July 28, 2022
Letter to Shareholders
• June quarter results were at the top end of guidance. Revenue rose 9% sequentially and 29% year-over-year. Earnings of $5.40 was also as the top end of guidance.
• While they have seen weakness in consumer markets for PCs and mobile devices, and concomitant softness in memory pricing in those segments, demand from KLA’s customers remains beyond their ability to supply, with “no material shipment profile beyond [normal schedule adjustments]
• Because of supply chain challenges at other WFE companies constraining tool deliveries, they are tempering their outlook for CY22 total WFE. They now expect the WFE market to grow high single digits to approximately $95B in 2022, off a base of roughly $87B in 2021. This is a meaningful reduction from the $100B+ they forecasted during the call last quarter. WFE companies are citing supply chain constraints as the reason for this rather than softening demand. Could the lockdowns in China still be causing this much disruption?
• During their June investor day, KLA stated a revenue growth goal for the company of 9-11% annually through CY26, including an upwardly revised 12-14% long-term CAGR in their Services business. Their model assumes baseline semiconductor industry growth at a 6-7% CAGR through 2026. KLA’s growth target above the industry indicates they believe process control intensity – combined capital expenditures and service – will increase for semiconductors overall.
• The company believes overall WFE will grow faster than semiconductor revenue over the next four years. Their forecasted mix is 55-60% foundry/logic and 40-45% memory.
• Their 2026E model is: $14B +/- $500M in revenue, 63% GM, 13% R&D, 8%SG&A, 41-43% operating margin, diluted EPS of $38.00 +/- $1.50, return >85% of FCF to shareholders in both dividends and repurchases. They are assuming in this model that they will gain share at the leading edge, raise the fraction of revenue that comes from legacy markets, and will grow in new markets.
• KLA Services was $512M in the June quarter, a 15% year-over-year increase. They pointed out they are the only WFE company that doesn’t include field upgrades and used tools sales in these results. It is “pure” services.
• Free cash flow was $3.01B in the last twelve months, up 54% year-over-year
• The company bought back $3.5B in shares in the last twelve months. They announced a new $6B repurchase plan and have already used $3B of this. Total capital returns to shareholders in the last four quarters were 183% of free cash flow.
• Non-GAAP operating expenses were $514M vs. their expectation of $525M, mostly because they didn’t hire as fast as planned. Operating expenses will be approximately $530M in the September quarter.
• Their tax rate of 14.8% exceeded their guidance of 13.5% because of equity market impact on their deferred compensation program
• In the quarter, tool sales broke down 55% foundry/logic and 45% memory
• Their Electronics, Packaging, and Components (EPC) group had $124M of revenue, up 27% from a year ago and 6% from the prior quarter
• PCB, Display, and Component inspection revenue was $249M, a 1% year-over-year rise and a 29% sequential increase
• Revenue by region for the June quarter was: China = 29%, Taiwan = 25%, Korea = 16%, US = 10%, Japan = 9%, Europe = 8%, rest of Asia = 3%
• The company made a tender offer for $500M of 4.65% Senior notes due 2024
• They are concerned about the 2023 market environment because of macro uncertainty, but today continue to see strong demand from customers.
• September quarter guidance: total revenue of $2.6B +/-$125M with Foundry/Logic at 64% and Memory at 36% of process control system sales. Within Memory, DRAM will be 40% and NAND will be 60%. This is a big shift away from DRAM. Non-GAAP gross margin will be in a range of 62% to 64%. Effective tax rate will be approximately 13.5% and GAAP diluted EPS will be $5.28 to $6.38 and non-GAAP will be $5.70 to $6.80, based on 143M fully diluted shares.
Financial Results
Statement of Operations
Revenue in the fourth quarter was $2.49B, 79% of this came from tools sales and the rest from services. The same 79% of the full year revenue of $9.21B was from selling equipment. Sales as a percent of revenue has come down over the last three years, from 25% in 2020, 24% in 2021, and now 21% in 2022. In their new 2026E Target Model, this trend is forecasted to reverse, with services growing at a 12-14% CAGR within an overall business that is increasing revenue at a 9-11% CAGR. Gross margin for the fourth quarter and for the year was 61%. R&D was 11.9% of revenue and SG&A was 9.5%, for a total overhead spending of $533.7M. Operating margin in the quarter was 60.8%. For the years 2022, 2021, and 2020, operating margins were 39.7%, 36.0%, and 30.3%. This is a return to the level of operating margins the company achieved in 2016 through 2018, prior to the Orbitech acquisition. The 2026E model has operating margin at 41-43%, with R&D a higher percent of revenue (13%) than it is today, and SG&A a lower fraction. The company is projecting to increase revenue by 40% from this quarter’s run rate. Over the last five years, KLA has grown revenue more than 2x while R&D spending has only grown 80%. Thus, KLA is forecasting this operating leverage trend to reverse in R&D. This is surprising to me. It may be that the company is developing new products to expand into different business areas, where revenue will lag overhead spending. Income taxes in the quarter were 15%, leaving net income of $805M. For the full year the company paid only a 5% tax rate and earned net income of $3.32B. The company forecasts their tax rate typically to be 13.5%. Adjusting the full year 2022 earning to this tax rate gives net income of $3.02B, $300M less than what was reported. This lowers EPS to $19.91 from $21.92. Net income in the quarter was $805.4M, or $5.40 per diluted share on 149.1M diluted shares. For the full fiscal year 2022, the company spent $479M on business acquisitions. Net $113M went into available-for-sale securities, and trading securities churned such that a net of only $5M was spent on them. Between buying business, capital expenditures, and adding to their available-for-sale securities balance, the company expended $876M in cash on investing activities. During the year, the company added $3.22B in new debt. $4.75B of cash was spent on share repurchases in the year, including $900M remaining on forward contracts with several large institutional shareholders. These are contracts to buy back shares at a price derived from the average share price in the next two quarters. The final settlement of these buybacks will be in the second fiscal quarter of 2023. $638M was paid out in dividends. For the full year, KLA spent all their operating cash flow on business acquisitions, capital expenditures, and adding available-for-sale securities, plus some share buybacks. In addition, they added $3.2B of new debt and spent all of it and more buying back $4.75B of their own stock. This is a strong statement on KLA’s view of the value of their stock now.
Statement of Cash Flows
The company continues their trend of spending less on capital expenditures than is going off in depreciation, countering the trend of the other WFE companies. For the full year 2022, capital expenditures were $307M while depreciation and amortization was $363M. Cash from operations for the year was $3.31B. Working capital consumed $305M of cash this year, a higher fraction of revenue (3.3%) than the previous two years (averaged 2.5% of revenue). To take out my judgements about working capital and stock-based compensation, I calculate a range of owner’s cash flows. The low end takes working capital changes as reported and removes share-based compensation from operating cash flow. At the high end, I keep share-based compensation as reported and add back in the cash investment into working capital. Taking out all effects of working capital isn’t, of course, realistic. It is just to provide an upper bound. The truth is somewhere in the middle. The low end for the full year is $2.88B, or $18.99 per share. The high end is $3.31B, or $21.85 per share. These are owner’s cash flow yield of 5.3% to 6.1%, on a share price of $359.80. KLA bought back a lot of their own stock this year, $4.64B worth, including forward contracts they entered in to, agreeing to buy shares from several major institutions between now and the second quarter of FY-23. The company also added $3.22B of debt during the year, mostly in new issuances with the rest from a revolver. They paid out $638M in dividends. To summarize for the full year, KLA brought in $3.31B in operating cash flow and another $3.22B worth of debt, for total cash in of $6.53B. They spent $479M on acquisitions (mostly buying ECI), $307M on CapEx, $119M on securities, and $639M paying dividends. These four items total $1.54B, leaving $4.99B. Of this, $4.86B was spent on share buy-backs. A clean way to think about cash flow in 2020 is that all the debt added was used to buy back stock, plus another $1.7B out of operating cash flow. From a year ago, the diluted share count declined from 154.3M to 149.1M, a value of $1.91B at a share price of $367.44.
Balance Sheet
$3.24B of long-term debt was added during FY-22, bringing the debt balance to $6.66B. KLA has no short-term debt. Most of this is $3B of senior notes with maturities in 2032, 2052, and 2062 at annual rates of 4.65%, 4.95% and 5.25%. As described above, management used the cash from all this new debt to buy back stock. Total assets rose to $12.6B. $309M of goodwill was added, out of the $479M of cash spent on acquisitions this year. Current assets grew by $1.47B with ~$500M of AR added and ~$600M of inventory. Cash and marketable securities rose by $213M. Current liabilities also grew, though not as much as current assets. With the big rise in debt, book value declined by $1.98B, to $1.4B.
Earnings Call Notes
Earnings call discussion and comments are all non-GAAP. Full year references are to the calendar year.
Rick Wallace (CEO)
• Their customers are seeing softness in PCs and mobile segments, and memory pricing is weakening
• They have tempered 2022 total WFE revenue but believe it will still grow over 2021
• They set records both in services and in their assembly inspection businesses
Bren Higgins (CFO)
• OpEx will be ~$530M in the September quarter and will scale up for the rest of the calendar year. They will size spending to meet their 2026E model.
• They reiterated $13.5% as their long-term tax rate
• They expect total WFE to be $95B for 2022, down from $100B three months ago. This is the result of supply chain constraints both at KLA and their peer WFE manufacturers.
• Demand is expected to continue to exceed supply for KLA’s products for the rest of 2022
• September 2022 quarter guidance: revenue of $2.6B +/- $125M (wider range than the +/-$120M last quarter), non-GAAP gross margin of 62% to 64%, same as last quarter. Operating expenses will be $525M and other expenses will be $43M. Their tax rate is expected to be 13.5%. GAAP diluted EPS is forecasted between $5.28 and $6.38 per share and non-GAAP diluted EPS of $5.70 to $6.80, based on a fully diluted share count of 143M.
Question and Answer
• They are not seeing any reduction in demand from customers. The opposite is true; pressure is as high now as ever for new equipment. Customers are not giving up tool delivery slots, and they want to be notified if any slots become available.
• During downturns in semiconductor spending, KLA typically sees their business hold up well, because their tools and software enable yield improvement, which is the highest marginal source of profitability for their customers.
• They received a letter related to possible restrictions on equipment shipments to China for technology below 14nm processes. Management said what they know today won’t affect revenue next quarter.
• Most of their PCS sales to China are to indigenous customers as the international customer facilities are more mature
• Within the June quarter, 45% of tool sales were memory, two-thirds of which was DRAM
• The big driver in their business is at the leading edge, vs. sales to customers to make older technologies
• The CHIPS act doesn’t change KLA’s strategy for where they will expand their manufacturing facilities. They are asset-light, especially compared to their customers. They put their facilities in locations that are best for their operations.
• EPC (process control) system sales for KLA will be higher in the second half than in the first half of 2022. They are seeing strength in tools for specialty products (automotive) and softness in PCB.
Summary
A quick valuation for KLA using their 2026E model, which estimates EPS at $38.00, would roughly double the share price from here over the next four years, assuming the shares trade at the same multiple. I think the risk to the $38.00 EPS being achieved is low as I bet they are being conservative with this figure. The risk is in the EPS multiple, which is in the range of the last seven years (between 13 and 29). A useful comparison is to ASML, now a darling since investors have woken up to their monopoly position. ASML trades at 29.1x earnings, Lam is at 13.6x, and Applied is trading at 14.2x. KLA is more like ASML than it is Lam and Applied, yet it trades at similar multiples to them. The company added $3.5B in debt during 2022 so they could buy back almost $5B worth of their own shares. The company sure believes their shares are cheap, and I agree with them. Also worth noting this quarter is the revision down for total WFE revenue in 2022 from $100B to $95B, caused by supply chain constraints. KLA is sticking to the story that customer demand is as strong as ever. It will soften at some point, but nearly impossible to time this. I wonder how much of that pending drop is already priced in, with KLA 18% off its all-time high. I don’t own enough of this company.
-S. Hughes (long KLAC)