Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion of our financial condition and results of operations should be read in conjunction with our Consolidated Financial Statements and the related notes included in Item 8, “Financial Statements and Supplementary Data,” in this Annual Report on Form 10-K. This discussion contains forward-looking statements, which involve risks and uncertainties. Our actual results could differ materially from those anticipated in the forward-looking statements as a result of certain factors, including but not limited to those discussed in Item 1A, “Risk Factors” and elsewhere in this Annual Report on Form 10-K. (See “Special Note Regarding Forward-Looking Statements.”)

CRITICAL ACCOUNTING ESTIMATES AND POLICIES

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 base these estimates and assumptions on historical experience, and evaluate them on an ongoing 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 Annual Report on Form 10-K. The accounting policies that reflect our more significant estimates, judgments and assumptions and which we believe are the most critical to aid in fully understanding and evaluating our reported financial results include the following:

Revenue Recognition. 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 we have demonstrated a history of successful installation and acceptance, we recognize revenue upon delivery and customer acceptance. Under certain circumstances, however, we recognize revenue 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% of the 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.

In many instances, products are sold in stand-alone arrangements. Services are sold separately through renewals of annual maintenance contracts. We have 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 each undelivered element 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.

We enter into volume purchase agreements with some of our customers. We accrue the estimated credits earned by our customers for such incentives, and in situations when the credit levels vary depending upon sales volume, we update our accrual based on the amount that we estimate will be purchased pursuant to the volume purchase agreements. Accruals for customer credits are recorded as an offset to revenue or deferred revenue.

Spare parts revenue is recognized when the parts have been shipped, risk of loss has passed to the customer and collection of the resulting receivable is reasonably assured.

Service and maintenance contract revenue is recognized ratably over the term of the maintenance contract. Revenue from services performed in the absence of a 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 software revenue recognition guidance. We periodically review selling prices to determine whether VSOE exists, and in 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 value of products that have been shipped and billed to customers which have not met our revenue recognition criteria, less applicable product and warranty costs. Deferred system profit does not include the profit associated with product shipments to certain customers in Japan, to whom title does not transfer until customer acceptance. Shipments to such 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.

Inventories. Inventories are stated at the lower of cost (on a first-in, first-out basis) or net realizable value. Net realizable value is the estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal and transportation. Demonstration units are stated at their manufacturing cost and written down to their net realizable value. We review and set standard costs semi-annually at current manufacturing costs in order to approximate actual costs. Our manufacturing overhead standards for product costs are calculated assuming full absorption of forecasted spending over projected volumes, adjusted for excess capacity. Abnormal inventory costs such as costs of idle facilities, excess freight and handling costs, and spoilage are recognized as current period charges. We write down product inventory based on forecasted demand and technological obsolescence and service spare parts inventory based on forecasted usage. These factors are impacted by market and economic conditions, technology changes, new product introductions and changes in strategic direction and require estimates that may include uncertain elements. Actual demand may differ from forecasted demand, and such differences may have a material effect on recorded inventory values.

Allowance for Doubtful Accounts. A majority of our accounts 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 probable credit losses based upon our assessment of the expected collectibility of the accounts receivable. The allowance for doubtful accounts is reviewed on a quarterly basis 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, such that the financial conditions of our customers are adversely affected and they are unable to meet their financial obligations to us, we may need to record additional allowances, which would result in a reduction of our net income.

Accounting for Stock-Based Compensation Plans. We account for stock-based awards granted to employees for services based on the fair value of those awards. The fair value of stock-based awards is measured at the grant date and is recognized as expense over the employee’s requisite service period. The fair value for restricted stock units granted without “dividend equivalent” rights is determined using the closing price of our common stock on the grant date, adjusted to exclude the present value of dividends which are not accrued on the restricted stock units. The fair value for restricted stock units granted with “dividend equivalent” rights is determined using the closing price of our common stock on the grant date. The award holder is not entitled to receive payments under dividend equivalent rights unless the associated restricted stock unit award vests (i.e., the award holder is entitled to receive credits, payable in cash or shares of our common stock, equal to the cash dividends that would have been received on the shares of our common stock underlying the restricted stock units had the shares been issued and outstanding on the dividend record date, but such dividend equivalents are only paid subject to the recipient satisfying the vesting requirements of the underlying award). Additionally, we estimate forfeitures based on historical experience and revise those estimates in subsequent periods if actual forfeitures differ from the estimated amounts. The fair value is determined using a Black-Scholes valuation model for purchase rights under our Employee Stock Purchase Plan. 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. The expected stock price volatility assumption is based on the market-based historical implied volatility from traded options of our common stock.

Contingencies and Litigation. We are subject to the possibility of losses from various contingencies. Considerable judgment is necessary to estimate the probability and amount of any loss from such contingencies. An accrual is made when it is probable that a liability has been incurred or an asset has been impaired and the amount of loss can be reasonably estimated. We accrue a liability and recognize as expense the estimated costs expected to be incurred over the next twelve months to defend or settle asserted and unasserted claims existing as of the balance sheet date. See Note 13, “Commitments and Contingencies” and Note 14, “Litigation and Other Legal Matters” to the Consolidated Financial Statements for additional details.

Goodwill and Intangible Assets. We assess goodwill for impairment annually as well as whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Long-lived purchased intangible assets are tested for impairment whenever events or changes in circumstances indicate that their carrying amounts may not be recoverable. See Note 6, “Goodwill and Purchased Intangible Assets” to the Consolidated Financial Statements for additional details. 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. We performed our annual qualitative assessment of the goodwill by reporting unit during the fiscal year ended June 30, 2018 and concluded that there was no impairment. There have been no significant events or circumstances affecting the valuation of goodwill subsequent to our annual impairment test. The next annual evaluation of the goodwill by reporting unit will be performed in the third quarter of the fiscal year ending June 30, 2019.

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 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 occur or, if it does, whether such charge would be material to our results of operations.

Income Taxes. We account for income taxes in accordance with the authoritative guidance, which requires income tax effects for changes in tax laws are recognized in the period in which the law is enacted.

Transition tax liability is recognized in the period when the change in the U.S. tax law was enacted and the income tax effects are recorded as a component of provision for income taxes from continuing operations. The calculation of the transition tax liability includes assumptions and reasonable estimates of the income tax effects and are based on provisional tax amounts. Several inputs were considered in the calculation, such as the calculation of the post-1986 foreign earnings and profit (“E&P”), income tax pools for all foreign subsidiaries, and the amount of those earnings held in cash and other specified assets. We applied the current interpretations from the U.S. federal and state governments and regulatory organization in our calculation of the transition tax liability and our reasonable estimate of the transition tax liability could change if further interpretations are provided for in the future. We expect to fully complete our provisional transition tax liability calculation within the reasonable measurement period allowed by the authoritative guidance.

Deferred tax assets and liabilities are recognized using enacted tax rates for the effect of temporary differences between the book and tax bases of recorded assets and liabilities. The guidance 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 a valuation allowance is necessary against a portion of the deferred tax assets, but we anticipate that our future taxable income will be sufficient to recover the remainder of our deferred tax assets. However, should there be a change in our ability to recover our deferred tax assets that are not subject to a valuation allowance, we could be required to record an additional valuation allowance against such deferred tax assets. This would result in an increase to our tax provision in the period in which we determine that the recovery is not probable.

On a quarterly basis, we provide for income taxes based upon an estimated 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. In accordance with the authoritative guidance on accounting for uncertainty in income taxes, we recognize liabilities for uncertain tax positions based on the two-step process. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates that it is more likely than not that the position will be sustained in audit, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount that is more than 50% likely of being realized upon ultimate settlement. We reevaluate these uncertain tax positions on a quarterly basis. This evaluation is based on factors including, but not limited to, changes in facts or circumstances, changes in tax law, effectively settled issues under audit and new audit activity. Any change in these factors could result in the recognition of a tax benefit or an additional charge to the tax provision.

Valuation of Marketable Securities. Our investments in available-for-sale securities are reported at fair value. Unrealized gains related to increases in the fair value of investments and unrealized losses related to decreases in the fair value are included in accumulated other comprehensive income (loss), net of tax, as reported on our Consolidated Statements of Stockholders’ Equity. However, changes in the fair value of investments impact our net income only when such investments are sold or an impairment charge is recognized. Realized gains and losses on the sale of securities are determined by specific identification of the security’s cost basis. We periodically review our investment portfolio to determine if any investment is other-than-temporarily impaired due to changes in credit risk or other potential valuation concerns, which would require us to record an impairment charge in the period during which any such determination is made. In making this judgment, we evaluate, among other things, the duration of the investment, the extent to which the fair value of an investment is less than its cost, the credit rating and any changes in credit rating for the investment, default and loss rates of the underlying collateral, structure and credit enhancements to determine if a credit loss may exist. Our assessment that an investment is not other-than-temporarily impaired could change in the future due to new developments or changes in our strategies or assumptions related to any particular investment.

Recent Accounting Pronouncements

For a description of recent accounting pronouncements, including those recently adopted and the expected dates of adoption as well as estimated effects, if any, on our consolidated financial statements of those not yet adopted, see Note 1, “Description of Business and Summary of Significant Accounting Policies” of the Notes to Consolidated Financial Statements.

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 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 advanced packaging, light emitting diode (“LED”), power devices, compound semiconductor, 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 hard disk drive manufacturers around the world. Our products, services and expertise are used by our customers to measure, detect, analyze and resolve critical product defects that arise in that environment in order to control nanometric level manufacturing processes. 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 or expansion plans. 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, particularly in the foundry and logic markets, which have higher levels of process control adoption than the memory market.

As we are a supplier to the global semiconductor and semiconductor-related industries, 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. In the global semiconductor related industries, China is emerging as a major region for manufacturing of logic and memory chips, adding to its role as the world’s largest consumer of ICs. Government initiatives are propelling China to expand its domestic manufacturing capacity and attracting semiconductor manufacturers from Taiwan, Korea, Japan and the US. China is currently seen as an important long-term growth region for the semiconductor capital equipment sector. We are also subject to the cyclical capital spending that has historically characterized the semiconductor and semiconductor-related industries. The timing, length, intensity and volatility of the capacity-oriented capital spending cycles of our customers are unpredictable.

The semiconductor industry has also been characterized by constant technological innovation. Currently, there are multiple drivers for growth in the industry with increased demand for chips providing computation power and connectivity for Artificial Intelligence (“AI”) applications and support for mobile devices at the leading edge of foundry and logic chip manufacturing. Qualification of early extreme ultraviolet (“EUV”) lithography processes and equipment is driving growth at leading logic/foundry and dynamic random-access memory (“DRAM”) manufacturers. Expansion of the Internet of Things (“IoT”) together with increasing acceptance of advanced driver assistance systems (“ADAS”) in anticipation of the introduction of autonomous cars have begun to accelerate legacy-node technology conversions and capacity expansions. Intertwined in these areas, spurred by data storage and connectivity needs, is the growth in demand for memory chips. On the other hand, higher design costs for the most advanced ICs could economically constrain leading-edge manufacturing technology customers to focus their resources on only the large technologically advanced products and applications. We believe that, over the long term, our customers will continue to invest in advanced technologies and new materials to enable smaller design rules and higher density applications that fuel demand for process control equipment, although the growth for such equipment may be adversely impacted by higher design costs for advanced ICs, reuse of installed products, and delays in production ramps by our customers in response to higher costs and technical challenges at more advanced technology nodes.

The demand for our products and our revenue levels are driven by our customers’ needs to solve the process challenges that they face as they adopt new technologies required to fabricate advanced ICs that are incorporated into sophisticated mobile devices. The timing for our customers in ordering and taking delivery of process control and yield management equipment is also determined by our customers’ requirements to meet the next generation production ramp schedules, and the timing for capacity expansion to meet end customer demand. Our earnings will depend not only on our revenue levels, but also on the amount of research and development spending required to meet our customers’ technology roadmaps. We have maintained production volumes and capacity to meet anticipated customer requirements and remain at risk of incurring significant inventory-related and other restructuring charges if business conditions deteriorate. Over the past year, our customers have taken delivery of higher volumes of process control equipment than they did in the previous year. However, any delay or push out by our customers in taking delivery of process control and yield management equipment may cause earnings volatility, due to increases in the risk of inventory related charges as well as timing of revenue recognition.

The following table sets forth some of our key consolidated financial information for each of our last three fiscal years:

	Year ended June 30,
(Dollar amounts in thousands, except diluted net income per share)	2018				2017				2016
Total revenues	$	4,036,701			$	3,480,014			$	2,984,493
Costs of revenues	$	1,447,369			$	1,287,547			$	1,163,391
Gross margin percentage	64		%		63		%		61		%
Net income	$	802,265			$	926,076			$	704,422
Diluted net income per share	$	5.10			$	5.88			$	4.49

Total revenues during the fiscal year ended June 30, 2018 increased by 16% compared to the fiscal year ended June 30, 2017. Our year over year revenue growth was primarily due to increases from sales of both our wafer inspection and patterning products as our customers continue to invest in process control and services, and an increase in the number of post-warranty systems installed at our customers’ sites over this time period for our service revenues.

Total revenues during the fiscal year ended June 30, 2017 increased by 17% compared to the fiscal year ended June 30, 2016. Our year over year revenue growth reflected increases from sales of both our inspection and metrology products as our customers continue to invest in process control and services. Increased revenues during the fiscal year ended June 30, 2017 were also driven by strong demand from our foundry customers and an increase in the number of post-warranty systems installed at our customers’ sites over this time period for our service revenues.

Proposed Merger with Orbotech, Ltd.

On March 18, 2018, we entered into an Agreement and Plan of Merger (the “Merger Agreement”) with Orbotech, Ltd. (“Orbotech”) pursuant to which we would acquire Orbotech for $38.86 in cash and 0.25 of a share of our common stock in exchange for each ordinary share of Orbotech, which at the time of announcement valued Orbotech at $3.2 billion in enterprise value. The merger contemplated by the Merger Agreement (the “Orbotech Merger”) is subject to receipt of required regulatory approvals and satisfaction of the other customary closing conditions. We intend to fund the cash portion of the purchase price with cash from the combined company's balance sheet.

In addition, we announced a $2 billion share repurchase authorization. The share repurchase program is targeted to be completed within 12 to 18 months following the close of this transaction. We intend to raise approximately $1 billion in new long-term debt financing to complete the share repurchase

For additional details, refer to Note 1 “Description of Business and Summary of Significant Accounting Policies” to the consolidated financial statements, and Item 1A, “Risk Factors”.

Revenues and Gross Margin

	Year ended June 30,
(Dollar amounts in thousands)	2018				2017				2016				FY18 vs. FY17							FY17 vs. FY16
Revenues:
Product	$	3,160,671			$	2,703,934			$	2,250,260			$	456,737			17	%		$	453,674			20	%
Service	876,030				776,080				734,233				99,950				13	%		41,847				6	%
Total revenues	$	4,036,701			$	3,480,014			$	2,984,493			$	556,687			16	%		$	495,521			17	%
Costs of revenues	$	1,447,369			$	1,287,547			$	1,163,391			$	159,822			12	%		$	124,156			11	%
Gross margin percentage	64		%		63		%		61		%		1		%					2		%

Product revenues

Our business is affected by the concentration of our customer base and our customers’ capital equipment procurement schedules as a result of their investment plans. Our product revenues in any particular period are significantly impacted by the amount of new orders that we receive during that period and, depending upon the duration of manufacturing and installation cycles, in the preceding period.

Product revenues increased by 17% in the fiscal year ended June 30, 2018 compared to the fiscal year ended June 30, 2017, primarily due to growth in revenues from our customers in Korea, China, and Japan. Our year over year increase in our product revenues were primarily driven by increased investments from our memory and wafer customers for next generation technology as well as capacity-related investments.

Product revenues increased by 20% in the fiscal year ended June 30, 2017 compared to the fiscal year ended June 30, 2016, primarily due to growth in revenues from our customers in Korea, Taiwan, and Europe & Israel. Our year over year increase in our product revenues were primarily driven by strong demand for our inspection and metrology products, increased investments by our foundry customers to support their new device architectures and, and sales of our next generation inspection products.

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 our 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 increased sequentially over the fiscal years ended June 30, 2016, 2017 and 2018, primarily as a result of an increase over time in the number of post-warranty systems installed at our customers’ sites over that time period.

Revenues - Top Customers

The following customers each accounted for more than 10% of our total revenues for the indicated periods:

Year ended June 30,
2018		2017		2016
Samsung Electronics Co., Ltd.		Samsung Electronics Co., Ltd.		Micron Technology, Inc.
		Taiwan Semiconductor Manufacturing Company Limited		Taiwan Semiconductor Manufacturing Company Limited

Revenues by region

Revenues by region for the periods indicated were as follows:

	Year ended June 30,
(Dollar amounts in thousands)	2018							2017							2016
Korea	$	1,178,601			29	%		$	688,094			20	%		$	367,905			12	%
China	643,033				16	%		412,098				12	%		430,074				14	%
Japan	638,358				16	%		351,202				10	%		444,216				15	%
Taiwan	636,363				16	%		1,104,307				32	%		894,557				30	%
North America	494,330				12	%		523,024				14	%		521,335				18	%
Europe & Israel	300,883				7	%		263,789				8	%		167,936				6	%
Rest of Asia	145,133				4	%		137,500				4	%		158,470				5	%
Total	$	4,036,701			100	%		$	3,480,014			100	%		$	2,984,493			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 table summarizes the major factors that contributed to the changes in gross margin percentage:

	Gross Margin Percentage
Fiscal year ended June 30, 2016	61.0	%
Revenue volume of products and services	1.5	%
Mix of products and services sold	0.6	%
Manufacturing labor, overhead and efficiencies	—	%
Other service and manufacturing costs	(0.1	)%
Fiscal year ended June 30, 2017	63.0	%
Revenue volume of products and services	0.8	%
Mix of products and services sold	0.9	%
Manufacturing labor, overhead and efficiencies	(0.4	)%
Other service and manufacturing costs	(0.2	)%
Fiscal year ended June 30, 2018	64.1	%

Changes in gross margin percentage driven by revenue volume of products and services 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 64.1% during the fiscal year ended June 30, 2018 from 63.0% during the fiscal year ended June 30, 2017, primarily due to a favorable mix of products and services sold, a higher revenue volume of products and services, and lower customer support costs, partially offset by higher manufacturing and service costs to support increased volume of product shipments.

Our gross margin increased to 63.0% during the fiscal year ended June 30, 2017 from 61.0% during the fiscal year ended June 30, 2016, primarily due to a higher revenue volume of products and services and a favorable mix of products and services sold, partially offset by other service and manufacturing costs.

Research and Development (“R&D”)

	Year ended June 30,
(Dollar amounts in thousands)	2018				2017				2016				FY18 vs. FY17							FY17 vs. FY16
R&D expenses	$	608,712			$	526,870			$	481,258			$	81,842			16	%		$	45,612			9	%
R&D expenses as a percentage of total revenues	15		%		15		%		16		%		—		%					(1		)%

R&D expenses may fluctuate with product development phases and project timing as well as our focused R&D efforts that are aligned with our overall business strategy. As technological innovation is essential to our success, we may incur significant costs associated with R&D projects, including compensation for engineering talent, engineering material costs, and other expenses.

R&D expenses during the fiscal year ended June 30, 2018 were higher compared to the fiscal year ended June 30, 2017, primarily due to an increase in employee-related expenses of $39.0 million as a result of additional engineering headcount, higher variable compensation, and higher employee benefit costs and an increase in engineering materials and supplies expenses of $32.7 million.

R&D expenses during the fiscal year ended June 30, 2017 were higher compared to the fiscal year ended June 30, 2016, primarily due to an increase in employee-related expenses of $25.4 million as a result of additional engineering headcount, higher variable compensation, and higher employee benefit costs, an increase in consulting expenses of $12.5 million, and an increase in engineering materials and supplies expenses of $9.9 million, partially offset by a decrease in depreciation expense of $7.3 million.

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 and focused 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”)

	Year ended June 30,
(Dollar amounts in thousands)	2018				2017				2016				FY18 vs. FY17							FY17 vs. FY16
SG&A expenses	$	443,426			$	389,336			$	379,399			$	54,090			14	%		$	9,937			3	%
SG&A expenses as a percentage of total revenues	11		%		11		%		13		%		—		%					(2		)%

SG&A expenses during the fiscal year ended June 30, 2018 were higher compared to the fiscal year ended June 30, 2017, primarily due to an increase in employee-related expenses of $36.5 million mainly as a result of additional headcount, higher variable compensation and employee benefit costs, an increase in Orbotech merger-related expense of $10.6 million, an increase in facilities-related expense of $4.8 million, and an increase in travel-related costs of $4.6 million, partially offset by $9.3 million of lower Lam Research Corporation merger-related expenses.

SG&A expenses during the fiscal year ended June 30, 2017 were higher compared to the fiscal year ended June 30, 2016, primarily due to an increase in consulting expenses of $7.1 million, an increase in employee-related expenses of $6.7 million mainly as a result of higher variable compensation and employee benefit costs, partially offset by a decrease in merger-related expenses of $6.6 million.

Restructuring Charges

During the fourth quarter of the fiscal year ended 2015, we announced a plan to reduce our global employee workforce to streamline our organization and business processes in response to changing customer requirements in its industry. The goals of this reduction were to enable continued innovation, direct our resources toward its best opportunities and lower our ongoing expense run rate.

We completed our global workforce reduction during the second quarter of the fiscal year ended June 30, 2017. Restructuring charges for the fiscal year ended June 30, 2017 was immaterial. Restructuring charges for the year ended June 30, 2016 were $8.9 million, of which $3.6 million were related to cost of revenues, $1.6 million to research and development expense and $3.7 million to selling, general and administrative expense lines of the consolidated statements of operations.

Interest Expense and Other Expense (Income), Net

	Year ended June 30,
(Dollar amounts in thousands)	2018				2017				2016
Interest expense	$	114,376			$	122,476			$	122,887
Other expense (income), net	$	(33,113	)		$	(19,461	)		$	(20,634	)
Interest expense as a percentage of total revenues	3		%		4		%		4		%
Other expense (income), net as a percentage of total revenues	1		%		1		%		1		%

The decrease in interest expense during the fiscal year ended June 30, 2018 compared to the fiscal year ended June 30, 2017, was primarily due to a $250.0 million repayment of the Senior Notes at maturity and prepayment of term loans.

During the fiscal year ended June 30, 2017 interest expense remained relatively unchanged compared to the fiscal year ended June 30, 2016.

Other expense (income), net is comprised primarily of 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, interest related accruals (such as interest and penalty accruals related to our tax obligations) and interest income earned on our investment and cash portfolio.

The increase in other expense (income), net during the fiscal year ended June 30, 2018 compared to the fiscal year ended June 30, 2017 was primarily due to an increase in interest income of $13.9 million and a decrease in accruals related to uncertain tax positions of $2.1 million, partially offset by a decrease in net gains from our investments in privately-held companies of $1.6 million.

The decrease in other expense (income), net during the fiscal year ended June 30, 2017 compared to the fiscal year ended June 30, 2016 was primarily due to an increase in interest accruals related to uncertain tax positions of $6.4 million, a decrease in net gains from our investments in privately-held companies of $3.6 million, partially offset by an increase in interest income of $8.8 million.

Provision for Income Taxes

The following table provides details of income taxes:

	Year ended June 30,
(Dollar amounts in thousands)	2018				2017				2016
Income before income taxes	$	1,455,931			$	1,173,246			$	858,192
Provision for income taxes	$	653,666			$	247,170			$	153,770
Effective tax rate	44.9		%		21.1		%		17.9		%

Our effective tax rate during the fiscal year ended June 30, 2018 was impacted by the Tax Cuts and Jobs Act (“the Act”), which was enacted into law on December 22, 2017. Income tax effects resulting from changes in tax laws are accounted for by us in accordance with the authoritative guidance, which requires that these tax effects be recognized in the period in which the law is enacted and the effects are recorded as a component of provision for income taxes from continuing operations. We have not fully completed our accounting for the tax effects of the enactment of the Act. As a result, we made an additional provision for income tax during the three months ended June 30, 2018 relating to the enactment of the Act.

This Act includes significant changes to the U.S. corporate income tax system which reduces the U.S. federal corporate tax rate from 35.0% to 21.0% as of January 1, 2018; shifts to a modified territorial tax regime which requires companies to pay a transition tax on earnings of certain foreign subsidiaries that were previously tax deferred; and creates new taxes on certain foreign-sourced earnings. The decrease in the U.S. federal corporate tax rate from 35.0% to 21.0% results in a blended statutory tax rate of 28.1% for the fiscal year ended June 30, 2018. The new taxes for certain foreign-sourced earnings under the Act are effective for the Company after the fiscal year ended June 30, 2018.

Tax expense was higher as a percentage of income before taxes during the fiscal year ended June 30, 2018 compared to the fiscal year ended June 30, 2017 primarily due to the impact of the following items:

•	Tax expense increased by $339.6 million during the fiscal year ended June 30, 2018 relating to a transition tax on the Company’s total post-1986 earnings and profits (“E&P”) which, prior to the enactment of the Act, was previously deferred from U.S. income taxes;

•	Tax expense increased by $102.1 million during the fiscal year ended June 30, 2018 relating to the re-measurement of the Company’s deferred tax assets and liabilities based on the Act’s new corporate tax rate of 21.0%; partially offset by

•	Tax expense decreased by $50.9 million relating to the reduction of the U.S. federal corporate tax rate from 35.0% to 28.1% for the fiscal year ended June 30, 2018.

As of June 30, 2018, we had not yet completed our accounting for the tax effects of the enactment of the Act. Our provision for income taxes for the fiscal year ended June 30, 2018 is based in part on a reasonable estimate of the effects on its transition tax and existing deferred tax balances. For the amounts which we were able to reasonably estimate, we recognized a provisional tax amount of $441.7 million for the fiscal year ended June 30, 2018. The provisional tax amount is included as a component of provision for income taxes from continuing operations. The components of the provisional tax amounts are as follows:

•

We recorded a provisional tax amount of $339.6 million for the transition tax liability. We will elect to remit the U.S. transition tax liability in installments over an eight-year period. We have not yet completed the calculation of the total post-1986 foreign E&P and the income tax pools for all foreign subsidiaries. Further, the transition tax is based in part on the amount of those earnings held in cash and other specified assets. This amount may change when we finalize the calculation of post-1986 foreign E&P previously deferred from U.S. federal and state governments and regulatory organizations may change the provisional tax liability or the accounting treatment of the provisional tax liability.

•

We recorded a provisional tax amount of $102.1 million to re-measure certain deferred tax assets and liabilities as a result of the enactment of the Act. We are still analyzing certain aspects of the Act and refining the estimate of the expected reversal of our deferred tax balances. This can potentially affect the measurement of these balances or potentially give rise to new deferred tax amounts.

The Act also includes provisions for Global Intangible Low-Taxed Income (“GILTI”) wherein taxes on foreign income are imposed in excess of a deemed return on tangible assets of foreign corporations. This income will effectively be taxed at a 10.5% tax rate in general. As a result, our deferred tax assets and liabilities are being evaluated if the deferred tax assets and liabilities should be recognized for the basis differences expected to reverse as a result of GILTI provisions that are effective for us after the fiscal year ending June 30, 2018, or should the tax on GILTI provisions be recognized in the period the Act was signed into law. Because of the complexity of the new provisions, we are continuing to evaluate on how the provisions will be accounted for under the U.S. generally accepted accounting principles wherein companies are allowed to make an accounting policy election of either (i) account for GILTI as a component of tax expense in the period in which we are subject to the rules (the “period cost method”), or (ii) account for GILTI in our measurement of deferred taxes (the “deferred method”). Currently, we have not elected a method and will only do so after our completion of the analysis of the GILTI provisions and our election method will depend, in part, on analyzing our global income to determine whether we expect to have future U.S. inclusions in our taxable income related to GILTI and, if so, the impact that is expected.

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

In the normal course of business, we are subject to examination by tax authorities throughout the world. We are under United States federal income tax examination for the fiscal year ended June 30, 2016. Although we believe our tax estimates are reasonable, the final determination of tax audits and any related litigation could be materially different from our historical income tax provisions and accruals. The results of an audit or litigation could have a material adverse effect on our results of operations or cash flows in the period or periods for which that determination is made.

Liquidity and Capital Resources

	As of June 30,
(Dollar amounts in thousands)	2018				2017				2016
Cash and cash equivalents	$	1,404,382			$	1,153,051			$	1,108,488
Marketable securities	1,475,936				1,863,689				1,382,806
Total cash, cash equivalents and marketable securities	$	2,880,318			$	3,016,740			$	2,491,294
Percentage of total assets	51		%		55		%		50		%
	Year ended June 30,
(In thousands)	2018				2017				2016
Cash flows:
Net cash provided by operating activities	$	1,229,120			$	1,079,665			$	759,696
Net cash provided by (used in) investing activities	291,618				(560,886		)		144,687
Net cash used in financing activities	(1,270,103		)		(472,805		)		(636,702		)
Effect of exchange rate changes on cash and cash equivalents	696				(1,411		)		2,782
Net increase in cash and cash equivalents	$	251,331			$	44,563			$	270,463

Cash and Cash Equivalents and Marketable Securities:

As of June 30, 2018, our cash, cash equivalents and marketable securities totaled $2.88 billion, which is a decrease of $136.4 million from June 30, 2017. The decrease is mainly due to the payment of $946.3 million for Senior Notes, term loans, and the borrowed amount under the Revolving Credit Facility, payment of dividends and dividend equivalents of $402.1 million, and stock repurchases of $203.2 million, partially offset by our cash generated from operations, proceeds from the Revolving Credit Facility, net of issuance costs, of $248.7 million, and net proceeds from marketable securities of $375.4 million. As of June 30, 2018, $1.93 billion of our $2.88 billion of cash, cash equivalents, and marketable securities were held by our foreign subsidiaries and branch offices. We have accrued U.S. federal taxes under the Tax Cut and Jobs Act and can repatriate these funds without incurring any additional U.S. federal tax other than if the U.S. dollar value of the funds increase. We currently intend to indefinitely reinvest $1.71 billion of the cash, cash equivalents and marketable securities held by our foreign subsidiaries. If, however, a portion of these funds were to be repatriated to the United States, we would be required to accrue and pay state and foreign taxes of approximately 1%-22% of the funds repatriated, in addition to the transition tax liability already computed on such balances. The amount of taxes due will depend on the amount and manner of the repatriation, as well as the location from which the funds are repatriated. We have accrued state and foreign tax on the remaining cash of $219.3 million of the$1.93 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.

Cash Dividends and Special Cash Dividend:

The total amount of regular quarterly cash dividends paid during the fiscal years ended June 30, 2018, 2017 and 2016 was $395.6 million, $335.4 million and $324.5 million, respectively. The increase in the amount of regular quarterly cash dividends paid during the fiscal year ended June 30, 2018 reflected the increase in the level of our regular quarterly cash dividend from $0.54 to $0.59 per share, and from $0.59 to $0.75 per share that were instituted during the three months ended September 30, 2017, and June 30, 2018, respectively. The amount of accrued dividends payable for regular quarterly cash dividends on unvested restricted stock units with dividend equivalent rights was $6.7 million and $4.8 million as of June 30, 2018 and 2017, respectively. These amounts will be paid upon vesting of the underlying unvested restricted stock units as described in Note 8, “Equity and Long-term Incentive Compensation Plans.”

On August 2, 2018, we announced that our Board of Directors had declared a quarterly cash dividend of $0.75 per share. Refer to Note 19, “Subsequent Events” to the consolidated financial statements for additional information regarding the declaration of our quarterly cash dividend announced subsequent to June 30, 2018.

On November 19, 2014, we declared a special cash dividend of $16.50 per share on our outstanding common stock which was paid on December 9, 2014 to our stockholders of record as of the close of business on December 1, 2014. Additionally, in connection with the special cash dividend, our Board of Directors and our Compensation Committee of our Board of Directors approved a proportionate and equitable adjustment to outstanding equity awards (restricted stock units and stock options) under the 2004 Equity Incentive Plan (the “2004 Plan”), as required by the 2004 Plan, subject to the vesting requirements of the underlying awards. As the adjustment was required by the 2004 Plan, the adjustment to the outstanding awards did not result in

any incremental compensation expense due to modification of such awards, under the authoritative guidance. The declaration and payment of the special cash dividend was part of our leveraged recapitalization transaction under which the special cash dividend was financed through a combination of existing cash and proceeds from the debt financing disclosed in Note 7, “Debt” that was completed during the three months ended December 31, 2014. As of the declaration date, the total amount of the special cash dividend accrued by us was approximately $2.76 billion, substantially all of which was paid out during the three months ended December 31, 2014, except for the aggregate special cash dividend of $43.0 million that was accrued for the unvested restricted stock units. As of June 30, 2018 and 2017, we had $2.8 million and $9.0 million, respectively, of accrued dividends payable for the special cash dividend with respect to outstanding unvested restricted stock units, which will be paid when such underlying unvested restricted stock units vest. We paid a special cash dividend with respect to vested restricted stock units during the fiscal years ended June 30, 2018, 2017 and 2016 of $6.4 million, $8.6 million and $21.8 million, respectively. Other than the special cash dividend declared during the three months ended December 31, 2014, we historically have not declared any special cash dividend.

Stock Repurchases:

The shares repurchased under our stock repurchase program have reduced our basic and diluted weighted-average shares outstanding for the fiscal years ended June 30, 2018 and 2017. The stock repurchase program is intended, in part, to offset shares issued in connection with the purchases under our ESPP program and the vesting of employee restricted stock units.

Fiscal Year 2018 Compared to Fiscal Year 2017

Cash Flows from Operating Activities:

We have historically financed our liquidity requirements through cash generated from operations. Net cash provided by operating activities during the fiscal year ended June 30, 2018 increased by $149.5 million compared to the fiscal year ended June 30, 2017, from $1.08 billion to $1.23 billion primarily as a result of the following key factors:

•	An increase in collections of approximately $533.0 million during the fiscal year ended June 30, 2018 compared to the fiscal year June 30, 2017, mainly driven by higher shipments;

•	An increase in interest income of approximately $14.0 million during the fiscal year ended June 30, 2018 compared to the fiscal year ended June 30, 2017, as U.S. dollar interest rates increased; partially offset by

◦	An increase in accounts payable payments of approximately $316.0 million during the fiscal year ended June 30, 2018 compared to the fiscal year ended June 30, 2017;

◦	An increase in income tax payments of $19.1 million during the fiscal year ended June 30, 2018 compared to the fiscal year ended June 30, 2017; and

◦	An increase in payroll and employee expenses of approximately $57.0 million during the fiscal year ended June 30, 2018 compared to the fiscal year ended June 30, 2017.

Cash Flows from Investing Activities:

Net cash provided by investing activities during the fiscal year ended June 30, 2018 was $291.6 million compared to net cash used by investing activities of $560.9 million during the fiscal year ended June 30, 2017. The change primarily resulted from net purchases of marketable securities of $492.8 million during the fiscal year ended June 30, 2017 compared to net liquidation of marketable securities of $375.4 million during the fiscal year ended June 30, 2018.

Cash Flows from Financing Activities:

Net cash used in financing activities during the fiscal year ended June 30, 2018 increased compared to the fiscal year ended June 30, 2017, from $472.8 million to $1.27 billion. Net cash used in financing activities were mainly impacted by:

•	An increase in the repayment of debt of $816.3 million during the fiscal year ended June 30, 2018 compared to the fiscal year ended June 30, 2017;

•	An increase in common stock repurchases of $178.2 million during the fiscal year ended June 30, 2018 compared to the fiscal year ended June 30, 2017

•	An increase in dividend and dividend equivalent payments of $58.1 million during the fiscal year ended June 30, 2018 compared to the fiscal year ended June 30, 2017, due to an increase in our quarterly dividend from $0.54 to $0.75 per share instituted during the fiscal year ended June 30, 2018, partially offset by

◦	An increase in proceeds from the Revolving Credit Facility, net of issuance costs of $248.7 million during the fiscal year ended June 30, 2018 compared to the fiscal year ended June 30, 2017.

Fiscal Year 2017 Compared to Fiscal Year 2016

Cash Flows from Operating Activities:

Net cash provided by operating activities during the fiscal year ended June 30, 2017 increased compared to the fiscal year ended June 30, 2016, from $759.7 million to $1.08 billion primarily as a result of the following key factors:

•	An increase in collections of approximately $567.0 million during the fiscal year ended June 30, 2017 compared to the fiscal year June 30, 2016, mainly driven by higher shipments;

•

The positive impact of our early adoption of the new accounting standard update for share-based payment awards to employees on a prospective basis during the fiscal year ended June 30, 2017, which no longer requires the excess tax benefit from share-based compensation to be shown as a reduction within cash flows from operating activities of $11.9 million compared to the fiscal ended June 30, 2016;

•	An increase in interest income of approximately $9.0 million during the fiscal year ended June 30, 2017 compared to the fiscal year ended June 30, 2016, as U.S. dollar interest rates increased; partially offset by

◦	An increase in accounts payable payments of approximately $71.0 million during the fiscal year ended June 30, 2017 compared to the fiscal year ended June 30, 2016;

◦	An increase in income tax payments of $129.0 million during the fiscal year ended June 30, 2017 compared to the fiscal year ended June 30, 2016, reflecting higher operating profits;

◦	An increase in payroll and employee expenses of approximately $85.0 million during the fiscal year ended June 30, 2017 compared to the fiscal year ended June 30, 2016, primarily due to a change in the timing of certain variable compensation payments; and

◦	Less unfavorable impacts from currency fluctuations of approximately $19.0 million during the fiscal year ended June 30, 2017 compared to the fiscal year ended June 30, 2016.

Cash Flows from Investing Activities:

Net cash used by investing activities during the fiscal year ended June 30, 2017 was $560.9 million compared to net cash provided by investing activities of $144.7 million during the fiscal year ended June 30, 2016. The change primarily resulted from net purchases of marketable securities of $493.2 million and cash used for a business acquisition of $28.6 million during the fiscal year ended June 30, 2018.

Cash Flows from Financing Activities:

Net cash used in financing activities during the fiscal year ended June 30, 2017 decreased compared to the fiscal year ended June 30, 2016, from $636.7 million to $472.8 million, primarily as a result of a decrease in common stock repurchases of $156.7 million and the impact of our early adoption of the new accounting standard update for share-based payment awards to employees on a prospective basis during the year ended June 30, 2017. This new standard no longer requires the excess tax benefit from share-based compensation to be shown as a cash inflow from financing activities, resulting in a change of $11.9 million from the year ended June 30, 2016.

Senior Notes:

In November 2014, we issued $2.50 billion aggregate principal amount of senior, unsecured long-term notes (collectively referred to as “Senior Notes”). We issued the Senior Notes as part of the leveraged recapitalization plan under which the proceeds from the Senior Notes in conjunction with the proceeds from the term loans (described below) and cash on hand were used (x) to fund a special cash dividend of $16.50 per share, aggregating to approximately $2.76 billion, (y) to redeem $750.0 million of 2018 Senior Notes, including associated redemption premiums, accrued interest and other fees and expenses and (z) for other general corporate purposes, including repurchases of shares pursuant to our stock repurchase program. The interest rate specified for each series of the Senior Notes will be subject to adjustments from time to time if Moody’s Investor Service, Inc. (“Moody’s”) or Standard & Poor’s Ratings Services (“S&P”) or, under certain circumstances, a substitute rating agency selected by us as a replacement for Moody’s or S&P, as the case may be (a “Substitute Rating Agency”), downgrades (or subsequently upgrades) its rating assigned to the respective series of Senior Notes such that the adjusted rating is below investment grade. If the adjusted rating of any series of Senior Notes from Moody’s (or, if applicable, any Substitute Rating Agency) is decreased to Ba1, Ba2, Ba3 or B1 or below, the stated interest rate on such series of Senior Notes as noted above will increase by 25 bps, 50 bps, 75 bps or 100 bps, respectively (“bps” refers to Basis Points and 1% is equal to 100 bps). If the rating of any series of Senior Notes from S&P (or, if applicable, any Substitute Rating Agency) with respect to such series of Senior Notes is decreased to BB+, BB, BB- or B+ or below, the stated interest rate on such series of Senior Notes as noted above will increase by 25 bps, 50 bps, 75 bps or 100 bps, respectively. The interest rates on any series of Senior Notes will permanently cease to be subject to any adjustment (notwithstanding any subsequent decrease in the ratings by any of Moody’s,

S&P and, if applicable, any Substitute Rating Agency) if such series of Senior Notes becomes rated “Baa1” (or its equivalent) or higher by Moody’s (or, if applicable, any Substitute Rating Agency) and “BBB+” (or its equivalent) or higher by S&P (or, if applicable, any Substitute Rating Agency), or one of those ratings if rated by only one of Moody’s, S&P and, if applicable, any Substitute Rating Agency, in each case with a stable or positive outlook. In October 2014, we entered into a series of forward contracts to lock the 10-year treasury rate (“benchmark rate”) on a portion of the Senior Notes with a notional amount of $1.00 billion in aggregate. For additional details, refer to Note 16, “Derivative Instruments and Hedging Activities” to the consolidated financial statements.

The original discount on the Senior Notes amounted to $4.0 million and is being amortized over the life of the debt. Interest is payable semi-annually on May 1 and November 1 of each year. The debt indenture (the “Indenture”) includes covenants that limit our ability to grant liens on its facilities and enter into sale and leaseback transactions, subject to certain allowances under which certain sale and leaseback transactions are not restricted. As of June 30, 2018, we were in compliance with all of the covenants under the Indenture associated with the Senior Notes.

Credit Facility (Term Loans and Unfunded Revolving Credit Facility) and Revolving Credit Facility:

In November 2014, we entered into $750.0 million of five-year senior unsecured prepayable term loans and a $500.0 million unfunded revolving credit facility (collectively, the “Credit Facility”).

In November 2017, we entered into a Credit Agreement (the “Credit Agreement”) providing for a $750.0 million five-year unsecured revolving credit facility (the “Revolving Credit Facility”), which replaced our prior Credit Facility. Subject to the terms of the Credit Agreement, the Revolving Credit Facility may be increased in an amount up to $250.0 million in the aggregate. We made borrowings of $250.0 million from the Revolving Credit Facility on the closing date, which were paid in full during the second half of the fiscal year ended June 30, 2018.

We may borrow, repay and reborrow funds under the Revolving Credit Facility until its maturity on November 30, 2022 (the “Maturity Date”), at which time such Revolving Credit Facility will terminate, and all outstanding loans under such facility, together with all accrued and unpaid interest, must be repaid. We may prepay the Revolving Credit Facility at any time without a prepayment penalty.

Borrowings under the Revolving Credit Facility will bear interest, at our option, at either: (i) the Alternative Base Rate (“ABR”) plus a spread, which ranges from 0 bps to 75 bps, or (ii) the London Interbank Offered Rate (“LIBOR”) plus a spread, which ranges from 100 bps to 175 bps. The spreads under ABR and LIBOR are subject to adjustment in conjunction with credit rating downgrades or upgrades. We are also obligated to pay an annual commitment fee on the daily undrawn balance of the Revolving Credit Facility, which ranges from 10 bps to 25 bps, subject to an adjustment in conjunction with changes to our credit rating. As of June 30, 2018, we elected to pay an annual commitment fee of 15 bps on the daily undrawn balance of the Revolving Credit Facility.

The Revolving Credit Facility requires us to maintain an interest expense coverage ratio as described in the Credit Agreement, on a quarterly basis, covering the trailing four consecutive fiscal quarters of no less than 3.50 to 1.00. In addition, we are required to maintain the maximum leverage ratio as described in the Credit Agreement, on a quarterly basis of 3.00 to 1.00, covering the trailing four consecutive fiscal quarters for each fiscal quarter, which can be increased to 4.00 to 1.00 for a period of time in connection with a material acquisition or a series of material acquisitions.

We were in compliance with the financial covenants under the Credit Agreement as of June 30, 2018 (the interest expense coverage ratio was 14.93 to 1.00 and the leverage ratio was 1.32 to 1.00). Considering our current liquidity position, short-term financial forecasts and ability to prepay the Revolving Credit Facility, if necessary, we expect to continue to be in compliance with our financial covenants at the end of our first quarter of the fiscal year ending June 30, 2019.

Contractual Obligations

The following is a schedule summarizing our significant obligations to make future payments under contractual obligations as of June 30, 2018:

	Fiscal year ending June 30,
(In thousands)	Total				2019				2020				2021				2022				2023				2024 and thereafter				Others
Debt obligations(1)	$	2,250,000			$	—			$	250,000			$	—			$	500,000			$	—			$	1,500,000			$	—
Interest payment associated with all debt obligations(2)	700,573				102,453				98,238				94,016				83,703				72,538				249,625				—
Purchase commitments(3)	530,783				525,729				4,509				490				55				—				—				—
Income taxes payable(4)	63,931				—				—				—				—				—				—				63,931
Operating leases	26,361				8,410				6,417				4,489				2,448				1,837				2,760				—
Cash long-term incentive program(5)	162,907				60,790				49,085				38,899				14,133				—				—				—
Pension obligations(6)	26,205				1,484				1,668				1,481				2,194				1,945				17,433				—
Executive Deferred Savings Plan(7)	199,505				—				—				—				—				—				—				199,505
Transition tax payable(8)	347,548				29,169				27,685				27,685				27,685				27,685				207,639				—
Other(9)	9,571				6,467				2,167				659				278				—				—				—
Total contractual cash obligations	$	4,317,384			$	734,502			$	439,769			$	167,719			$	630,496			$	104,005			$	1,977,457			$	263,436

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(1)	Represents $2.25 billion aggregate principal amount of Senior Notes due from fiscal year 2020 to fiscal year 2035.

(2)

The interest payments associated with the Senior Notes obligations included in the table above are based on the principal amount multiplied by the applicable coupon rate for each series of Senior Notes. Our future interest payments are subject to change if our then effective credit rating is below investment grade as discussed above. The interest payment under the Revolving Credit Facility for the undrawn balance is payable at 15 bps as a commitment fee based on the daily undrawn balance and we utilized the existing rate for the projected interest payments included in the table above. Our future interest payments for the Revolving Credit Facility is subject to change due to any upgrades or downgrades to our then effective credit rating.

(3)

Represents an estimate of significant commitments to purchase inventory from our suppliers as well as an estimate of significant purchase commitments associated with other goods and services in the ordinary course of business. 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. 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 the arrangements are renegotiated or canceled. Certain agreements provide for potential cancellation penalties.

(4)	Represents the estimated income tax payable obligation related to uncertain tax positions as well as related accrued interest. We are unable to make a reasonably reliable estimate of the timing of payments in individual years due to uncertainties in the timing of tax audit outcomes.

(5)	Represents the amount committed under our cash long-term incentive program. The expected payment after estimated forfeitures is approximately $132.2 million.

(6)	Represents an estimate of expected benefit payments up to fiscal year 2028 that was actuarially determined and excludes the minimum cash required to contribute to the plan. As of June 30, 2018, our defined benefit pension plans do not have material required minimum cash contribution obligations.

(7)	Represents the amount committed under our non-qualified executive deferred compensation plan. We are unable to make a reasonably reliable estimate of the timing of payments in individual years due to the uncertainties in the timing around participant’s separation and any potential changes that participants may decide to make to the previous distribution elections.

(8)	Represents our reasonable estimate of a provisional tax amount for the transition tax liability associated with our deemed repatriation of accumulated foreign earnings as a result from the enactment of the Tax Cuts and Jobs-Act into law on December 22, 2017.

(9)

Represents amounts committed for accrued dividends payable, substantially all of which are for the special cash dividend for the unvested restricted stock units as of the dividend record date as well as quarterly cash dividends for unvested restricted stock units granted with dividend equivalent rights. For additional details, refer to Note 8, “Equity and Long-term Incentive Compensation Plans,” to the Consolidated Financial Statements.

We have adopted a cash-based long-term incentive (“Cash LTI”) program for many of our employees as part of our employee compensation program. Cash LTI awards issued to employees under the Cash Long-Term Incentive Plan (“Cash LTI Plan”) generally vest in three or four equal installments, with one-third or one-fourth of the aggregate amount of the Cash LTI award vesting on each yearly anniversary of the grant date over a three or 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 and services.

The following table shows total receivables sold under factoring agreements and proceeds from sales of LCs for the indicated periods:

	Year ended June 30,
(In thousands)	2018				2017				2016
Receivables sold under factoring agreements	$	217,462			$	152,509			$	205,790
Proceeds from sales of LCs	$	5,511			$	48,780			$	21,904

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

We maintain guarantee arrangements available through various financial institutions for up to $22.4 million, of which $15.6 million had been issued as of June 30, 2018, primarily to fund guarantees to customs authorities for value-added tax (“VAT”) and other operating requirements of our subsidiaries in Europe and Asia.

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 13, “Commitments and Contingencies” to the Consolidated Financial Statements for additional details.

Working Capital:

Working capital was $3.33 billion as of June 30, 2018, which is an increase of $232.0 million compared to our working capital as of June 30, 2017. As of June 30, 2018, our principal sources of liquidity consisted of $2.88 billion of cash, cash equivalents and marketable securities. Our liquidity may be affected by many factors, some of which are based on the normal ongoing operations of the business, spending for business acquisitions including the pending acquisition of Orbotech, and other factors such as uncertainty in the global and regional economies 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 and our $750.0 million Revolving Credit Facility, will be sufficient to satisfy our liquidity requirements associated with working capital needs, capital expenditures, cash dividends, stock repurchases and other contractual obligations, including repayment of outstanding debt, for at least the next 12 months.

Our credit ratings as of June 30, 2018 are summarized below:

Rating Agency	Rating
Fitch	BBB+
Moody’s	Baa2
Standard & Poor’s	BBB

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

Off-Balance Sheet Arrangements

Under our foreign currency risk management strategy, we utilize derivative instruments to protect our earnings and cash flows 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 16, “Derivative Instruments and Hedging Activities” to the Consolidated Financial Statements for additional details). Our outstanding foreign currency hedge contracts, with maximum remaining maturities of approximately ten months as of June 30, 2018 and 2017, were as follows:

	As of June 30,
(In thousands)	2018				2017
Cash flow hedge contracts- foreign currency
Purchase	$	8,116			$	19,305
Sell	$	115,032			$	128,672
Other foreign currency hedge contracts
Purchase	$	130,442			$	165,563
Sell	$	154,442			$	118,504

In October 2014, we entered into a series of forward contracts (“Rate Lock Agreements”) to lock the benchmark rate on a portion of the Senior Notes. The Rate Lock Agreements had a notional amount of $1.00 billion in aggregate which matured in the second quarter of the fiscal year ended June 30, 2015. The Rate Lock Agreements were terminated on the date of pricing of the $1.25 billion of 4.650% Senior Notes due in 2024 and we recorded the fair value of $7.5 million as a gain within accumulated other comprehensive income (loss) as of December 31, 2014.We recognized $0.8 million for each of the fiscal years ended June 30, 2018, 2017 and 2016, for the amortization of the gain recognized in accumulated other comprehensive income (loss), which amount reduced the interest expense. As of June 30, 2018, the unamortized portion of the fair value of the forward contracts for the rate lock agreements was $4.8 million.

During the three months ended June 30, 2018, we entered into a series of forward contracts (the “2018 Rate Lock Agreements”) to lock the benchmark interest rate prior to expected debt issuances. The objective of the 2018 Rate Lock Agreements was to hedge the risk associated with the variability in interest rates due to the changes in the benchmark rate leading up to the closing of the intended financing, on the notional amount being hedged. The 2018 Rate Lock Agreement had a notional amount of $500.0 million in aggregate with contract maturity dates in the first half of the fiscal year ending June 30, 2019. Each forward contract will be closed on the earlier of the completion date of pricing of the portion of the intended debt being hedged or the expiration date. We designated each of the 2018 Rate Lock Agreements as a qualifying hedging instrument to be accounted for as a cash flow hedge, under which the effective portion of the gain or loss on the derivative is reported as a component of accumulated other comprehensive income (loss) (“OCI”), and subsequently amortized into earnings as a component of interest expenses over the term of the underlying debt. The ineffective portion, if any, will be recognized in earnings immediately. The fair market value of the 2018 Rate Lock Agreements outstanding as of the fiscal year ended June 30, 2018 was $4.9 million.

Indemnification Obligations. 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 commitments on pricing, tool reliability, spare parts stocking levels, service response time and other commitments. 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 significant 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.

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.