We have historically financed our operations through cash generated from operations. Cash provided by operating activities was $71 million and $171 million for the six months ended December 31, 2005 and 2004, respectively. Cash provided by operating activities during the six months ended December 31, 2005 consisted primarily of net income of $153 million increased by non-cash depreciation of $35 million and stock-based compensation of $71 million, offset by an increase in accounts receivable of $53 million, an increase in inventories of $50 million, a decrease in deferred system profit of $46 million, and a decrease in other current liabilities of $63 million. Net cash provided by operating activities during the six months ended December 31, 2004 consisted primarily of $238 million provided by net income, adjusted for $37 million of non-cash depreciation and amortization, an increase in other current liabilities of $30 million and partially offset by an increase in net accounts receivable balances by $60 million, an increase in inventory balances by $11 million, an increase in other asset balances by $27 million, a decrease in accounts payable balances by $21 million and a decrease in deferred profit balances by $17 million.
Cash used in investing activities was $6 million and $191 million during the six months ended December 31, 2005 and 2004, respectively. Investing activities typically consist of purchases and sales or maturities of marketable securities, purchases of capital assets to support long-term growth and acquisitions of technology or other companies to allow access to new market segments or emerging technologies.
We generated $17 million of cash in financing activities during the six months ended December 31, 2005, compared with $30 million of cash used in financing activities during the six months ended December 31, 2004. Issuance of common stock primarily through the exercise of employee stock options and purchased under our employee stock purchase plan provided $136 million and $71 million during the six months ended December 31, 2005 and 2004, respectively. We used $84 million and $111 million during the six months ended December 31, 2005 and 2004, respectively to repurchase shares of our common stock under the stock repurchase program initiated in 1997. During the third fiscal quarter of 2005, our Board of Directors also approved the initiation of a quarterly cash dividend and declared a dividend of 12 cents per share of our outstanding common stock. The total amount of dividend paid during the six months ended December 31, 2005 was $47 million. Further, the dividend for the third fiscal quarter of 2006 was declared on January 24, 2006 and is payable on March 1, 2006 to our stockholders of record on February 15, 2006. The total amount of dividend payable during the third quarter of fiscal year 2006 is approximately $24 million.
The following is a schedule summarizing our significant operating lease commitments as of December 31, 2005 (in millions):
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Operating leases | | $ | 22.2 | | $ | 4.0 | | $ | 6.4 | | $ | 4.1 | | $ | 2.9 | | $ | 1.8 | | $ | 3.0 | |
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We have agreements with financial institutions to sell certain of our trade receivables and promissory notes from customers without recourse. During the three months ended December 31, 2005 and 2004, approximately $57 million and $64 million of receivables were sold under these arrangements, respectively. During the six months ended December 31, 2005 and 2004, approximately $111 million and $130 million of receivables were sold under these arrangements, respectively.
In addition, from time to time we will discount without recourse, Letters of Credit (“LCs”) received from customers in payment of goods. During the three months ended December 31, 2005, several LCs were sold with proceeds totaling $16 million. Discounting fees were $146,000 for the three months ended December 31, 2005. No LCs were sold during the three months ended December 31, 2004. During the six months ended December 31, 2005 and 2004, several LCs were sold with proceeds totaling $34 million and $10 million. Discounting fees were $291,000 and $44,000 for the six months ended December 31, 2005 and 2004, respectively.
We maintain certain open inventory purchase commitments with our suppliers to ensure a smooth and continuous supply chain for key components. Our liability in these purchase commitments is generally restricted to a forecasted time-horizon as mutually agreed upon between the parties. This forecast time-horizon can vary among different suppliers. We estimate our open inventory purchase commitment as of December 31, 2005 to be approximately $134 million. 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 cancelled. Certain agreements provide for potential cancellation penalties.
At December 31, 2005, our principal sources of liquidity consisted of $2.2 billion of cash, cash equivalents, and marketable securities. Our liquidity is affected by many factors, some of which are based on the normal ongoing operations of the business, and others of which relate to the uncertainties of global economies and the semiconductor and the semiconductor equipment industries. Although cash requirements will fluctuate based on the timing and extent of these factors, our management believes that cash generated from operations, together with the liquidity provided by existing cash balances, will be sufficient to satisfy our liquidity requirements for at least the next twelve months.
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Off-Balance Sheet Arrangements
We have no material off-balance sheet arrangements other than the significant contractual obligations fully disclosed in the Notes to our Condensed Consolidated Financial Statements.
CRITICAL ACCOUNTING ESTIMATES
The preparation of our 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. We based these estimates and assumptions on historical experience, and evaluate them on an on-going basis to ensure 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 the Company’s related disclosure in this Quarterly Report on Form 10-Q. The items in our financial statements requiring significant estimates and judgments are as follows:
Revenue Recognition We recognize revenue when persuasive evidence of an arrangement exists, the sale price is fixed or determinable, delivery has occurred or services rendered, and collectibility is reasonably assured. System revenue includes hardware and software that is incidental to the product. We generally recognize system revenue upon positive affirmation by the customer that the system has been installed and is operating according to pre-determined specifications. This positive affirmation is generally evidenced by an acceptance document signed by the customer. In certain cases, we deviate from the need for written acceptance and recognize system revenue upon shipment. Total revenue recognized under conditions where we deviate from the need for a written acceptance by the customer were approximately 2.6%, 3.2% and 9.4% of total revenue for the three months ended December 31, 2005, September 30, 2005 and December 31, 2004, respectively. Shipping charges billed to customers are included in system revenue and the related shipping costs are included in cost of revenues.
Revenue from software license fees is typically recognized upon shipment if collection of the resulting receivable is probable, the fee is fixed or determinable, and vendor-specific objective evidence exists to allocate a portion of the total fee to any undelivered elements of the arrangement. Such undelivered elements in these arrangements typically consist of services and/or upgrades. If vendor-specific objective evidence does not exist for the undelivered elements of the arrangement, all revenue is deferred until such evidence does exist, or until all elements are delivered, whichever is earlier. In instances where an arrangement to deliver software requires significant modification or customization, license fees are recognized under the percentage of completion method of contract accounting. Allowances are established for potential product returns and credit losses.
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 revenue is recognized ratably over the term of the maintenance contract. If maintenance is included in an arrangement, which includes a software license agreement, amounts related to maintenance are allocated based on vendor specific objective evidence. Consulting and training revenue is recognized when the related services are performed.
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.
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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 twelve months. Non-standard warranty is recognized ratably as revenue when the applicable warranty term period commences.
Inventory Reserves We review the adequacy of our inventory reserves on a quarterly basis. For production inventory, our methodology involves matching our on-hand and on-order inventory with our build forecast over the next twelve months. We then evaluate the parts found to be in excess of the twelve-month demand and take appropriate reserves to reflect the risk of obsolescence. For spare parts inventory, we match our on-hand inventory against twenty-four months of usage. We then evaluate the parts in excess of the twenty-four month usage and take appropriate reserves to reflect risk of obsolescence. Both methodologies are significantly affected by the usage assumption. The longer the time period of estimated usage, the lower the reserves are required. Based on our past experience, we believe the twelve-month/twenty-four month time periods best reflect the reasonable and relative obsolescence risks. If actual demand or usage were to be substantially lower than estimated, additional inventory adjustments for excess or obsolete inventory may be required, which could have a material adverse effect on our business, financial condition and results of operations. Inventory reserves, once established, are not reversed until the related inventory has been sold or scrapped.
Allowance for Doubtful Accounts A majority of our trade receivables are derived from sales to large multinational semiconductor manufacturers throughout the world. In order to monitor potential credit losses, we perform ongoing credit evaluations of our customers’ financial condition. An allowance for doubtful accounts is maintained for potential credit losses based upon our assessment of the expected collectibility of all accounts receivable. The allowance for doubtful accounts is reviewed periodically to assess the adequacy of the allowance. We take into consideration (1) any circumstances of which we are aware of a customer’s inability to meet its financial obligations; and (2) our judgments as to prevailing economic conditions in the industry and their impact on our customers. If circumstances change, and the financial condition of our customers were adversely affected resulting in their inability to meet their financial obligations to us, we may need to take additional allowances, which would result in a reduction of our net income.
Warranty We provide standard warranty coverage on our systems for 40 hours per week for twelve months, providing labor and parts necessary to repair the systems during the warranty period. We account for the estimated warranty cost as a charge to cost of revenues when revenue is recognized. The estimated warranty cost is based on historical product performance and field expenses. Utilizing actual service records, we calculate the average service hours and parts expense per system and apply the labor and overhead rates to determine the estimated warranty charge. We update these estimated charges every quarter. The actual product performance and/or field expense profiles may differ, and in those cases we adjust our warranty reserves accordingly. The difference between the estimated and actual warranty costs tends to be larger for new product introductions for which there is limited or no historical product performance on which to base the estimated warranty expense; more mature products with longer product performance histories tend to be more stable in our warranty charge estimates. Non-standard warranty generally includes services incremental to the standard 40-hour per week coverage for twelve months. Non-standard warranty is deferred as unearned revenue and is recognized ratably as revenue when the applicable warranty term period commences.
Stock-based Compensation We estimate the fair value of stock options using a Black-Scholes valuation model, consistent with the provisions of SFAS No. 123(R), SEC SAB No. 107 and our prior period pro forma disclosures of net earnings, including stock-based compensation (determined under a fair value method as prescribed by SFAS No.123). SFAS No. 123(R) requires the use of option pricing models that were not developed for use in valuing employee stock options. The Black-Scholes option-pricing model was developed for use in estimating the fair value of short-lived exchange traded options that have no vesting restrictions and are fully transferable. In addition, option-pricing models require the
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input of highly subjective assumptions, including the option’s expected life and the price volatility of the underlying stock. The expected stock price volatility assumption was determined using the implied volatility of the Company’s common stock. We determined that implied volatility is more reflective of market conditions and a better indicator of expected volatility than a blended volatility. Prior to the adoption of SFAS No. 123(R), we used a combination of historical and implied volatility in deriving its expected volatility assumption.
Contingencies and Litigation We are named from time to time as a party to various legal proceedings. While we currently believe the ultimate outcome of these proceedings will not have a material adverse effect on our financial position, results of operations or cash flows; the results of complex legal proceedings are difficult to predict. We would accrue the cost of an adverse judgment if, in our estimation, the adverse settlement is probable and we can reasonably estimate the ultimate cost to us. We have made no such accruals as of December 31, 2005.
Income Taxes We account for income taxes in accordance with Statement of Financial Accounting Standard No. 109, “Accounting for Income Taxes,” (SFAS No. 109) which requires that deferred tax assets and liabilities be recognized using enacted tax rates for the effect of temporary differences between the book and tax bases of recorded assets and liabilities. SFAS No. 109 also requires that deferred tax assets be reduced by a valuation allowance if it is more likely than not that a portion of the deferred tax asset will not be realized. We have determined that our future taxable income will be sufficient to recover all of our deferred tax assets. However, should there be a change in our ability to recover our deferred tax assets, we could be required to record a valuation allowance against our deferred tax assets. This would result in an increase to our tax provision in the period in which we determined that the recovery was not probable.
On a quarterly basis, we provide for income taxes based upon an annual effective income tax rate. The effective tax rate is highly dependent upon the geographic composition of worldwide earnings, tax regulations governing each region, availability of tax credits and the effectiveness of our tax planning strategies. We carefully monitor the changes in many factors and adjust our effective income tax rate on a timely basis. If actual results differ from these estimates, this could have a material effect on our financial condition and results of operations.
In addition, the calculation of our tax liabilities involves dealing with uncertainties in the application of complex tax regulations. We recognize liabilities for anticipated tax audit issues in the U.S. and other tax jurisdictions based on our estimate of whether, and the extent to which, additional tax payments are probable. If we ultimately determine that payment of these amounts is unnecessary, we reverse the liability and recognize a tax benefit during the period in which we determine that the liability is no longer necessary. We record an additional charge in our provision for taxes in the period in which we determine that the recorded tax liability is less than we expect the ultimate assessment to be.
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FACTORS AFFECTING RESULTS, INCLUDING RISKS AND UNCERTAINTIES
Fluctuations in Operating Results and Stock Price
Our operating results and stock price have varied widely in the past, and our future operating results will continue to be subject to quarterly variations based upon numerous factors, including those listed in this section and throughout this Quarterly Report on Form 10-Q. Our stock price will continue to be subject to daily variations as well. In addition, our future operating results and stock price may not follow any past trends. We believe the factors that could make our results fluctuate and difficult to predict include:
| • | our ability to successfully implement new systems; |
| • | the cyclical nature of the semiconductor industry; |
| • | global economic uncertainty; |
| • | changing international economic conditions; |
| • | competitive pressure; |
| • | our ability to develop and implement new technologies and introduce new products; |
| • | our ability to comply with internal controls evaluations and attestation requirements; |
| • | our customers’ acceptance and adoption of our new products and technologies; |
| • | our ability to maintain supply of key components; |
| • | our ability to manage our manufacturing requirements; |
| • | our reliance on services provided by third parties; |
| • | our ability to protect our intellectual property; |
| • | our ability to attract, retain, and replace key employees; |
| • | our ability to manage risks associated with acquisitions; |
| • | litigation; |
| • | worldwide political instability; |
| • | recently enacted and proposed changes in securities laws and regulations; |
| • | earthquake and other uninsured risks; |
| • | future changes in accounting and tax standards or practices; |
| • | changing regulatory environment; |
| • | our exposure to fluctuations in foreign currency exchange rates; and |
| • | our ability to guard against computer viruses |
Operating results also could be affected by sudden changes in customer requirements and other economic conditions affecting customer demand and the cost of operations in one or more of the global markets in which we do business. As a result of these or other factors, we could fail to achieve our expectations as to future revenue, gross profit and income from operations. Our failure to meet the performance expectations set and published by external sources could result in a sudden and significant drop in the price of our stock, particularly on a short-term basis, and could negatively affect the value of any investment in our stock.
Implementation of New Systems
We may experience difficulties with our new enterprise resource planning (“ERP”) system implemented as of February 7, 2005 that could disrupt our ability to timely and accurately process and report key components of the results of our consolidated operations, our financial position and cash flows. Any disruptions or difficulties that may occur in connection with this new ERP system or any future systems could also adversely affect our ability to complete the evaluation of our internal controls and attestation activities pursuant to Section 404 of the Sarbanes-Oxley Act of 2002. System failure or malfunctioning may result in disruption of operations and the inability to process transactions and could adversely affect our financial results. If we encounter unforeseen problems with regard to system operations or the new ERP system, we could be adversely affected.
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Semiconductor Equipment Industry Volatility
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. The timing, length and severity of the up-and-down cycles in the semiconductor equipment industry are difficult to predict. This cyclical nature of the industry in which we operate affects our ability to accurately predict future revenue and, thus, future expense levels. 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 a down cycle, 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. 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. If we fail to respond to industry cycles, our business could be seriously harmed.
Global Economic Uncertainty
Our business is ultimately driven by the global demand for electronic devices by consumers and businesses. The picture of end-user demand has been mixed over the last few months and visibility has been reduced as a result of high oil prices, the continued threat of terrorist activities and political instability in certain regions of the world. A protracted global economic slowdown may adversely affect our business and results of operations.
International Trade, Operations and Economic Conditions
We serve an increasingly global market. A majority of our annual revenue is derived from outside the United States, and we expect that international revenue will continue to represent a substantial percentage of our revenue. Our international revenue and operations are affected by economic conditions specific to each country and region. Because of our significant dependence on international revenue, a decline in the economies of any of the countries or regions in which we do business could negatively affect our operating results.
Managing global operations and sites located throughout the world presents challenges associated with, among other things, cultural diversity and organizational alignment. Moreover, each region in the global semiconductor equipment market exhibits unique characteristics that can cause capital equipment investment patterns to vary significantly from period to period. Periodic local or international economic downturns, trade balance issues, political instability or terrorism in regions where we have operations along with fluctuations in interest and currency exchange rates could negatively affect our business and results of operations. Although we attempt to manage near-term currency risks through the use of hedging instruments, there can be no assurance that such efforts will be adequate.
Competition
Our industry includes large manufacturers with substantial resources to support customers worldwide. Our future performance depends, in part, upon our ability to continue to compete successfully 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 us. 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 service 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.
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In addition, we face competition from smaller emerging semiconductor equipment companies whose strategy is to provide a portion of the products and services, similar to what we offer, using innovative technology to sell products into specialized markets. Loss of competitive position could negatively affect our prices, customer orders, revenue, gross margins, and market share, any of which would negatively affect our operating results and financial condition. Our failure to compete successfully with these other companies would seriously harm our business.
Technological Change and Customer Requirements
Success in the semiconductor equipment industry depends, in part, on continual improvement of existing technologies and rapid innovation of new solutions. For example, in the current semiconductor industry, the size of semiconductor devices continues to shrink and the industry is currently transitioning to the use of new materials and is innovating fab processes. While we expect these trends will increase our customers’ reliance on our diagnostic products, we cannot ensure that they 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 which 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. 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.
In this environment, we must continue to make significant investments in research and development in order to enhance the performance and functionality of our products, to keep pace with competitive products and to satisfy customer demands for improved performance, features and functionality. There can be no assurance that revenue from future products or product enhancements will be sufficient to recover the development costs associated with such products or enhancements or that we will be able to secure the financial resources necessary to fund future development. Substantial research and development costs typically are incurred before we confirm the technical feasibility and commercial viability of a product, and not all development activities result in commercially viable products. In addition, we cannot ensure 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.
Key Suppliers
We use a wide range of materials in the production of our products, including custom electronic and mechanical components, and we use numerous suppliers to supply these materials. We generally do not have guaranteed supply arrangements with our suppliers. Because of the variability and uniqueness of customers’ orders, we do not maintain an extensive inventory of materials for manufacturing. We seek to minimize the risk of production and service interruptions and/or shortages of key parts by selecting and qualifying alternative suppliers for key parts, monitoring the financial stability of key 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. Our business would be harmed if we do not receive sufficient parts to meet our production requirements in a timely and cost-effective manner.
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Manufacturing Disruption
Most of our manufacturing facilities are located in the United States, with a small operation located in Israel. Operations at our manufacturing facilities and our assembly subcontractors are subject to disruption for a variety of reasons, including work stoppages, acts of war, terrorism, fire, earthquake, energy shortages, flooding or other natural disasters. Such disruption could cause delays in shipments of products to our customers. We cannot ensure that alternate production capacity would be available if a major disruption were to occur or that, if it were available, it could be obtained on favorable terms. Such disruption could result in cancellation of orders or loss of customers and could seriously harm our business. We currently are in the initial stages of design and implementation of a new integrated financial and supply chain management system. Disruptions or delays in making changes to our integrated financial and supply chain management system could adversely impact our operations and our ability to forecast sales demand, ship products, manage our product inventory and record and report financial and management information on a timely and accurate basis.
Reliance on services provided by third parties
We outsource a number of services including our transportation and logistics management of spare parts 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, or our ability to quickly respond to changing market conditions. Disruptions or delays at our third-party service providers due to events such as regional economic, business, environmental, political, informational technology system failures, or military actions could adversely impact our operations and our ability to ship products, manage our product inventory and record and report financial and management information on a timely and accurate basis.
Intellectual Property Obsolescence and Infringement
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 technology that are similar or superior to our technology or may design around the patents we own, adversely affecting our business.
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.
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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. Our customary practice is to evaluate such 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, or instigation of litigation or other administrative proceedings could seriously harm our operating results and financial condition.
Key Employees
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 or retain additional highly qualified employees to meet our needs in the future, our business and operations could be harmed.
Acquisitions
In addition to our efforts to develop new technologies from internal sources, we also seek to 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. Acquisitions involve numerous risks, including management issues and costs in connection with the integration of the operations and personnel, technologies and products of the acquired companies, the possible write-downs of impaired assets, and the potential loss of key employees of the acquired companies. The inability to manage these risks effectively could seriously harm our business.
Litigation
From time to time we are involved in litigation of various types, including litigation alleging infringement of intellectual property rights and other claims. Litigation tends to be expensive and requires significant management time and attention and could have a negative effect on our results of operations or business if we lose or have to settle a case on significantly adverse terms.
Terrorism and Political Instability
The threat of terrorism targeted at the regions of the world in which we do business, including the United States, increases the uncertainty in our markets and may delay any recovery in the general economy. Any delay in the recovery of the economy and the semiconductor industry could adversely affect our business. Increased international political instability, as demonstrated by the September 2001 terrorist attacks, disruption in air transportation and further enhanced security measures as a result of the terrorist attacks, and the continuing instability in the Middle East, may hinder our ability to do business and may increase our costs of operations. Such continuing instability could 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 this international political instability continues or increases, 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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Increasing Costs Associated with Securities Laws and Regulations Compliance
Changes in and additions to the laws and regulations affecting public companies over the last four years, including the provisions of the Sarbanes-Oxley Act of 2002, have increased and will continue to increase our expenses as we evaluate the implications of these new rules and devote additional resources to comply with the new requirements. The Sarbanes- Oxley Act mandates, among other things, that companies adopt new and more extensive corporate governance measures and imposes comprehensive reporting and disclosure requirements, sets stricter independence and financial expertise standards for audit committee members and imposes increased civil and criminal penalties for companies, their chief executive officers and chief financial officers and directors for securities law violations. In particular, we will continue to incur additional administrative expense as we fulfill the requirements of Section 404 of the Sarbanes-Oxley Act, which requires management to report on, and our Independent Registered Public Accounting Firm to attest to, our internal control over financial reporting. In addition, The Nasdaq National Market, on which our common stock is listed, has also adopted comprehensive rules and regulations relating to corporate governance. These laws, rules and regulations have increased and will 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. We also expect these developments to make it more difficult and more expensive for us to obtain director and officer liability insurance in the future, and we may be required to accept reduced coverage or incur substantially higher costs to obtain coverage. Further, our board members, Chief Executive Officer and Chief Financial Officer could face an increased risk of personal liability in connection with the performance of their duties. As a result, we may have difficultly attracting and retaining qualified board members and executive officers, which would adversely affect our business.
Earthquake and Other Uninsured Risks
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 costs and cannot be mitigated with insurance. An earthquake could significantly disrupt our manufacturing operations, most of which are conducted in California. It could also significantly delay our research and engineering effort on new products, most 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 the 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.
Future Changes in Accounting and Taxation Standards or Practices
A change in accounting standards or practices or a change in existing taxation rules or practices can have a significant effect on our reported results and may even affect our reporting of transactions completed before the change is effective. New accounting pronouncements and taxation rules and varying interpretations of accounting pronouncements and taxation practice have occurred and may occur in the future. Changes to existing rules or the questioning of current practices may adversely affect our reported financial results or the way we conduct our business.
For example, the adoption of SFAS No. 123(R), 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 had a material impact on our consolidated financial statements, as reported under generally accepted accounting principles in the United States.
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Exposure to various risks related to the regulatory environment.
We are subject to various risks related to new, different, inconsistent or even conflicting laws, rules and regulations that may be enacted by legislative bodies and/or regulatory agencies in the countries in which we operate and with which we must comply.
Exposure to fluctuations in foreign currency exchange rates
We have some exposure to fluctuations in foreign currency exchange rates. We have international subsidiaries that operate and sell our products globally. We routinely hedge these exposures in an effort to minimize the impact of currency fluctuations. However, we may still be adversely affected by changes in foreign currency exchange rates or declining economic conditions in these countries.
Computer viruses may disrupt our operations
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. Any such event could have an adverse effect on our business, operating results, and financial condition.
Effects of Recent Accounting Pronouncements
In December 2004, the FASB issued SFAS No. 123 (revised 2004), “Share-Based Payment.” SFAS No. 123(R) which requires us to measure all employee stock-based compensation awards using a fair value method and record such expense in our consolidated financial statements. In March 2005, the SEC issued SAB 107, which provides the Staff’s views regarding interactions between SFAS No. 123(R) and certain SEC rules and regulations and provides interpretations of the valuation of share-based payments for public companies. The adoption of SFAS No. 123(R) requires additional accounting related to the income tax effects and additional disclosure regarding the cash flow effects resulting from share-based payment arrangements. The adoption of SFAS No. 123(R) during the first quarter of fiscal year 2006 had a material impact on our consolidated results of operations, financial position and statement of cash flows. For more information on stock-based compensation costs during the three months and six months ended December 31, 2005, refer to Note 6 “Stock Based Compensation” of the Notes to the Condensed Consolidated Financial Statements included in Item 1 of this quarterly report.
In June 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections”, a replacement of APB Opinion No. 20, “Accounting Changes”, and SFAS No. 3, “Reporting Accounting Changes in Interim Financial Statements”. SFAS No. 154 changes the requirements for the accounting for and reporting of a change in accounting principle. Previously, most voluntary changes in accounting principles were required recognition via a cumulative effect adjustment within net income of the period of the change. SFAS No. 154 requires retrospective application to prior periods’ financial statements, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. SFAS No. 154 is effective for accounting changes made in fiscal years beginning after December 15, 2005; however, the Statement does not change the transition provisions of any existing accounting pronouncements. The adoption of SFAS No. 154 did not have a material effect on our consolidated financial position, results of operations or cash flows.
In March 2005, the FASB published FASB Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations,” which clarifies that the term, conditional asset retirement obligation, as used in SFAS No. 143, “Accounting for Asset Retirement Obligations,” refers to a legal obligation to perform an asset retirement activity in which the timing and (or) method of settlement are conditional on a future event that may or may not be within the control of the entity. The uncertainty about the timing and (or) method of settlement of a conditional asset retirement obligation should be factored into the measurement of the liability when sufficient information exists. The interpretation also clarifies when an entity would have sufficient information to reasonably estimate the fair value of an asset retirement obligation. The adoption of this Interpretation did not have a material effect on our consolidated financial position, results of operations or cash flows.
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In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets, an amendment of APB Opinion No. 29. SFAS No. 153 addresses the measurement of exchanges of nonmonetary assets and redefines the scope of transactions that should be measured based on the fair value of the assets exchanged. SFAS No. 153 is effective for us for nonmonetary asset exchanges beginning in the first quarter of fiscal 2006. The adoption of SFAS No. 153 did not have a material effect on our consolidated financial position, results of operations or cash flows.
In November 2004, the FASB issued SFAS No. 151, “Inventory Costs, an amendment of ARB No. 43, Chapter 4”. SFAS No. 151 clarifies that abnormal inventory costs such as costs of idle facilities, excess freight and handling costs, and wasted materials (spoilage) are required to be recognized as current period charges. The provisions of SFAS No.151 are effective for the fiscal year beginning July 1, 2005. The adoption of SFAS No. 151 did not have a material impact on our consolidated financial position, results of operations and cash flows.
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ITEM 3. | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK |
We are exposed to financial market risks, including changes in interest rates, foreign currency exchange rates and marketable equity security prices. To mitigate these risks, we utilize derivative financial instruments. We do not use derivative financial instruments for speculative or trading purposes. All of the potential changes noted below are based on sensitivity analyses performed on our financial position at December 31, 2005. Actual results may differ materially.
As of December 31, 2005, we had an investment portfolio of fixed income securities of $1.3 billion, excluding those classified as cash and cash equivalents. These securities, as with all fixed income instruments, are subject to interest rate risk and will fall in value if market interest rates increase. If market interest rates were to increase immediately and uniformly by 10% from levels as of December 31, 2005, the fair value of the portfolio would have declined by $8 million.
As of December 31, 2005, we had net forward contracts to sell $336 million in foreign currency in order to hedge currency exposures (see Note 11 of the Notes to the Condensed Consolidated Financial Statements under “Derivative Instruments”). If we had entered into these contracts on December 31, 2005, the U.S. dollar equivalent would be $336 million. A 10% adverse move in all currency exchange rates affecting the contracts would decrease the fair value of the contracts by $45 million. However, if this occurred, the fair value of the underlying exposures hedged by the contracts would increase by a similar amount. Accordingly, we believe that the hedging of our foreign currency exposure should have no material impact on net income or cash flows.
ITEM 4. | CONTROLS AND PROCEDURES |
Evaluation of Disclosure Controls and Procedures and Related CEO and CFO Certifications
We conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures (Disclosure Controls) as of the end of the period covered by this Quarterly Report. The controls evaluation was conducted under the supervision and with the participation of management, including our Chief Executive Officer (CEO) and Chief Financial Officer (CFO). Based on this evaluation, our CEO and our CFO have concluded that our disclosure controls and procedures were effective as of the end of the period covered by this Quarterly Report to ensure that information we are required to disclose in reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.
Attached as exhibits to this Quarterly Report are certifications of the CEO and the CFO, which are required in accordance with Rule 13a-14 of the Securities Exchange Act of 1934, as amended (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 ensure that information required to be disclosed in our reports filed under the Exchange Act, such as this Quarterly Report, is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure Controls are also designed to ensure that such information is accumulated and communicated to our management, including the CEO and CFO, as appropriate to allow timely decisions regarding required disclosure. Our Disclosure Controls include components of our
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internal control over financial reporting, which consists of control processes designed to provide reasonable assurance regarding the reliability of our financial reporting and the preparation of financial statements in accordance with generally accepted accounting principles in the U.S. To the extent that components of our internal control over financial reporting are included within our Disclosure Controls, they are included in the scope of our quarterly controls evaluation.
Limitations on the Effectiveness of Controls
The Company’s management, including the CEO and CFO, does not expect that our Disclosure Controls or our 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 controls over financial reporting
There were no changes in our internal controls over financial reporting that occurred during the period covered by this Quarterly Report on Form 10-Q that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
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PART II. OTHER INFORMATION
We are named from time to time as a party to lawsuits in the normal course of our business. Litigation, in general, and intellectual property and securities litigation in particular, can be expensive and disruptive to normal business operations. Moreover, the results of complex legal proceedings are difficult to predict.
ITEM 2. | UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS |
Following is a summary of stock repurchases for the quarter ended December 31, 2005.(1)
Period | | Total Number of Shares (or Units) Purchased(2) | | Average Price Paid per Share (or Unit) | | Maximum Number
of Shares (or Units)
that May Yet Be
Purchased Under the
Plans or Programs(3) |
| |
| |
| |
|
October 1, 2005 to October 31, 2005 | | | 455,000 | | $ | 47.78 | | | 7,156,500 | |
November 1, 2005 to November 30, 2005 | | | 330,000 | | $ | 48.98 | | | 6,826,500 | |
December 1, 2005 to December 31, 2005 | | | 212,000 | | $ | 51.75 | | | 6,614,500 | |
| |
|
| |
|
| |
|
| |
Total | | | 997,000 | | $ | 49.02 | | | | |
| |
|
| |
|
| |
|
| |
|
(1) | In July 1997, the Board of Directors authorized KLA-Tencor to systematically repurchase shares of its common stock in the open market. This program was put into place in order to reduce the dilution that results from KLA-Tencor’s issuance of its shares pursuant to its employee benefit and incentive plans such as the stock option and employee stock purchase plans. Since the inception of the repurchase program in 1997 through December 31, 2005, the Board of Directors has authorized KLA-Tencor to repurchase a total of 27.8 million shares. All such shares remain as treasury shares and are retired. |
| |
(2) | All shares were purchased pursuant to the program publicly announced in July 1997 and as extended by the Board of Directors most recently in February 2005 by an additional 10.0 million shares. |
| |
(3) | The stock repurchase program has no expiration date. We intend to continue making further purchases under the stock repurchase program. |
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ITEM 4. | SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS |
The Annual Meeting of Stockholders of KLA-Tencor Corporation was held on November 4, 2005 at the Company’s offices in Milpitas, California. Of the 197,626,388 shares of Common Stock outstanding as of September 6, 2005 (the record date), 174,199,154 shares (88.14%) were present or represented by proxy at the meeting.
1. | The table below presents the results of the election to the Company’s board of directors. |
| | Votes for | | Votes Withheld | |
| |
|
| |
|
| |
Kenneth Levy | | | 169,282,397 | | | 4,916,756 | |
Jon D. Tompkins | | | 172,140,045 | | | 2,059,108 | |
Lida Urbanek | | | 165,135,799 | | | 9,063,354 | |
| The terms of Kenneth Levy, Jon D. Tompkins and Lida Urbanek as directors of the Company, continued after the meeting. |
| |
2. | The stockholders approved the Company’s Performance Bonus Plan. This proposal received 168,988,721 votes for; 4,274,568 votes against and 935,863 abstentions. |
| |
3. | The stockholders ratified the appointment of PricewaterhouseCoopers LLP as the Company’s independent accountants for the fiscal year ended June 30, 2006. This proposal received 170,296,027 votes for, 3,025,446 votes against and 877,680 abstentions. |
| |
4. | The stockholders approved the proposal for Majority Voting for Directors. This proposal received 94,154,544 votes for, 58,282,599 votes against and 1,308,286 abstentions. |
| 10.14 Amended and restated agreement by and between KLA-Tencor Corporation and Kenneth L. Schroeder* |
| |
| 10.15 KLA-Tencor Corporation Performance Bonus Plan* |
| |
| 31.1 Certification of Chief Executive Officer under Rule 13a-14(a) of the Securities Exchange Act of 1934. |
| |
| 31.2 Certification of Chief Financial Officer under Rule 13a-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. |
| |
|
|
| * Denotes a management contract, plan or arrangement |
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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) |
| |
| |
February 1, 2006 | /s/ RICHARD P. WALLACE |
(Date) |
|
| Richard P. Wallace |
| Chief Executive Officer |
| (Principal Executive Officer) |
| |
| |
February 1, 2006 | /s/ JEFFREY L. HALL |
(Date) |
|
| Jeffrey L. Hall |
| Senior Vice President and |
| Chief Financial Officer |
| (Principal Accounting Officer) |
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KLA-TENCOR CORPORATION
EXHIBIT INDEX
| | | | | Incorporated by Reference |
| | | | |
|
Exhibit
Number | | Exhibit Description | | Form | | File No. | | Exhibit
Number | | Filing Date |
| |
| |
| |
| |
| |
|
| 3.1 | | Amended and Restated Certificate of Incorporation | | 10-Q | | No. 000-09992 | | 3.1 | | May 14, 1997 |
| | | | | | | | | | | |
| 3.2 | | Certificate of Amendment of Amendment and Restated Certificate of Incorporation | | 10-Q | | No. 000-09992 | | 3.1 | | February 14, 2001 |
| | | | | | | | | | | |
| 3.3 | | Bylaws, as amended November 17, 1998 | | S-8 | | No. 333-68415 | | 3.2 | | December 4, 1998 |
| | | | | | | | | | | |
| 4.1 | | Amended and Restated Rights Agreement dated as of August 25, 1996 between the Company and First National Bank of Boston, as Rights Agent. The Agreement includes the Form of Right Certificate as Exhibit A and the Summary of Terms of Rights as Exhibit B | | 8-A/A, Amendment No. 2 | | No. 0-9992 | | 1 | | September 24, 1996 |
| | | | | | | | | | | |
| 10.1 | | 1998 Outside Director Option Plan* | | S-8 | | No. 333-68423 | | 10.1 | | December 4, 1998 |
| | | | | | | | | | | |
| 10.2 | | 1997 Employee Stock Purchase Plan* | | S-8 | | No. 333-45271 | | 10.2 | | January 30, 1998 |
| | | | | | | | | | | |
| 10.3 | | Tencor Instruments Amended and Restated 1993 Equity Incentive Plan | | S-8 | | No. 333-22939 | | 10.75 | | March 7, 1997 |
| | | | | | | | | | | |
| 10.4 | | Restated 1982 Stock Option Plan, as amended November 18, 1996* | | S-8 | | No. 333-22941 | | 10.74 | | March 7, 1997 |
| | | | | | | | | | | |
| 10.5 | | Excess Profit Stock Plan* | | S-8 | | No. 333-60883 | | 10.15 | | August 7, 1997 |
| | | | | | | | | | | |
| 10.6 | | Form of KLA-Tencor Corporation Corporate Officers Retention Plan* | | S-4 | | No. 333-23075 | | 10.2 | | March 11, 1997 |
| | | | | | | | | | | |
| 10.7 | | Form of Indemnification Agreement* | | 10-K | | No. 000-09992 | | 10.3 | | September 29, 1997 |
| | | | | | | | | | | |
| 10.8 | | Livermore Land Purchase and Sale Agreement | | 10-K | | No. 000-09992 | | 10.16 | | September 28, 2000 |
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| 10.9 | | Severance Agreement and General Release | | 10-K | | No. 000-09992 | | 10.9 | | August 30, 2004 |
| | | | | | | | | | | |
| 10.10 | | 2004 Equity Incentive Plan* | | Proxy | | No. 000-09992 | | Appendix A | | September 9, 2004 |
| | | | | | | | | | | |
| 10.11 | | Form of Option Agreement under 1998 Outside Director Option Plan* | | 8-K | | No. 000-09992 | | 10.1 | | October 18, 2004 |
| | | | | | | | | | | |
| 10.12 | | Blue29 Corporation 2003 Stock Incentive Plan* | | S-8 | | No. 333-120218 | | 10.1 | | November 4, 2004 |
| | | | | | | | | | | |
| 10.13 | | Agreement by and between KLA-Tencor Corporation and Kenneth L. Schroeder* | | 8-K | | No. 000-09992 | | 10.1 | | February 23, 2005 |
| | | | | | | | | | | |
| 10.14 | | Amended and restated agreement by and between KLA-Tencor Corporation and Kenneth L. Schroeder* | | | | | | | | |
| | | | | | | | | | | |
| 10.15 | | KLA-Tencor Corporation Performance Bonus Plan* | | | | | | | | |
| | | | | | | | | | | |
| 31.1 | | Certification of Chief Executive Officer under Rule 13a-14(a) of the Securities Exchange Act of 1934 | | | | | | | | |
| | | | | | | | | | | |
| 31.2 | | Certification of Chief Financial Officer under Rule 13a-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 | | | | | | | | |
| | | | | | | | | | | |
|
* Denotes a management contract, plan or arrangement |
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