Fitch Downgrades KLA-Tencor to 'BBB-' on Leveraged Recapitalization; Outlook Stable

Fitch Ratings has downgraded the ratings for KLA-Tencor Corporation (KLA-Tencor) to 'BBB-' from 'BBB'. The action follows the company's announcement that it will issue $3.25 billion of incremental debt in connection with a leveraged recapitalization transaction (the transaction). The Rating Outlook is Stable. The rating actions affect approximately $4 billion of total debt, pro forma for the completion of the transaction. A full list of rating actions follows at the end of this release.

The rating actions reflect KLA-Tencor's weakened credit protection measures, pro forma for the transaction. Fitch estimates total leverage (total debt to operating EBITDA) will increase to approximately 4x for the latest 12 months (LTM) ended Sept. 30, 2014, pro forma for the transaction, versus 1x prior to the transaction. Fitch believes the higher leverage weakly positions KLA-Tencor's credit profile within the 'BBB-' rating. However, Fitch anticipates increased complexity for semiconductor makers will drive solid operating performance over the intermediate term and result in total leverage below 3x in fiscal 2017.

KLA-Tencor plans to issue $3.25 billion of incremental debt, consisting of senior unsecured notes and a pre-payable term loan facility. The company will use net proceeds, along with cash on hand, to fund a $2.75 billion special dividend payable by the end of calendar 2014 and $250 million of incremental share repurchases within 12 to 18 months.

The incremental stock buyback authorization is in addition to existing share repurchase program authorizations, under which approximately 13.3 million of shares were available for repurchase as of Sept. 30, 2014. KLA-Tencor also will enter into a senior unsecured revolving credit facility to further support domestic liquidity.

The transaction represents the company's effort to return growing cash balances to current long-term shareholders on a one time basis. Fitch believes the company's operating model could support a non-investment grade rating, given KLA-Tencor's critical value to the semiconductor supply chain. However, KLA-Tencor remains committed to managing its long-term capital structure for an investment grade rating, and Fitch anticipates mid-cycle total leverage below 3x over the longer-term.

The senior notes and term loan and revolving credit facility all are rated at 'BBB-' given Fitch's belief the credit support provided by a domestic subsidiaries guarantee benefitting only the term loan and revolving credit facility is de minimis. Nonetheless, Fitch also believes notching could be appropriate were the IDR to fall below investment grade or the financial contribution of domestic subsidiaries became material.

Fitch expects solid operating results through the cycle, driven by yield challenges associated with increased complexity. The continuation of a multi-year technology upgrade cycle by leading edge semiconductor makers will drive strong near-term results. Beyond the near term, operating performance will remain cyclical.

KLA-Tencor is on track to meet Fitch's expectation for high single to low double digit revenue growth in calendar 2014, driven by higher semiconductor capital spending. Capital investments are projected to be up 10% for the year. Intel Corp.'s transition to 20 nanometer (nm), foundries' 3D technologies pilot programs, memory's technology upgrades and DRAM capacity additions are driving top line growth.

Fitch remains concerned with lower profitability trends for the business and estimates operating EBITDA margin just above 30%, versus levels approaching 40% in fiscal 2011-2012. An increasing sales mix to less profitable memory makers in recent years and research and development (R&D) investment growth outpacing that of the top line are driving profit margin lower. Given increasing complexity around multi-tiered structures, 450mm wafers, FinFET and advanced packaging, R&D investments have intensified and should remain elevated.

KEY RATINGS DRIVERS

The ratings on KLA-Tencor continue to be supported by:

--The company's technology leadership resulting in strong market share positions in the process control market for semiconductors and a growing mix of less volatile services revenues;

--Secular long-term growth trends, including increased technological complexity and shortened life cycles for semiconductor products (Moore's Law) and increased outsourcing to foundry partners;

--More than $250 million of annual free cash flow (FCF) through a typical cycle, driven by solid profitability and minimal capital intensity. Lower receivables and inventory support FCF in a downturn, as was the case in fiscal 2009 and fiscal 2013 when KLA-Tencor generated positive FCF while sales declined 40% and 10%, respectively.

Fitch's ratings concerns focus on:

--KLA-Tencor's need for substantial ongoing investments in R&D and sales and marketing, each of which Fitch believes will continue to represent 10% - 20% of revenues (although capital spending for semiconductor equipment makers is comparatively low) to maintain technology and market leadership;

--Substantial customer concentration with expectations for ongoing customer consolidation, particularly at the leading edge;

--The highly cyclical demand patterns associated with the semiconductor equipment market.

Negative rating actions could occur if:

--KLA-Tencor does not use FCF, beyond the contemplated share repurchase programs, for debt reduction, resulting in expectations for a prolonged period of total leverage above 3x and suggesting a shift in financial policies;

--Structurally lower profitability and FCF from reduced pricing power or elevated R&D, resulting in expectations for a prolonged period of total leverage above 3x.

Positive rating action is unlikely until near-term total leverage returns to and remains below 3x.

As of Sept. 30, 2014, Fitch believes KLA-Tencor's liquidity was solid and supported by approximately 3 billion of cash, cash equivalents, and marketable securities (the majority of which was located in the U.S.). Pro forma for the transaction, the company's new revolving credit facility and $250 million to $750 million of annual FCF also will support liquidity.

Total debt was $750 million as of Sept. 30, 2014, consisting of $750 million of 6.9% of senior notes due 2018.

Fitch downgrades KLA-Tencor as follows:

--IDR to 'BBB-' from 'BBB';

--Senior unsecured debt to 'BBB-' from 'BBB'.

Fitch assigns the following ratings related to the leveraged recapitalization:

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

--Senior unsecured revolving credit facility at 'BBB-';

--Senior unsecured notes at 'BBB-'.

Additional information is available at 'www.fitchratings.com'.

Applicable Criteria and Related Criteria:

--'Corporate Rating Methodology' (May 28, 2014).

Applicable Criteria and Related Research:

Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=749393

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=906634

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