Standard & Poor's Ratings Services affirmed its 'BBB' corporate credit rating on Lam Research Corp. (Nasdaq: LRCX). The outlook is stable.

At the same time, we affirmed our 'BBB' issue-level ratings on the unsecured senior and convertible notes issued by Lam Research Corp.

In addition, we affirmed our 'BBB' corporate credit rating on KLA-Tencor Corp. The outlook is stable.

We also affirmed the 'BBB' issue-level rating on the company's unsecured term loan and senior notes. Upon closing, we expect to withdraw our corporate credit rating on KLA-Tencor and our issue-level rating on its term loan and continue to rate the existing $2.5 billion unsecured notes, which will be guaranteed by Lam Research.

"Our rating affirmation on Lam Research reflects our view that the company's acquisition of KLA-Tencor strengthens its business risk profile because of greater product diversity, expanded served available market, and improved standing with its customers as a critical vendor within the semiconductor industry," said Standard & Poor's credit analyst Tuan Duong. "We anticipate that the transaction will yield some revenue and cost synergies given the companies' complementary customer base and product lines. However, our assessment is tempered by the company's high absolute amount of pro forma funded debt, which could reduce the company's operating flexibility in the event of a downturn, and its lack of track record operating at this scale."

We revised Lam Research's business risk profile to "satisfactory" from "fair" reflecting the benefits it will gain from the acquisition of KLA-Tencor. Pro forma for the transaction, Lam Research's revenue will be approximately $8 billion at the end of fiscal 2015, positioning it as the second-largest semiconductor capital equipment manufacturer (after Applied Materials Inc.), holding leadership positions across product categories and critical processes such as etch, deposition, single-wafer clean and process control. KLA-Tencor has strong market leadership within process control categories as evidenced by its gross margin of about 60%, which is above average for the semiconductor capital equipment industry. Historically, Lam Research has had a strong position in etch and no exposure to process control. Currently, etch accounts for approximately 69% of Lam Research's product revenues according to Gartner Inc. KLA-Tencor's offerings will diversify revenue streams to include wafer
defect inspection and metrology, lessening the concentration in etch and deposition. The addition of KLA-Tencor expands Lam Research's portfolio into adjacent product areas and expands its served available market by about $4 billion following close of the transaction.

Although Lam Research's acquisition will diversify its offerings, meaningful customer concentration remains a risk--its top three customers accounted for about 50% of total revenues in fiscal 2015 while KLA-Tencor's top three customers accounted for about 38% of total revenues. We expect this industry concentration to persist, driven by semiconductor companies' ongoing transition to a fabless or fab-lite model by outsourcing its semiconductor manufacturing and to rising costs. Furthermore, high capital intensity in the semiconductor industry limits the number of players that can continually invest in leading edge technologies. In the current market environment, we expect Lam Research's revenues to grow in the mid- to high-single digits over the next two years driven by investments in advanced semiconductor and memory chips.

"Our stable outlook on Lam Research reflects our expectation that the company will be able to successfully integrate the acquisition of KLA-Tencor, achieve the planned $250 million cost synergies, and maintain its leadership positions in etch, deposition, process control, and single-wafer clean product categories within the semiconductor capital equipment market while preserving its moderate financial policies by sustaining leverage below 2.5x," Mr. Duong continued.

"We could lower the rating on the company if it experiences difficulty integrating the acquisition of KLA-Tencor or stronger-than-expected competitive pressure or pursues more aggressive financial policies such that leverage is sustained above 2.5x."

Although unlikely over the next two years, we could upgrade the company if it maintains its market leadership in its product offerings while improving its financial risk profile such that leverage approaches a net cash position, which would provide a buffer the highly volatile industry cyclicality.

"The stable outlook on KLA-Tencor reflects our view that the company will be able to maintain its strong market position in the process control and yield management segments of the semiconductor capital equipment industry, while generating funds from operations to debt of above 30% and maintaining debt leverage below 3x. We expect to withdraw the rating on KLA-Tencor and our issue-level ratings on its term loan facility upon closing of the transaction," Mr. Duong added.

We could lower our ratings on the company if a pronounced industry contraction hampers its business performance, leading to a reduction in EBITDA and cash flow generation such that adjusted leverage exceeds 3x on a sustained basis or the FFO-to-debt ratio drops below 30%. We could also lower our ratings on KLA-Tencor if it pursues a more aggressive financial policy, whether through debt-financed acquisitions or shareholder returns, leading to the same leverage and FFO-to-debt ratio thresholds.

An upgrade is unlikely over the next two years, given our expectation of modest deleveraging over the next two years and that the company will maintain he current scale and scope of its business.