KLA Corporation (KLAC) Earnings Call Transcript & Summary

Good afternoon, and thank you for attending JPMorgan's 48th Annual Technology Media and Communications Conference. My name is Harlan Sur. I'm the semiconductor and semiconductor capital equipment analyst for the firm. Very pleased to have the team from KLA here today, Rick Wallace, President and Chief Executive Officer; Bren Higgins, CFO; Kevin Kessel; and Ed Lockwood of the IR team. I'll ask Rick to kick us off with some opening comments, and then we'll go ahead and start the Q&A. [Operator Instructions] With that, thanks, guys, for joining us. And with that, let me turn it over to Rick.

Good afternoon, everyone. Thank you, Harlan, for the introduction. This is obviously quite different than prior conferences, but one thing that hasn't changed is I have to start with the safe harbor statement. So everything I say will be covered by that, and we will make some forward-looking statements. I think the theme of the day for KLA for the month is really -- it's about our resiliency. And I think what you've seen in the last couple of months, we announced our earnings last week, is how we were able to perform in a really unprecedented environment. And I attribute that to the ability that we've had as a company to really hone our operating system, the KLA operating system, which is really the driving factor for managing all our businesses. And of course, we had challenges early on to navigate the supply chain. We talked about that in our call. But what was really gratifying through the March quarter and we're seeing extended now is the support by our customers and the interest in our equipment and really the partnership we've had with our customers around the world to enable them to continue to make their investments in their technology transfer and their ability to work on new technologies and advance their road maps in addition to support their capacity needs. So we had a strong quarter. We talked about it in the earnings call. We left the March quarter with record backlog, and we felt -- feel really good about where we're positioned. We also had a strong market share in 2019. The Gartner report came out and we gained share. And we attribute that to our engagement with our customers and the technology innovation across the company. So we feel well positioned. There are certainly going to be additional challenges in this COVID world that we're all dealing with. But thanks to the outstanding work of all our employees across KLA, and I'd really like to recognize them, as well as our interactions with our customers, we feel like we're going to be in a strong position to be able to support our customers as they navigate these choppy waters.

Great. Thanks for the opening remarks there. On resiliency, I think we should start off there because I think it's very applicable here. KLA team seems to be navigating COVID-19 relatively well, drove better earnings in the March quarter, strong free cash flow, putting forth a relatively strong forward guidance, although the range of the guide was rather large. You did mention more logistical personnel-related impacts, installs and qualifications and the likes. Maybe you can just help us understand what cost impacts you're incurring in due to COVID-19, whether it be related to social distancing, logistics, freight and so on? But specifically, my question is, I would have expected a bigger impact to the gross margins, but the team is still holding gross margins at a very strong 60% plus level.

Yes, I'll let Bren take that one.

Yes. Harlan, nice to see you. It is -- I think we've done a pretty good job with things overall. We are incurring costs related to some of the things you talked about. There are expedite fees. There are logistical costs. So those are things that we're dealing with. I would not classify them as at a material level overall, and they're embedded in how we're thinking about our guidance. From a resource perspective, we are running our factories as we generally always have. And so what that means is, is that we build our tools and bays, and we're able to comply with social distancing and other protocols. Clean rooms are very safe spaces to be in general, and given the way the tools are built, we haven't had to add excess resources to comply. We are adding some extra resources into the field teams locally as we deal with quarantine periods and travel restrictions, and we can't leverage our centralized teams to support customers. So all that's embedded in the guidance. We're dealing with it. I would say that it's probably less than $5 million in aggregate impact in a given quarter. But like I said, it's contemplated in our guidance. And our margins tend to move around mostly by product mix type factors more so than any sort of period type expense like this. So we're dealing with it. And ultimately, those resources get absorbed into either our service business or absorbed just into our factory teams as we manage our growth moving forward. One thing that is also contributing, I think, to the good performance of the company is the strength of the service business. We continue to see growth in service. Service provides an accretive revenue stream to the company. And so we've been pleased with the ability to continue to execute that. And given the global infrastructure we have and resources and staffing that we're able to continue to support our customers as they run their facilities even in the impacted areas where the facilities continue to run.

Great. Yes. I mean, strong execution on the supply and operations side. On the demand side of things relative to COVID-19, has the team seen any customer spending time line starting to push out?

The -- we noted this on the call. I think, by and large, it's been remarkable in terms of our customer behavior. And let me quantify that. Really our large customers that are driving most of the spending are sticking with their plans, and we're certainly seeing strong demand. We've talked about exiting with record backlog. And they also talk about continuing their plans as they look forward for a new technology node and transition. Obviously, there's a softness in the semiconductor supporting the automobile industry, which would be the 1 sector that we think we were hoping in 2020 was going to resume growth, and now that's going to be deferred. But it's almost been made up by the other drivers. And I think the work from home and virtual world that we're in now has driven a lot of our customers to being supportive in those efforts, which is driving demand at a level that's really remarkable given everything else that's going on in the environment. So no, we have not seen that. We've had conversations. We widened the range mainly because of how much we just don't know about how this is going to -- this health crisis is, of course, going to become an -- has already become an economic impact to the world economy. And we just don't know how to handicap that, hence the prudence around the range. But no, our conversations with customers continue to be very positive. We've had a lot of interactions. They were quite happy and surprised, frankly, at our ability to support them, and we got a lot of positive feedback from them on that, both in terms of service, but also new tools installation. And I think it has -- we've strengthened our partnership with them because we're really helping them in a time where they're, of course, trying to keep their factories running. As Bren said, they're doing that. But no, so far, demand looks good. We haven't forecasted the year, as you know, and we'll have to see how the quarter develops in terms of, I think, the economy in general before we're able to really weigh in on how the second half will look.

If you break it down by segments, Harlan, I think if you look at logic and foundry and the breadth of investment that's happening there, a, that business tends to be pretty focused on certain nodes, supporting certain customers and so we've seen some breadth of that investment. And we continue to expect to see that over the course of this year. As we move into the second half, the memory business is interesting in that it's really been somewhat soft since the middle of '18. So we're coming into '20 after pretty significant corrections in that part of the overall semiconductor environment. And so I think our customers are in a place where they can continue to invest. Certainly, they're going to do things to progress their technology road maps. And as we look at the second half of the year, I think that's probably the part of the business that might be more sensitive to demand changes for them that might influence their plans. But they've been very disciplined for a long period of time. They have facilities. So I think it's been fairly well-managed so far. So I think that's why we're seeing the signals that we're seeing, but clearly, with the caveat that the second half is a bit of a question for everybody. But internally, we see things holding up. And as we said, not much different today than what we thought 3 months ago overall, with the exception of the couple of markets that Rick talked about.

And so let's go with that. So if we look at the profile that you see today, you've described this year's WFE spending profile, as you mentioned, fairly balanced on the foundry and logic side, with shrink here in the first half continuing into the second half. You've discussed the potential for improved memory in the back half of the year, obviously, with the caveat that macro weakness could result in lower investments there. First question on the sustainability of foundry and logic into the second half, is it being driven by a broadening of spenders beyond your large foundry customers? And then second question is, on the second half bias on memory spend, is that more NAND or DRAM bias?

So yes, to answer your question, it is a broadening of investment into the second half. And there are product cycles that tends to drive leading customers to invest the way that they do. But you are seeing a broadening of investment that gives us some confidence around how that will play out in the second half. Pretty balanced. I think that -- certainly, to Rick's earlier point, the drivers around work from home has influenced, I think, the DRAM space a little bit more. So I think that, that part is a little bit more insulated from some of the consumer dynamics that you might see on the NAND side. So as I look at it, I probably handicap it a little bit more that way, but pretty balanced into the second half.

Great. And then something that you touched upon on the earnings call, but we want to kind of revisit the environment. Could be -- your interpretation could be changing, but with the recent Department of Commerce's BIS initiative on licensing requirements for equipment shipments to China, that could be used for defense purposes. Your interpretation last week was that it would probably only impact tools that are manufactured in the U.S., which would include sort of your -- some of your flagship products, like your broadband plasma and mask inspection-based platforms that are manufactured here in the Bay Area. Again, it's only been a week, but I'm sure that you've gotten more clarity. Any changes to your prior view?

Let me start, and then Bren can fill in some of the details because he's got a lot of the specific about what we already have to do. I think in aggregate, we're getting a little bit more clarity, but it's still pretty vague in terms of the way to interpret it. And as we work through the details of that, I think the intent is clear, but the implementation is the part of that, that we're still working through. But I would note a couple of things. Our leading-edge tools, by and large, are not shipping into China. What we're shipping is tools in the most part, take even the flagship, the BBP that you talk about, we're really talking about tools that are several years old in terms of when they've been introduced that model into the market. And that's -- the example in lithography would be EUV isn't being allowed to be shipped into China. And so our tools that would be on a level of that. So that's a very small part of what we're looking at. So if you're talking about really leading-edge, enabling, which historically has not been. The focus has been on concern about selling directly to the military and also enabling leading-edge tools. I would say, in aggregate, that's not a big part of what the Chinese customers have been buying from us. And then we can already talk -- we can talk to the military implication shipping to military based on what we already have to do, and that's an area that Bren's very plugged into.

I mean, we already have to assure that our tools aren't being used to build military products. The definition in the most recent order are -- is broader about just military customers. And to the earlier point, we'll see how it ultimately plays out over the next few months as some of these issues are surfaced and we work with our peers to bring up some of the complexity that's in the order. But -- so we're already at that place already. And so what you would have to do is you go through a diligence process of seeing if customers are selling to military customers or not. And if that diligence process says, yes, then you have to get a license. If it doesn't, then you can continue to ship as normal. So now, we'll see if any of these changes or not, but that's generally how -- what the rule says, and we'll have to see. I think there's a couple of points also that when you think about the composition of the investment that's happening in China today, there's the memory composition, which is more commodity-like products, to Rick's point, in all cases, everything more trailing edge versus leading edge. And then on the foundry logic side, more application specific, most of it more trailing edge. And then there's also materials investments, investments in wafer capacity and reticle capacity to support the overall infrastructure. In a lot of those cases, those are new facilities, and so don't really have customers as of today. So there's a lot of dynamics there that we'll have to understand. Obviously, we're going to do everything we need to do to comply with the regulations. And we'll see where we end up in a couple of months. And then we'll have a better visibility in terms of the impact, both near-term and long-term. It could be just an administrative dynamic, but we'll have to just see how it plays out.

Great. And the team does have fairly large operations in Singapore, whether it's because of trade or just overall good business continuity planning. How feasible is it to move production of some of your high value-add reticle and BBP optical tools to this location if need be?

Let me take the first part and then I'll let Bren fill it in again. So years ago, we started to -- we made an effort, I'd say, probably 15 years ago, to make our ability to produce products, both in the U.S. was where we originally were almost everything was produced, and we build out Singapore, to your point, but also Israel. And so we have a large operation in Israel and in Singapore. And what we demonstrated over time is very efficient ability to transition products and even subsystems to the different factories around the world. So our process and our procurement process is one that really enables us to do that. And it's really a matter of choice of a number of factors that determine where we do that. There are already aspects of BBP -- of the BBP tool that are -- there are parts of that subsystems that are built in Singapore. So it's not a major effort to transition because those factories are up and running in both cases, and it's been a pretty standard practice. And then, Bren, can you fill that out a bit?

Yes. They're mature operations. And if you look at what we do, I would say that the level of -- there was probably a time where what we moved to Singapore was -- and even to Israel was less complex products. But we started those operations about 15 years ago. And certainly, in Israel, in that case, a lot longer ago than that. And so I would say that today, we are capable of building the most complex systems in the company just about anywhere in the world. So if you look, for example, we're building the new AXION 3D metrology tool, we're going to build that in Israel. So there are a lot of factors that go into why we build and what we build where. And to Rick's point, we do subsystems in certain places. And it's -- typically, there's cost elements, but there's also capability and there's the supply chain and proximity to customer aspects of those, call them more operational drivers for why we do what we do. So certainly, we have the flexibility to do that, and we're always looking to optimize our footprint about what we do where. And so it's not stuff that's transferable overnight. But certainly, to Rick's point, we've demonstrated the capability to be able to move and import products if we decide to do that.

Great. Rick, on the earnings call, you expressed high confidence on sustained process control intensity this year. In your foundry and logic market, clearly, the leading foundry supplier has steadily moved down the path of Moore's law. And the equipment industry and KLA has certainly benefited from the aggressive technology migration cadence. Now it looks like one of your large logic customers is finally executing on getting back to a 2, 2.5-year cadence on node migrations, after almost a full year pause and probably much reuse. Now that you have multiple large customers, foundry and logic, moving at an aggressive cadence over the next few years, is this contributing to your confidence on sustained process control intensity, not just for this year but going forward?

Yes. Those are really good observations, Harlan. I think if you look at the delay, this kind of lithography holiday, where there was no real advancement in the wavelength and there was no EUV for a number of years. Scaling, even though there was progress made, scaling has kind of resumed, to your point. And on top of that, because of the cost effectiveness of the advanced nodes, I think you're seeing more customers, more design starts happening, which is what's driving, I think, these players to invest and provide more than having just 1 supplier of that. And of course, the combination of more advanced designs, new lithography technology and higher mix, all is good for process control. And it's been coupled with the successful introduction of our new capability, not just BBP, which I'm sure we can talk more about, but also the other tools that we've had. And I think that's what's been driving it. We did see a strong year in market share in 2019. And a lot of that was associated with some of our new capability, winning some early decisions at customers that we think will then scale as we go forward into larger share and also higher process control. So we feel very good about being validated on those investments that we've been making over the years.

Great. And then on the market share front, I mean, the team had another solid year in 2019, gaining nearly 300 basis points of share in core process control. You're now almost 5x larger than your second largest competitor. How should we think about share over the next few years, especially considering new pool offerings such as e-beam inspection, X-ray metrology and just the overall R&D scale that KLA has over its competitors?

I think it's a very interesting question. I mean, this industry is made up, in general, with the large players over time and often get bigger because they have this natural flywheel advantage of R&D spend and innovation driving. And you have a disproportionate amount of available money to spend on R&D. And I think that last year, really -- the big story last year was not just the strength of reticle inspection, which was significant because it was part of all the new designs that were happening at the advanced nodes, but also the resurgence of BBP and the broadening of the Gen 5 customer base to more production areas, which was driving, I think, a lot of the questions people had, and we could talk about optical e-beam, too, I'm sure. But this was a real demonstration of early innings of the broadening of BBP. And I think we feel good about where that can go because that product is still new in terms of -- it's a couple of years in, but the general lifetime of a generation like that could be 10 years, and it's been longer for Gen 4. So we feel like we're in really good position. Our customers are excited because we're giving them capabilities that they didn't know what's going to be available at the kind of cost of ownership. There was that concern in the industry a few years ago that to support these nodes, you have to be on e-beam. And we've demonstrated that e-beam continues to be a niche part of that segment. And in our case, we'll use it to guide some of the more advanced optical inspections, but that's been largely why. And then you mentioned the metrology. The metrology challenges aren't getting easier either. And that's not just logic, that's also in memory. So we feel good about both our metrology and inspection business. And I think there's a long way to go in terms of customers continuing to have confidence. I have to say that this last few months, we've heard from a lot of customers. I think it reinforced their confidence in dealing with KLA. And I think that's a positive going forward because we were able to deliver when others didn't. And I think that was very important to them.

Let's -- along those same lines of share, I mean, EUV, EUV mask inspection has been a great story for the team, driving strong investments in your mask inspection business as well as your wafer inspection for EUV mask print check. Your reticle inspection business grew almost 40% last year. You gained 500 points of share. You own 60% of this market. And despite your share gains, your R&D scale, your leadership in the mask shop, there still seems to be quite a bit of competitive noise out there. Help us understand your roadmap for EUV mask inspection over the next several years and your plans to bring an at-wavelength actinic inspection platform to the market?

Yes. That's well put. I think we had success. I think, we early on, in our -- maybe as we grew up as a company, I remember before the Tencor deal, we tried to push really hard on brightfield inspection for every application. And Tencor had darkfield inspection. And really the story that told us is once we had both, we really recognize the customers really have to have the best cost of ownership solution to solve the problem that they can have. And once we became a portfolio company, we can't quit trying to push just the latest technology that may or may not be appropriate for the job. And I think what we're seeing, and this is a recurring theme is if you're only doing e-beam inspection, what you have to do is tell the world that the world only needs e-beam inspection. And so if you're only doing actinic reticle inspection, of course, you're going to tell the world that that's what they need, and you can create some buzz around it. The truth is what our customers need is the most cost-effective way to solve their problems that you can possibly get. And the benefit of a portfolio is we don't have to dictate a point solution for any application. So the reticle inspection is a great example. If today, people had an actinic reticle tool for EUV, it would be overmatched and overpriced and the cost of ownership would be too high for the job that needs to be solved. And the job that can be solved, can be solved with a 6xx in a print down to verify with the Gen 5 that you're really finding the defects that matter. There will be a time when we need actinic inspection for EUV, but it will be concurrent with high-NA EUV. That's not going to be for at least 3 years in mask production. So right now, the customers, the reason they're choosing to buy from KLA, it's the most cost-effective solution for them. So we keep trying to -- we end up historically. We've always battled a point answer that looks to be a leading disruptive technology but -- and even our customers might get excited about that idea, but they keep coming back to what's the most cost-effective way to solve the problem. And that's why back to the optical e-beam example, if you can do it optically, you'd much rather do it optically than by e-beam. If you can measure a mask with a 6xx and print down with a Gen 5, that's a better solution. Until it's not, until it doesn't work. And when it doesn't work, that's when we will have the Gen 5 -- the EUV reticle. But before that, we'll have a multi-beam e-beam tool to measure the reticles in the mask house because that's the next best solution in terms of cost of ownership. So I really think the portfolio solution allows us to think more along the lines of the economic buyer in our customers and less about just the technologies that wants the latest generation.

We have -- appreciate that. We have a question from one of the investors. Question is, Intel has petitioned in the U.S. government to expand the semi industry in the U.S. potentially at the expense of maybe some of the offshore foundries. How does that theoretically shift or impact the share or potential economics of KLA?

So we're in the fortunate position that our market share is nominally the same everywhere in the world. It really doesn't matter where a factory has been built. Now I would like to believe that we can compete anywhere in the world. So if it was in the U.S., we do very well here. But the issue is for doing that, unless it's a very large investment, it won't have the efficiency and the scale that you would need to be competitive with some of the operations in Asia. And so in aggregate, I think, it's at worst-case even for KLA because if we will fight and win the business either place. In some cases, it might actually be better because the efficiency of that fab is unlikely to be as efficient as what it is in and those mega cluster of fabs that are happening right now in Taiwan.

And a lot of efficiency over the years has come from the consolidation of customers and scaling to big mega-fabs. And that's what's kept WFE from growing all that fast. And all that efficiency has played out. You introduced this, this turns to make it may be a little less efficient, which means more WFE growth associated with it. And to Rick's point, given our market position, that's a positive for KLA from that point of view.

That's on the product side. On your flagship optical pattern wafer inspection franchise, it does appear that, again, the bear case thesis on optical inspection being overtaken by e-beam really isn't playing out. In fact, the team continues to strengthen its hold on the optical market with advanced systems like Gen 5, for example. But in the meantime, KLA did introduce a differentiated e-beam inspection platform last year. You actually showed up in the Gartner shared tables for the first time in 5 years. How is the team going to capitalize on your leadership in optical to drive synergies with your new e-beam platform to either sustain or potentially even grow your leadership in the overall wafer inspection market?

It's a great question. And we've seen all the long -- we always felt there's a market for e-beam inspection. We were always clear on the challenge we thought that, that market had. There was a size of that market. But it was not going to overtake optical, partly because you can continue to improve the optical tools. And I can tell you, there are several generations, or at least improvements we can continue to make to optical to make sure that, that continues to be the primary tool. However, a directed e-beam tool that has the capabilities that we have in this one and some of the same algorithms that we have can help in terms of some of the engineering analysis and a few layers in the application specifically for some certain defect types. And that will be why I think we're seeing early success. We have, we think, a superior e-beam architecture, but also it's the coupling that will enable us to optimize further the optical tool and then also give feedback to the e-beam tool with especially leveraging the algos that we have. So we think that will be a place, and that's part of the growth story that we laid out, the relatively modest growth story we laid out in terms of our overall process control portfolio for the 2023 time line. And I know Bren has spent a lot of time looking at this as the CFO to make sure that investment was rational. What holds you?

Well, one thing, I think, you have to even further segment down within e-beam inspection. You have electrical defect test called voltage contrast that happens with e-beam and also small physicals. Our tool is focused on the physical defect part of it because we think that's how we enable and increase the relevance of the optical capability. So in a scaling environment where smaller defects matter, we can use this connectivity across the tools and some of the machine learning algorithms that are built into the tools to try to use that to point the optical inspectors to make them even more valuable to customers. So you couple that, that higher signals and noise, if you will, with production level throughputs and it's pretty compelling from an overall high-end pattern inspection point of view. So it's really about enabling that part of the market opportunity for us. And we certainly saw some of that momentum in '19. And I would expect to see even more in '20 based on just what we're seeing with optical and that doesn't include the print check application that Rick talked about earlier, which is about reticle qualification for EUV. So it's created some opportunities for us, and we think ultimately will drive the relevance of optical inspection, which is the strongest market or biggest business in the company.

Let's talk about capital return. When I think about KLA, lots of different differentiators. When I look at the financial profile, 60% plus up gross margins, well north of 30%-plus operating margins, high 20s free cash flow margins. You've got the leadership in the process control. But also capital return has been a big differentiator for the team, right? You have the stated goal of returning 70% to 75% of free cash flow to shareholders. Your payout ratio was over 100% in the March quarter on 28% free cash flow margins. Very strong, I would argue, in a very tough environment. How should we think about the buybacks and dividends as we move through the year, even if fundamentals do weaken in the second half of the year?

Well, if you back up, I mean, we've been pretty consistent for the last 10 years in terms of how we think about deploying the capital of the company. And to your point, we either deploy it back into our business, which is our #1 priority or achieving our growth objectives from an inorganic point of view. And then putting what is unallocated back to work in terms of returning to shareholders. We have a pretty deep understanding of what it takes to run this business, how much liquidity we need, why we have the level of debt we do in the capital structure, and so that allows us to really to have a long-term perspective and think about different demand environments about how we think about deploying cash and returning to shareholders. So the dividend, the dividend, we target a payout ratio through cycle of about 35%. We have a goal to grow the dividend payout at the rate of the growth of free cash flow for the company. So with our expectations for top line, the operating leverage in our model, we should be able to grow our dividend payout over 10% and our track record has been higher than that over the last 10 years, but that's generally our target. And with the payout ratio we have, that even in difficult environments, we can still maintain a regular cadence. It gets valued if it's predictable in terms of growth plan and how it's managed. And so we try to be fairly explicit about that. Certainly, in times like this, you do have the ability to turn on and off share repurchases. We do believe that we will consistently deliver over 70%. We're being more prudent today, obviously, with some of the questions overall in the market and the general economy about our share repurchase activity. As you said, it was pretty high in March. It was also pretty high in December. And most of our free -- our share repurchases are funded out of ongoing cash flow from the business just given the level of cash we have. So we'll continue to be prudent. But the long-term strategy is intact, and we don't think about it any differently because of the situation we're in because we built it in a way that tested it against good and bad or potentially bad environments.

We're just about out of time. Rick, Bren, Kevin, Ed, appreciate the insights, keep up with great execution, and thank you for participating in our conference.

Thanks for having us, Harlan. Take care. Stay safe.

Glad to be here.