

 
$
0.80

 
$
0.98

 
$
0.63

 
$
0.80

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

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•
Revenue Recognition
•
Inventories
•
Warranty
•
Allowance for Doubtful Accounts
•
Equity and Cash-Based Long-Term Incentive Compensation Plans
•
Contingencies and Litigation
•
Goodwill and Intangible Assets
•
Income Taxes
•
Valuation of Marketable Securities
There were no significant changes in our critical accounting estimates and policies during the three months ended December 31, 2013. Please refer to Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in Part II, Item 7 of our Annual Report on Form 10-K for our fiscal year ended June 30, 2013 for a more complete discussion of our critical accounting policies and estimates.
Valuation of Goodwill and Intangible Assets
We have four reporting units: Defect Inspection, Metrology, Service and Other. As of December 31, 2013, substantially all of the goodwill balance resided in the Defect Inspection reporting unit. The fair value of each of our reporting units was substantially in excess of its estimated carrying amount at the time of the most recent quantitative analysis of goodwill impairment performed during the three months ended December 31, 2010. There have been no triggering events or changes in circumstances since that quantitative analysis to indicate that the fair value of any of our reporting units would be less than its carrying amount.
We performed a qualitative assessment of the goodwill by reporting unit as of November 30, 2013 during the three months ended December 31, 2013 and concluded that there was no impairment. We assess goodwill for impairment annually as well as whenever events or changes in circumstances indicate that the carrying amount of goodwill in any reporting unit may not be recoverable. Long-lived assets are tested for recoverability whenever events or changes in circumstances indicate that the assets' carrying amount may not be recoverable.
Our next annual assessment of the goodwill by reporting unit will be performed during the three months ending December 31, 2014. If we were to encounter challenging economic conditions, such as a decline in our operating results, an unfavorable industry or macroeconomic environment, a substantial decline in our stock price, or any other adverse change in market conditions, we may be required to perform the two-step quantitative goodwill impairment analysis. In addition, if such conditions have the effect of changing one of the critical assumptions or estimates we use to calculate the value of our goodwill or intangible assets, we may be required to record goodwill and/or intangible asset impairment charges in future periods, whether in connection with our next annual impairment assessment in the second quarter of fiscal year 2015 or prior to that, if any triggering event occurs outside of the quarter during which the annual goodwill impairment assessment is performed. It is not possible at this time to determine if any such future impairment charge would result or, if it does, whether such charge would be material to our results of operations.
Revenue Recognition
We recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the selling price is fixed or determinable, and collectibility is reasonably assured. We derive revenue from three sources—sales of systems, spare parts and services. In general, we recognize revenue for systems when the system has been installed, is operating according to predetermined specifications and is accepted by the customer. When a customer delays installation for delivered products for which we have demonstrated a history of successful installation and acceptance, we recognize revenue upon customer acceptance. Under certain circumstances, however, we recognize revenue upon shipment, prior to acceptance from the customer, as follows:
•
When the customer fab has previously accepted the same tool, with the same specifications, and when we can objectively demonstrate that the tool meets all of the required acceptance criteria.
•
When system sales to independent distributors have no installation requirement, contain no acceptance agreement, and 100% payment is due based upon shipment.
•
When the installation of the system is deemed perfunctory.
•
When the customer withholds acceptance due to issues unrelated to product performance, in which case revenue is recognized when the system is performing as intended and meets predetermined specifications.
In circumstances in which we recognize revenue prior to installation, the portion of revenue associated with installation is deferred based on estimated fair value, and that revenue is recognized upon completion of the installation.

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In many instances, products are sold in stand-alone arrangements. Services are sold separately through renewals of annual maintenance contracts. We also allow for multiple element revenue arrangements in cases where certain elements of a sales arrangement are not delivered and accepted in one reporting period. To determine the relative fair value of each element in a revenue arrangement, we allocate arrangement consideration based on the selling price hierarchy. For substantially all of the arrangements with multiple deliverables pertaining to products and services, we use vendor-specific objective evidence (“VSOE”) or third-party evidence (“TPE”) to allocate the selling price to each deliverable. We determine TPE based on historical prices charged for products and services when sold on a stand-alone basis. When we are unable to establish relative selling price using VSOE or TPE, we use estimated selling price (“ESP”) in our allocation of arrangement consideration. The objective of ESP is to determine the price at which we would transact a sale if the product or service were sold on a stand-alone basis. ESP could potentially be used for new or customized products. We regularly review relative selling prices and maintain internal controls over the establishment and updates of these estimates. In a multiple element revenue arrangement, we defer revenue recognition associated with the relative fair value of the undelivered elements until that element is delivered to the customer. To be considered a separate element, the product or service in question must represent a separate unit of accounting, which means that such product or service must fulfill the following criteria: (a) the delivered item(s) has value to the customer on a stand-alone basis; and (b) if the arrangement includes a general right of return relative to the delivered item(s), delivery or performance of the undelivered item(s) is considered probable and substantially in our control. If the arrangement does not meet all the above criteria, the entire amount of the sales contract is deferred until all elements are accepted by the customer.
Trade-in rights are occasionally granted to customers to trade in tools in connection with subsequent purchases. We estimate the value of the trade-in right and reduce the revenue recognized on the initial sale. This amount is recognized at the earlier of the exercise of the trade-in right or the expiration of the trade-in right.
 Spare parts revenue is recognized when the product has been shipped, risk of loss has passed to the customer and collection of the resulting receivable is probable.
Service and maintenance contract revenue is recognized ratably over the term of the maintenance contract. Revenue from services performed in the absence of a maintenance contract, including consulting and training revenue, is recognized when the related services are performed and collectibility is reasonably assured.
We sell stand-alone software that is subject to the software revenue recognition guidance. We periodically review selling prices to determine whether VSOE exists, and in some situations where we are unable to establish VSOE for undelivered elements such as post-contract service, revenue is recognized ratably over the term of the service contract.
We also defer the fair value of non-standard warranty bundled with equipment sales as unearned revenue. Non-standard warranty includes services incremental to the standard 40-hour per week coverage for 12 months. Non-standard warranty is recognized ratably as revenue when the applicable warranty term period commences.
The deferred system profit balance equals the amount of deferred system revenue that was invoiced and due on shipment, less applicable product and warranty costs. Deferred system revenue represents the value of products that have been shipped and billed to customers which have not met our revenue recognition criteria. Deferred system profit does not include the profit associated with product shipments to customers in Japan, to whom title does not transfer until customer acceptance. Shipments to customers in Japan are classified as inventory at cost until the time of acceptance.
We enter into sales arrangements that may consist of multiple deliverables of our products and services where certain elements of the sales arrangement are not delivered and accepted in one reporting period. Judgment is required to properly identify the accounting units of the multiple deliverable transactions and to determine the manner in which revenue should be allocated among the accounting units. Additionally, judgment is required to interpret various commercial terms and determine when all criteria of revenue recognition have been met in order for revenue recognition to occur in the appropriate accounting period. While changes in the allocation of the estimated selling price between the accounting units will not affect the amount of total revenue recognized for a particular arrangement, any material changes in these allocations could impact the timing of revenue recognition, which could have a material effect on our financial position and results of operations.

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Recent Accounting Pronouncements
In July 2013, the Financial Accounting Standards Board (“FASB”) issued an accounting standard update that provides explicit guidance on the financial statement presentation of an unrecognized tax benefit when a net operating loss carryforward, a similar tax loss or a tax credit carryforward exists. Under the new standard update, in most circumstances, an unrecognized tax benefit, or a portion of an unrecognized tax benefit, should be presented in our financial statements as a reduction to a deferred tax asset for a net operating loss carryforward, a similar tax loss or a tax credit carryforward. This accounting standard update will be effective for our interim period ending September 30, 2014 and applied prospectively with early adoption permitted. We are currently evaluating the impact of this accounting standard update on our consolidated financial statements.
RESULTS OF OPERATIONS
Revenues and Gross Margin
 
Three months ended
 
 
 
 
(Dollar amounts in thousands)
December 31,
2013
 
September 30,
2013
 
December 31,
2012
 
Q2 FY14 vs.
Q1 FY14
 
Q2 FY14 vs.
Q2 FY13
Revenues:
 
 
 
 
 
 
 
 
 
 
 
Product
$
544,183

 
$
501,740

 
$
523,023

 
$
42,443

 
8
%
 
$
21,160

 
4
 %
Service
160,946

 
156,597

 
149,988

 
4,349

 
3
%
 
10,958

 
7
 %
Total revenues
$
705,129

 
$
658,337

 
$
673,011

 
$
46,792

 
7
%
 
$
32,118

 
5
 %
Costs of revenues
$
285,814

 
$
277,657

 
$
303,915

 
$
8,157

 
3
%
 
$
(18,101
)
 
(6
)%
Gross margin percentage
59
%
 
58
%
 
55
%
 
 
 
 
 
 
 
 
 
Six months ended
 
 
(Dollar amounts in thousands)
December 31,
2013
 
December 31,
2012
 
Q2 FY14 YTD vs.
Q2 FY13 YTD
Revenues:
 
 
 
 
 
 
 
Product
$
1,045,923

 
$
1,097,101

 
$
(51,178
)
 
(5
)%
Service
317,543

 
296,619

 
20,924

 
7
 %
Total revenues
$
1,363,466

 
$
1,393,720

 
$
(30,254
)
 
(2
)%
Costs of revenues
$
563,471

 
$
621,140

 
$
(57,669
)
 
(9
)%
Gross margin percentage
59
%
 
55
%
 
 
 
 
Product revenues
Our business is cyclical with respect to the capital equipment procurement practices of semiconductor manufacturers, with revenues impacted by the investment patterns of such manufacturers. Our product revenues in any particular quarter are significantly impacted by the amount of new orders that we receive during that quarter and, due to the duration of manufacturing and installation cycles, in the preceding quarters.
Product revenues increased during the three months ended December 31, 2013 compared to the three months ended September 30, 2013, as we experienced higher levels of shipments during the period, primarily due to higher shipment backlog at the beginning of the period relative to the three months ended September 30, 2013. The higher shipment backlog was largely attributable to an increase in demand as our customers adopted new device architectures and process technologies at the leading edge.
Product revenues increased during the three months ended December 31, 2013 compared to the three months ended December 31, 2012, primarily due to higher levels of shipments during the period resulting from higher shipment backlog at the beginning of the period relative to the three months ended December 31, 2012, partially offset by a lower level of previously deferred revenues recognized during the three months ended December 31, 2013 from certain customers that had experienced liquidity challenges. The higher shipment backlog was largely attributable to an increase in demand as our customers adopted new device architectures and process technologies at the leading edge. The growth in revenues reflected increases in both of our primary reporting units, defect inspection and metrology.

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Product revenues decreased during the six months ended December 31, 2013 compared to the six months ended December 31, 2012, primarily due to a lower level of shipment backlog at the beginning of the period as well as a higher proportion of our shipments being latest generation products that have not yet qualified for revenue upon shipment, in each case relative to the six months ended December 31, 2012. In addition, revenues during the six months ended December 31, 2012 reflected the recognition, upon satisfaction of collectibility criteria, of previously deferred revenues from certain customers that had experienced liquidity challenges.
Service revenues
Service revenues are generated from maintenance contracts, as well as billable time and material service calls made to our customers after the expiration of the warranty period. The amount of service revenues is typically a function of the number of post-warranty systems installed at our customers’ sites and the utilization of those systems, but it is also impacted by other factors, such as our rate of service contract renewals, the types of systems being serviced and fluctuations in foreign exchange rates. Service revenues during the three and six months ended December 31, 2013 increased compared to the three months ended September 30, 2013 and three and six months ended December 31, 2012, respectively, primarily due to an increase in the number of post-warranty systems installed at our customers' sites.
Revenues by region
The following is a summary of revenues by geographic region, based on ship-to location, for the indicated periods (as a percentage of total revenues): 
 
Three months ended
(Dollar amounts in thousands)
December 31, 2013
 
September 30, 2013
 
December 31, 2012
North America
$
148,233

 
21
%
 
$
179,395

 
28
%
 
$
169,629

 
25
%
Taiwan
148,825

 
21
%
 
117,291

 
18
%
 
223,493

 
33
%
Japan
64,223

 
9
%
 
81,412

 
12
%
 
92,849

 
14
%
Europe & Israel
70,295

 
10
%
 
121,487

 
18
%
 
59,753

 
9
%
Korea
152,750

 
22
%
 
77,278

 
12
%
 
57,259

 
9
%
Rest of Asia
120,803

 
17
%
 
81,474

 
12
%
 
70,028

 
10
%
Total
$
705,129

 
100
%
 
$
658,337

 
100
%
 
$
673,011

 
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 trend to continue.
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, including our ability to scale our operations efficiently and effectively in response to prevailing business conditions.
The following tables summarize the major factors that contributed to the changes in gross margin percentage for the periods indicated:
 
Gross Margin Percentage
 
 
Gross Margin Percentage
 
Three months ended
 
 
Three months ended
 
Six months ended
September 30, 2013
57.8
 %
 
December 31, 2012
54.8
%
 
55.4
 %
Revenue volume of products and service
0.8
 %
 
Revenue volume of products and service
0.3
%
 
(0.9
)%
Mix of products and services sold
(0.2
)%
 
Mix of products and services sold
0.1
%
 
1.1
 %
Manufacturing labor, overhead and efficiencies
1.0
 %
 
Manufacturing labor, overhead and efficiencies
1.2
%
 
0.7
 %
Other service and manufacturing costs
0.1
 %
 
Other service and manufacturing costs
3.1
%
 
2.4
 %
December 31, 2013
59.5
 %
 
December 31, 2013
59.5
%
 
58.7
 %

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Changes in gross margin percentage driven by revenue volume reflect our ability to leverage existing infrastructure to generate higher revenues. It also includes the effect of fluctuations in foreign exchange rates, average customer pricing and customer revenue deferrals associated with volume purchase agreements. Changes in gross margin percentage from mix of products and services sold reflect the impact of changes in the composition within product and service offerings. Changes in gross margin percentage from manufacturing labor, overhead and efficiencies reflect our ability to manage costs and drive productivity as we scale our manufacturing activity to respond to customer requirements; this includes the impact of capacity utilization, use of overtime and variability of cost structure. Changes in gross margin percentage from other service and manufacturing costs include the impact of customer support costs, including the efficiencies with which we deliver services to our customers, and the effectiveness with which we manage our production plans and inventory risk.
Our gross margin increased to 59.5% during the three months ended December 31, 2013 from 57.8% during the three months ended September 30, 2013, primarily due to higher revenue volume of products and service and increase in capacity utilization, partially offset by a less favorable mix of products and services sold.
Our gross margin increased to 59.5% during the three months ended December 31, 2013 from 54.8% during the three months ended December 31, 2012, primarily due to higher revenue volume of products and service, efficiencies from manufacturing and overhead spending and a lower requirement for excess and obsolescence inventory reserves.
Our gross margin increased to 58.7% during the six months ended December 31, 2013 from 55.4% during the six months ended December 31, 2012, primarily due to a more favorable mix of products and services sold, a lower requirement for excess and obsolescence inventory reserves and a decrease in customer support costs, partially offset by lower revenue volume.
Engineering, Research and Development (“R&D”)
(Dollar amounts in thousands)
Three months ended
 
 
 
 
 
 
 
 
December 31,
2013
 
September 30,
2013
 
December 31,
2012
 
Q2 FY14 vs.
Q1 FY14
 
Q2 FY14 vs.
Q2 FY13
R&D expenses
$
134,587

 
$
132,273

 
$
121,608

 
$
2,314

 
2
%
 
$
12,979

 
11
%
R&D expenses as a percentage of total revenues
19
%
 
20
%
 
18
%
 
 
 
 
 
 
 
 
(Dollar amounts in thousands)
Six months ended
 
 
 
 
December 31,
2013
 
December 31,
2012
 
Q2 FY14 YTD vs.
Q2 FY13 YTD
R&D expenses
$
266,860

 
$
241,350

 
$
25,510

 
11
%
R&D expenses as a percentage of total revenues
20
%
 
17
%
 
 
 
 
In recent years, our R&D expenses have generally increased over time, primarily due to higher costs associated with advanced product and technology development projects. We incur significant costs associated with these projects, including engineering material costs, headcount and other expenses, as technological innovation is essential to our success. During certain periods, R&D expenses may fluctuate relative to product development phases and project timing.
R&D expenses during the three months ended December 31, 2013 increased compared to the three months ended September 30, 2013, primarily due to the stage and timing of our development projects, as described in the previous paragraph. R&D expenses during the three months ended December 31, 2013 were impacted by an increase in employee-related expenses of $3.7 million as a result of additional engineering headcount and variable compensation, partially offset by a reduction in materials spending of $2.2 million due to the timing of project spending.
R&D expenses during the three months ended December 31, 2013 increased compared to the three months ended December 31, 2012, primarily due to the stage and timing of our development projects, as described above. R&D expenses during the three months ended December 31, 2013 were impacted by an increase in employee-related expenses of $13.4 million as a result of additional engineering headcount and variable compensation and a lower level of subsidies for R&D, partially offset by an increase in the benefit to R&D expenses from external funding of $3.7 million.

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R&D expenses during the six months ended December 31, 2013 increased compared to the six months ended December 31, 2012, primarily due to the stage and timing of our development projects, as described above. R&D expenses during the six months ended December 31, 2013 were impacted by an increase in employee-related expenses of $22.3 million as a result of additional engineering headcount and variable compensation, a lower level of subsidies for R&D and an increase in depreciation of property and equipment of $2.0 million, partially offset by an increase in the benefit to R&D expenses from external funding of $3.2 million.
R&D expenses include the benefit of $4.2 million, $3.6 million and $0.5 million of external funding received from government grants during the three months ended December 31, 2013, September 30, 2013 and December 31, 2012, respectively, for certain strategic development programs.
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”)
  
Three months ended
 
 
 
 
 
 
 
 
(Dollar amounts in thousands)
December 31,
2013
 
September 30,
2013
 
December 31,
2012
 
Q2 FY14 vs.
Q1 FY14
 
Q2 FY14 vs.
Q2 FY13
SG&A expenses
$
96,746

 
$
98,496

 
$
94,241

 
$
(1,750
)
 
(2
)%
 
$
2,505

 
3
%
SG&A expenses as a percentage of total revenues
14
%
 
15
%
 
14
%
 
 
 
 
 
 
 
 
  
Six months ended
 
 
 
 
(Dollar amounts in thousands)
December 31,
2013
 
December 31,
2012
 
Q2 FY14 YTD vs.
Q2 FY13 YTD
SG&A expenses
$
195,242

 
$
191,426

 
$
3,816

 
2
%
SG&A expenses as a percentage of total revenues
14
%
 
14
%
 
 
 
 
SG&A expenses during the three months ended December 31, 2013 decreased compared to the three months ended September 30, 2013, primarily due to our receipt of $1.1 million in proceeds from a class action settlement as well as our recovery of $1.1 million in receivables that had been previously classified as bad debt during the three months ended December 31, 2013.
SG&A expenses during the three months ended December 31, 2013 increased compared to the three months ended December 31, 2012, primarily due to an increase in employee-related expenses of $7.0 million as a result of additional headcount and variable compensation expense, partially offset by a decrease in legal expenses of $3.1 million that was partly attributable to the receipt of class action settlement proceeds described above.
SG&A expenses during the six months ended December 31, 2013 increased compared to the six months ended December 31, 2012, primarily due to an increase in employee-related expenses of $12.5 million as a result of additional headcount and higher variable compensation, partially offset by a decrease in consulting expenses of $3.2 million and a decrease in legal expenses of $3.5 million that was partly attributable to the receipt of class action settlement proceeds described above during the three months ended December 31, 2013.

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Interest Income and Other, Net and Interest Expense
 
(Dollar amounts in thousands)
Three months ended
December 31, 2013
 
September 30, 2013
 
December 31, 2012
Interest income and other, net
$
2,074

 
$
3,615

 
$
5,058

Interest expense
$
13,311

 
$
13,662

 
$
13,431

Interest income and other, net as a percentage of total revenues
—
%
 
1
%
 
1
%
Interest expense as a percentage of total revenues
2
%
 
2
%
 
2
%
 
 
 
 
 
 
(Dollar amounts in thousands)
 
 
Six months ended
December 31, 2013
 
December 31, 2012
Interest income and other, net
 
 
$
5,689

 
$
8,546

Interest expense
 
 
$
26,973

 
$
26,934

Interest income and other, net as a percentage of total revenues
 
 
—
%
 
1
%
Interest expense as a percentage of total revenues
 
 
2
%
 
2
%
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, gains or losses from revaluations of certain foreign currency denominated assets and liabilities as well as foreign currency contracts, impairments associated with equity investments in privately-held companies, and interest-related accruals (such as interest and penalty accruals related to our tax obligations).
Interest income and other, net during the three months ended December 31, 2013 decreased compared to the three months ended September 30, 2013 and December 31, 2012, in each case primarily due to an impairment charge of $1.4 million related to an equity investment in a privately-held company that was deemed to be an other-than-temporary impairment recognized during the three months ended December 31, 2013.
The decrease in interest income and other, net during the six months ended December 31, 2013 compared to the six months ended December 31, 2012 was primarily due to an impairment charge of $1.4 million related to an equity investment in a privately-held company and a decrease in interest income of $1.4 million driven by lower interest rates.
Interest expense is primarily attributable to the $750 million aggregate principal amount of senior fixed rate notes that we issued in the fourth quarter of the fiscal year ended June 30, 2008.
Provision for Income Taxes
The following table provides details of income taxes:    
(Dollar amounts in thousands)
Three months ended December 31,
 
Six months ended December 31,
 
2013
 
2012
 
2013
 
2012
Income before income taxes
$
176,745

 
$
144,874

 
$
316,609

 
$
321,416

Provision for income taxes
$
37,499

 
$
38,244

 
$
66,166

 
$
79,419

Effective tax rate
21.2
%
 
26.4
%
 
20.9
%
 
24.7
%
Our estimated annual effective tax rate for the fiscal year ending June 30, 2014 is approximately 21.4%.
There is no material difference between the tax expense as a percentage of income during the three months ended December 31, 2013 and the estimated annual effective tax rate.
Tax expense was lower as a percentage of income before income taxes during the three months ended December 31, 2013 compared to the three months ended December 31, 2012 primarily due to the impact of the following items:
•
Tax expense was decreased by $4.7 million during the three months ended December 31, 2013 due to an increase in the proportion of our earnings generated in jurisdictions with tax rates lower than the U.S. statutory tax rate;
•
Tax expense was decreased by $1.7 million during the three months ended December 31, 2013 related to the U.S. federal research credit. The research credit was not available during the three months ended December 31, 2012,

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because the credit expired on December 31, 2011. On January 2, 2013, the American Taxpayer Relief Act of 2012 reinstated the research credit and extended the credit through December 31, 2013; and
•
Tax expense was decreased by $2.6 million during the three months ended December 31, 2013 related to a non-taxable increase in the value of the assets held within our Executive Deferred Savings Plan.
Tax expense was lower as a percentage of income before income taxes during the six months ended December 31, 2013 compared to the six months ended December 31, 2012 primarily due to the impact of the following items:
•
Tax expense was decreased by $7.4 million during the six months ended December 31, 2013 due to an increase in the proportion of our earnings generated in jurisdictions with tax rates lower than the U.S. statutory tax rate;
•
Tax expense was decreased by $3.1 million during the six months ended December 31, 2013 related to the U.S. federal research credit. The research credit was not available during the six months ended December 31, 2012, because the credit expired on December 31, 2011. On January 2, 2013, the American Taxpayer Relief Act of 2012 reinstated the research credit and extended the credit through December 31, 2013.
•
Tax expense was decreased by $3.6 million during the six months ended December 31, 2013 related to a non-taxable increase in the value of the assets held within our Executive Deferred Savings Plan.
In the normal course of business, we are subject to examination by tax authorities throughout the world. We are subject to U.S. federal income tax examination for all years beginning from the fiscal year ended June 30, 2010. We are subject to state income tax examinations for all years beginning from the fiscal year ended June 30, 2009. We are also subject to examinations in other major foreign jurisdictions, including Singapore, for all years beginning from the fiscal year ended June 30, 2009. It is possible that certain examinations may be concluded in the next twelve months. We believe it is possible that we may recognize up to $7.2 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 examinations with various tax authorities.
LIQUIDITY AND CAPITAL RESOURCES
(Dollar amounts in thousands)
As of
December 31, 2013
 
As of
June 30, 2013
Cash and cash equivalents
$
793,382

 
$
985,390

Marketable securities
2,157,279

 
1,933,491

Total cash, cash equivalents and marketable securities
$
2,950,661

 
$
2,918,881

Percentage of total assets
54
%
 
55
%
 
 
 
 
 
Six months ended December 31,
(In thousands)
2013
 
2012
Cash flow:
 
 
 
Net cash provided by operating activities
$
292,519

 
$
322,836

Net cash used in investing activities
(262,788
)
 
(69,402
)
Net cash used in financing activities
(221,319
)
 
(238,233
)
Effect of exchange rate changes on cash and cash equivalents
(420
)
 
818

Net increase (decrease) in cash and cash equivalents
$
(192,008
)
 
$
16,019

As of December 31, 2013, our cash, cash equivalents and marketable securities totaled $3.0 billion, which is an increase of $31.8 million from June 30, 2013. As of December 31, 2013, $1.2 billion of our $3.0 billion of cash, cash equivalents and marketable securities were held by our foreign subsidiaries and branch offices. We currently intend to permanently reinvest $1.0 billion of the cash held by our foreign subsidiaries and branch offices. If, however, a portion of these funds were to be needed for our operations in the United States, we would be required to accrue and pay U.S. and foreign taxes of approximately 30%-50% of the funds repatriated. The amount of taxes due will depend on the amount and manner of the repatriation, as well as the location from where the funds are repatriated. We have accrued (but have not paid) U.S. taxes on the remaining cash of $139.0 million of the $1.2 billion held by our foreign subsidiaries and branch offices. As such, these funds can be returned to the U.S. without accruing any additional U.S. tax expense.

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During the three months ended December 31, 2013, our Board of Directors declared a dividend of $0.45 per share of our outstanding common stock, which was paid on December 2, 2013 to our stockholders of record as of the close of business on November 18, 2013. During the same period in fiscal year 2013, our Board of Directors declared and paid a quarterly cash dividend of $0.40 per share. The total amount of dividends paid during the three months ended December 31, 2013 and 2012 was $75.0 million and $66.5 million, respectively. The total amount of dividends paid during the six months ended December 31, 2013 and 2012 was $149.6 million and $133.2 million, respectively. The increase in the amount of dividends paid during the three and six months ended December 31, 2013 reflects the increase in the level of our quarterly dividend from $0.40 to $0.45 per share that was instituted during the three months ended September 30, 2013.
The shares repurchased under our stock repurchase program have allowed our basic and diluted weighted-average shares outstanding for the three months ended December 31, 2013, compared to the three months ended December 31, 2012, to remain relatively unchanged. The share repurchase program decrease partially offsets shares issued in connection with the exercise of employee stock options, purchases under our ESPP program and the vesting of employee restricted stock units.
We have historically financed our liquidity requirements through cash generated from operations. Net cash provided by operating activities during the six months ended December 31, 2013 decreased compared to the six months ended December 31, 2012 primarily as a result of the following factors:
•
A decrease in collections of approximately $11 million during the six months ended December 31, 2013 compared to the six months ended December 31, 2012,
•
An increase in payroll payments of approximately $21 million during the six months ended December 31, 2013 compared to the six months ended December 31, 2012, and
•
Payments of approximately $15 million upon the vesting of cash-based long-term incentive ("Cash LTI") awards during the six months ended December 31, 2013 under our Cash LTI employee compensation plan, where no such payments occurred during the six months ended December 31, 2012, partially offset by
•
A decrease in accounts payable payments of approximately $28 million during the six months ended December 31, 2013 compared to the six months ended December 31, 2012.
Net cash used in investing activities during the six months ended December 31, 2013 increased compared to the six months ended December 31, 2012 primarily as a result of a $193 million increase in the use of cash for purchase of available-for-sale and trading securities, net of sales and maturities.
Net cash used in financing activities during the six months ended December 31, 2013 decreased by $17 million compared to the six months ended December 31, 2012. Net cash used in financing activities was impacted by:
•
An increase in proceeds from the issuance of common stock of $32 million during the six months ended December 31, 2013 compared to the six months ended December 31, 2012 due to an increase in employee stock option exercises, and
•
A decrease in common stock repurchases of $16 million during the six months ended December 31, 2013 compared to the six months ended December 31, 2012, which were partially offset by
•
An increase in dividend payments of $16 million during the six months ended December 31, 2013 compared to the six months ended December 31, 2012, reflecting an increase in our quarterly dividend from $0.40 to $0.45 per share that was instituted during the three months ended September 30, 2013, and
•
An increase of $21 million in payroll tax withholding payments related to the net share settlement of vested and released restricted stock units during the six months ended December 31, 2013 compared to the six months ended December 31, 2012.

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The following is a schedule summarizing our significant obligations to make future payments under contractual obligations as of December 31, 2013:
 
Fiscal year ending June 30,
(In thousands)
Total
 
2014 (2)
 
2015
 
2016
 
2017
 
2018
 
Thereafter
 
Other
Long-term debt obligations(1)
$
750,000

 
$
—

 
$
—

 
$
—

 
$
—

 
$
750,000

 
$
—

 
$
—

Interest payment associated with long-term debt obligations
224,250

 
25,875

 
51,750

 
51,750

 
51,750

 
43,125

 
—

 
—

Purchase commitments
262,896

 
245,118

 
15,955

 
1,823

 
—

 
—

 
—

 
—

Non-current income tax payable(3)
69,578

 
—

 
—

 
—

 
—

 
—

 
—

 
69,578

Operating leases
27,696

 
4,093

 
7,084

 
5,667

 
4,521

 
3,261

 
3,070

 
—

Cash long-term incentive program(4)
108,730

 
601

 
30,781

 
30,781

 
30,781

 
15,786

 
—

 
—

Pension obligations
20,692

 
674

 
1,607

 
1,615

 
1,506

 
1,865

 
13,425

 
—

Total contractual cash obligations
$
1,463,842

 
$
276,361

 
$
107,177

 
$
91,636

 
$
88,558

 
$
814,037

 
$
16,495

 
$
69,578

__________________
(1)
In April 2008, we issued $750 million aggregate principal amount of senior notes due in 2018.
(2)
Remaining 6 months.
(3)
Represents the non-current income tax payable obligation and related accrued interest. 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.
(4)
Represents the amount committed under our cash long-term incentive program. Expected payment after estimated forfeitures is approximately $99.2 million.
Starting in fiscal year 2013 we adopted a cash-based long-term incentive program for many of our employees as part of our employee compensation program. Cash-based long-term incentive (“Cash LTI”) awards issued to date to employees under our Cash Long-Term Incentive Plan (“Cash LTI Plan”) vest in four equal installments, with 25% of the aggregate amount of the Cash LTI award vesting on each yearly anniversary of the grant date over a four-year period. In order to receive payments under the Cash LTI Plan, participants must remain employed by us as of the applicable award vesting date.
We have agreements with financial institutions to sell certain of our trade receivables and promissory notes from customers without recourse. In addition, we periodically sell certain letters of credit (“LCs”), without recourse, received from customers in payment for goods.
The following table shows total receivables sold under factoring agreements for the indicated periods:
 
Three months ended December 31,
 
Six months ended December 31,
(In thousands)
2013
 
2012
 
2013
 
2012
Receivables sold under factoring agreements
$
10,412

 
$
37,026

 
$
56,294

 
$
85,560

Factoring fees for the sale of certain trade receivables were recorded in interest income and other, net and were not material for the periods presented.
We maintain guarantee arrangements available through various financial institutions for up to $26.5 million, of which $24.6 million had been issued as of December 31, 2013, primarily to fund guarantees to customs authorities for value-added tax (“VAT”) and other operating requirements of our subsidiaries in Europe and Asia.
We maintain certain open inventory purchase commitments with our suppliers to ensure a smooth and continuous supply 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 forecasted time-horizon can vary among different suppliers. Our open inventory purchase commitments were approximately $262.9 million as of December 31, 2013 and are primarily due within the next 12 months. Actual expenditures will vary based upon the volume of the transactions and length of contractual service provided. In addition, the amounts paid under these arrangements may be less in the event that the arrangements are renegotiated or canceled. Certain agreements provide for potential cancellation penalties.

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We provide standard warranty coverage on our systems for 40 hours per week for 12 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; our warranty charge estimates for more mature products with longer product performance histories tend to be more stable. Non-standard warranty coverage generally includes services incremental to the standard 40 hours per week coverage for 12 months. See Note 12, “Commitments and Contingencies,” to the condensed consolidated financial statements for a detailed description.
Working capital was $3.6 billion as of December 31, 2013, which is an increase of $89.6 million compared to our working capital as of June 30, 2013. As of December 31, 2013, our principal source of liquidity consisted of $3.0 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 and regional 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 and cash equivalents balances, will be sufficient to satisfy our liquidity requirements for at least the next 12 months.
Our credit ratings and outlooks as of December 31, 2013 are summarized below:
Rating Agency
Rating
 
Outlook
Fitch
BBB
 
Stable
Moody’s
Baa1
 
Stable
Standard & Poor’s
BBB
 
Stable
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.

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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 (see Note 13, “Derivative Instruments and Hedging Activities,” to the condensed consolidated financial statements for a detailed description). Our outstanding hedge contracts, with maximum maturity of 18 months, were as follows:
 
(In thousands)
As of
December 31, 2013
 
As of
June 30, 2013
Cash flow hedge contracts
 
 
 
Purchase
$
20,288

 
$
14,641

Sell
$
69,197

 
$
35,178

Other foreign currency hedge contracts
 
 
 
Purchase
$
101,064

 
$
99,175

Sell
$
68,876

 
$
97,901

Indemnification Obligations and Certain Contractual Commitments. Subject to certain limitations, we are obligated to indemnify our current and former directors, officers and employees with respect to certain litigation matters and investigations that arise in connection with their service to us. These obligations arise under the terms of our certificate of incorporation, our bylaws, applicable contracts, and Delaware and California law. The obligation to indemnify generally means that we are required to pay or reimburse the individuals’ reasonable legal expenses and possibly damages and other liabilities incurred in connection with these matters. For example, we have paid or reimbursed legal expenses incurred in connection with the investigation of our historical stock option practices and the related litigation and government inquiries by a number of our current and former directors, officers and employees. Although the maximum potential amount of future payments we could be required to make under the indemnification obligations generally described in this paragraph is theoretically unlimited, we believe the fair value of this liability, to the extent estimable, is appropriately considered within the reserve we have established for currently pending legal proceedings.
We are a party to a variety of agreements pursuant to which we 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 we customarily agree to hold the other party harmless against losses arising from, or provide customers with other remedies to protect against, bodily injury or damage to personal property caused by our products, non-compliance with our product performance specifications, infringement by our products of third-party intellectual property rights and a breach of warranties, representations and covenants related to matters such as title to assets sold, validity of certain intellectual property rights, non-infringement of third-party rights, and certain income tax-related matters. In each of these circumstances, payment by us is typically subject to the other party making a claim to and cooperating with us pursuant to the procedures specified in the particular contract. This usually allows us 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, our obligations under these agreements may be limited in terms of amounts, activity (typically at our option to replace or correct the products or terminate the agreement with a refund to the other party), and duration. In some instances, we may have recourse against third parties and/or insurance covering certain payments made by us.
In addition, we may in limited circumstances enter into agreements that contain customer-specific pricing, discount, rebate or credit commitments offered by us. Furthermore, we may give these customers limited audit or inspection rights to enable them to confirm that we are complying with these commitments. If a customer elects to exercise its audit or inspection rights, we may be required to expend significant resources to support the audit or inspection, as well as to defend or settle any dispute with a customer that could potentially arise out of such audit or inspection. To date, we have made no accruals in our consolidated financial statements for this contingency. While we have not in the past incurred significant expenses for resolving disputes regarding these types of commitments, we cannot make any assurance that we will not incur any such liabilities in the future. One significant customer recently notified us of its intent to exercise its audit rights, and we cannot predict the outcome of that audit at this time.

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It is not possible to predict the maximum potential amount of future payments under these or similar agreements due to the conditional nature of our obligations and the unique facts and circumstances involved in each particular agreement. Historically, payments made by us under these agreements have not had a material effect on our business, financial condition, results of operations or cash flows.
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. All of the potential changes noted below are based on sensitivity analyses performed on our financial position as of December 31, 2013. Actual results may differ materially.
As of December 31, 2013, we had an investment portfolio of fixed income securities of $2.2 billion. 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 December 31, 2013, the fair value of the portfolio would have declined by $1.2 million.
As of December 31, 2013, we had net forward and option contracts to sell $16.7 million in foreign currency in order to hedge certain currency exposures (see Note 13, “Derivative Instruments and Hedging Activities,” to the condensed consolidated financial statements for a detailed description). If we had entered into these contracts on December 31, 2013, the U.S. dollar equivalent would have been $11.8 million. A 10% adverse move in all currency exchange rates affecting the contracts would decrease the fair value of the contracts by $20.3 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, as a result of the hedging of certain of our foreign currency exposure, changes in most relevant foreign currency exchange rates should have no material impact on our income or cash flows.
In April 2008, we issued $750 million aggregate principal amount of 6.90% senior, unsecured long-term debt due in 2018. The fair market value of long-term fixed interest rate debt is subject to interest rate risk. Generally, the fair market value of fixed interest rate debt will increase as interest rates fall and decrease as interest rates rise. As of December 31, 2013, the book value and the fair value of our fixed rate debt were $747.6 million and $874.9 million, respectively.
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 that we held as of December 31, 2013.


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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 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.
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.
Changes in Internal Control over Financial Reporting
There were no changes in the Company's internal control over financial reporting during the three months ended December 31, 2013 that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting.

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PART II. OTHER INFORMATION
ITEM 1.
LEGAL PROCEEDINGS
The information set forth above under Note 11, “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    
A description of factors that could materially affect our business, financial condition or operating results is provided below.
Risks Associated with Our Industry
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. 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. Our ability to recognize revenue from a particular customer may also be negatively impacted by the customer's funding status, which could be weakened not only by adverse business conditions or inaccessibility to capital markets for any number of macroeconomic or company-specific reasons, but also by funding limitations imposed by the customer's unique corporate structure. Any of these factors could negatively impact our business, operating results and financial condition.
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.

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In addition, our management typically provides quarterly forecasts for certain financial metrics, which, when made, are based on business and operational forecasts that are believed to be reasonable at the time. However, largely due to the cyclicality of our business and the industries in which we operate, and the fact that business conditions in our industries can change very rapidly as part of these cycles, our actual results may vary (and have varied in the past) from forecasted results. These variations can occur for any number of reasons, including, but not limited to, unexpected changes in the volume or timing of customer orders, product shipments or product acceptances; an inability to adjust our operations rapidly enough to adapt to changing business conditions; or a different than anticipated effective tax rate. The impact on our business of delays or cancellations of customer orders may be exacerbated by the short lead times that our customers expect between order placement and product shipment. This is because order delays and cancellations may lead not only to lower revenues, but also, due to the advance work we must do in anticipation of receiving a product order in order to meet the expected lead times, to significant inventory write-offs and manufacturing inefficiencies that decrease our gross margin. Any of these factors could materially and adversely affect our financial results for a particular quarter and could cause those results to differ materially from financial forecasts we have previously provided. We provide these forecasts with the intent of giving investors and analysts a better understanding of management's expectations for the future, but parties reviewing such forecasts must recognize that such forecasts are comprised of, and are themselves, forward-looking statements subject to the risks and uncertainties described in this Item 1A and elsewhere in this report and in our other public filings and public statements. If our operating or financial results for a particular period differ from our forecasts or the expectations of investment analysts, or if we revise our forecasts, the market price of our common stock could decline.
Ongoing changes in the technology industry, as well as the semiconductor industry in particular, could expose our business to significant risks.
The semiconductor equipment industry and other industries that we serve are constantly developing and changing over time. Many of the risks associated with operating in these industries are comparable to the risks faced by all technology companies, such as the uncertainty of future growth rates in the industries that we serve, pricing trends in the end-markets for consumer electronics and other products (which place a growing emphasis on our customers' cost of ownership), changes in our customers' capital spending patterns and, in general, an environment of constant change and development, including decreasing product and component dimensions; use of new materials; and increasingly complex device structures, applications and process steps. If we fail to appropriately adjust our cost structure and operations to adapt to any of these trends, or, with respect to technological advances, if we do not timely develop new technologies and products that successfully anticipate and address these changes, we could experience a material adverse effect on our business, financial condition and operating results.
In addition, we face a number of risks specific to ongoing changes in the semiconductor industry, as the significant majority of our sales are made to semiconductor manufacturers. Some of the trends that our management monitors in operating our business include the following:
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the increasing cost of building and operating fabrication facilities and the impact of such increases on our customers’ investment decisions;
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differing market growth rates and capital requirements for different applications, such as memory, logic and foundry;
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the emergence of disruptive technologies that change the prevailing semiconductor manufacturing processes (or the economics associated with semiconductor manufacturing) and, as a result, also impact the inspection and metrology requirements associated with such processes;
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the possible introduction of integrated products by our larger competitors that offer inspection and metrology functionality in addition to managing other semiconductor manufacturing processes;
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changes in semiconductor manufacturing processes that are extremely costly for our customers to implement and, accordingly, impact the amount of their budgets that are available for process control equipment;
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the possibility that next-generation technological advances within the semiconductor manufacturing industry could actually reverse the historical trend of declining cost per transistor, and the impact that such reversal would have upon our industry and business;
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the bifurcation of the semiconductor manufacturing industry into (a) leading edge manufacturers driving continued research and development into next-generation products and technologies and (b) other manufacturers that are content with existing (including previous generation) products and technologies;
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the ever escalating cost of next-generation product development, which may result in joint development programs between us and our customers to help fund such programs that could restrict our control of, ownership of and profitability from the products and technologies developed through those programs;
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the potential industry transition from 300mm to 450mm wafers; and
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the entry by some semiconductor manufacturers into collaboration or sharing arrangements for capacity, cost or risk with other manufacturers, as well as increased outsourcing of their manufacturing activities, and greater focus only on specific markets or applications, whether in response to adverse market conditions or other market pressures.

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Any of the changes described above may negatively affect our customers’ rate of investment in the capital equipment that we produce, 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 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. This increasing concentration exposes our business, financial condition and operating results to a number of risks, including the following:
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The mix and type of customers, and sales to any single customer, may vary significantly from quarter to quarter and from year to year, which exposes our business and operating results to increased volatility tied to individual customers.
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New orders from our foundry customers in the past several years constituted a significant portion of our total orders. This concentration increases the impact that future business or technology changes within the foundry industry may have on our business, financial condition and operating results.
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In a highly concentrated business environment, if a particular customer does not place an order, or if 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.
•
In recent years, our customer base has become increasingly concentrated due to corporate consolidation, acquisitions and business closures. As a result of this consolidation, the customers that survive the 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.
•
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.
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The highly concentrated business environment also increases our exposure to risks related to the financial condition of each of our customers. For example, as a result of the challenging economic environment during fiscal year 2009, we were (and in some cases continue to be) exposed to additional risks related to the continued financial viability of certain of our customers. To the extent our customers experience liquidity issues in the future, 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.
Risks Related to Our Business Model and Capital Structure
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.

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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.
In addition, the complexity of our products exposes us to other risks. We regularly recognize revenue from a sale upon shipment of the applicable product to the customer (even before receiving the customer's formal acceptance of that product) in certain situations, including sales of products for which installation is considered perfunctory, transactions in which the product is sold to an independent distributor and we have no installation obligations, and sales of products where we have previously delivered the same product to the same customer location and that prior delivery has been accepted. However, our products are very technologically complex and rely on the interconnection of numerous subcomponents (all of which must perform to their respective specifications), so it is conceivable that a product for which we recognize revenue upon shipment may ultimately fail to meet the overall product's required specifications. In such a situation, the customer may be entitled to certain remedies, which could materially and adversely affect our operating results for various periods and, as a result, our stock price.
Our success is dependent in part on our technology and other proprietary rights. If we are unable to maintain our lead or protect our proprietary technology, we may lose valuable assets.
Our success is dependent in part on our technology and other proprietary rights. We own various United States and international patents and have additional pending patent applications relating to some of our products and technologies. The process of seeking patent protection is lengthy and expensive, and we cannot be certain that pending or future applications will actually result in issued patents or that issued patents will be of sufficient scope or strength to provide meaningful protection or commercial advantage to us. Other companies and individuals, including our larger competitors, may develop technologies and obtain patents relating to our business that are similar or superior to our technology or may design around the patents we own, adversely affecting our business. In addition, we at times engage in collaborative technology development efforts with our customers and suppliers, and these collaborations may constitute a key component of certain of our ongoing technology and product research and development projects. The termination of any such collaboration, or delays caused by disputes or other unanticipated challenges that may arise in connection with any such collaboration, could significantly impair our research and development efforts, which could have a material adverse impact on our business and operations.
We also maintain trademarks on certain of our products and services and claim copyright protection for certain proprietary software and documentation. However, we can give no assurance that our trademarks and copyrights will be upheld or successfully deter infringement by third parties.
While patent, copyright and trademark protection for our intellectual property is important, we believe our future success in highly dynamic markets is most dependent upon the technical competence and creative skills of our personnel. We attempt to protect our trade secrets and other proprietary information through confidentiality and other agreements with our customers, suppliers, employees and consultants and through other security measures. We also maintain exclusive and non-exclusive licenses with third parties for strategic technology used in certain products. However, these employees, consultants and third parties may breach these agreements, and we may not have adequate remedies for wrongdoing. In addition, the laws of certain territories in which we develop, manufacture or sell our products may not protect our intellectual property rights to the same extent as do the laws of the United States. In any event, the extent to which we can protect our trade secrets through the use of confidentiality agreements is limited, and our success will depend to a significant extent on our ability to innovate ahead of our competitors.

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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.
Our business would be harmed if we do not receive parts sufficient in number and performance to meet our production requirements and product specifications 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. Through our business interruption planning, we seek to minimize the risk of production and service interruptions and/or shortages of key parts by, among other things, monitoring the financial stability of key suppliers, identifying (but not necessarily qualifying) possible alternative suppliers and maintaining appropriate inventories of key parts. Although we make reasonable efforts to ensure that parts are available from multiple suppliers, key parts may be available only from a single supplier or a limited group of suppliers. Also, key parts we obtain from some of our suppliers incorporate the suppliers’ proprietary intellectual property; in those cases we are increasingly reliant on third parties for high-performance, high-technology components, which reduces the amount of control we have over the availability and protection of the technology and intellectual property that is used in our products. In addition, if certain of our key suppliers experience liquidity issues and are forced to discontinue operations, which is a heightened risk during economic downturns, that would affect their ability to deliver parts and could result in delays for our products. Similarly, especially with respect to suppliers of high-technology components, our suppliers themselves have increasingly complex supply chains, and delays or disruptions at any stage of their supply chains may prevent us from obtaining parts in a timely manner and result in delays for our products. Our operating results and business may be adversely impacted if we are unable to obtain parts to meet our production requirements and product specifications, or if we are only able to do so on unfavorable terms. Furthermore, a supplier may discontinue production of a particular part for any number of reasons, including the supplier's financial condition or business operational decisions, which would require us to purchase, in a single transaction, a large number of such discontinued parts in order to ensure that a continuous supply of such parts remains available to our customers. Such “end-of-life” parts purchases could result in significant expenditures by us in a particular period, and ultimately any unused parts may result in a significant inventory write-off in a future period, either of which could have a material and adverse impact on our financial condition and results of operations for the applicable periods.
If we fail to operate our business in accordance with our business plan, our operating results, business and stock price may be significantly and adversely impacted.
We attempt to operate our business in accordance with a business plan that is established annually, revised frequently (generally quarterly), and reviewed by management even more frequently (at least monthly). Our business plan is developed based on a number of factors, many of which require estimates and assumptions, such as our expectations of the economic environment, future business levels, our customers’ willingness and ability to place orders, lead-times, and future revenue and cash flow. Our budgeted operating expenses, for example, are based in part on our future revenue expectations. However, our ability to achieve our anticipated revenue levels is a function of numerous factors, including the volatile and cyclical nature of our primary industry, customer order cancellations, macroeconomic changes, operational matters regarding particular agreements, our ability to manage customer deliveries and resources for the installation and acceptance of our products (for products where customer acceptance is required before we can recognize revenue from such sales), our ability to manage delays or accelerations by customers in taking deliveries and the acceptance of our products (for products where customer acceptance is required before we can recognize revenue from such sales), our ability to operate our business and sales processes effectively, and a number of the other risk factors set forth in this Item 1A.

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Because our expenses are in most cases relatively fixed in the short term, any revenue shortfall below expectations could have an immediate and significant adverse effect on our operating results. Similarly, if we fail to manage our expenses effectively or otherwise fail to maintain rigorous cost controls, we could experience greater than anticipated expenses during an operating period, which would also negatively affect our results of operations. If we fail to operate our business consistent with our business plan, our operating results in any period may be significantly and adversely impacted. Such an outcome could cause customers, suppliers or investors to view us as less stable, or could cause us to fail to meet financial analysts’ revenue or earnings estimates, any of which could have a material adverse impact on our business, financial condition or stock price.
In addition, our management is constantly striving to balance the requirements and demands of our customers with the availability of resources, the need to manage our operating model and other factors. In furtherance of those efforts, we often must exercise discretion and judgment as to the timing and prioritization of manufacturing, deliveries, installations and payment scheduling. Any such decisions may impact our ability to recognize revenue, including the fiscal period during which such revenue may be recognized, with respect to such products, which could have a material adverse effect on our business, financial condition or stock price.
There can be no assurance that we will continue to declare cash dividends at all or in any particular amounts.
Our Board of Directors first instituted a quarterly dividend during the fiscal year ended June 30, 2005. Since that time, we have announced several increases in the amount of our quarterly dividend level. We intend to continue to pay quarterly dividends subject to capital availability and periodic determinations by our Board of Directors that cash dividends are in the best interest of our stockholders and are in compliance with all laws and agreements applicable to the declaration and payment of cash dividends by us. Future dividends may be affected by, among other factors: our views on potential future capital requirements for investments in acquisitions and the funding of our research and development; legal risks; stock repurchase programs; changes in federal and state income tax laws or corporate laws; and changes to our business model. Our dividend payments may change from time to time, and we cannot provide assurance that we will continue to declare dividends at all or in any particular amounts. A reduction in our dividend payments could have a negative effect on our stock price.
There are risks associated with our outstanding indebtedness.
As of December 31, 2013, we had $750 million aggregate principal amount of outstanding indebtedness represented by our senior notes that will mature in 2018, and we may incur additional indebtedness in the future. Our ability to pay interest and repay the principal for our indebtedness is dependent upon our ability to manage our business operations and the other risk factors discussed in this section. There can be no assurance that we will be able to manage any of these risks successfully.
In addition, changes by any rating agency to our outlook or credit rating could negatively affect the value and liquidity of both our debt and equity securities. Factors that can affect our credit rating 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.
In certain circumstances involving a change of control followed by a downgrade of the rating of our senior notes, we 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. We cannot make any assurance that we will have sufficient financial resources at such time or will be able to arrange financing to pay the repurchase price of the senior notes. Our 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 we may be party at such time. If we fail 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 our obligations.
We are exposed to risks related to our commercial terms and conditions, including our indemnification of third parties, as well as the performance of our products.
Although our standard commercial documentation sets forth the terms and conditions that we intend to apply to commercial transactions with our business partners, counterparties to such transactions may not explicitly agree to our terms and conditions. In situations where we engage in business with a third party without an explicit master agreement regarding the applicable terms and conditions, or where the commercial documentation applicable to the transaction is subject to varying interpretations, we may have disputes with those third parties regarding the applicable terms and conditions of our business relationship with them. Such disputes could lead to a deterioration of our commercial relationship with those parties, costly and time-consuming litigation, or additional concessions or obligations being offered by us to resolve such disputes, or could impact our revenue or cost recognition. Any of these outcomes could materially and adversely affect our business, financial condition and results of operations.

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In addition, in our commercial agreements, from time to time in the normal course of business we indemnify third parties with whom we enter into contractual relationships, including customers and lessors, with respect to certain matters. We have agreed, under certain conditions, to hold these third parties harmless against specified losses, such as those arising from a breach of representations or covenants, other third party claims that our products when used for their intended purposes infringe the intellectual property rights of such other third parties, or other claims made against certain parties. We may be compelled to enter into or accrue for probable settlements of alleged indemnification obligations, or we may be subject to potential liability arising from our customers’ involvements in legal disputes. In addition, notwithstanding the provisions related to limitations on our liability that we seek to include in our business agreements, the counterparties to such agreements may dispute our interpretation or application of such provisions, and a court of law may not interpret or apply such provisions in our favor, any of which could result in an obligation for us to pay material damages to third parties and engage in costly legal proceedings. It is difficult to determine the maximum potential amount of liability under any indemnification obligations, whether or not asserted, due to our limited history of prior indemnification claims and the unique facts and circumstances that are likely to be involved in any particular claim. Our business, financial condition and results of operations in a reported fiscal period could be materially and adversely affected if we expend significant amounts in defending or settling any purported claims, regardless of their merit or outcomes.
We are also exposed to potential costs associated with unexpected product performance issues. Our products and production processes are extremely complex and thus could contain unexpected product defects, especially when products are first introduced. Unexpected product performance issues could result in significant costs being incurred by us, including increased service or warranty costs, providing product replacements for (or modifications to) defective products, litigation related to defective products, product recalls, or product write-offs or disposal costs. These costs could be substantial and could have an adverse impact upon our business, financial condition and operating results. In addition, our reputation with our customers could be damaged as a result of such product defects, which could reduce demand for our products and negatively impact our business.
Furthermore, we occasionally enter into volume purchase agreements with our larger customers, and these agreements may provide for certain volume purchase incentives, such as credits toward future purchases. We believe that these arrangements are beneficial to our long-term business, as they are designed to encourage our customers to purchase higher volumes of our products. However, these arrangements could require us to recognize a reduced level of revenue for the products that are initially purchased, to account for the potential future credits or other volume purchase incentives. As a result, these volume purchase arrangements, while expected to be beneficial to our business over time, could materially and adversely affect our results of operations in near-term periods, including the revenue we can recognize on product sales and therefore our gross margins.
In addition, we may in limited circumstances enter into agreements that contain other types of customer-specific pricing, discount, rebate or credit commitments offered by us, which may adversely impact our revenues, margins or financial results. Furthermore, we may give these customers limited audit or inspection rights to enable them to confirm that we are complying with these commitments. If a customer elects to exercise its audit or inspection rights, we may be required to expend significant resources to support the audit or inspection, as well as to defend or settle any dispute with a customer that could potentially arise out of such audit or inspection. To date, we have made no accruals in our consolidated financial statements for this contingency. While we have not in the past incurred significant expenses for resolving disputes regarding these types of commitments, we cannot make any assurance that we will not incur any such liabilities in the future. One significant customer recently notified us of its intent to exercise its audit rights, and we cannot predict the outcome of that audit at this time. Our business, financial condition and results of operations in a reported fiscal period could be materially and adversely affected if we expend significant amounts in supporting an audit or inspection, or defending or settling any purported claims, regardless of their merit or outcomes.

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There are risks associated with our receipt of government funding for research and development.
We are exposed to additional risks related to our receipt of external funding for certain strategic development programs from various governments and government agencies, both domestically and internationally. Governments and government agencies typically have the right to terminate funding programs at any time in their sole discretion, so there is no assurance that these sources of external funding will continue to be available to us in the future. In addition, under the terms of these government grants, the applicable granting agency typically has the right to audit the costs that we incur, directly and indirectly, in connection with such programs. Any such audit could result in modifications to, or even termination of, the applicable government funding program. For example, if an audit were to identify any costs as being improperly allocated to the applicable program, those costs would not be reimbursed, and any such costs that had already been reimbursed would have to be refunded. We do not know the outcome of any future audits. Any adverse finding resulting from any such audit could lead to penalties (financial or otherwise), termination of funding programs, suspension of payments, fines and suspension or prohibition from receiving future government funding from the applicable government or government agency, any of which could adversely impact our operating results, financial condition and ability to operate our business.
We have recorded significant restructuring, inventory write-off and asset impairment charges in the past and may do so again in the future, which could have a material negative impact on our business.
During the fiscal year ended June 30, 2009, we recorded material restructuring charges of $38.7 million related to our global workforce reduction, large excess inventory write-offs of $85.6 million, and material impairment charges of $446.7 million related to our goodwill and purchased intangible assets. If we again encounter challenging economic conditions once again, we may implement additional cost reduction actions, discontinue certain business operations or make other organizational changes, which would require us to take additional, potentially material, restructuring charges related to, among other things, employee terminations or exit costs. We may also be required to write off additional inventory if our product build plans or usage of service inventory decline. Also, as our lead times from suppliers increase (due to the increasing complexity of the parts and components they provide) and the lead times demanded by our customers decrease (due to the time pressures they face when introducing new products or technology or bringing new facilities into production), we may be compelled to increase our commitments, and therefore our risk exposure, to inventory purchases to meet our customers’ demands in a timely manner, and that inventory may need to be written-off if demand for the underlying product declines for any reason. Such additional write-offs could constitute material charges.
As noted above, we recorded a material charge during the fiscal year ended June 30, 2009 related to the impairment of our goodwill and purchased intangible assets. Goodwill represents the excess of costs over the net fair value of net assets acquired in a business combination. Goodwill is not amortized, but is instead tested for impairment at least annually in accordance with authoritative guidance for goodwill. Purchased intangible assets with estimable useful lives are amortized over their respective estimated useful lives using the straight-line method, and are reviewed for impairment in accordance with authoritative guidance for long-lived assets. The valuation of goodwill and intangible assets requires assumptions and estimates of many critical factors, including revenue and market growth, operating cash flows, market multiples, and discount rates. A substantial decline in our stock price, or any other adverse change in market conditions, particularly if such change has the effect of changing one of the critical assumptions or estimates we previously used to calculate the value of our goodwill or intangible assets (and, as applicable, the amount of any previous impairment charge), could result in a change to the estimation of fair value that could result in an additional impairment charge.
Any such additional material charges, whether related to restructuring or goodwill or purchased intangible asset impairment, may have a material negative impact on our operating results and related financial statements.
We are exposed to risks related to our financial arrangements with respect to receivables factoring and banking arrangements.
We enter into factoring arrangements with financial institutions to sell certain of our trade receivables and promissory notes from customers without recourse. In addition, we maintain bank accounts with several domestic and foreign financial institutions, any of which may prove not to be financially viable. If we were to stop entering into these factoring arrangements, our operating results, financial condition and cash flows could be adversely impacted by delays or failures in collecting trade receivables. However, by entering into these arrangements, and by engaging these financial institutions for banking services, we are exposed to additional risks. If any of these financial institutions experiences financial difficulties or is otherwise unable to honor the terms of our factoring or deposit arrangements, we may experience material financial losses due to the failure of such arrangements or a lack of access to our funds, any of which could have an adverse impact upon our operating results, financial condition and cash flows.

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We are subject to the risks of additional government actions in the event we were to breach the terms of any settlement arrangement into which we have entered.
In connection with the settlement of certain government actions and other legal proceedings related to our historical stock option practices, we have explicitly agreed as a condition to such settlements that we will comply with certain laws, such as the books and records provisions of the federal securities laws. If we were to violate any such law, we might not only be subject to the significant penalties applicable to such violation, but our past settlements may also be impacted by such violation, which could give rise to additional government actions or other legal proceedings. Any such additional actions or proceedings may require us to expend significant management time and incur significant accounting, legal and other expenses, and may divert attention and resources from the operation of our business. These expenditures and diversions, as well as an adverse resolution of any such action or proceeding, could have a material adverse effect on our business, financial condition and results of operations.
General Commercial, Operational, Financial and Regulatory Risks
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 caused our customers to decrease, cancel or delay their equipment and service orders from us in the economic slowdown during fiscal year 2009. 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 at times in the past several years 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, 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 value 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.

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A majority of our annual revenues are derived from outside the United States, and we maintain significant operations outside the United States. We are exposed to numerous risks as a result of the international nature of our business and operations.
A majority of our annual revenues are derived from outside the United States, and we maintain significant operations outside the United States. We expect that these conditions will continue in the foreseeable future. Managing global operations and sites located throughout the world presents a number of challenges, including but not limited to:
•
managing cultural diversity and organizational alignment;
•
exposure to the unique characteristics of each region in the global semiconductor market, which can cause capital equipment investment patterns to vary significantly from period to period;
•
periodic local or international economic downturns;
•
potential adverse tax consequences, including withholding tax rules that may limit the repatriation of our earnings, and higher effective income tax rates in foreign countries where we do business;
•
government controls, either by the United States or other countries, that restrict our business overseas or the import or export of semiconductor products or increase the cost of our operations;
•
compliance with customs regulations in the countries in which we do business;
•
tariffs or other trade barriers (including those applied to our products or to parts and supplies that we purchase);
•
political instability, natural disasters, legal or regulatory changes, acts of war or terrorism in regions where we have operations or where we do business;
•
fluctuations in interest and currency exchange rates. Fluctuations in currency exchange rates may adversely impact our ability to compete on price with local providers or the value of revenues we generate from our international business. 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;
•
longer payment cycles and difficulties in collecting accounts receivable outside of the United States;
•
difficulties in managing foreign distributors (including monitoring and ensuring our distributors' compliance with all applicable United States and local laws); and
•
inadequate protection or enforcement of our intellectual property and other legal rights in foreign jurisdictions.
Any of the factors above could have a significant negative impact on our business and results of operations.
We might be involved in claims or disputes related to intellectual property or other confidential information that may be costly to resolve, prevent us from selling or using the challenged technology and seriously harm our operating results and financial condition.
As is typical in the semiconductor equipment industry, from time to time we have received communications from other parties asserting the existence of patent rights, copyrights, trademark rights or other intellectual property rights which they believe cover certain of our products, processes, technologies or information. In addition, we occasionally receive notification from customers who believe that we owe them indemnification or other obligations related to intellectual property claims made against such customers by third parties. With respect to intellectual property infringement disputes, our customary practice is to evaluate such infringement assertions and to consider whether to seek licenses where appropriate. However, we cannot ensure that licenses can be obtained or, if obtained, will be on acceptable terms or that costly litigation or other administrative proceedings will not occur. The inability to obtain necessary licenses or other rights on reasonable terms could seriously harm our results of operations and financial condition. Furthermore, we may potentially be subject to claims by customers, suppliers or other business partners, or by governmental law enforcement agencies, related to our receipt, distribution and/or use of third-party intellectual property or confidential information. Legal proceedings and claims, regardless of their merit, and associated internal investigations with respect to intellectual property or confidential information disputes are often expensive to prosecute, defend or conduct; may divert management's attention and other company resources; and/or may result in restrictions on our ability to sell our products, settlements on significantly adverse terms or adverse judgments for damages, injunctive relief, penalties and fines, any of which could have a significant negative effect on our business, results of operations and financial condition. There can be no assurance regarding the outcome of future legal proceedings, claims or investigations. The instigation of legal proceedings or claims, our inability to favorably resolve or settle such proceedings or claims, or the determination of any adverse findings against us or any of our employees in connection with such proceedings or claims could materially and adversely affect our business, financial condition and results of operations, as well as our business reputation.

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We are exposed to various risks related to the legal (including environmental), regulatory and tax environments in which we perform our operations and conduct our business.
We are subject to various risks related to compliance with new, existing, different, inconsistent or even conflicting laws, rules and regulations enacted by legislative bodies and/or regulatory agencies in the countries in which we operate and with which we must comply, including environmental, safety, antitrust, anti-corruption/anti-bribery, unclaimed property and export control regulations. Our failure or inability to comply with existing or future laws, rules or regulations, or changes to existing laws, rules or regulations (including changes that result in inconsistent or conflicting laws, rules or regulations), in the countries in which we operate could result in violations of contractual or regulatory obligations that may adversely affect our operating results, financial condition and ability to conduct our business. From time to time, we may receive inquiries or audit notices from governmental or regulatory bodies, or we may participate in voluntary disclosure programs, related to legal, regulatory or tax compliance matters, and these inquiries, notices or programs may result in significant financial cost (including investigation expenses, defense costs, assessments and penalties), reputational harm and other consequences that could materially and adversely affect our operating results and financial condition.
Our properties and many aspects of our business operations are subject to various domestic and international environmental laws and regulations, including those that control and restrict the use, transportation, emission, discharge, storage and disposal of certain chemicals, gases and other substances. Any failure to comply with applicable environmental laws, regulations or requirements may subject us to a range of consequences, including fines, suspension of certain of our business activities, limitations on our ability to sell our products, obligations to remediate environmental contamination, and criminal and civil liabilities or other sanctions. In addition, changes in environmental regulations (including regulations relating to climate change and greenhouse gas emissions) could require us to invest in potentially costly pollution control equipment, alter our manufacturing processes or use substitute (potentially more expensive and/or rarer) materials. Further, we use hazardous and other regulated materials that subject us to risks of strict liability for damages caused by any release, regardless of fault. We also face increasing complexity in our manufacturing, product design and procurement operations as we adjust to new and prospective requirements relating to the materials composition of our products, including restrictions on lead and other substances and requirements to track the sources of certain metals and other materials. The cost of complying, or of failing to comply, with these and other regulatory restrictions or contractual obligations could adversely affect our operating results, financial condition and ability to conduct our business.
In addition, we may from time to time be involved in legal proceedings or claims regarding employment, contracts, product performance, product liability, antitrust, environmental regulations, securities, unfair competition and other matters (in addition to proceedings and claims related to intellectual property matters, which are separately discussed elsewhere in this Item 1A). These legal proceedings and claims, regardless of their merit, may be time-consuming and expensive to prosecute or defend, divert management’s attention and resources, and/or inhibit our ability to sell our products. There can be no assurance regarding the outcome of current or future legal proceedings or claims, which could adversely affect our operating results, financial condition and ability to operate our business.
Recent regulations related to “conflict minerals” may force us to incur additional expenses, may result in damage to our business reputation and may adversely impact our ability to conduct our business.
In August 2012, under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, the SEC adopted new requirements for companies that use certain minerals and derivative metals (referred to as “conflict minerals,” regardless of their actual country of origin) in their products. Some of these metals are commonly used in electronic equipment and devices, including our products. These new requirements require companies to investigate, disclose and report whether or not such metals originated from the Democratic Republic of Congo or adjoining countries. We have an extremely complex supply chain, with numerous suppliers (many of whom are not obligated by the new law to investigate their own supply chains) for the components and parts used in each of our products. As a result, we may incur significant costs to comply with the diligence and disclosure requirements, including costs related to determining the source of any of the relevant metals used in our products. In addition, because our supply chain is so complex, we may not be able to sufficiently verify the origin of all the relevant metals used in our products through the due diligence procedures that we implement, which may harm our business reputation. Though we do not anticipate that our customers will need to know our conflict mineral status to satisfy their own SEC reporting obligations (if any), we may also face difficulties in satisfying customers if they nonetheless require that we prove or certify that our products are “conflict free.” Key components and parts that can be shown to be “conflict free” may not be available to us in sufficient quantity, or at all, or may only be available at significantly higher cost to us. If we are not able to meet customer requirements, customers may choose to disqualify us as a supplier. Any of these outcomes could adversely impact our business, financial condition or operating results.

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We depend on key personnel to manage our business effectively, and if we are unable to attract, retain and motivate our key employees, our sales and product development could be harmed.
Our employees are vital to our success, and our key management, engineering and other employees are difficult to replace. We generally do not have employment contracts with our key employees. Further, we do not maintain key person life insurance on any of our employees. The expansion of high technology companies worldwide has increased demand and competition for qualified personnel. If we are unable to retain key personnel, or if we are not able to attract, assimilate and retain additional highly qualified employees to meet our needs in the future, our business and operations could be harmed.
We outsource a number of services to third-party service providers, which decreases our control over the performance of these functions. Disruptions or delays at our third-party service providers could adversely impact our operations.
We outsource a number of services, including our transportation and logistics management of spare parts and certain accounting functions, to domestic and overseas third-party service providers. While outsourcing arrangements may lower our cost of operations, they also reduce our direct control over the services rendered. It is uncertain what effect such diminished control will have on the quality or quantity of products delivered or services rendered, on our ability to quickly respond to changing market conditions, or on our ability to ensure compliance with all applicable domestic and foreign laws and regulations. In addition, many of these outsourced service providers, including certain hosted software applications that we use for confidential data storage, employ “cloud computing” technology for such storage (which refers to an information technology hosting and delivery system in which data is not stored within the user's physical infrastructure but instead are delivered to and consumed by the user as an Internet-based service). These providers' cloud computing systems may be susceptible to “cyber incidents,” such as intentional cyber attacks aimed at theft of sensitive data or inadvertent cyber-security compromises, that are outside of our control. If we do not effectively develop and manage our outsourcing strategies, if required export and other governmental approvals are not timely obtained, if our third-party service providers do not perform as anticipated, or do not adequately protect our data from cyber-related security breaches, or if there are delays or difficulties in enhancing business processes, we may experience operational difficulties (such as limitations on our ability to ship products), increased costs, manufacturing or service interruptions or delays, loss of intellectual property rights or other sensitive data, quality and compliance issues, and challenges in managing our product inventory or recording and reporting financial and management information, any of which could materially and adversely affect our business, financial condition and results of operations.
We rely upon certain critical information systems for our daily business operation. Our inability to use or access these information systems at critical points in time could unfavorably impact the timeliness and efficiency of our business operations.
Our global operations are linked by information systems, including telecommunications, the internet, our corporate intranet, network communications, email and various computer hardware and software applications. Despite our implementation of network security measures, our tools and servers are vulnerable to computer viruses, break-ins and similar disruptions from unauthorized tampering with our computer systems and tools located at customer sites, or could be subject to system failures or malfunctions for other reasons. System failures or malfunctioning, such as difficulties with our customer relationship management (“CRM”) system, could disrupt our operations and our ability to timely and accurately process and report key components of our financial results. Our enterprise resource planning (“ERP”) system is integral to our ability to accurately and efficiently maintain our books and records, record transactions, provide critical information to our management, and prepare our financial statements. Any disruptions or difficulties that may occur in connection with our ERP system or other systems (whether in connection with the regular operation, periodic enhancements, modifications or upgrades of such systems or the integration of our acquired businesses into such systems) could adversely affect our ability to complete important business processes, such as the evaluation of our internal control over financial reporting pursuant to Section 404 of the Sarbanes-Oxley Act of 2002. Any such event could have an adverse effect on our business, operating results and financial condition.
Acquisitions are an important element of our strategy but, because of the uncertainties involved, we may not find suitable acquisition candidates and we may not be able to successfully integrate and manage acquired businesses. We are also exposed to risks in connection with strategic alliances into which we may enter.
In addition to our efforts to develop new technologies from internal sources, part of our growth strategy is to pursue acquisitions and acquire new technologies from external sources. As part of this effort, we may make acquisitions of, or significant investments in, businesses with complementary products, services and/or technologies. There can be no assurance that we will find suitable acquisition candidates or that acquisitions we complete will be successful. In addition, we may use equity to finance future acquisitions, which would increase our number of shares outstanding and be dilutive to current stockholders.

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If we are unable to successfully integrate and manage acquired businesses or if acquired businesses perform poorly, then our business and financial results may suffer. It is possible that the businesses we have acquired, as well as businesses that we may acquire in the future, may perform worse than expected or prove to be more difficult to integrate and manage than expected. In addition, we may lose key employees of the acquired companies. As a result, risks associated with acquisition transactions may give rise to a material adverse effect on our business and financial results for a number of reasons, including:
•
we may have to devote unanticipated financial and management resources to acquired businesses;
•
the combination of businesses may cause the loss of key personnel or an interruption of, or loss of momentum in, the activities of our company and/or the acquired business;
•
we may not be able to realize expected operating efficiencies or product integration benefits from our acquisitions;
•
we may experience challenges in entering into new market segments for which we have not previously manufactured and sold products;
•
we may face difficulties in coordinating geographically separated organizations, systems and facilities;
•
the customers, distributors, suppliers, employees and others with whom the companies we acquire have business dealings may have a potentially adverse reaction to the acquisition;
•
we may have to write-off goodwill or other intangible assets; and
•
we may incur unforeseen obligations or liabilities in connection with acquisitions.
At times, we may also enter into strategic alliances with customers, suppliers or other business partners with respect to development of technology and intellectual property. These alliances typically require significant investments of capital and exchange of proprietary, highly sensitive information. The success of these alliances depends on various factors over which we may have limited or no control and requires ongoing and effective cooperation with our strategic partners. Mergers and acquisitions and strategic alliances are inherently subject to significant risks, and the inability to effectively manage these risks could materially and adversely affect our business, financial condition and operating results.
Disruption of our manufacturing facilities or other operations, or in the operations of our customers, due to earthquake, flood, other natural catastrophic events, health epidemics or terrorism could result in cancellation of orders, delays in deliveries or other business activities, or loss of customers and could seriously harm our business.
We have significant manufacturing operations in the United States, Singapore, Israel, Belgium, Germany and China. In addition, our business is international in nature, with our sales, service and administrative personnel and our customers located in numerous countries throughout the world. Operations at our manufacturing facilities and our assembly subcontractors, as well as our other operations and those of our customers, are subject to disruption for a variety of reasons, including work stoppages, acts of war, terrorism, health epidemics, fire, earthquake, volcanic eruptions, energy shortages, flooding or other natural disasters. Such disruption could cause delays in, among other things, shipments of products to our customers, our ability to perform services requested by our customers, or the installation and acceptance of our products at customer sites. We cannot ensure that alternate means of conducting our operations (whether through alternate production capacity or service providers or otherwise) would be available if a major disruption were to occur or that, if such alternate means were available, they could be obtained on favorable terms.
In addition, as part of our cost-cutting actions, we have consolidated several operating facilities. Our California operations are now primarily centralized in our Milpitas facility. The consolidation of our California operations into a single campus could further concentrate the risks related to any of the disruptive events described above, such as acts of war or terrorism, earthquakes, fires or other natural disasters, if any such event were to impact our Milpitas facility.
We are predominantly uninsured for losses and interruptions caused by terrorist acts and acts of war. If international political instability continues or increases, our business and results of operations could be harmed.
The threat of terrorism targeted at, or acts of war in, the regions of the world in which we do business increases the uncertainty in our markets. Any act of terrorism or war that affects the economy or the semiconductor industry could adversely affect our business. Increased international political instability in various parts of the world, disruption in air transportation and further enhanced security measures as a result of terrorist attacks may hinder our ability to do business and may increase our costs of operations. We maintain significant manufacturing and research and development operations in Israel, an area that has historically experienced a high degree of political instability, and we are therefore exposed to risks associated with future instability in that region. Such instability could directly impact our ability to operate our business (or our customers' ability to operate their business) in the affected region, cause us to incur increased costs in transportation, make such transportation unreliable, increase our insurance costs, and cause international currency markets to fluctuate. This same instability could have the same effects on our suppliers and their ability to timely deliver their products. If international political instability continues or increases in any region in which we do business, our business and results of operations could be harmed. We are predominantly uninsured for losses and interruptions caused by terrorist acts and acts of war.

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We self insure certain risks including earthquake risk. If one or more of the uninsured events occurs, we could suffer major financial loss.
We purchase insurance to help mitigate the economic impact of certain insurable risks; however, certain other risks are uninsurable or are insurable only at significant cost or cannot be mitigated with insurance. An earthquake could significantly disrupt our manufacturing operations, a significant portion of which are conducted in California, an area highly susceptible to earthquakes. It could also significantly delay our research and engineering efforts on new products, much of which is also conducted in California. We take steps to minimize the damage that would be caused by an earthquake, but there is no certainty that our efforts will prove successful in the event of an earthquake. We self insure earthquake risks because we believe this is a prudent financial decision based on our large cash reserves and the high cost and limited coverage available in the earthquake insurance market. Certain other risks are also self-insured either based on a similar cost-benefit analysis, or based on the unavailability of insurance. If one or more of the uninsured events occurs, we could suffer major financial loss.
We are exposed to foreign currency exchange rate fluctuations. Although we hedge certain currency risks, we may still be adversely affected by changes in foreign currency exchange rates or declining economic conditions in these countries.
We have some exposure to fluctuations in foreign currency exchange rates, primarily the Euro and the Japanese Yen. We have international subsidiaries that operate and sell our products globally. In addition, an increasing proportion of our manufacturing activities are conducted outside of the United States, and many of the costs associated with such activities are denominated in foreign currencies. We routinely hedge our exposures to certain foreign currencies with certain financial institutions in an effort to minimize the impact of certain currency exchange rate fluctuations, but these hedges may be inadequate to protect us from currency exchange rate fluctuations. To the extent that these hedges are inadequate, or if there are significant currency exchange rate fluctuations in currencies for which we do not have hedges in place, our reported financial results or the way we conduct our business could be adversely affected. Furthermore, if a financial counterparty to our hedges experiences financial difficulties or is otherwise unable to honor the terms of the foreign currency hedge, we may experience material financial losses.
We are exposed to fluctuations in interest rates and the market values of our portfolio investments; impairment of our investments could harm our earnings. In addition, we and our stockholders are exposed to risks related to the volatility of the market for our common stock.
Our investment portfolio primarily consists of both corporate and government debt securities that have a maximum effective 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 market interest rates and bond yields increase, those securities with a lower yield-at-cost show a mark-to-market unrealized loss. We have the ability to realize the full value of all these investments upon maturity. However, an impairment of the fair market value of our investments, even if unrealized, must be reflected in our financial statements for the applicable period and may therefore have a material adverse effect on our results of operations for that period.
In addition, the market price for our common stock is volatile and has fluctuated significantly during recent years. The trading price of our common stock could continue to be highly volatile and fluctuate widely in response to various factors, including without limitation conditions in the semiconductor industry and other industries in which we operate, fluctuations in the global economy or capital markets, our operating results or other performance metrics, or adverse consequences experienced by us as a result of any of the risks described elsewhere in this Item 1A. Volatility in the market price of our common stock could cause an investor in our common stock to experience a loss on the value of their investment in us and could also adversely impact our ability to raise capital through the sale of our common stock or to use our common stock as consideration to acquire other companies.
We are exposed to risks in connection with tax and regulatory compliance audits in various jurisdictions.
We are subject to tax and regulatory compliance audits (such as related to customs or product safety requirements) in various jurisdictions, and such jurisdictions may assess additional income or other taxes, penalties, fines or other prohibitions against us. Although we believe our tax estimates are reasonable and that our products and practices comply with applicable regulations, the final determination of any such audit and any related litigation could be materially different from our historical income tax provisions and accruals related to income taxes and other contingencies. The results of an audit or litigation could have a material adverse effect on our operating results or cash flows in the period or periods for which that determination is made.

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A change in our effective tax rate can have a significant adverse impact on our business.
We earn profits in, and are therefore potentially subject to taxes in, the U.S. and numerous foreign jurisdictions, including Singapore, Israel and the Cayman Islands, the countries in which we earn the majority of our non-U.S. profits. Due to economic, political or other conditions, tax rates in those jurisdictions may be subject to significant change. A number of factors may adversely impact our future effective tax rates, such as the jurisdictions in which our profits are determined to be earned and taxed; changes in the tax rates imposed by those jurisdictions; the resolution of issues arising from tax audits with various tax authorities; changes in the valuation of our deferred tax assets and liabilities; adjustments to estimated taxes upon finalization of various tax returns; increases in expenses not deductible for tax purposes, including write-offs of acquired in-process research and development and impairment of goodwill in connection with acquisitions; changes in available tax credits; changes in stock-based compensation expense; changes in tax laws or the interpretation of such tax laws (for example, proposals for fundamental United States international tax reform); changes in generally accepted accounting principles; and the repatriation of earnings from outside the United States for which we have not previously provided for United States taxes. A change in our effective tax rate can materially and adversely impact our results from operations.
Compliance with federal securities laws, rules and regulations, as well as NASDAQ requirements, is becoming increasingly complex, and the significant attention and expense we must devote to those areas may have an adverse impact on our business.
Federal securities laws, rules and regulations, as well as NASDAQ rules and regulations, require companies to maintain extensive corporate governance measures, impose comprehensive reporting and disclosure requirements, set strict independence and financial expertise standards for audit and other committee members and impose civil and criminal penalties for companies and their chief executive officers, chief financial officers and directors for securities law violations. These laws, rules and regulations have increased, and in the future are expected to continue to increase, the scope, complexity and cost of our corporate governance, reporting and disclosure practices, which could harm our results of operations and divert management’s attention from business operations.
A change in accounting standards or practices or a change in existing taxation rules or practices (or changes in interpretations of such standards, practices or rules) can have a significant effect on our reported results and may even affect reporting of transactions completed before the change is effective.
New accounting pronouncements and taxation rules and varying interpretations of accounting pronouncements and taxation rules have occurred and will continue to occur in the future. Changes to (or revised interpretations or applications of) existing tax or accounting rules or the questioning of current or past practices may adversely affect our reported financial results or the way we conduct our business.
For example, the adoption of the authoritative guidance for stock-based compensation, which required us to measure all employee stock-based compensation awards using a fair value method beginning in fiscal year 2006 and record such expense in our consolidated financial statements, has had a material impact on our consolidated financial statements, as reported under accounting principles generally accepted in the United States.

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ITEM 2.
UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
Equity Repurchase Plans
The following is a summary of stock repurchases for the three months ended December 31, 2013 (1):
Period
Total Number of
Shares
Purchased (2)
 
Average Price Paid
per Share
 
Maximum Number of
Shares that May
Yet Be Purchased  Under
the Plans or Programs (3)
October 1, 2013 to October 31, 2013
340,640

 
$
62.05

 
4,473,472

November 1, 2013 to November 30, 2013
299,105

 
$
63.86

 
4,174,367

December 1, 2013 to December 31, 2013
319,395

 
$
62.83

 
3,854,972

Total
959,140

 
$
62.87

 
 
__________________ 
(1)
In July 1997, our Board of Directors authorized us to systematically repurchase up to 17.8 million shares of our common stock in the open market. This plan was put into place to reduce the dilution from our employee benefit and incentive plans, such as our equity incentive and employee stock purchase plans, and to return excess cash to our stockholders. Our Board of Directors has authorized us to repurchase additional shares of our common stock under the repurchase program in February 2005 (up to 10.0 million shares), February 2007 (up to 10.0 million shares), August 2007 (up to 10.0 million shares), June 2008 (up to 15.0 million shares), February 2011 (up to 10.0 million shares), and November 2012 (up to 8.0 million shares), in each case in addition to the originally authorized 17.8 million shares described in the first sentence of this footnote.
(2)
All shares were purchased pursuant to the publicly announced repurchase program described in footnote 1 above. Shares are reported based on the settlement date of the applicable repurchase.
(3)
The stock repurchase program has no expiration date. Future repurchases of our common stock under our repurchase program may be effected through various different repurchase transaction structures, including isolated open market transactions or systematic repurchase plans.
ITEM 3.
DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4.
MINE SAFETY DISCLOSURES
Not applicable.
ITEM 5.
OTHER INFORMATION
None.

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ITEM 6.
EXHIBITS
 
 
 
Incorporated by Reference
Exhibit
Number
 
Exhibit Description
Form
File
Number
Exhibit
Number
Filing
Date
 
 
 
 
 
 
 
10.45
 
2004 Equity Incentive Plan (as amended and restated (as of November 6, 2013)) *
DEF14A
No. 000-09992
App. A
September 26, 2013
 
 
 
 
 
 
 
10.46
 
KLA-Tencor Corporation Performance Bonus Plan *
DEF14A
No. 000-09992
App. B
September 26, 2013
 
 
 
 
 
 
 
31.1
 
Certification of Chief Executive Officer Under Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934
 
 
 
 
 
 
 
 
 
 
 
31.2
 
Certification of Chief Financial Officer Under Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934
 
 
 
 
 
 
 
 
 
 
 
32
 
Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350
 
 
 
 
 
 
 
 
 
 
 
101.INS
 
XBRL Instance Document
 
 
 
 
 
 
 
 
 
 
 
101.SCH
 
XBRL Taxonomy Extension Schema Document
 
 
 
 
 
 
 
 
 
 
 
101.CAL
 
XBRL Taxonomy Extension Calculation Linkbase Document
 
 
 
 
 
 
 
 
 
 
 
101.DEF
 
XBRL Taxonomy Extension Definition Linkbase Document
 
 
 
 
 
 
 
 
 
 
 
101.LAB
 
XBRL Taxonomy Extension Label Linkbase Document
 
 
 
 
 
 
 
 
 
 
 
101.PRE
 
XBRL Taxonomy Extension Presentation Linkbase Document
 
 
 
 


__________
* Denotes a management contract, plan or arrangement


62
Table of Contents

SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
 
 
 
 
KLA-Tencor Corporation
 
 
 
 
(Registrant)
 
 
 
January 23, 2014
 
 
 
/s/ RICHARD P. WALLACE
(Date)
 
 
 
Richard P. Wallace
 
 
 
 
President and Chief Executive Officer
(Principal Executive Officer)
 
 
 
January 23, 2014
 
 
 
/s/ BREN D. HIGGINS
(Date)
 
 
 
Bren D. Higgins
 
 
 
 
Executive Vice President and Chief Financial Officer
(Principal Financial Officer)
 
 
 
January 23, 2014
 
 
 
/s/ VIRENDRA A. KIRLOSKAR
(Date)
 
 
 
Virendra A. Kirloskar
 
 
 
 
Senior Vice President and Chief Accounting Officer
(Principal Accounting Officer)

63
Table of Contents

KLA-TENCOR CORPORATION
EXHIBIT INDEX
 
 
 
 
Incorporated by Reference
Exhibit
Number
 
Exhibit Description
Form
File
Number
Exhibit
Number
Filing
Date
 
 
 
 
 
 
 
10.45
 
2004 Equity Incentive Plan (as amended and restated (as of November 6, 2013)) *
DEF14A
No. 000-09992
App. A
September 26, 2013
 
 
 
 
 
 
 
10.46
 
KLA-Tencor Corporation Performance Bonus Plan*
DEF14A
No. 000-09992
App. B
September 26, 2013
 
 
 
 
 
 
 
31.1
 
Certification of Chief Executive Officer under Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934
 
 
 
 
 
 
 
 
 
 
 
31.2
 
Certification of Chief Financial Officer under Rule 13a-14(a) /15d-14(a) of the Securities Exchange Act of 1934
 
 
 
 
 
 
 
 
 
 
 
32
 
Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350
 
 
 
 
 
 
 
 
 
 
 
101.INS
 
XBRL Instance Document
 
 
 
 
 
 
 
 
 
 
 
101.SCH
 
XBRL Taxonomy Extension Schema Document
 
 
 
 
 
 
 
 
 
 
 
101.CAL
 
XBRL Taxonomy Extension Calculation Linkbase Document
 
 
 
 
 
 
 
 
 
 
 
101.DEF
 
XBRL Taxonomy Extension Definition Linkbase Document
 
 
 
 
 
 
 
 
 
 
 
101.LAB
 
XBRL Taxonomy Extension Label Linkbase Document
 
 
 
 
 
 
 
 
 
 
 
101.PRE
 
XBRL Taxonomy Extension Presentation Linkbase Document
 
 
 
 

__________
* Denotes a management contract, plan or arrangement

64