April 28, 2022
Letter to Shareholders
• The company outlook for the WFE industry in 2022 is similar to three months ago, excepting they now believe the second half of the year will be stronger than previously anticipated. Total WFE demand will exceed $100B, the third consecutive year of double-digit growth. This would be KLA’s seventh consecutive year of growth. Their final tally of total WFE market size in 2021 was $87B.
• According to Gartner, the WFE market grew 43% in 2021, to $10.4B. KLA’s share rose 1% to 54%. KLA’s market share is more than 4x their nearest competitor. The three competitors they generically cited all have between 5% and 10% market share.
• KLA is “intensifying” their efforts in advanced packaging and automotive. I think this will be an area of outsized grown in the next decade as the industry looks to packaging as an additional vector of improving overall device performance, with Moore’s Law bending.
• The company executed 349 equipment installations in the March quarter, better than the previous record of 293. Services revenue is consistently outperforming the 9-11% long-term growth rate
• Operating expenses will grow to approximately $525M in the June quarter and trend higher over the remainder of 2022. This is driven by their expectations for revenue growth as well as labor cost pressures.
• The company continues to target 40% to 50% operating margin leverage on revenue growth
• Wafer Inspection, Patterning (which includes metrology and reticle inspection), and Services grew 29%, 53% and 14% year-over-year, respectively. The PCB, Display and Component inspection business declined 13% year-over-year and is now 5% of revenue. Any growth they find in PCB, Display and Component is a bonus on top of their WFE business.
• China was 31% of company revenue in the third quarter, followed by Taiwan at 23% and Korea at 21%. The United States is at 10% of total. Note this is the region the equipment is used, not by company headquarters.
• KLA is forecasting quarterly sequential revenue growth throughout 2022 and overall year-over-year revenue to increase more than 20%. They expect to outperform overall WFE with this assessment based on their bookings momentum and strong backlog position.
• June quarter guidance: total revenue of $2.425B +/-$125M with Foundry/Logic at 56% and Memory at 44%. Within Memory, DRAM will be 66% and NAND will be 34%. Non-GAAP gross margin will be in a range of 61.5% to 63.5%. Full year 2022 gross margins will be in a range of 63% +/- 50 bps. Effective tax rate will be approximately 13.5% and GAAP diluted EPS will be $4.60 to $5.70 and non-GAAP will be $4.93 to $6.03, based on 150M fully diluted shares.
• Demand remains “robust” while supply chain issues remain a challenge
Financial Results
Statement of Operations
Total revenue in the third quarter was $2.29B, a 3% sequential decline. This revenue broke down 79% tools and 21% services. This split was 80-20 last quarter and 75-25 the quarter before that. Services will be more stable than tool sales, in absolute dollars. Gross margin was 61.0% for the quarter, 40 bps lower than the previous quarter. Overhead was $501M, up another 5% from the second quarter. The company continues to invest for the future market growth they are anticipating. Operating margin in the quarter was 39.1%. 13.6% of income was provisioned for income taxes. This is a typical rate for KLA, in contrast to the 22% they provisioned in the previous quarter. Net income in the quarter was $730.1M or $4.83 per diluted share, on a share count of 151M. These earnings are up from the second quarter, but only because last quarter had an unusually high tax rate. Were last quarter’s earnings taxed at the same rate as this quarter was, income would have been $800M. Thus, adjusted earnings were about 12% lower quarter-over-quarter.
Statement of Cash Flows
I’m going to try something different in my cash flow analysis. To date, I take stock-based compensation back out of operating cash flow. I have done this because I don’t want to lose sight of the dilutive effect stock grants to labor have. This approach has always left me uncomfortable because of how stock grant and stock buyback transactions all happen at different prices. This means, with the publically-available information, I can never fully square the effects of these transactions. I also realized recently, thanks to a comment from a Fool on another board, that I am double counting in my owner’s cash flow calculation. I take the cash flow from stock-based compensation back out, but I also pick up the dilutive effect of these shares (to some degree, because the share count given each quarter is a weighted average for the period) in my owner’s cash flow yield calculation. The changes I am making is to leave the equity-based compensation effect back in, and I’ll do a check on how share count has changed in recent quarters, to see how much equity grants are reducing the effect of share buy backs.
Working capital and other similar assets and liabilities were not distorting this quarter, so I’m not making any adjustments related to these items for my owner’s cash flow. With the change to my calculation related to equity compensation, my owner’s cash flow is the common definition of free cash flow this quarter, which is $718.6M. This was an unusual quarter for KLA in that their capital expenditures ($100M) exceeded depreciation and amortization ($92M). Annualizing this quarters FCF and dividing by a market cap of $47.59B gives a cash flow yield of 6.0%. This is better than last quarter because the share price has declined more than cash flow. What did the company do with the cash generated in the quarter? They closed on their acquisition of ECI Technology for $431.5M in cash. ECI is a provider of chemical management systems for semiconductor and related industries. Because of this large cash outlay, transactions in available-for-sale securities and trading securities were close to neutral in the quarter, consuming about $40M of cash. They took out a net value of $275M from their revolving credit facility in the quarter. The company also paid off $20M in other debt. The 10Q doesn’t say why they drew cash from their revolver, but my guess is they think the stock price is low and they want to take advantage of that. The company bought back $565M worth of stock during the quarter and paid out $159 in dividends. Between these two shareholder return transactions, more than 100% of free cash flow in the quarter was returned to the owners of the company. In the last twelve months, KLA’s share count has been reduced by 3.97M shares. At today’s share price ($318.87), that is a total value of $1.27B. In the last year, KLA has spent $1.694B in cash on share repurchases. This is in the zip code with the total value the share count has come down, but still more than $400M of this cash return to shareholders is not apparent today. The large decline in share price is the reason for this.
Balance Sheet
Total book value rose by $30M to $4.08B. With the just-closed acquisition, goodwill stands at $2.3B, or 20% of total assets. Cash and equivalents was $2.5B while long-term debt is $3.7B. KLA generates so much cash that having a negative net cash balance isn’t a problem, but it is unusual to see in the semiconductor companies I follow. Most are neutral to positive. But there are some other things happening on KLA’s balance sheet that should be considered when analyzing their position. The company has $3.6B worth of AR and Inventories, compared to $2.8B in AP, deferred revenue, and other current liabilities. Once this is considered, their balance sheet doesn’t look as short of cash, with an extra net $800M in current assets. But as I said, the company generates a torrent of cash and has good visibility into their order book, so liquidity is not a concern.
Earnings Call Notes
Earnings call discussion and comments are all non-GAAP
Rick Wallace (CEO)
• The company will hold an investor day on June 16th in New York City
• Gartner estimated the total process control market to be $10.4B in 2021 with KLA having a market share 4x their next largest competitor. They increased their market share 1% year-over-year. The company’s market share in the optical inspection subset of the market is greater than 80%. The optical inspection market grew 50% in 2021, according to Gartner
Bren Higgins (CFO)
• Results for the quarter were in the upper end of the guided range
• Their pace of new hiring has been lower than was previously planned
• Operating expenses will grow to $525M in the June quarter. Bren called out labor cost pressures when providing this number.
• Free cash flow margin in the quarter was 31.4%. Impressive. Most impressive.
• System revenue breakdown was 63% Foundry/Logic, 26% DRAM, and 11% NAND
• Their long-term target for cash flow return to shareholders continues to be 70%
• Their outlook for the full year 2022 remains the same as it was last quarter. For calendar 2022 they expect the WFE market to grow in the mid-teens % off of a base of $87B in calendar 2021. Last quarter they said “high-teens %” but off of a base of $86B. The company believes the second half of the year will have greater revenue than the first half.
• Supply chain shortages continue to hinder their capacity to meet customer demand
• COVID lockdowns in China are exacerbating supply chain constraints. These lockdowns may also impact the ability of some tool installations at customers. This would push out revenue in time.
• Quarterly revenue for the company is expected to increase sequentially each quarter throughout calendar 2022 and will grow more than 20% year-over-year. Demand will exceed supply for the rest of 2022.
• Company gross margin for the full year 2022 is expected to be 63% +/-50 bps
• June 2022 quarter guidance: revenue of $2.5B +/- $120M (wider range than the +/-$100M last quarter), non-GAAP gross margin of 61.5% to 63.5%, 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 $4.60 and $5.70 per share and non-GAAP diluted EPS of $4.93 to $6.03, based on a fully diluted share count of 150M. These are also wider ranges than were given for the March quarter, which is to be expected given the larger revenue range. For systems revenue, memory is expected to be 44% and foundry/logic will be 56%. Within memory, DRAM is forecasted to be 66% of memory and NAND will be 34%.
• Brin made the noteworthy comment that the effects of inflation on cost are outstripping the benefits of scale they normally see in a rising revenue environment. Though he didn’t quantify this effect, it will compress operating margins relative to what would normally be seen with increasing scale. This doesn’t necessarily mean operating margin will shrink. It may just mean it won’t expand as fast as it would with tame inflation.
Question and Answer
• The visibility into future sales they have because of their backlog tells them that they will continue to see market share gains over the next two years
• Blended lead time is “well over a year” today, with wide variation depending on product line. They have some products that are booking out into 2024 today.
• Book-to-bill will remain above 1.0 for the rest of 2022
• Technology migrations and the transition to EUV have been drivers in the strength in equipment sales to DRAM customers
• The nature of process control systems means they are not shipping partial equipment, as at least one other WFE company has said they are doing. This means there isn’t a swell of revenue recognition coming from partially installed tools being completed.
• They are seeing new wafer starts being added across all segments and process nodes. Wafer additions in memory are limited, more of it is in foundry/logic.
• Supply chain issues continue to be a headwind, which the executives characterized as “whack-a-mole”
• The ratio of optical to E-Beam inspection continues to be around 80-20, where it has been for years. E-Beam is getting traction in reticle inspection. KLA sees them as complementary technologies with E-Beam not having high enough throughput to be more than an engineering and defect discovery tool.
• Within their Foundry sales, around 80% of those sales are for leading edge (10 nm and below) applications
Summary
Between their guidance and commentary, KLA is predicting the company will have record revenue in each quarter for the rest of the year. Equipment lead times are more than twelve months out and the company has a health backlog. The visibility WFE companies have to future demand, in the form of their backlogs and customer conversations, gives them a better aggregate view than anyone else of the next one to two years of semiconductor capital equipment spending. That said, fab owners can cancel orders if things really turn down, albeit with a substantial penalty. I don’t believe KLA would be saying revenue will continue to grow for at least the next three quarters unless they were highly confident in that prediction. That being the case, the current share price, with an owner’s cash flow yield of 6%, makes KLA’s shares cheap relative to recent history. A couple other historical facts to consider with KLA. Their share count at 174M at the start of 2010, now 151M, a reduction of 13%. This is not very impressive for twelve years of share repurchases. What is impressive is how their cash flow and dividend has grown. The dividend has risen at a 15% CAGR from 2006 to 2022. Free cash flow per share increased from $2.46 to $18.84 from the beginning of 2010 to today. That is an 18% CAGR. There will be a downturn in semiconductors at some point. There always is. But as I continue to watch the WFE companies and their customers each quarter, my conviction is growing that semi equipment makers are great long-term holdings. Among them, KLA is the hidden gem, because the Market doesn’t seem to recognize they are a near-monopoly and have the best margins among their peer group, including ASML.
-Smooth Hughes (long KLAC)