September 2022 Quarter Financials and Analyst Call

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October 26, 2022

Letter to Shareholders

  • Revenue of $2.7B was at the top end of the guided range, up 31% year-over-year and 10% sequentially. GAAP EPS of $7.20 and non-GAAP EPS of $7.06 were both above the top end of the guided range.
  • Macro-driven slowdown in consumer markets, particularly PC and mobile, are leading customers to reduced CY23 capex budgets, especially memory makers
  • Recent U.S. government regulations on exports to China will prevent KLA from servicing certain customers in the PRC in some ways on some products. The full impact of these legal changes are under evaluation.
  • The company stands by its long-term financial targets. They plan to return greater than 85% of free cash flow to shareholders. KLA has a 9-11% annual revenue growth objective through CY26. This includes a 12-14% CAGR in their services business. This model assumes a baseline semiconductor industry growth model of 6-7% through 2026.
  • In the September quarter, services revenue was $529M, up 16% year-over-year. This is well below overall revenue growth for the year, the reverse of what is expected by the company over the long term. However, this reversal is more about how strong the WFE market has been in the last year. When WFE turns, the decline will be meaningful. The services business will be steadily growing.
  • KLA talks about free cash flow regularly, a strong sign for any company. Free cash flow margin was 34% in the quarter and 32% for the last twelve months.
  • The company is intensifying efforts in Advanced Packaging and Automotive electronics. This is an area where KLA can outgrow the overall semiconductor industry, by applying their process control expertise to the outsized growth occurring in advanced packaging.
  • For the twelve months ended September 30, capital returns to shareholders were $5.2B, or 166% of free cash flow and included $44.6B in share repurchases and $664M in dividends.
  • September semiconductor process control segment revenue was 63% foundry/logic and 37% memory. This was the fastest-growing segment at 35% year-over-year and 13% sequentially. Specialty semiconductor process was up 25%/3% (year-over-year/sequentially) and PCB, display, and component was -1%/-19%. Slowing consumer electronics were responsible for the weakness in the last segment.
  • Revenue by region for the September quarter was (previous quarter): China = 31% (29%), Taiwan = 27% (25%), Korea = 15% (16%), US = 6% (10%), Japan = 8% (9%), Europe = 6% (8%), rest of Asia = 4% (3%)
  • On July 7, 2022, KLA announced they had completed a tender offer for $500M of 4.65% senior notes due 2024
  • The company has increased their dividend at a 15% CAGR between 2006 and 2022
  • Based on December guidance, the company expects to outgrow the overall WFE market in 2022, coming in with mid-20% revenue growth. They believe the overall WFE industry will grow in the mid-to-high single digits to the low $90B range for the full year 2022. This is down from a forecast of $95B given last quarter.
  • Industry spending is expected to slow. The company is planning for CY23 WEF to decline approximately 20% based on macro concerns and recent public statements from several [memory] customers, and the impact of U.S. restrictions on China. The China restrictions will have a gross direct revenue impact of $600M to $900M in CY23, for both systems and services, with services representing 10% to 15% of the total.
  • December quarter guidance: total revenue of $2.8B +/-$150M with Foundry/Logic at 76% and Memory at 24% of process control system sales. New China restrictions are a $100M hit to this guidance. Within Memory, DRAM will be 45% and NAND will be 55%. DRAM is slightly lower than last quarter. Both memory types are weakening. Non-GAAP gross margin will be in a range of 61.5% to 63.5%. Effective tax rate will be approximately 13.5% and GAAP diluted EPS will be $5.94 to $7.34 and non-GAAP will be $6.30 to $7.70, based on 140M fully diluted shares.

Financial Results

Statement of Operations

Revenue in the September quarter was $2.72B, split 80.6% from tools and 19.4% from services. Gross margin was $1.68B, or 61.8%. This may be the peak for revenue as guidance has a midpoint $120M below the September period. This will be the end of an extraordinary run up in sales, from less than $1B per quarter five years ago. This gross margin is a couple hundred basis points below where KLA was before the last semiconductor slump. With their pricing power, the only reason I see for them to not reach those gross margin levels again is fear of regulation. The company has more than 80% market share. Operating margin was 40.8%. The company has displayed some operating leverage over the last few years. Operating margin is at an all-time high while gross margin is still not at the best levels in history. The company’s new paper issuance earlier this year nearly doubled their outstanding debt. This is why quarterly interest expense was $74.4M compared to $38.3M a year ago. Other income included $47M, slightly inflating earnings this period. Net income was $1.03B, or $7.20 per diluted share. Average share count in the September quarter was 142.6 million. Results all the way down the statement of operations are records or near-records. This quarter and next will be the apex of the mountain for this cycle. Memory spending is pulling back severely as customers Micron and Hynix have announced WFE reductions for 2023 of more than 50%. The foundry market continues to be strong, however. Depending on the timing of when foundry/logic peaks and when memory recovers, the shape of the pending WFE downturn could be a double trough or a single.

Statement of Cash Flows

For the most recent quarter, cash from operations was $1.01B, almost matched to the $1.03B of net income. Again, depreciation and amortization was greater than capital expenditures, $101.9M compared to $84.4M. KLA is the only WFE company I see like this. Stock-based compensation is pretty small, $35.0M in the quarter. Just the same, I calculated a range of owner’s cash flow, imagining I owned the whole company. Working capital was about neutral this quarter, so I did the range with and without stock-based compensation added back in. Annualizing the Q4 total gives a range of $24.97 to $25.95 per share, or an owner’s cash flow yield of 7.9% to 8.2%. This is not historically cheap on a price-to-cash flow basis, but it does harken back to the value at the time before the World discovered its dependence on semiconductors in 2019. Management mostly churned available-for-sale securities and trading securities. They also sold a business during the period. This netted out to $53.5M spent on financing activities in the quarter, so the proceeds from selling the business offset some capital expenditures. The company took $300M out on their revolver and paid down $662.3M in debt during the period. They slowed down share buybacks greatly, only expending $89.8M here. They paid out $188.0M in dividends to shareholders. Summed up, from the one billion in cash from operations brought in this quarter, one-third of it went to pay down debt and anther another $278M went out to owners. A net of $53M was invested, between capital expenditures, securities, and selling a business off. This totaled to an additional $234M in cash added to KLA’s balance sheet in the September quarter.

Balance Sheet

Current assets grew by almost half a billion dollars in the last quarter, to $7.64B. The biggest items behind this were a combination of more cash (plus $234M) and more inventory (plus $261M). Goodwill came down slightly, because of a combination of business acquisitions and dispositions. Business purchases are also why land, property, and equipment increased by $61M, to $913M, in a quarter when capital expenditures were well below depreciation. Total cash and marketable securities were $2.95B at the end of the quarter, up from $2.70B at the end of the prior period. Total liabilities were down slightly in the quarter, to $11.02B, from $11.20B. Most notable on this side of the ledger is the increase in current liabilities of $268M (to $3.14B) and the decrease in long-term debt of $348M (to $6.31B). KLA’s long-term debt is truly long. There is $6.375B of it as of the end of September. All is fixed rate with effective interest rates between 3.302% and 5.670%. One tranche, $750M worth, is due November 1, 2024. The next maturity date isn’t until 2029, and the longest is 2062. The company has pricing power and fixed rate long-duration debt, so they aren’t too unhappy about the current high rate of inflation. Book value at the end of the quarter was $2.10B, or $14.74 per share.

Share Repurchase History

KLA’s management hasn’t shown special skill with their share repurchases. The second calendar quarter of 2022 was, by more than a factor of four, the largest share buy-back in company history. The stock was down off previous highs during this time, but more time will need to pass to judge the quality of these repurchases. My comment on their lack of skill comes from earlier buybacks. Repurchasing magnitudes look more driven by time of year than by an evaluation of the share price. In 2015, 2019, 2020, 2021, and 2022 – all the biggest years for share buybacks – the purchases were heavily weighted to the first two quarters of the calendar year. The 2015 buying was after a peak in 2014, though the bottom was reached in the latter half of the year. From late 2018 to early 2022, KLA’s share price rose steadily, so the repurchases during that time benefitted from an overall increase in the share price, which came both from earnings growth and multiple expansion, rather than timing the cycle. KLA’s buybacks to me look more timed by the availability of cash than by any insight into the semiconductor cycles or the stock price value. The company has demonstrated commitment to steady share repurchases over its history. These activities have offset dilution from equity grants to executives and employees and have taken the share count down by 10.5% in the last ten years.

Earnings Call Notes

Earnings call discussion and comments are all non-GAAP. Full year references are to the calendar year.

Rick Wallace (CEO)

  • Patterning systems revenue grew 49% sequentially and 67% year-over-year. This is the business sub-segment closely associated with monitoring lithography performance for customers. This growth is largely driven by the increased use of EUV technology.
  • The company is engaging collaboratively with the U.S. government to adhere to new export restrictions to China
  • Consumer market demand, especially PC and mobile, continue to weaken, leading memory customers to sharply reduce capital expenditures in 2023

Bren Higgins (CFO)

  • Supply chain restrictions are improving but still limit output
  • Gross margin exceeded the midpoint of the guided range because of higher-than-expected revenue from semiconductor process control systems, which carry stronger gross margins than other products
  • Based on the midpoint of December guidance, KLA is positioned for mid-20% revenue growth for the total company in calendar 2022. This would significantly outperform the overall WFE market, which is currently projected to be up mid-to-high single digits year-over-year in 2022, to the low $90B range.
  • Calendar 2023 WFE is expected to decline approximately 20%, based on lower memory customer purchases and restrictions on exports to China.

Question and Answer

  • KLA has outgrown the overall WFE market for the last few years. Most of the volatility in WFE is caused by memory, which has lower intensity of KLA’s products than foundry/logic does.
  • Roughly 75% of their services business is on contracts
  • 90%-plus of EUV reticles in production run through KLA systems. 2023 should be another strong year for reticle inspection for the company with the adoption of EUV continuing.
  • Their services business in China is lower than their overall revenue fraction from China
  • For the company next year, they expect service growth to be mid-to-high single digits
  • Lead times will remain extended for some time on their most advanced technologies. For high-volume, lower-tech products, the lead times will become more normal as 2023 progresses.
  • Without the new China restrictions, revenue guidance for the December quarter would have been $100M, proportioned between products and services. They can’t reallocate tools originally destined for China to other customers that quickly. The only way this makes sense to me is if configurations were non-fungible between China and other customers, and/or import paperwork takes a lot of time in other geographies.
  • From an analyst, WFE intensity (spend as a percent of total semiconductor sales) has been 15% to 16% in the last two years, above the previous average of 13% to 14%. The company believes the forces of scaling, completion of consolidation, and regionalization will lead to WFE growing faster than the overall semiconductor industry.
  • The China restriction impact is on revenue and won’t affect mix in such a way that gross margin will be altered
  • KLA hasn’t seen any cancellations yet, though they expect to see some come in as they go into and through 2023
  • OpEx for the company will flatten out for the next few quarters
  • Services being cut off for some KLA tools in the field in China will make that equipment difficult to keep running over the long term

Summary

It seems that every time I review KLA’s results, I think I don’t own enough shares. I had the same thought this quarter. I won’t repeat my valuation comments from last quarter here, except to say that I continue to believe KLA is the mispriced WFE company. The question that continues to hang over WFE is when will the downturn in foundry spending come. The cycles aren’t as steep in foundry/logic as they are in memory, but they still happen, and foundry has been on a tear for more than two years. That said, KLA has a characteristic that is unique among WFE companies. That is, their business benefits from the proliferation of devices within fabs to a degree that it doesn’t for Applied, Lam, ASML, or Tel. That is, more designs means more reticles, which means more reticle inspection capacity needed from KLA. Device count proliferation leads to some added wafer processing equipment needed, because it makes fabs less efficient, but not nearly as much as it does for KLA. The memory spending cuts are clear for everyone to see and the WFE industry forecasts so far from ASML, Lam, and KLA all have 2023 WFE down from 2022 by around 20%. Therefore, the WFE company share prices have all adjusted for the memory downturn. I plan to continue adding to my WFE holdings in the coming quarters in what I believe will be a choppy market. Long term, semiconductor WFE is an area I have high confidence in as a buy and hold investment.

-S. Hughes (long KLAC)

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