KLA Corporation (KLAC) Earnings Call Transcript & Summary

Okay. I would like to get started. Thank you all for coming. I'm Toshiya Hari. I cover the semiconductor and semi-cap equipment space at Goldman Sachs. Very pleased to have Bren Higgins, Executive Vice President and Chief Financial Officer from KLA, as well as Ahmad Khan, President of the Semiconductor Process Control Group. Bren, I wanted you to kick us off by kind of reflecting on 2019.

Sure. Well, thank you, Toshiya. Yes. No, thank you, Toshiya, for having us. So over the course of the session here, we'll make some forward-looking statements, and those statements are subject to risk, and you can see a full list of our risk factors in our SEC filings. It's quite a list. So I encourage you to take a look at it. Very happy to have Ahmad here, too. So for those who don't know Ahmad, Ahmad runs all of the Semiconductor Process Control business for KLA. So I'll be throwing some questions to Ahmad as we go here to get his perspective. So 2019 was a good year for the company. If you just take a step back, I mean, we did a branding change, which is an exciting thing for the employees and certainly part of how we're thinking about the next sort of step of our future as a company, both in terms of opportunities within the parts of KLA that we had in process control, but also exposing us to more opportunities outside of front-end process of manufacturing. And so we're excited about that. We closed the Orbotech transaction, which gives us that exposure, which we're excited about. And then we've seen a nice progression through the year in terms of strength in logic and foundry, supported by what we believe is a very strong competitive position, a portfolio approach to delivering products to market that makes it a differentiator. And as we move through the year, we saw considerable strength in the logic/foundry part of the business, mostly around foundry. Memory turned out was weak and stayed weak. But the foundry intensity was very strong. And I think the strength of the 7-nanometer node maybe surprised some people, including our customer, in terms of overall strength. And so we were able to participate in that. And so against the backdrop of an industry that, at the beginning of the year people thought would be down 20% to 25%, memory was down in excess of 30%, ended up down what we think is about 10% or so, given the strength of logic/foundry in terms of how it offset that. So for the year, our business finished -- we were slightly organically, just slightly above flat. So about 1% growth in a down industry year. And I think that reflects our exposure to those markets, both in terms of process control intensity, with a high mix environment for foundry, technology progression at 7-nanometer with EUV coming in, which, well, I'm sure we'll talk about that. We think we're very well positioned as we go into 2020. Service business also performing very well. 70%-plus of the service revenue stream is contract-based. And so we had a little bit of weakness in the first half of the year in service, driven by lower utilizations as memory customers were idling capacity, but then we saw that strength in the second half. So we believe that that's well positioned to grow double digits, 9% to 11% type growth as we move into '20. So we think we're pretty well positioned. We're excited about what's in front of us.

Great. And then, for 2020, WFE, I don't think you guys necessarily gave a specific number on the call, but you did talk about a very healthy outlook. Can you remind us what kind of growth expectations you have for logic and foundry, NAND and DRAM? And for NAND, specifically, is it 1 or 2 customers is broad-based? What sort of participation are you seeing at the customer level?

Sure. So I think when you look at WFE, we think WFE is going to finish somewhere around $49 billion, $50 billion in 2019. And so as we move into 2020, we talked about a plus 10%, sort of plus or minus type growth year this year, driven by what we expect to be a broadening of foundry and logic investment, both from other foundry customers, more intensity in the logic space and a stronger year in China from logic/foundry. So all of that collectively would drive about 10% to 15% growth year-to-year. 3 months ago, I would have said flat, but given the strength of some of the announcements we've seen from some of our major customers and as we've seen the funnel in China sort of fill out, we think that there's growth there. On the flash side, again, after a pretty significant down year, we would expect to see some correction there, probably somewhere in that 15% to 20% type range of growth from '19 and maybe more middle to second half of the year. On the DRAM side, not expecting to see much -- I mean, it's sort of a flattish outlook. And so we'll see how the year progresses. I mean, one thing with memory customers is, we tend to see things turn off fast and turn back on fast. So we'll see how it goes as we progress through the year. But we're excited about that outlook. Given the process control intensity of memory, you would expect with more memory that, that put some pressure on that, but we have a number of new products in the company that we're bringing to market. And so we would think that the contribution from those products should lead us to a year where process control intensity should be flat. We think there's some minor share opportunities. And against that industry backdrop, we would expect the company to grow in line with the industry, maybe a little bit better. So you take that drop-through in terms of the operating leverage model, the company should drive 1.5x revenue growth rate in terms of earnings growth. That's how we're sizing and expect running the company.

Bren, the broadening of the spending profile that you spoke to for logic and foundry in China, I'm guessing that's kind of lagging edge, maybe leading edge for them, but lagging edge in...

Sure.

In relation to your leading edge foundry customers. Are those technology buys or capacity buys or there is a little bit of both? What's driving that sort of broadening of demand in China?

Yes. So I'll start and I'll let Ahmad weigh in here. But yes, it is more trailing edge. It's more IoT-centric, certainly have industrial and automotive and some of the broadening of demand that is now consuming some of the trailing edge nodes as well. And so there's demand -- domestic demand that they're shipping into, but also other demand out there. So given the road maps, we're talking about the leading edge road maps, our 7-nanometer into 5 as we progress through '20. You're looking for maybe in sort of 14-nanometer and above type technologies in China today, and a lot of activity at more lagging edge. Now as you're new into that, you're trying to progress a road map and that those customers rely as those dynamics are that high mix drives higher complexity in devices. And so more support from companies like KLA in terms of supporting their road maps. So I think it's a good opportunity for us from a participation and a share perspective. And it reflects the broader demand that we believe that exists out there for -- and diversification of demand for semiconductors.

Yes. I think you've covered it well. What I would add is the infrastructure spend on top of that, for example, for mask houses. There's a infrastructure spend for reticle inspection to ensure that you are able to generate the best reticles and clean reticles. On top of that wafer houses that need to set up shops to ensure that they are able to generate wafers for the local market. And for all of those, the inspection metrology requirements are pretty tight. So it's -- from a KLA point of view, we still sell lot of the leading edge equipment into that market because the specs are quite difficult to attain. The rest of it, I think, it's well covered by what Bren said earlier.

Understood.

Yes. I think one of the issues in China though and when the memory ramp of 2017 and 2018 was the ability of the customers to get wafers. So a lot of that wafer supply was consumed by just the general leaders out there. So there is a desire to build some internal wafer capability to be able to produce bare wafers. And so when you're looking at memory devices and particularly vertical memory devices, you start to have more stringent -- to Ahmad's point, stringent requirements on specs, both from a flatness and wafer geometry point of view, but also just general cleanliness and other attributes. So it's an aspect of our business. We're exposed to that. I think sometimes people forget about, but it's a very strong product position and something that sort of augments our broader growth profile.

So just to confirm. So these are local Chinese bare wafer manufacturers?

Yes.

The coronavirus, obviously, a very fluid evolving situation. I think you were probably the first company in my coverage to quantify the potential impact in your guide. It must have been a pretty tricky process. I guess it's been about a week since you reported, and maybe a little bit more than that. Any new findings in terms of potential supply chain disruptions or changes to the demand outlook?

Yes. I don't think it's -- I mean, obviously, it's a very fluid situation. I think from a financial point of view, it hasn't really changed all that much. I mean, certainly, logistically, it's a challenge with people trying to get people in and get them back out and it supports our worldwide customer base and quarantine periods around people and so on. What we tried to do, and maybe I have a good fortune of being able to go tool by tool in terms of how we drive a bottoms-up revenue plan and identify what we thought as tools that were in Hubei province across the broader business that we thought would be impacted in terms of just delay in timing. And so that, we adjusted our midpoint of our guidance to reflect that. Now more broadly, supply chain, other dynamics here, we expanded the range to try to compensate for what else could potentially happen. We do source some components out of China. And so those components -- as those go into our factories to support other shipments. So we want to see how that would play out. Everything started, I wouldn't call it normalized, but we did see some improvement this week as people return from the Lunar New Year. Facilities starting back up, maybe not at 100% capacity, but certainly, facilities that are starting up that we believe will catch up. So not much to say beyond what I said last week at earnings. So we'll play through this quarter. As you think about our 2020 view, given our lead time, given our customer plans tend to have some longevity to them, unless there's some sort of broader issue that ultimately impacts their demand profile that affects how they think about supply, our 2020 view is basically consistent that I wouldn't expect it to have any lasting effects. But over the course of the next couple of quarters, we're scrambling a bit to manage and meet our customer demands and working our way through it.

Okay. But the base case is, whatever you kind of removed from your March quarter guide, I think it was 3% to 5%?

Right.

Would it show up in the June quarter? Is that sort of the base case scenario as of today?

Still the base case. Yes.

Got it. In terms of process control, the market as a percentage of total WFE, I think it's been sort of in the low to mid-teens for a while. It definitely ticked up in 2019. The market was down double digits. You guys -- Bren, to your point, you were flat to up organically. What were some of the drivers that, that drove that increase?

Sure. Why don't I let Ahmad take that.

Yes. So I think, as you know, process control intensity in logic/foundry is higher, and we did well there. We released a few products a couple of years back. Gen5 was a product that we had mentioned quite a bit, and that product started to ramp in a big way in 2019, serving the logic/foundry case. And in this case, both logic and foundry and -- did quite well. We have seen cases at multiple customers where Gen5 has been able to solve problem, not only for the node that they were purchasing, let's say, 5-nanometer node, in one case, but also we're back boarding Gen5 to previous nodes and -- to solve these defectivity problems and, therefore, driving improvement in yield. So that was one major factor. And I think that drove to the overall growth in the business. At the same time, the mask infrastructure setup was important, as you know, the number of designs that were predicted a few years back for 7-nanometer were not very high, but we have seen that that's not the case anymore. The foundry partners, customers, they've done a really nice job, pulling all the customers, their customers to go to advanced nodes. And for that reason, customers are building several mask shops to ensure that they're able to produce all the reticles that are required. So this really drives process control intensity because process control intensity for a mask inspection is quite high. You cannot ship a reticle with a defect, not even one defect to the wafer fab because, as you know, it will print on every single wafer, and that defect would be not considered good. So mask shop infrastructure was quite important to set up. So overall, those were some [Audio Gap] this is -- this happened in foundry. We also drove very close engagement in logic to do the same for Gen5 and drive Gen5 utilization in logic, and we saw the growth there also.

Yes. One thing about the reticle inspection is, you would have thought we would have seen more of the demand that surprised so many people because it does behave like a process tool. And that every reticle has to be inspected before it leaves the reticle house. And to Ahmad's point, a very high in inspection. It's 100% defect detection, and it's a market that we have a very strong share in. So for every design sort of drives a significant reticle side and so, there's a lot of demand for those tools. So that's a business that inflected strongly. I would say at least 20% year-on-year. And I would expect to continue, given what we expect to see follow-on in terms of 7-nanometer activity, but also expectations around 5. So it's one of those areas that, that given what we're now seeing there that gives us confidence around the growth expectations for logic and foundry, both from the leader, but also from other suppliers.

Right.

And just to add one more point, with the introduction of EUV, the defect modes on the wafer and on the reticle change in a significant way. On reticle, it changes because the line widths are shrinking. And for that reason, there is new investment required, new machines required in order to control that defectivity. But on the wafer side, you all previous know how it doesn't really work. And this is one of the reasons why Gen5 did quite well in the wafer side also and several other systems because the defect modes change completely. And for that reason, we saw growth. Moving forward, with implementation of EUV -- further implementation of EUV in 5-nanometer and 3-nanometer, we see, again, process control intensity continuing at a high rate because the defect and the metrology modes would change quite a bit. And for that reason, your previous know-how doesn't always work. You need new tools. You need to upgrade your fleet in a significant way, and that drives revenue growth. And then eventually, with sub-3-nanometer with nanosheet and gate-all-around coming in, that changes the entire front end transistor structure and that changes defect and metrology modes. And we're developing new machines now to ensure that we will be able to meet needs for that. Quite a lot of pull-in from all the R&D locations at customers for that type of close development. We have a very good infrastructure internally for close partnership with our customers early in the phase of their development to ensure that we're able to help them with this development, but at the same time, this ensures that when they make their HVM decisions that they choose KLA.

Just on that point on EUV, how should we think about the growth in your opportunity set, as some of the memory companies perhaps start to embrace EUV in their processes? I guess, one, in particular, relatively near term, 1 to 2 years and then that broadening out potentially 2, 3, 4 customers?

Yes. So what I would say is similar to logic, it's all about, as you mentioned earlier, one in particular. And then -- so there is a gradient in memory as to who's going to adopt first, who's going to adopt second and potentially third. And then the next gradient is how many layers the first person would implement, second layer, third. But first, going back to the infrastructure spend, there is almost a fixed infrastructure spend if you're going to do EUV. And KLA gets that benefit. Meaning, you need to set up the mask shop. That requires reticle inspection tools. You need to do inspections in the wafer fab. At the recent Investor Day, I spoke about a new product that we're developing called Gen5 EUV extension. And this is a product that it really focuses on ensuring that the reticle defects in wafer fab are also monitored using wafer inspection. So these products need to get introduced, even if you do 1 layer or 3 layers or 5 layers or 10 layers. So there's an initial infrastructure spend for R&D and setting up the line. We benefit from that. And then, of course, as EUV scales with the number of layers, we would be from that. So we are, again, partnering closely with customers who are looking at going into memory, EUV and helping them with that structure.