QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2012
or
£
TRANSITION REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission File Number 000-09992
KLA-Tencor Corporation
(Exact name of registrant as specified in its charter)
Delaware
04-2564110
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
One Technology Drive, Milpitas, California
95035
(Address of Principal Executive Offices)
(Zip Code)
(408) 875-3000
(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No £
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No £
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer x
Accelerated filer £
Non-accelerated filer £
Smaller reporting company £
(Do not check if a smaller reporting company)
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes £ No x
As of April 12, 2012, there were 167,327,833 shares of the registrant’s Common Stock, $0.001 par value, outstanding.
Notes to Condensed Consolidated Financial Statements
(Unaudited)
NOTE 1 – BASIS OF PRESENTATION
Basis of Presentation. The condensed consolidated financial statements have been prepared by KLA-Tencor Corporation (“KLA-Tencor” or the “Company”) pursuant to the rules and regulations of the U.S. Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations. In the opinion of management, the unaudited interim financial statements reflect all adjustments (consisting only of normal, recurring adjustments) necessary for a fair statement of the financial position, results of operations and cash flows for the periods indicated. These financial statements and notes, however, should be read in conjunction with Item 8, “Financial Statements and Supplementary Data” included in the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2011, filed with the SEC on August 5, 2011.
The condensed consolidated financial statements include the accounts of KLA-Tencor and its majority-owned subsidiaries. All significant intercompany balances and transactions have been eliminated.
The results of operations for the three and nine months ended March 31, 2012 are not necessarily indicative of the results that may be expected for any other interim period or for the full fiscal year ending June 30, 2012.
Certain reclassifications have been made to the prior year’s Condensed Consolidated Balance Sheet and notes to conform to the current year presentation. The reclassifications had no effect on the Condensed Consolidated Statements of Operations or Cash Flows.
Management Estimates. The preparation of the condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the condensed consolidated financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates.
Recent Accounting Pronouncements. In December 2011, the Financial Accounting Standards Board (“FASB”) issued an accounting standard update requiring enhanced disclosure about certain financial instruments and derivative instruments that are offset in the balance sheet or subject to an enforceable master netting arrangement or similar agreement. The disclosure requirement becomes effective retrospectively in the first quarter of the Company's fiscal year ending June 30, 2014. The Company does not expect that the requirement will have an impact on its financial position, results of operations or cash flows as it is disclosure-only in nature.
In September 2011, the FASB issued an accounting standard update intended to simplify testing goodwill for impairment. The amendments allow an entity to first assess qualitative factors to determine whether it is necessary to perform the two-step quantitative goodwill impairment test. An entity will no longer be required to calculate the fair value of a reporting unit unless the entity determines, based on a qualitative assessment, that it is more likely than not that the fair value of the reporting unit is less than its carrying amount. The amendment becomes effective for annual and interim goodwill impairment tests performed for the Company's fiscal year ending June 30, 2013, and early adoption is permitted. The Company elected to early adopt this accounting guidance at the beginning of the three months ended December 31, 2011 (see Note 5, “Goodwill and Purchased Intangible Assets,” for a detailed description).
In June 2011, the FASB issued an accounting standard update requiring an increase in the prominence of items reported in other comprehensive income. The amendment eliminates the option to present components of other comprehensive income as part of the statement of changes in stockholders' equity and requires that the total of comprehensive income, the components of net income, and the components of other comprehensive income be presented in a single continuous statement of comprehensive income or in two separate but consecutive statements. The amendment also required presentation of adjustments for items that are reclassified from other comprehensive income in the statement where the components of net income and the components of other comprehensive income are presented, which was indefinitely deferred by the FASB in December 2011. The amendment (other than the portion regarding the presentation of reclassification adjustments which, as noted above, has been deferred indefinitely) becomes effective during the first quarter of the Company's fiscal year ending June 30, 2013. Early adoption is permitted. The amendment will impact the presentation of the financial statements but will not have an impact on the Company's financial position, results of operations or cash flows.
In May 2011, the FASB issued an accounting standard update providing guidance on achieving a consistent definition of and common requirements for measurement of fair value between U.S. GAAP and International Financial Reporting Standards (“IFRS”). This amendment was effective prospectively for the Company's interim reporting period ended March 31, 2012. Early application is not permitted. The amendment did not have an impact on the Company's financial position, results of operations or cash flows.
NOTE 2 – FAIR VALUE MEASUREMENTS
The Company’s financial assets and liabilities are measured and recorded at fair value, except for equity investments in privately-held companies. These equity investments are generally accounted for under the cost method of accounting and are periodically assessed for other-than-temporary impairment when an event or circumstance indicates that an other-than-temporary decline in value may have occurred. The Company’s non-financial assets, such as goodwill, intangible assets, and land, property and equipment, are recorded at cost and are assessed for impairment when an event or circumstance indicates that an other-than-temporary decline in value may have occurred.
Fair Value Hierarchy. The authoritative guidance for fair value measurements establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy are described below:
Level 1
Valuations based on quoted prices in active markets for identical assets or liabilities that the entity has the ability to access.
Level 2
Valuations based on quoted prices for similar assets or liabilities, quoted prices in markets that are not active, or other inputs that are observable or can be corroborated by observable data for substantially the full term of the assets or liabilities.
Level 3
Valuations based on inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.
A financial instrument’s level within the fair value hierarchy is based on the lowest level of any input that is significant to the fair value measurement.
All of the Company’s financial instruments were classified within Level 1 or Level 2 of the fair value hierarchy as of March 31, 2012, because they were valued using quoted market prices, broker/dealer quotes, or alternative pricing sources with reasonable levels of price transparency. The types of instruments valued based on quoted market prices in active markets include money market funds, U.S. Government agency securities and certain U.S. Treasury securities and sovereign securities. Such instruments are generally classified within Level 1 of the fair value hierarchy.
The types of instruments valued based on other observable inputs include commercial paper, corporate debt securities, municipal securities and certain U.S. Treasury securities and sovereign securities. The market inputs used to value these instruments generally consist of market yields, reported trades and broker/dealer quotes. Such instruments are generally classified within Level 2 of the fair value hierarchy.
The principal market in which the Company executes its foreign currency contracts is the institutional market in an over-the-counter environment with a relatively high level of price transparency. The market participants usually are large commercial banks. The Company’s foreign currency contracts’ valuation inputs are based on quoted prices and quoted pricing intervals from public data sources and do not involve management judgment. These contracts are typically classified within Level 2 of the fair value hierarchy.
The types of instruments valued based on unobservable inputs included the auction rate securities that were held by the Company as of and prior to June 30, 2010. Such instruments were classified within Level 3 of the fair value hierarchy. The Company estimated the fair value of these auction rate securities using a discounted cash flow model incorporating assumptions that market participants would use in their estimates of fair value. Some of these assumptions included estimates for interest rates, timing and amount of cash flows, and expected holding periods of the auction rate securities.
Financial assets (excluding cash held in operating accounts and time deposits) and liabilities measured at fair value on a recurring basis as of the date indicated below were presented on the Company’s Condensed Consolidated Balance Sheet as follows:
As of March 31, 2012 (In thousands)
Total
Quoted Prices in
Active Markets
for Identical
Assets (Level 1)
Significant Other
Observable Inputs
(Level 2)
Assets
Cash equivalents:
U.S. Treasury securities
$
1,900
$
—
$
1,900
U.S. Government agency securities
9,963
9,963
—
Corporate debt securities
31,999
—
31,999
Money market and other
551,568
551,568
—
Marketable securities:
U.S. Treasury securities
93,888
87,390
6,498
U.S. Government agency securities
551,790
551,790
—
Municipal securities
41,768
—
41,768
Corporate debt securities
840,124
—
840,124
Sovereign securities
33,897
11,861
22,036
Equity securities
1,943
1,943
—
Total cash equivalents and marketable securities(1)
2,158,840
1,214,515
944,325
Other current assets:
Derivative assets
4,149
—
4,149
Other non-current assets:
Executive Deferred Savings Plan:
Money market and other
1,974
1,974
—
Mutual funds
128,174
92,820
35,354
Executive Deferred Savings Plan total
130,148
94,794
35,354
Total financial assets(1)
$
2,293,137
$
1,309,309
$
983,828
Other current liabilities:
Derivative liabilities
$
(585
)
$
—
$
(585
)
Total financial liabilities
$
(585
)
$
—
$
(585
)
________________
(1) Excludes cash of $141.2 million held in operating accounts and time deposits of $69.7 million as of March 31, 2012.
Financial assets (excluding cash held in operating accounts and time deposits) and liabilities measured at fair value on a recurring basis as of the date indicated below were presented on the Company’s Condensed Consolidated Balance Sheet as follows:
As of June 30, 2011 (In thousands)
Total
Quoted Prices in
Active Markets
for Identical
Assets (Level 1)
Significant Other
Observable Inputs
(Level 2)
Assets
Cash equivalents:
U.S. Treasury securities
$
4,400
$
—
$
4,400
U.S. Government agency securities
6,010
6,010
—
Corporate debt securities
21,982
—
21,982
Money market and other
481,770
481,770
—
Marketable securities:
U.S. Treasury securities
54,496
52,396
2,100
U.S. Government agency securities
314,173
314,173
—
Municipal securities
38,957
—
38,957
Corporate debt securities
853,403
—
853,403
Sovereign securities
32,086
14,696
17,390
Total cash equivalents and marketable securities(1)
1,807,277
869,045
938,232
Other current assets:
Derivative assets
1,970
—
1,970
Other non-current assets:
Executive Deferred Savings Plan:
Money market and other
1,806
1,806
—
Mutual funds
126,227
95,971
30,256
Executive Deferred Savings Plan total
128,033
97,777
30,256
Total financial assets(1)
$
1,937,280
$
966,822
$
970,458
Other current liabilities:
Derivative liabilities
$
(2,127
)
$
—
$
(2,127
)
Total financial liabilities
$
(2,127
)
$
—
$
(2,127
)
________________
(1) Excludes cash of $165.9 million held in operating accounts and time deposits of $65.4 million as of June 30, 2011.
Changes in the Company’s Level 3 securities for the indicated periods were as follows:
Three months ended March 31,
Nine months ended March 31,
(In thousands)
2012
2011
2012
2011
Beginning aggregate fair value of Level 3 securities
$
—
$
—
$
—
$
16,825
Net settlements
—
—
—
(16,825
)
Ending aggregate fair value of Level 3 securities
$
—
$
—
$
—
$
—
During the fiscal year ended June 30, 2010 (and in prior fiscal years), the Company’s investment portfolio included auction rate securities, which were investments with contractual maturities generally between 20 to 30 years. In February 2008, because sell orders exceeded buy orders, auctions failed for approximately $48.2 million in par value of municipal auction rate securities that were then held by the Company. By letter dated August 8, 2008, the Company received notification from UBS AG (“UBS”), in connection with a settlement entered into between UBS and certain regulatory agencies, offering to repurchase all of the Company’s auction rate security holdings at par value. The Company formally accepted the settlement offer and entered into a repurchase agreement with UBS on November 11, 2008. On June 30, 2010, UBS repurchased the Company's $16.8 million of then-remaining auction rate securities at par value, and the repurchase was subsequently settled in July 2010.
KLA-Tencor has a non-qualified deferred compensation plan whereby certain executives and non-employee directors may defer a portion of their compensation. Participants are credited with returns based on their allocation of their account balances among measurement funds. The Company controls the investment of these funds, and the participants remain general creditors of KLA-Tencor. Distributions from the plan commence the quarter following a participant’s retirement or termination of employment, except in cases where such distributions are required to be delayed in order to avoid a prohibited distribution under Internal Revenue Code Section 409A. As of March 31, 2012, the Company had a deferred compensation plan related asset and liability included as a component of other non-current assets and other current liabilities on its Condensed Consolidated Balance Sheet.
NOTE 4 – MARKETABLE SECURITIES
The amortized cost and fair value of marketable securities as of the dates indicated below were as follows:
As of March 31, 2012 (In thousands)
Amortized
Cost
Gross
Unrealized
Gains
Gross
Unrealized
Losses
Fair
Value
U.S. Treasury securities
$
95,693
$
140
$
(45
)
$
95,788
U.S. Government agency securities
561,286
777
(310
)
561,753
Municipal securities
41,623
150
(5
)
41,768
Corporate debt securities
868,270
4,366
(513
)
872,123
Money market and other
551,568
—
—
551,568
Sovereign securities
33,789
110
(2
)
33,897
Equity securities
1,927
16
—
1,943
Subtotal
2,154,156
5,559
(875
)
2,158,840
Add: Time deposits(1)
69,663
—
—
69,663
Less: Cash equivalents
622,678
—
—
622,678
Marketable securities
$
1,601,141
$
5,559
$
(875
)
$
1,605,825
As of June 30, 2011 (In thousands)
Amortized Cost
Gross Unrealized Gains
Gross Unrealized Losses
Fair Value
U.S. Treasury securities
$
58,754
$
165
$
(23
)
$
58,896
U.S. Government agency securities
319,375
931
(123
)
320,183
Municipal securities
38,688
275
(6
)
38,957
Corporate debt securities
870,591
5,162
(368
)
875,385
Money market and other
481,770
—
—
481,770
Sovereign securities
31,932
179
(25
)
32,086
Subtotal
1,801,110
6,712
(545
)
1,807,277
Add: Time deposits(1)
65,402
—
—
65,402
Less: Cash equivalents
545,475
—
(2
)
545,473
Marketable securities
$
1,321,037
$
6,712
$
(543
)
$
1,327,206
________________
(1)
Time deposits excluded from fair value measurements.
KLA-Tencor’s investment portfolio consists of both corporate and government securities that have a maximum maturity of three years. The longer the duration of these securities, the more susceptible they are to changes in market interest rates and bond yields. As yields increase, those securities with a lower yield-at-cost show a mark-to-market unrealized loss. All unrealized losses are due to changes in market interest rates, bond yields and/or credit ratings. The Company has the ability to realize the full value of all of these investments upon maturity. The following table summarizes the fair value and gross unrealized losses of the Company’s investments that were in an unrealized loss position as of the date indicated below:
As of March 31, 2012 (In thousands)
Fair Value
Gross Unrealized Losses(1)
U.S. Treasury securities
$
39,027
$
(45
)
U.S. Government agency securities
196,537
(310
)
Municipal securities
6,747
(5
)
Corporate debt securities
230,504
(513
)
Sovereign securities
6,027
(2
)
Total
$
478,842
$
(875
)
__________________
(1)
Of the total gross unrealized losses, there were no amounts that, as of March 31, 2012, had been in a continuous loss position for 12 months or more.
The contractual maturities of securities classified as available-for-sale, regardless of their classification on the Company's Condensed Consolidated Balance Sheet, as of the date indicated below were as follows:
As of March 31, 2012 (In thousands)
Amortized Cost
Fair Value
Due within one year
$
369,877
$
371,080
Due after one year through three years
1,231,264
1,234,745
$
1,601,141
$
1,605,825
Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Net realized gains on the Company's investments for the three months ended March 31, 2012 and 2011 were $0.1 million and $0.4 million, respectively. Net realized gains on the Company's investments for the nine months ended March 31, 2012 and 2011 were $0.7 million and $1.9 million, respectively.
NOTE 5 – GOODWILL AND PURCHASED INTANGIBLE ASSETS
Goodwill
The following table presents goodwill balances as of the dates indicated below:
(In thousands)
As of March 31, 2012
As of June 30, 2011
Gross goodwill balance
$
604,473
$
604,742
Accumulated impairment losses
(276,586
)
(276,586
)
Net goodwill balance
$
327,887
$
328,156
The changes in the gross goodwill balance since June 30, 2011 resulted primarily from foreign currency translation adjustments.
Goodwill represents the excess of the purchase price over the fair value of the net tangible and identifiable intangible assets acquired in each business combination. In September 2011, the FASB amended its guidance to simplify testing goodwill for impairment, allowing an entity to first assess qualitative factors to determine whether it is necessary to perform the two-step quantitative goodwill impairment test.
The Company performed a qualitative assessment of the goodwill by reporting unit as of November 30, 2011 during the three months ended December 31, 2011 and concluded that it was more likely than not that the fair value of each of the reporting units exceeded its carrying amount. As of December 31, 2011 and 2010, the Company's assessment indicated that goodwill in the reporting units was not impaired. There have been no significant events or circumstances affecting the valuation of goodwill subsequent to the qualitative assessment performed in the second quarter of the fiscal year ending June 30, 2012. The next annual assessment of the goodwill by reporting unit will be performed in the second quarter of the fiscal year ending June 30, 2013.
Purchased Intangible Assets
The components of purchased intangible assets as of the dates indicated below were as follows:
(In thousands)
As of March 31, 2012
As of June 30, 2011
Category
Range of
Useful Lives
Gross
Carrying
Amount
Accumulated
Amortization
and
Impairment
Net
Amount
Gross
Carrying
Amount
Accumulated
Amortization
and
Impairment
Net
Amount
Existing technology
4-7 years
$
134,561
$
106,568
$
27,993
$
134,561
$
94,172
$
40,389
Patents
6-13 years
57,648
45,372
12,276
57,648
40,591
17,057
Trade name/Trademark
4-10 years
19,893
14,053
5,840
19,893
12,907
6,986
Customer relationships
6-7 years
54,823
38,035
16,788
54,823
33,565
21,258
Other
0-1 year
16,200
16,200
—
16,200
15,988
212
Total
$
283,125
$
220,228
$
62,897
$
283,125
$
197,223
$
85,902
For the three months ended March 31, 2012 and 2011, amortization expense for other intangible assets was $7.3 million and $8.0 million, respectively. For the nine months ended March 31, 2012 and 2011, amortization expense for other intangible assets was $23.0 million and $24.9 million, respectively. Based on the intangible assets recorded as of March 31, 2012, and assuming no subsequent additions to, or impairment of, the underlying assets, the remaining estimated amortization expense is expected to be as follows:
In April 2008, the Company issued $750 million aggregate principal amount of 6.90% senior, unsecured long-term debt due in 2018 with an effective interest rate of 7.00%. The discount on the debt amounted to $5.4 million and is being amortized over the life of the debt using the straight-line method as opposed to the interest method due to immateriality. Interest is payable semi-annually on November 1 and May 1. The debt indenture includes covenants that limit the Company’s ability to grant liens on its facilities and to enter into sale and leaseback transactions, subject to significant allowances under which certain sale and leaseback transactions are not restricted. The Company was in compliance with all of its covenants as of March 31, 2012.
In certain circumstances involving a change of control followed by a downgrade of the rating of the Company’s senior notes, the Company will be required to make an offer to repurchase the senior notes at a purchase price equal to 101% of the aggregate principal amount of the notes, plus accrued and unpaid interest. The Company’s ability to repurchase the senior notes in such event may be limited by law, by the indenture associated with the senior notes, by the Company’s then-available financial resources or by the terms of other agreements to which the Company may be party at such time. If the Company fails to repurchase the senior notes as required by the indenture, it would constitute an event of default under the indenture governing the senior notes which, in turn, may also constitute an event of default under other obligations.
Based on the trading prices of the debt on the applicable dates, the fair value of the debt as of March 31, 2012 and June 30, 2011 was $892.5 million and $863.5 million, respectively.
NOTE 7 – STOCK-BASED COMPENSATION
Equity Incentive Program
Under the Company’s current equity incentive program, the Company issues equity awards from its 2004 Equity Incentive Plan (the “2004 Plan”), which provides for the grant of options to purchase shares of its common stock, stock appreciation rights, restricted stock units, performance shares, performance units and deferred stock units to its employees, consultants and members of its Board of Directors. The 2004 Plan permits the issuance of up to 32.0 million shares of common stock. Any 2004 Plan awards of restricted stock units, performance shares, performance units or deferred stock units with a per share or unit purchase price lower than 100% of fair market value on the grant date are counted against the total number of shares issuable under the 2004 Plan as 1.8 shares for every one share subject thereto.
The following table summarizes the combined activity under the Company's equity incentive plans for the indicated period:
(In thousands)
Available
For Grant
Balances as of June 30, 2011(1)
11,554
Restricted stock units granted(2)(3)
(4,080
)
Restricted stock units canceled(2)
420
Options canceled/expired/forfeited
755
Plan shares expired(4)
(705
)
Balances as of March 31, 2012(1)
7,944
__________________
(1)
Includes shares available for issuance under the 2004 Plan, as well as under the Company’s 1998 Outside Director Option Plan (the “Outside Director Plan”), which only permits the issuance of stock options to the Company’s non-employee members of the Board of Directors. As of March 31, 2012, 1.7 million shares were available for grant under the Outside Director Plan.
(2)
The number of restricted stock units provided in this row reflects the application of the 1.8x multiple described above.
(3)
Includes 0.2 million restricted stock units granted to senior management during the nine months ended March 31, 2012 with performance-based vesting criteria (in addition to service-based vesting criteria for any of such restricted stock units that are deemed to have been earned). As of March 31, 2012, it had not yet been determined the extent to which (if at all) the performance-based vesting criteria of such restricted stock units had been satisfied. Therefore, this line item includes all such performance-based restricted stock units, reported at the maximum possible number of shares that may ultimately be issuable under such restricted stock units if all applicable performance-based and service-based criteria are fully satisfied.
Represents the portion of shares listed as “Options canceled/expired/forfeited” above that were issued under the Company’s equity incentive plans other than the 2004 Plan or the Outside Director Plan. Because the Company is only currently authorized to issue equity awards under the 2004 Plan and the Outside Director Plan, any equity awards that are canceled, expire or are forfeited under any other Company equity incentive plans do not result in additional shares being available to the Company for future grant.
Except for stock options granted to non-employee Board members as part of their regular compensation package for service through the end of the first quarter of fiscal year 2008, the Company has granted only restricted stock units under its equity incentive program since September 2006. For the preceding several years until September 30, 2006, stock options were granted at the market price of the Company’s common stock on the date of grant (except for the previously disclosed retroactively priced options which were granted primarily prior to the fiscal year ended June 30, 2002), generally with a vesting period of five years and an exercise period not to exceed seven years (ten years for options granted prior to July 1, 2005) from the date of issuance. Restricted stock units may be granted with varying criteria such as service-based and/or performance-based vesting.
The fair value of stock-based awards is measured at the grant date and is recognized as an expense over the employee’s requisite service period. The fair value is determined using a Black-Scholes valuation model for purchase rights under the Company’s Employee Stock Purchase Plan and using the closing price of the Company’s common stock on the grant date for restricted stock units.
The following table shows pre-tax stock-based compensation expense for the indicated periods:
Three months ended March 31,
Nine months ended March 31,
(In thousands)
2012
2011
2012
2011
Stock-based compensation expense by:
Costs of revenues
$
3,194
$
2,990
$
10,703
$
10,597
Engineering, research and development
4,995
5,568
16,572
19,000
Selling, general and administrative
12,725
10,289
33,781
32,894
Total stock-based compensation expense
$
20,914
$
18,847
$
61,056
$
62,491
The following table shows stock-based compensation capitalized as inventory as of the dates indicated below:
(In thousands)
As of March 31, 2012
As of June 30, 2011
Inventory
$
7,648
$
6,701
Stock Options
The following table summarizes the activity and weighted-average exercise price for stock options under all plans during the nine months ended March 31, 2012:
Stock Options
Shares
(In thousands)
Weighted-Average
Exercise Price
Outstanding stock options as of June 30, 2011
7,675
$
45.38
Granted
—
$
—
Exercised
(2,735
)
$
42.27
Canceled/expired/forfeited
(755
)
$
46.89
Outstanding stock options as of March 31, 2012
4,185
$
47.18
Vested and exercisable as of March 31, 2012
4,183
$
47.18
The Company has not issued any stock options since November 1, 2007. The weighted-average remaining contractual terms for total options outstanding under all plans, and for total options vested and exercisable under all plans, as of March 31, 2012 were each 1.67 years. The aggregate intrinsic values for total options outstanding under all plans, and for total options vested and exercisable under all plans, as of March 31, 2012 were each $32.0 million.
The authoritative guidance on stock-based compensation permits companies to select the option-pricing model used to estimate the fair value of their stock-based compensation awards. The Black-Scholes option-pricing model requires the input of assumptions, including the option’s expected life and the expected price volatility of the underlying stock. For purposes of the fair value estimates presented in this report, the Company has based its expected stock price volatility assumption on the market-based implied volatility from traded options of the Company’s common stock. As of March 31, 2012, the unrecognized stock-based compensation balance related to stock options was immaterial.
The following table shows the total intrinsic value of options exercised, total cash received from employees and non-employee Board members as a result of stock option exercises and tax benefits realized by the Company in connection with these stock option exercises for the indicated periods:
Three months ended March 31,
Nine months ended March 31,
(In thousands)
2012
2011
2012
2011
Total intrinsic value of options exercised
$
13,690
$
15,244
$
20,259
$
18,533
Total cash received from employees and non-employee Board members as a result of stock option exercises
$
74,640
$
74,926
$
104,543
$
90,473
Tax benefits realized in connection with these exercises
$
4,619
$
5,290
$
6,782
$
6,742
The Company generally settles employee stock option exercises with newly issued common shares, except in certain tax jurisdictions where settling such exercises with treasury shares provides the Company or one of its subsidiaries with a tax benefit.
Restricted Stock Units
The following table shows the applicable number of restricted stock units and weighted-average grant date fair value for restricted stock units granted, vested and released, withheld for taxes, and forfeited during the nine months ended March 31, 2012 and restricted stock units outstanding as of March 31, 2012 and June 30, 2011:
Restricted Stock Units
Shares
(In thousands) (1)
Weighted-Average
Grant Date
Fair Value
Outstanding restricted stock units as of June 30, 2011
6,540
$
33.56
Granted(2)
2,267
$
36.39
Vested and released
(1,403
)
$
39.67
Withheld for taxes
(714
)
$
39.68
Forfeited
(233
)
$
32.37
Outstanding restricted stock units as of March 31, 2012(2)
6,457
$
32.59
__________________
(1)
Share numbers reflect actual shares subject to awarded restricted stock units. Under the terms of the 2004 Plan, each of the share numbers presented in this column is multiplied by 1.8 to calculate the impact on the share reserve under the 2004 Plan.
(2)
Includes 0.2 million restricted stock units granted to senior management during the nine months ended March 31, 2012 with performance-based vesting criteria (in addition to service-based vesting criteria for any of such restricted stock units that are deemed to have been earned). As of March 31, 2012, it had not yet been determined the extent to which (if at all) the performance-based vesting criteria of such restricted stock units had been satisfied. Therefore, this line item includes all such performance-based restricted stock units, reported at the maximum possible number of shares that may ultimately be issuable under such restricted stock units, if all applicable performance-based and service-based criteria are fully satisfied.
The restricted stock units granted by the Company since the beginning of the fiscal year ended June 30, 2007 generally vest in two equal installments on the second and fourth anniversaries of the date of grant. Prior to the fiscal year ended June 30, 2007, the restricted stock units granted by the Company generally vested in two equal installments over four or five years from the date of the grant. The value of the restricted stock units is based on the closing market price of the Company’s common stock on the date of award. The restricted stock units have been awarded under the Company’s 2004 Plan, and each unit will entitle the recipient to one share of common stock when the applicable vesting requirements for that unit are satisfied. However, for each share actually issued under the awarded restricted stock units, the share reserve under the 2004 Plan will be reduced by 1.8 shares, as provided under the terms of the 2004 Plan.
The following table shows the grant date fair value after estimated forfeitures and weighted-average grant date fair value per unit for the restricted stock units granted and tax benefits realized by the Company in connection with vested and released restricted stock units for the indicated periods:
(In thousands, except for weighted-average grant date fair value)
Three months ended March 31,
Nine months ended March 31,
2012
2011
2012
2011
Grant date fair value after estimated forfeitures
$
2,013
$
1,820
$
58,789
$
44,069
Weighted-average grant date fair value per unit
$
51.32
$
46.17
$
36.39
$
30.90
Tax benefits realized in connection with vested and released restricted stock units
$
326
$
1,075
$
28,562
$
23,414
As of March 31, 2012, the unrecognized stock-based compensation expense balance, net of estimated forfeitures, related to restricted stock units was $115.4 million and will be recognized over an estimated weighted-average amortization period of 2.3 years.
Employee Stock Purchase Plan
KLA-Tencor’s Employee Stock Purchase Plan (“ESPP”) provides that eligible employees may contribute up to 10% of their eligible earnings toward the semi-annual purchase of KLA-Tencor’s common stock. The ESPP is qualified under Section 423 of the Internal Revenue Code. The employee’s purchase price is derived from a formula based on the closing price of the common stock on the first day of the offering period versus the closing price on the date of purchase (or, if not a trading day, on the immediately preceding trading day).
Effective January 1, 2010, the offering period (or length of the look-back period) under the ESPP has a duration of six months, and the purchase price with respect to each offering period beginning on or after such date is, until otherwise amended, equal to 85% of the lesser of (i) the fair market value of the Company’s common stock at the commencement of the applicable six-month offering period or (ii) the fair market value of the Company’s common stock on the purchase date.
The Company estimates the fair value of purchase rights under the ESPP using a Black-Scholes valuation model. The fair value of each purchase right under the ESPP was estimated on the date of grant using the Black-Scholes option valuation model and the straight-line attribution approach with the following weighted-average assumptions:
Three months ended March 31,
Nine months ended March 31,
2012
2011
2012
2011
Stock purchase plan:
Expected stock price volatility
39.3
%
35.0
%
36.0
%
38.0
%
Risk-free interest rate
0.1
%
0.2
%
0.1
%
0.2
%
Dividend yield
3.0
%
2.6
%
3.2
%
3.1
%
Expected life of options (in years)
0.50
0.50
0.50
0.50
The following table shows total cash received from employees for the issuance of shares under the ESPP, the number of shares purchased by employees through the ESPP, the tax benefits realized by the Company in connection with the disqualifying dispositions of shares purchased under the ESPP and the weighted-average fair value per share for the indicated periods:
(In thousands, except for weighted-average fair value per share)
Three months ended March 31,
Nine months ended March 31,
2012
2011
2012
2011
Total cash received from employees for the issuance of shares under the ESPP
$
—
$
—
$
19,195
$
16,175
Number of shares purchased by employees through the ESPP
—
—
545
701
Tax benefits realized in connection with the disqualifying dispositions of shares purchased under the ESPP
$
1,289
$
1,699
$
2,132
$
2,170
Weighted-average fair value per share based on Black-Scholes model
The ESPP shares are replenished annually on the first day of each fiscal year by virtue of an evergreen provision. The provision allows for share replenishment equal to the lesser of 2.0 million shares or the number of shares which KLA-Tencor estimates will be required to be issued under the ESPP during the forthcoming fiscal year. During the fiscal year ended June 30, 2011, a total of 2.0 million additional shares were reserved under the ESPP. To date, no additional shares have been reserved under the ESPP with respect to the fiscal year ending June 30, 2012. As of March 31, 2012, a total of 2.9 million shares were reserved and available for issuance under the ESPP.
NOTE 8 – STOCK REPURCHASE PROGRAM
Since July 1997, the Board of Directors has authorized the Company to systematically repurchase in the open market up to 72.8 million shares of its common stock under a repurchase program, including 10.0 million shares authorized in February 2011. This program was put into place to reduce the dilution from KLA-Tencor’s equity incentive plans and employee stock purchase plan, and to return excess cash to the Company’s stockholders. Subject to market conditions, applicable legal requirements and other factors, the repurchases will be made from time to time in the open market in compliance with applicable securities laws, including the Securities Exchange Act of 1934 and the rules promulgated thereunder such as Rule 10b-18. As of March 31, 2012, 4.6 million shares were available for repurchase under the Company’s repurchase program.
Share repurchases for the indicated periods (based on the settlement date of the applicable repurchase) were as follows:
Three months ended March 31,
Nine months ended March 31,
(In thousands)
2012
2011
2012
2011
Number of shares of common stock repurchased
1,341
1,286
4,510
4,817
Total cost of repurchases
$
66,934
$
57,810
$
196,906
$
175,071
NOTE 9 – NET INCOME PER SHARE
Basic net income per share is calculated by dividing net income available to common stockholders by the weighted-average number of common shares outstanding during the period. Diluted net income per share is calculated by using the weighted-average number of common shares outstanding during the period, increased to include the number of additional shares of common stock that would have been outstanding if the shares of common stock underlying the Company’s outstanding dilutive stock options and restricted stock units had been issued. The dilutive effect of outstanding options and restricted stock units is reflected in diluted net income per share by application of the treasury stock method. Under the treasury stock method, the amount the employee must pay for exercising stock options, the amount of compensation cost for future service that the Company has not yet recognized, and the amount of tax benefits that is to be recorded in additional paid-in capital when the award becomes deductible are assumed to be used to repurchase shares. The following table sets forth the computation of basic and diluted net income per share:
(In thousands, except per share amounts)
Three months ended March 31,
Nine months ended March 31,
2012
2011
2012
2011
Numerator:
Net income
$
205,346
$
209,783
$
508,138
$
549,471
Denominator:
Weighted-average shares-basic, excluding unvested restricted stock units
167,070
167,629
166,748
166,978
Effect of dilutive options and restricted stock units
3,076
3,684
3,275
2,996
Weighted-average shares-diluted
170,146
171,313
170,023
169,974
Basic net income per share
$
1.23
$
1.25
$
3.05
$
3.29
Diluted net income per share
$
1.21
$
1.22
$
2.99
$
3.23
Anti-dilutive securities excluded from the computation of diluted net income per share
The total amount of dividends paid during the three months ended March 31, 2012 and 2011 was $58.5 million and $41.9 million, respectively. The total amount of dividends paid during the nine months ended March 31, 2012 and 2011 was $175.1 million and $125.5 million, respectively.
NOTE 10 – COMPREHENSIVE INCOME
The components of comprehensive income, net of tax, were as follows:
Three months ended March 31,
Nine months ended March 31,
(In thousands)
2012
2011
2012
2011
Net income
$
205,346
$
209,783
$
508,138
$
549,471
Other comprehensive income (loss):
Currency translation adjustments
67
4,711
(6,259
)
22,689
Gains on cash flow hedging instruments
1,525
1,010
1,208
1,210
Change in unrecognized losses and transition obligation related to pension and post-retirement plans
114
93
354
265
Unrealized gains (losses) on investments
1,050
(953
)
(861
)
(1,382
)
Other comprehensive income (loss)
2,756
4,861
(5,558
)
22,782
Total comprehensive income
$
208,102
$
214,644
$
502,580
$
572,253
NOTE 11 – INCOME TAXES
The following table provides details of income taxes:
(Dollar amounts in thousands)
Three months ended March 31,
Nine months ended March 31,
2012
2011
2012
2011
Income before income taxes
$
274,033
$
301,520
$
668,202
$
776,023
Provision for income taxes
$
68,687
$
91,737
$
160,064
$
226,552
Effective tax rate
25.1
%
30.4
%
24.0
%
29.2
%
The Company’s estimated annual effective tax rate for the fiscal year ending June 30, 2012 is approximately 24.0%.
The difference between the actual effective tax rate of 25.1% during the quarter and the estimated annual effective tax rate of 24.0% is primarily due to the tax impact of the following items during the three months ended March 31, 2012:
•
Tax expense was increased by $5.7 million due to shortfalls from employee stock activity. A shortfall arises when the tax deduction is less than book compensation. Windfalls are recorded as increases to capital in excess of par value. Shortfalls are recorded as decreases to capital in excess of par value to the extent that cumulative windfalls exceed cumulative shortfalls. Shortfalls in excess of cumulative windfalls are recorded as provision for income taxes.
•
Tax expense was decreased by $3.4 million due to a non-taxable increase in the value of the assets held within the Company’s Executive Deferred Savings Plan.
Tax expense was lower as a percentage of income during the three months ended March 31, 2012 compared to the three months ended March 31, 2011 primarily due to:
•
A decrease in tax expense of $5.0 million during the three months ended March 31, 2012 related to state income taxes as a result of the adoption of California budget legislation, signed on February 20, 2009, which allows a taxpayer to elect an alternative method to attribute taxable income to California for tax years beginning on or after January 1, 2011;
•
A decrease in tax expense of $13.0 million during the three months ended March 31, 2012 related to an increase in the proportion of the Company's earnings generated in jurisdictions with tax rates lower than the U.S. statutory tax rate; and
•
A decrease in tax expense of $2.7 million during the three months ended March 31, 2012 related to shortfalls from employee stock activity. The Company incurred a tax expense of $5.7 million due to shortfalls from employee stock activity during the three months ended March 31, 2012 compared to a tax expense of $8.4 million due to shortfalls from employee stock activity during the three months ended March 31, 2011; partially offset by
•
An increase in tax expense of $4.5 million during the three months ended March 31, 2012 related to a decrease in the domestic manufacturing deduction as a result of a change in the timing of when revenue is recognized for federal income tax purposes.
Tax expense was lower as a percentage of income during the nine months ended March 31, 2012 compared to the nine months ended March 31, 2011 primarily due to:
•
A tax benefit of $18.3 million recognized during the nine months ended March 31, 2012 resulting from a decrease in the Company's unrecognized tax benefits due to the settlement of a U.S. federal income tax examination;
•
A tax benefit of $18.0 million recognized during the nine months ended March 31, 2012 resulting from a decrease in reserves for uncertain tax positions taken in prior years;
•
A decrease in tax expense of $12.2 million during the nine months ended March 31, 2012 related to state income taxes as a result of the adoption of California budget legislation, signed on February 20, 2009, which allows a taxpayer to elect an alternative method to attribute taxable income to California for tax years beginning on or after January 1, 2011; and
•
A decrease in tax expense of $31.8 million during the nine months ended March 31, 2012 related to an increase in the proportion of the Company's earnings generated in jurisdictions with tax rates lower than the U.S. statutory tax rate; partially offset by
•
An increase in tax expense of $23.6 million during the nine months ended March 31, 2012 related to a migration of a portion of the Company's manufacturing to Singapore;
•
An increase in tax expense of $7.4 million during the nine months ended March 31, 2012 related to a non-deductible decrease in the value of the assets held within the Company's Executive Deferred Savings Plan. The Company incurred a tax benefit of $1.0 million due to a non-taxable increase in the value of the assets held within the Company's Executive Deferred Savings Plan during the nine months ended March 31, 2012 compared to a tax benefit of $8.4 million due to a non-taxable increase in the value of the assets held within the Company's Executive Deferred Savings Plan during the nine months ended March 31, 2011; and
•
An increase in tax expense of $12.6 million during the nine months ended March 31, 2012 related to a decrease in the domestic manufacturing deduction as a result of a change in the timing of when revenue is recognized for federal income tax purposes.
In the normal course of business, the Company is subject to examination by tax authorities throughout the world. The Company is subject to U.S. federal income tax examination for all years beginning from the fiscal year ended June 30, 2010. The Company is subject to state income tax examinations for all years beginning from the fiscal year ended June 30, 2007. The Company is also subject to examinations in other major foreign jurisdictions, including Singapore, for all years beginning from the fiscal year ended June 30, 2007. It is possible that certain examinations may be concluded in the next twelve months. The Company believes it is possible that it may recognize up to $2.4 million of its existing unrecognized tax benefits within the next twelve months as a result of the lapse of statutes of limitations and the resolution of examinations with various tax authorities.
Indemnification Obligations. As a result of the Company's indemnification obligations in connection with the litigation and government inquiries related to the Company's historical stock option practices, the Company has been paying defense costs for one former officer and employee facing an SEC civil action to which the Company is not a party. That former officer and the SEC have settled the civil action. As a result, during the three months ended December 31, 2011, the Company and the former officer entered into an agreement that releases each other from liabilities stemming from the former officer's employment with the Company and materially concludes the Company's indemnification obligations to the former officer. The terms of that release agreement have been appropriately considered within the reserve the Company has established for currently pending legal proceedings.
Other Legal Matters. The Company is named from time to time as a party to lawsuits in the normal course of its business. Actions filed against the Company include commercial, intellectual property, customer, and labor and employment related claims, including complaints of alleged wrongful termination and potential class action lawsuits regarding alleged violations of federal and state wage and hour and other laws. Litigation, in general, and intellectual property and securities litigation in particular, can be expensive and disruptive to normal business operations. Moreover, the results of legal proceedings are difficult to predict, and the costs incurred in litigation can be substantial, regardless of outcome. The Company believes the amounts provided in its condensed consolidated financial statements are adequate in light of the probable and estimated liabilities. However, because such matters are subject to many uncertainties, the ultimate outcomes are not predictable, and there can be no assurances that the actual amounts required to satisfy alleged liabilities from the matters described above will not exceed the amounts reflected in the Company's condensed consolidated financial statements or will not have a material adverse effect on its results of operations, financial condition or cash flows.
NOTE 13 – COMMITMENTS AND CONTINGENCIES
Factoring. KLA-Tencor has agreements (referred to as "factoring agreements") with financial institutions to sell certain of its trade receivables and promissory notes from customers without recourse. The Company does not believe it is at risk for any material losses as a result of these agreements. In addition, the Company periodically sells certain letters of credit (“LCs”), without recourse, received from customers in payment for goods.
The following table shows total receivables sold under factoring agreements and proceeds from sales of LCs for the indicated periods:
Three months ended March 31,
Nine months ended March 31,
(In thousands)
2012
2011
2012
2011
Receivables sold under factoring agreements
$
71,897
$
50,417
$
322,227
$
207,028
Proceeds from sales of LCs
$
9,500
$
9,900
$
14,010
$
94,163
Factoring and LC fees for the sale of certain trade receivables were recorded in interest income and other, net and were not material for the periods presented.
Facilities. KLA-Tencor leases certain of its facilities under arrangements that are accounted for as operating leases. Rent expense was $2.3 million and $2.1 million for the three months ended March 31, 2012 and 2011, respectively. Rent expense was $6.8 million and $6.3 million for the nine months ended March 31, 2012 and 2011, respectively.
The following is a schedule of expected operating lease payments:
Fiscal year ending June 30,
Amount
(In thousands)
2012 (remaining 3 months)
$
2,134
2013
7,509
2014
4,776
2015
2,441
2016
2,216
2017 and thereafter
3,432
Total minimum lease payments
$
22,508
Purchase Commitments. KLA-Tencor maintains certain open inventory purchase commitments with its suppliers to ensure a smooth and continuous supply for key components. The Company’s liability under these purchase commitments is generally restricted to a forecasted time-horizon as mutually agreed upon between the parties. This forecasted time-horizon can vary among different suppliers. The Company’s open inventory purchase commitments were approximately $339.3 million as of March 31, 2012 and are primarily due within the next 12 months. Actual expenditures will vary based upon the volume of the transactions and length of contractual service provided. In addition, the amounts paid under these arrangements may be less in the event that the arrangements are renegotiated or canceled. Certain agreements provide for potential cancellation penalties.
Guarantees. KLA-Tencor provides standard warranty coverage on its systems for 40 hours per week for twelve months, providing labor and parts necessary to repair the systems during the warranty period. The Company accounts for the estimated warranty cost as a charge to costs of revenues when revenue is recognized. The estimated warranty cost is based on historical product performance and field expenses. Utilizing actual service records, the Company calculates the average service hours and parts expense per system and applies the actual labor and overhead rates to determine the estimated warranty charge. The Company updates these estimated charges on a quarterly basis. The actual product performance and/or field expense profiles may differ, and in those cases the Company adjusts its warranty accruals accordingly.
The following table provides the changes in the product warranty accrual for the indicated periods:
(In thousands)
Three months ended March 31,
Nine months ended March 31,
2012
2011
2012
2011
Beginning balance
$
43,476
$
30,892
$
41,528
$
21,109
Accruals for warranties issued during the period
13,615
11,859
35,017
33,651
Changes in liability related to pre-existing warranties
796
1,229
3,726
80
Settlements made during the period
(12,677
)
(6,754
)
(35,061
)
(17,614
)
Ending balance
$
45,210
$
37,226
$
45,210
$
37,226
The Company maintains guarantee arrangements available through various financial institutions for up to $19.9 million, of which $18.1 million had been issued as of March 31, 2012, primarily to fund guarantees to customs authorities for value-added tax ("VAT") and other operating requirements of the Company’s subsidiaries in Europe and Asia.
KLA-Tencor is a party to a variety of agreements pursuant to which it may be obligated to indemnify the other party with respect to certain matters. Typically, these obligations arise in connection with contracts and license agreements or the sale of assets, under which the Company customarily agrees to hold the other party harmless against losses arising from, or provides customers with other remedies to protect against, bodily injury or damage to personal property caused by the Company's products, non-compliance with the Company's product performance specifications, infringement by the Company's products of third-party intellectual property rights and a breach of warranties, representations and covenants related to such matters as title to assets sold, validity of certain intellectual property rights, non-infringement of third-party rights, and certain income tax-related matters. In each of these circumstances, payment by the Company is typically subject to the other party making a claim to and cooperating with the Company pursuant to the procedures specified in the particular contract. This usually allows the Company to challenge the other party's claims or, in case of breach of intellectual property representations or covenants, to control the defense or settlement of any third-party claims brought against the other party. Further, the Company's obligations under these agreements may be limited in terms of amounts, activity (typically at the Company's option to replace or correct the products or terminate the agreement with a refund to the other party), and duration. In some instances, the Company may have recourse against third parties and/or insurance covering certain payments made by the Company.
Subject to certain limitations, the Company is obligated to indemnify its current and former directors, officers and employees with respect to certain litigation matters and investigations that arise in connection with their service to the Company. These obligations arise under the terms of the Company's certificate of incorporation, its bylaws, applicable contracts, and Delaware and California law. The obligation to indemnify generally means that the Company is required to pay or reimburse the individuals' reasonable legal expenses and possibly damages and other liabilities incurred in connection with these matters.
It is not possible to predict the maximum potential amount of future payments under these or similar agreements due to the conditional nature of the Company's obligations and the unique facts and circumstances involved in each particular agreement. Historically, payments made by the Company under these agreements have not had a material effect on its business, financial condition, results of operations or cash flows.
NOTE 14 – DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
The authoritative guidance requires companies to recognize all derivative instruments and hedging activities, including foreign currency exchange contracts, as either assets or liabilities at fair value on the balance sheet. Changes in the fair value of derivatives that do not qualify for hedge treatment, as well as the ineffective portion of any hedges, are reflected in the Condensed Consolidated Statement of Operations. In accordance with the guidance, the Company designates foreign currency forward exchange and option contracts as cash flow hedges of certain forecasted foreign currency denominated sales and purchase transactions.
KLA-Tencor’s foreign subsidiaries operate and sell KLA-Tencor’s products in various global markets. As a result, KLA-Tencor is exposed to risks relating to changes in foreign currency exchange rates. KLA-Tencor utilizes foreign currency forward exchange contracts and option contracts to hedge against future movements in foreign exchange rates that affect certain existing and forecasted foreign currency denominated sales and purchase transactions, such as the Japanese yen, the euro and the Israeli new shekel. KLA-Tencor does not use derivative financial instruments for speculative or trading purposes. The Company routinely hedges its exposures to certain foreign currencies with various financial institutions in an effort to minimize the impact of certain currency exchange rate fluctuations. These currency forward exchange contracts and options, designated as cash flow hedges, generally have maturities of less than 18 months. Cash flow hedges are evaluated for effectiveness monthly, based on changes in total fair value of the derivatives. If a financial counterparty to any of the Company’s hedging arrangements experiences financial difficulties or is otherwise unable to honor the terms of the foreign currency hedge, the Company may experience material losses.
For derivative instruments that are designated and qualify as cash flow hedges, the effective portion of the gains or losses on the derivative is reported as a component of accumulated other comprehensive income (loss) (“OCI”) and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. Changes in the fair value of currency forward exchange and option contracts due to changes in time value are excluded from the assessment of effectiveness. Gains and losses on the derivative representing either hedge ineffectiveness or hedge components excluded from the assessment of effectiveness are recognized in current earnings.
For derivative instruments that are not designated as accounting hedges, gains and losses are recognized in interest income and other, net. The Company uses foreign currency forward contracts to hedge certain foreign currency denominated assets or liabilities. The gains and losses on these derivatives are largely offset by the changes in the fair value of the assets or liabilities being hedged.
