Fitch Removes KLA-Tencor from Positive Watch and Affirms IDR at 'BBB-'; Outlook Positive

CHICAGO--()--Fitch Ratings has removed KLA-Tencor Corporation (KLA-Tencor) from Rating Watch Positive and affirmed the ratings including the Long-Term Issuer Default Rating (IDR) at 'BBB-'. The Rating Outlook is now Positive. Fitch's actions affect $3.6 billion of total debt, including the $500 million undrawn revolving credit facility (RCF). A full list of ratings follows at the end of this release.

Fitch's actions follow KLA-Tencor's termination of its merger agreement with Lam Research Corporation (Lam), as the Positive Watch incorporated Fitch's expectation that it would upgrade KLA-Tencor's ratings to 'BBB+' upon consummation of the transaction. The affirmation at 'BBB-' reflects the company's still elevated total leverage (total debt-to-operating EBITDA) on a standalone basis, while the Positive Outlook reflects Fitch's expectations for continued deleveraging over the next 12-24 months from a combination of voluntary debt reduction, which the company articulated it will make a priority, and profitability growth.

On Oct. 6, 2016, KLA-Tencor announced the termination of its merger agreement with Lam due to the U.S. Department of Justice advising KLA-Tencor and Lam it would not continue with a consent decree the parties had been negotiating. The deal would have combined technology and market share leaders in the process and process control segments of the semiconductor capital equipment industry, consolidating leading edge technology and research and development (R&D) platforms critical to the continuation of Moore's Law.

Fitch believes credit protection measures remain consistent with a 'BBB-' rating following the company's leveraged recapitalization in fiscal 2015. Fitch estimates total leverage of 2.8x for the fiscal year ended June 30, 2016, versus 3.8x for the prior fiscal year, due mostly to profitability growth but also a $117.5 million prepayment on the term loans. Solid revenue growth, driven by increasing complexity of yield challenges and higher profitability from operating leverage and restructuring actions drove solid FCF of $381.7 million (Fitch defined as after dividends), enabling debt reduction with domestic cash flow.

Fitch expects continued solid top-line performance through the cycle, driven by secular trends and likely share gains over time, given competitive advantages related to KLA-Tencor's R&D scale, installed base, and cumulative intellectual property (IP) portfolio. Profitability should remain cyclical, given operating leverage and sales mix variance, but structurally higher due to restructuring. In the near term, operating EBITDA margin should compress to the mid-30% range from a Fitch estimated 37% for fiscal 2016, due to restarting stalled projects and rebuilding certain administrative organizations depleted in anticipation of the merger.

KEY RATING DRIVERS

--Commitment to Technology Leadership: Fitch believes KLA-Tencor's commitment to maintaining technology leadership has resulted in R&D scale advantages, significant installed base and substantial cumulative IP. The company's technology leadership should continue to drive strong and growing market share positions in the process control market for semiconductors and higher mix of less volatile services revenues;

--Secular Growth Trends: Fitch believes secular long-term growth trends will drive low-single-digit revenue growth for the semiconductor capital equipment industry. Ever-increasing technological complexity (including FinFET, multi-patterning, 3D NAND), short life cycles for certain semiconductor markets products and increased outsourcing to foundry partners will drive demand, although within a cyclical context;

--FCF Through the Cycle: Fitch expects $250 million to $500 million of annual FCF through a typical cycle, driven by strong profitability from operating leverage in an upturn, working capital liquidation in a downturn, and structurally minimal capital intensity. Fitch also expects positive FCF in a severe downturn, as KLA-Tencor demonstrated by generating positive FCF in fiscal 2009, despite a 40% sales decline.

--Substantial R&D Intensity: Fitch expects KLA-Tencor's R&D intensity will remain significant and represent 17%-18% as a percentage of revenue. In the short term, the company can flex investments, but Fitch believes R&D is largely fixed over the longer term and is critical to maintaining its pace of innovation. KLA-Tencor spends more in annual R&D than the revenue of many of its competitors, which has resulted in substantial cumulative R&D and a meaningful competitive advantage.

--Substantial and Growing Customer Concentration: Fitch expects spending on the leading edge, which continues to be exponentially costly, will remain consolidated and has the potential to consolidate further. Fitch believes KLA-Tencor will continue to derive a significant amount of revenue from capital-spending leaders driving Moore's Law (Intel Corp., Samsung, and Taiwan Semiconductor Manufacturing Company Limited), resulting in top-line volatility. However, consolidation among customers below the top 3 could exacerbate volatility and constrain KLA-Tencor's pricing power.

KEY ASSUMPTIONS

Fitch's key assumptions within the rating case for KLA-Tencor include:

--Low- to mid-single-digit revenue growth through the cycle, supported by secular trends, growing backlog, expectations for share gains and growing services business. Fitch expects mid-single-digit revenue growth in the near term, supported by strong orders exiting fiscal 2016, although industry forecasts for negative semiconductor growth in calendar 2017 could result in more cautious capital spending;

--Operating EBITDA margins contract to mid-30% range in fiscal 2017, due to increased R&D and general and administrative (G&A) investments following the merger termination, offsetting higher revenue levels. Through the cycle, Fitch expects operating EBITDA margins will range from the low- to mid-30% range;

--Dividends grow 10% annually, while share repurchases are limited to offsetting dilution;

--KLAC uses domestic annual FCF, which Fitch estimates at $100 million to $150 million based upon sales mix and historical domestic liquidity patterns, to repay the term loan, resulting in total leverage in the company's target range of 2x-2.5x in the fiscal 2018-2019 period.

RATING SENSITIVITIES

Positive rating actions could occur if:

--KLAC continues using FCF for debt reduction, resulting in Fitch's near-term expectations for mid-cycle total leverage below 2.5x;

--Fitch expects mid-cycle operating EBITDA margin above 35%, reinforcing the company's technology leadership and pricing power within the context of escalating investment levels to support Moore's Law.

The Rating Outlook could be revised to Stable if:

--Operating performance underperforms meaningfully due to competitive concerns, resulting in FCF below Fitch's expected forecasted range of $250 million to $500 million;

--KLAC fails to use FCF for debt reduction resulting in total leverage sustained near 3x.

LIQUIDITY

Fitch expects liquidity will remain adequate and as of June 30, 2016 was supported by:

--$2.5 billion of cash, cash equivalents and marketable securities, although $1.7 billion was located outside the U.S.;

--Undrawn $500 million RCF expiring Nov. 2019.

Fitch also expects $250 million to $500 million of annual FCF to support liquidity.

Total debt at June 30, 2016 was $3.1 billion and consisted of:

--$250 million of 2.375% senior notes due Nov. 1, 2017;

--$250 million of 3.375% senior notes due Nov. 1, 2019;

--$500 million of 4.125% senior notes due Nov. 1, 2021;

--$1.25 billion of 4.65% senior notes due Nov. 1, 2024;

--$250 million of 5.65% senior notes due Nov. 1, 2034; and

--$576 million term loans due 2019, for which there are no scheduled payments in fiscal 2017-2018, since KLA-Tencor made $117.5 million of principal prepayments in fiscal 2016.

FULL LIST OF RATING ACTIONS

Fitch has affirmed the following ratings:

KLA-Tencor Corporation

--Long-Term Issuer Default Rating at 'BBB-';

--Senior unsecured term loan A at 'BBB-';

--Senior unsecured RCF at 'BBB-';

--Senior unsecured notes at 'BBB-'.

Date of Relevant Rating Committee: Oct. 17, 2016

Summary of Financial Statement Adjustments - Fitch made no financial statement adjustments that depart materially from those contained in the published financial statements of KLA-Tencor Corporation.

Additional information is available on www.fitchratings.com.

Applicable Criteria

Criteria for Rating Non-Financial Corporates (pub. 27 Sep 2016)

https://www.fitchratings.com/site/re/885629

Additional Disclosures

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https://www.fitchratings.com/creditdesk/press_releases/content/ridf_frame.cfm?pr_id=1013332

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https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1013332

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https://www.fitchratings.com/regulatory

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or
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or
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Contacts

Fitch Ratings
Primary Analyst
Jason Pompeii, +1 312-368-3210
Senior Director
70 W Madison St
Chicago IL 50502
or
Secondary Analyst
David Peterson, +1 312-368-3177
Senior Director
or
Committee Chairperson
Sharon Bonelli, +1 212-908-0581
Senior Director
or
Media Relations, New York
Elizabeth Fogerty, +1 212-908-0526
elizabeth.fogerty@fitchratings.com