KLA Corporation (KLAC) Earnings Call Transcript & Summary

Perfect. So I'm Joe Quatrochi, the semi cap analyst at Wells Fargo. Something that we had highlighted back in a report in September 2019 was that we think the semi cap service is an underappreciated aspect of the industry, given its recurring nature of revenue and as well as the growing installed base to drive those revenue streams. Today, we're pleased to feature KLA's Bren Higgins, CFO; as well as the Head of Global Operations, Brian Lorig -- I'm sorry, EVP Global Support and Services, there we go, to discuss KLA Services business. First, we're going to focus on having a few comments from Bren, and then we'll focus our questions to Brian on the Services business. Bren?

Joe, thank you for having us. Appreciate being here. Before we get to Brian, and I'm really excited to have him here today and to spend a little bit of time talking about the Service business, I do want to provide a little bit of just overall context on where we are. We've had a fair amount of investor engagement over the last couple of weeks or so. So just to provide some context on where we are today and then would love to dive into Services. Obviously, I'll make some forward-looking statements today, and those are covered by safe harbor. And you can find our risk factors in our SEC filings, which you can access from our website. 2020 has been a very interesting year, challenging in a lot of ways, I think, highlights the strength of a couple of things. First of all, I think KLA's business model, our operating model, how we run the company and how our teams execute, which has been fantastic. But also that the end market drivers for our industry, which have been compelling in a lot of ways have been accelerated. And so when you just take a 30,000-foot view and look at the company this year, we're going to grow our top line somewhere in the mid-teens. If you take a midpoint November quarter. And our earnings per share guidance, our earnings per share will grow about 30%, so about 2x the top line. So really pleased with that, with gross margins in the mid-61 percentile and then operating margins greater than 36%. So really nice performance in the year, driven mostly by the strength of the foundry and logic business for the company, foundry and logic has had strong sustainability over the course of the year. We've had breadth of investment. If you look at the design start activity, that has been at the leading edge. That's been really good for the business. We've also had a fair amount of trailing edge activity, which has also been good despite some softness in the automotive market that looks like it's going to start to come back next year. So we're really, really excited about that. As we were moving through the September quarter and we saw upside in the order profile, led record backlog levels as we entered this quarter and as we look at the funnel for December and even into the first part of the year I think an important message was, for us, at earnings last month was the sustainability of these business levels as we move into '21. '21, I think the foundry/logic dynamics are sustaining and will continue. We feel very good about that. And we haven't provided a point number or an estimate on growth for the industry into '21. But if I think if you look at foundry/logic at these levels and you look at what has been pretty healthy or disciplined management of CapEx investment on the memory side, we expect to see some memory recovery into next year and memory growth finally after a couple of years of limited growth at best. So I think we feel pretty good about that. We certainly see that in the funnel right now. It seems a little more DRAM heavy into next year than flash, and we'll have more to say about that in our January call. If you look at our Electronics, Component and Packaging business, which is the Orbotech business plus component inspection. We had a very strong year in Specialty Semiconductor, up over 20% as we closed the year, printed circuit board should have a record year. We expect both those businesses to grow next year. So -- and then the component, which is finished package inspection, driven mostly by some of the 5G dynamics that are out there has also been very strong. And so we're very pleased with that business as well. So it's a pretty good setup. And as we look at even '21 and then beyond that, we talked a lot about some targets, some longer-term targets for 2023 at Investor Day back last year. And an important message for us at earnings was to reiterate our confidence in meeting or exceeding those targets, both top line of $7 billion to $7.5 billion of revenue and EPS targets at $15, plus or minus $0.50. So we feel very good about that. The Service business is, I think, important, and I'm glad, as I said earlier, to have Brian here, KLA's Service business is a little bit different than our peers. And so we'll -- as we walk through some of the questions here, we'll talk a little bit more about that. It's a very resilient business. It grows with the installed base. Our tools are in service for a long period of time. The revenue growth rate has been over the long run, about 10%. This year, we'll grow about 11%. Our view is that one, over the long run, it will continue to grow in this range of 9% to 11%. I think the other dynamic that's important for us here is that as the industry has consolidated and you have bigger fabs that are more concentrated in terms of location, it's really enabled us to leverage a lot of the investments that we've made over the years in infrastructure to drive really good profitability out of the business as well. And we're operating at record levels of profitability on that revenue growth. So we're excited about that. So with that, why don't we go ahead with the questions? And looking forward to the discussion today.

Perfect, Bren. That's a great overview. So Brian, maybe to frame the discussion, first, maybe talk about -- or give us a few metrics or key statistics of KLA's Services business?

Yes. Thanks, Joe, and thanks for hosting us today. I'm happy to be here. So I thought I'd start with just a little bit of history about the Service business, then talk about the size and scale and then finish with a little bit on the resiliency. So first, as you know, KLA has been around for more than 40 years. And our large and growing installed base is really a great reflection of KLA's long history of product leadership and really about the enduring value that our products provide our customers. We have tools that have been in customer production for more than 25 years. And we recognized really early on in our history that having a very strong service organization was important to complement the complexity of our products to ensure that we could deliver on that return on investment that our customers are looking for. And so that's really the mission of our service organization, which is to partner with our customers to maximize the value of their KLA assets. So maybe just a little bit on some numbers, again, we talked about the large and growing installed base. It is more than 56,000 tools. And that's about 50% from our Semi Process Control business and about 50% from our EPC businesses. And these tools are located all around the world, more than 4,000 customer facilities dotted around the world. And so you can imagine that managing and supporting that fleet of tools drives a lot of service call activity. We have more than 250,000 service calls each year in support of the business. And behind each one of those service calls is a value chain that's required in order to deliver to the customer commitment. And that's all required, of course, to meet the commitments that we make to our customers. And finally, just a little bit about resiliency of the business and resiliency, both in the form of being able to support our customers in spite of challenges and then also from a financial perspective. I think COVID, of course, created a lot of challenges for many of us. And the Service business at KLA was certainly challenged with some of the travel restrictions and other issues that we faced. And the team has done a fantastic job stepping up, leveraging the KLA operating model to continue to deliver at a very high level with our customers. And we see that not just in accolades from our customers, but also in share of wallet as we've seen contract penetration increase over this period of time from about 70% to over 75%. So really attribute to, I think, the value that we provide to our customers. And of course, because of that value we're providing, it has created a very resilient financial model. It is a recurring revenue stream on this business. We've seen growth rates at the upper end of our targeted 9% to 11%. We think we'll be up near the 11% this year. So very, very strong, resilient and important business for us.

Yes, Joe, I mean when you just take a step back and think about the growth rate of Service is almost twice as fast as the systems business. And so it's growing as a percent of the total. And given the nature of the contract stream, it gives us a fairly good view and predictability about what to expect from the business. And it really allows us to optimize the cost structure underneath. As Brian said, we do a lot to deliver to the entitlement that we have established with our customers. And then because we have that visibility, we can optimize and manage the resources closely. And so I think that allows us to get a lot of efficiency out of it and get a good view of not just the revenue stream, but the profitability stream, which we believe is accretive to the overall company average, but then also a predictable cash flow stream that has always given us confidence around the ability to pay dividends, the ability to have leverage in the cap structure and so on of just having the Service business and what it's able to contribute to the overall company.

That's perfect. And maybe, Brian, I think when people think about services, right, they typically tend to think about maintenance or break/fix, things like that. But it's really -- it's more than that. So can you give us kind of take a -- maybe a double-click into exactly what are the types of value-added services really that KLA provides to customers? Why are those customers signing those long-term contracts with you?

Yes. Yes. Thanks, Joe. So I think maybe first, just to level set on a little bit of the differences between the -- at least on the semi PC part of our Service business versus our process peers. So one of the things, KLA is a high mix, high complexity, relatively low volume producer of process control solutions. So when you look at -- we talk about the portfolio of products that we have. And if you look at any one of those product lines, and you start to look at installed base of any one of those product lines, relatively speaking, at any given customer at any given fab, the number of that product versus a process tool is going to be relatively much smaller. And so what that drives is a very different requirement from our customers, both in terms of the criticality of our tool to their production. So they need those -- there's not rich redundancy. So they need those tools up and available at all times and running at committed performance specs. And the second thing is because of that low volume, it makes it a challenge to maintain the proficiency to diagnose and troubleshoot challenging problems. So we don't have a large consumable business. We have much more complex subassemblies that go into the system. And so our Service business is more around a system-level support and trying to reduce variability in availability or variability in performance. So we don't think of ourselves as a break/fix organization. Again, we think of ourselves as providing the solution to maintain that high level of uptime. And if you think about that large installed base of, again, more than 23,000 tools, there's customers that are in the leading-edge development. There are customers that are in high-volume manufacturing. And then there's a trailing edge component. And so that's going to drive very different service requirements, and we're able to tailor our offerings to meet whatever the specific need is of our customer. The one thing that is common, independent of where you are in that product life cycle, is to create a positive service event. You need the right people, the right parts and the right knowledge and systems. And so when we look at the KLA infrastructure, which again, has been -- we've been building for the last 40 years, from a people perspective, these are highly-trained customer support engineers, many, with advanced degrees that are doing, again, a lot of this troubleshooting, and they have access to domain expertise all around the world that they can call upon when they have an issue that they can't solve themselves. Similarly with our parts of over 160,000 unique parts that are available for purchase, this -- these are, again, unique subassemblies that have significant intellectual property and agreements with our suppliers in terms of supply. So the ROI on outsourcing or trying to re-engineer or reverse engineer some of those parts is much more difficult than a consumable that may be running at significantly higher volume. And then finally, when you think about our training infrastructure, again, it takes 9 to 18 months to get a new engineer trained. And then we have regular refresher training that ensures that we maintain proficiency. And so average tenure of a KLA CSE is more than 10 years. So I think when you look at that collection of infrastructure, it's really about being able to access the KLA network. From an aggregator perspective, we've got the ability to lift the installed base across the world versus just looking at the installed base at a particular customer at a particular fab.

That's super helpful. And you kind of touched upon it, but when we start to look at your long-term model of 9% to 11% revenue growth underpinning the Services business, I mean, we start to maybe dissect that a little bit. Talk about some of those drivers. I think you talked about 56,000 in your installed base, which, if I remember correctly, your Analyst Day just over a year ago was, I think, 44,000. So quite impressive growth in about a year. But what are the other drivers of that revenue?

Yes. So I think certainly, the growing installed base is important. I think the increasing complexity of our systems and then the expansion in trailing edge nodes is also a driver for us. So I talked about -- we think about 3 different categories of the installed base. The leading-edge development, the high volume, leading edge, high-volume manufacturing and then trailing edge manufacturing. And of course, the needs are very different as you move through there. So with our leading-edge development customers, we partner very closely with our product divisions to make sure that we are able to ship, install, ramp, qualify and move into production and then maintain very high availability while customers are developing latest leading-edge technology. And then as our customers move through that life cycle, they want to fan that out to high-volume manufacturing. And many of our customers have fabs around the world. They do development in one fab, and they want to fan it out to sites that are geographically located all around the world. So our opportunity there is to help participate in that scaling. And again, it's back to this variability -- reducing variability, both in terms of how those tools perform, we want them to perform the same independent of where they are in the world, and we want the availability to match independent of what process they're running. And then finally, if you think about this trailing edge manufacturing, which is a significant portion of our overall installed base, is in this trailing edge. Lots of 200-millimeter tools. I mentioned earlier that we have tools that are still in production after 25 years, after shipment. And so this is a much different value proposition that our customers are looking for. They're trying to extend the useful life of that asset. And so if you go back to the year 2000, the average life of our installed base was 4 years. In 2019, it increased to 14 years, and we see that trend continuing. We think customers are going to continue to want to exercise this equipment. And this presents an opportunity for us, both in terms of creating supply continuity and maintaining proficiency to support this older equipment. But also, we have a dedicated team that focuses on creating upgrades and enhancements to, again, solve difficult obsolescence problems or create some performance improvements on some of that older equipment or even simply upgrading software such that you can run the latest virus and security scans on your operating system. So I think when we look at this collection of categories on the installed base, we think there's different drivers for each one of them, and they all present a great opportunity, which is in support of our 9% to 11% targeted growth rate. The other thing that we are working on, which has been a big driver here in COVID, is the challenges that we've seen around being able to travel. And that's driven a lot of initiatives for our Service business. Specifically, we're building up a lot more home team capability. So that we don't have to fly in engineers to do to troubleshoot each problem as a complement to that buildup of in region resources. We're driving a lot of remote support capability so that our customers -- or rather our CSEs can access again, domain expertise at a moment's notice and bring virtually that domain expertise into the fab. We've also driven a big change in our training. We're now leveraging AR/VR mixed reality to do more of our training for our CSEs. Again, we talked about that length of time on the proficiency. So that's an aim to try to shorten that. And then finally, just around digital transformation, leveraging all the new capability, both in terms of getting tool off or data off our tools, but also about -- we talked about the 250,000 transactions. So looking at every opportunity in our supply chain to create more efficiencies so that we can better support our customers and drive effectiveness with our business processes.

Yes, Joe, if I can just add, in that area, and it's even more broadly than just service. I think one of the lessons learned in COVID, there's been a few. I think one is it's validated a lot of what we've done in supply chain in terms of how we've had flexibility across suppliers and the ability to -- and hedging strategies to give us flexibility to usually, we've always thought about it as responding to increases in demand, but it turns out that having flexibility to respond to disruption in supply matters a lot, too. And I think that's been a real validation point. But on the resource part of it is being able to do a lot of this work either remotely or localizing our teams just given the environment, I think, has been an essential aspect of doing business, and certainly, customers have been very receptive to it. But over the long run, creates a lot of opportunity for us to further drive more efficiency and optimization in this part of the business. And so I'm really excited that as we start to normalize and can really leverage these things that we're investing in today, I think there's more investment to come, but I really think that there's opportunities to continue to drive operating leverage out of our model. And I think that comes it's not just service, it's an installation of tools. It's an application support, which is direct customer collaboration. It's an engineering support product introduction. I think there's a lot of opportunities there for us to continue to drive that efficiency.

That's super helpful. And maybe staying on driving synergies and efficiency, back at the Analyst Day last year, you talked about the plans to optimize services within the Orbotech piece of their business. Where do we stand on that program today? And maybe can you talk about some of the progress that you've made and maybe some of the points of focus?

Yes. Let me start, and then I'll let Brian jump in. One aspect of our thesis around looking at M&A opportunities, we look for market-leading positions in markets where technology is increasing. We think we can deploy our model and drive, drive higher levels of profitability and efficiency out of those kinds of positions. But another aspect is complex systems and complex system integration and a Service stream. And one of the things that we've discovered is that anytime you have small suppliers, that they struggle a little bit with the infrastructure to drive profitability out of the service model or in customer engagement where just the customer power with big customers puts a lot of pressure on that part of the business. We realized long ago, how important this is and how it can drive a long-term stream. And so when we look for opportunities, it's an aspect of that opportunities, can we get more out of that position, which includes the long-term revenue potential of service. So I think that, that is something that we've started to work with, and I'll let Brian to talk a little bit more about some of the things we're doing.

Yes. Thanks, Bren. Yes, it really has [indiscernible] opportunities as we engage with -- continuing to engage with the Orbotech divisions. I think the good news is these product lines look a lot like KLA product lines. They have leadership, product leadership, and they have a Service business. And so I think we see a lot of similarities there. And again, leveraging the KLA operating model, we're able to look for opportunities to leverage our infrastructure, whether that's logistics lines or depots or field offices or our CRM system and the way that we track and deliver to our commitments. So I think all these are great opportunities. We've had several engagements with the Orbotech team and feel really good about the progress that we're making and the opportunities that exist for us.

Yes. The go-to markets are all different, right? They have process tools in SPTS or different markets. So there's always a little bit of variability. But what's clear is, I think there's a couple of areas. First of all, the leveraging of the infrastructure, which is important. But the other part is being able to think about the go-to-market, the value offerings, the ability to differentiate those offerings and then deliver to those entitlements that you establish. And I think that, that's a mindset about the KLA approach that's, I think, is transferable to other businesses. Obviously, there will be uniqueness along the way in certain markets that we'll have to adapt to. But in general, I think a lot of this is transferable to other businesses and markets.

That's perfect. And maybe in the last 20 seconds, we've got left, is there anything that we missed on the services side of the business that we should be talking about? Or is there maybe a final kind of statement here or color you'd like to give?

No, I think it was great to peel the onion a little bit here today, and I appreciate the time to do it. I said a lot in the introduction about the long-term growth potential, what we believe the target model is the increasing profitability that's coming from it, the predictableness of 75% plus contract penetration. And I think opportunities to drive a lot of that through acquired businesses. So we're excited about it. We think it's an important part of the company, and we look forward to driving it going forward.

That's perfect. Guys, thank you for the time.

Joe, thank you. Thanks for having us.

Yes. Thank you, Joe. Appreciate it.

Thanks, everybody.