KLA Corporation (KLAC) Earnings Call Transcript & Summary

Yes. I think these are very good questions. And what I would say, it all starts from the design aspect, meaning that our customers are making very careful calculations on how EUV enables them to deliver performance that they need to deliver to their customers. And what we see is essentially that as you add the number of layers with EUV, that performance continues to increase, and that's why we are clearly seeing the foundry/logic trend towards EUV, foundry specifically. And we also see trends that the logic side will also turn heavier towards EUV. DRAM is heading in the right direction, as you said, with one player and the second and the third, they're all looking at EUV at this point. And it really benefits us because if you're going to put one layer in EUV or 10 layers in EUV, I mean, you need an infrastructure. So we come in first to really support the infrastructure, to support the start of the EUV. And then as the layers go up, the defect modes on all those layers change. I will tell you that there are specific segments that we're essentially not changing. For example, mask requal. Mask requal is a segment that essentially had a holiday for maybe 4 or 5 nodes, where essentially, mask would have almost the same type of pitches because you're doing double patterning on the wafer. But with the increase of EUV, those masks have completely changed in a huge way. And what we see is now double-digit growth in those segments, where we see new systems being purchased by customers for requalification of masks in line in the wafer fabs. So this is just an example of where the growth comes from. And we see that -- I see that this is going to continue until N3 node and then continue to N2 node.

Helpful. I guess taking a step back, I wanted to ask about the competitive landscape. Your market share, your competitive position in process control has been very, very stable, very, very dominant, despite the aspirational goals that your competitors or potential competitors have talked about. Ahmad, I guess, if you can, again, take a step back and speak to the key components that sort of make up that competitive moat that KLA has around process control, that would be super helpful. And I think there are still pockets within the broader process control market where they're perhaps under-indexed relative to some of the other parts where you're very dominant. Are there any specific areas where you're aggressively investing to potentially raise your profile even more?

Yes. It's a very good question. First thing I would say is that our R&D discipline is very, very good, meaning that we reinvest a large amount of R&D dollars across the board to ensure that we are able to bring in new technologies for our customers, and they're brought at the right time. The second thing I would say is that we really look at it from a portfolio perspective. Because we're not a single-point product company, I'm able to move those R&D dollars from product to product and really double down and triple down on product development. As a product is going into HBM and it delivers, you can remove the R&D from there and move it to another product. And that has really enabled us to accelerate product growth and new platform growth that enables us to have an even larger portfolio. So that's been the discipline that we have been using, and that enables us to be really ready for each node when the customer needs a solution. The third thing I would say is that we have a very good discipline of component development and also system development. So we're looking at inflections 3 to 4 to 5 years from now that the customers are going to need, and we start doing development on it well ahead of the time so that we are able to meet those needs. For example, gate all around development, we started about 4 to 5 years ago, and we are very confident that by the time customers are going to go put gate all around in production, that we would have a new variant of optical inspection system and a new variant of metrology system that is going to be really focused towards making sure those defect modes are dealt with. So that is kind of like the overall moat that enables us to really stay differentiated. Gen 5 is a really good example. We started the product several, several years back, and then we took about 2 to 3 years to really insert it in the marketplace, where we had evaluations at each of the customers. But really, the Gen 5 started to take off, especially when EUV was introduced because the middle end and back end of the process really changed so significantly that the defect modes that customers needed to find were really focused towards the wavelength that Gen 5 has. And that's why we saw a huge growth in optical inspection. We see the same trend happening now for Gen 4. Even though Gen 4 sounds like an older system, these are 2 concurrent products. 4 and 5 are always going at the same time. We see that when gate all around comes in, Gen 4, which is really suitable for that wavelength, to go after those types of defects, is going to see a huge growth. So that's kind of the way I look at it. To your second question, areas where we are investing quite a bit and delivering is there is the e-beam portfolio. We introduced a new product called eSL10. That was an important product for us. And our thinking behind introducing e-beam is, really, how do we take this high-resolution inspector and couple it with Gen 4 and Gen 5 to really bring faster time to results to customers. We don't see any use case where an e-beam technology can take really full layers of inspection. And the reason for that is because not -- there's no technology today that is present that can do inspection at those speeds. So the coupling of the technologies is really important. So we are investing quite a bit in that. We are investing quite a bit in data sciences to enable this collaboration, so that that is seamless to our customer. They just buy 2 systems and they get a better result. So we're investing in that. We're investing in x-ray technology because, as you know, both in NAND and DRAM and now in the future in logic, there is going to be 3D-type measurements. So we're investing in those areas. So those are some of the ones that come to my mind. Mask requalification is another really important segment. We're bringing in our next-generation system, reticle inspection system, that's going to be -- is going to be targeted towards 3-nanometer for mask qualification. That's going to be a really important product that comes out and serves that market. So again, it's really about the portfolio approach. And it's also about bringing the product at the right time. We don't bring products well ahead of the time because the customers don't really need it and the cost of ownership is really not going to make sense. So it's really timing the market, investing the R&D dollars really well to bring the solution when the customer needs. And we get that feedback from the customer because we have a very large portfolio. So the engagement from R&D to production really enables us to understand when the product is needed, what performance is needed and how do we do a great collaboration.

So Toshiya, I think I got a couple of other points on just the portfolio approach and what I think it enables from just an overall competitive advantage point of view is, first, is that having products across the different technologies, across all the different either metrology and inspection challenges that our customers are dealing with, enables us to get information using some of the tools that Ahmad talked about that helps our customers identify problems in certain areas that might be caused by systematic issues in other parts of the process. Overlay metrology is an example, where a lot of litho challenges in overlay come from non-litho process. And so point product competitors don't necessarily have that visibility, if you will, to those challenges, and so that creates an opportunity. The other is, is that because you have these different technologies, is you allow customers to pick and choose depending on where they are in their process control and sampling strategy and also the maturation of whatever their process is, to pick and choose different technologies to optimize their production at the best economic point. And so that's another advantage that we offer from very high-end, very sensitive tools, from development aspects of what they're doing, but also enabling production monitoring where they know what they look for -- they're looking for and they go for tools that have little less sensitivity but more speed. So we're able to allow them to optimize across the entire portfolio and meet their cost of ownership requirements, which ultimately is an economic decision that they're making to try to drive productivity out of these fabs.

Great. And then as a quick follow-up, I just wanted to ask a question on optical versus e-beam. Ahmad, to your earlier comment, maybe it's not optical versus e-beam if they're complementary technologies, and maybe that's the point that you guys are trying to make. But one of the knocks on KLA several years ago was very strong in optical, the e-beam solution wasn't quite there and you had a couple of competitors who were kind of speaking to that point. Obviously, since then, things have changed. Optical is significantly better. You've shown your ability to continue to innovate. And you've got an e-beam offering. So as a company, how are you thinking about that e-beam versus optical debate and how you're able to address both markets?

Yes, I think it's a great question. And I personally never see it as optical versus e-beam simply because there is so much performance in optical that there's no amount of e-beam systems that you can bring into the market that can offload what an optical system does. And I have seen customers evaluate that in the past and always come to the same conclusion. So the onus is really on KLA, which is to innovate and solve the most difficult customer problems with the best cost of ownership at the fastest time to results. Our customers cannot wait 8 hours to 10 hours a day doing a full die inspection. I mean they can do a full wafer inspection in less than an hour. So it's a very, very hard math to do to be able to justify if it's one versus the other. The second thing I would say is that in optical, we have really shown, year after year after year, if you look at the performance of our optical portfolio in 2018, 2019, 2020, 2021, I mean, we see growth in the optical portfolio, which really shows that our customers have evaluated these tools and evaluated the upgrades that we're doing to the systems and bringing the new systems in and showing that they are actually solving the EUV challenges and the new process challenges that they are facing. I'll give you one example. We have seen 2 customers to use the latest-generation systems and backport them for a previous node. So a customer who has basically essentially said that the node has matured in its yield, we brought in new features and optical tools for the next-generation node, and the customer looks at that and says, "Okay, how can this help in the previous node," and implemented that also. So we see very good performance optically in the marketplace, and I continue to feel that this is for many nodes to continue. I mentioned a few minutes ago that with the nanosheet introduction, the front end is going to change. And we believe that that's going to drive Gen 4 growth because it has a slightly longer wavelength that is very friendly to nanosheet architecture. But that doesn't mean that we don't want to invest in e-beam. I think e-beam has its unique signal that enables us to bring certain types of inspections to the table in R&D that we were not able to do. And again, I go back to the portfolio approach. I want to go to a customer and be able to solve all the problems. So they go to KLA, we solve all the problems and then be able to offer them the best cost of ownership at the same time. So that missing e-beam portfolio in the past did not enable me to do that. Now that we have the full portfolio, we are able to engage in R&D and look at all defect problems and then complement both optical and the e-beam where required. It's not always required, where required for very difficult players, and we enable those solutions now at the same time and drive those to HBM. So again, it's a very -- it's a really great investment in e-beam. We're going to continue to do that. We went with e-beam inspection. We are going to drive that platform to e-beam review and then to other applications at the same time, again, complementing all of our optical tools. Defect inspection, metrology systems, all of those systems will get feedback from our e-beam systems to enable them even further.

Got it. Shifting gears a little bit, Bren, I wanted to talk a little bit about Orbotech. It's been about 2 years since you completed the acquisition. You've demonstrated healthy revenue growth. I think on your most recent call, you spoke to additional cost synergies. It seems like you've executed really well. But if you had to grade yourself, how would you grade yourself? And what's sort of left on the to-do list as it relates to Orbotech?

Yes. No, if you just go back to the investment thesis of why we thought that made sense for us, as we were looking for companies at market-leading positions and in markets that had good profitability structures, where technology was evolving over time, and had an opportunity to leverage some of the capabilities of KLA from a technology point of view, and -- but also had a complex system integration environment, that we could leverage that as well as a service infrastructure that at least -- or an opportunity that we could leverage what we do in our Service business. And so I think one of the things that we've seen as we move forward is we've been able to check the box there. We're really pleased with the product positioning, particularly in the Specialty Semiconductor part of the business and in PCB, as the technology evolution in PCB is becoming very exciting in terms of just the tighter pitches on boards, the introduction of flex boards, new PCB technologies and then the evolving sort of integration of the PCB into the heterogeneous package. And so all those opportunities, we think, create good situations for us as we think about all the areas that our customers are pursuing to drive cost innovation capability. Its front-end process node shrinks for sure, but in this, more than more opportunities, it's also creating some opportunities for us. On the Specialty Semiconductor side, you've had markets where they had a very good position, and those markets are inflecting. And we think that the relationships that we have with customers can help enable a higher level of collaboration in those markets. So we think that, that fits. Their exposure to packaging is also significant. And so between PCB, what we're already doing in KLA, plus the SPTS, or Specialty Semiconductor part of that, we've been able to put the channels together and we're continuing to do that to enable just more collaboration, visibility and engagement with customers. And sometimes, small companies struggle with some of that just because of the fact that are you going to take a risk with a smaller company versus KLA. So we bring credibility, we bring a broader set of resources to help solve problems, and that's favorable. We always felt very good about our operating model and how we run companies, whether it's our strategic planning processes, whether it's our product development processes, resource planning. Ahmad talked about how we look at portfolios and manage resources across the company, frankly how we start with fully allocated P&Ls for every business that every business stands on its own. And as we put that into Orbotech, and we still have systems to go, which I think provides another leg of opportunity for us in this area, we've been able to satisfy the part of our thesis that we thought was true that could we get more out of market-leading positions in terms of profitability. I'm less concerned about the ratios of margins. I'm much more focused on the operating leverage we can drive out of those kinds of positions, where we think we can get paid for incremental value in evolving technology markets. So yes, the synergy, classic synergy, but also just efficiency opportunity is in excess of what we expected. We talked in the call about a $50 million base targeted announcement, and we're in excess of $80 million today from a net synergy point of view. And as we go forward, I think there's probably another $10 million or more of opportunity out there related to the next step of systems integration, but also facilities. Sometimes, leases and things like that, consolidating facilities and depots and things like that can take some time. So I feel very good about where we're at. I think there's more work to be done here. I think the next step for us is how do we introduce new products that take advantage of some of the things I talked about earlier, whether it's technology or deeper collaboration with customers. And so that's still to come. So we haven't checked that box fully in terms of driving top line opportunities. But I'm encouraged about where we're at. And we always felt, given the deals we've done in the past, that some of our operating model competencies could play out in M&A-type transactions with the characteristics that I talked about. And with Orbotech, I think it's proven at a much broader level for the company that we can go and drive that. And so we feel very good about the model and the implications it has on other opportunities that fit those kind of market attributes I mentioned.

Great. Bren, we've got a couple of minutes left. I would love to get your thoughts on the Services business and how you're thinking about capital allocation as well. On the Services side, you had another very strong year. Your Services business is a little unique vis-à-vis some of your peers in semi cap equipment. So if you can kind of speak to that, that would be great. And then from a capital allocation standpoint, you've been very committed and you've been returning a ton of cash to shareholders. How should we think about the balance between organic investments, capital return and potentially M&A going forward?

Okay. Yes. No, that's a good question. So on Service, the strength of the demand side has driven more service opportunity, for sure, where we're shipping more systems, and those systems have long shelf lives and long useful lives. And so as those tools come off of warranty, they create service opportunities, and they tend to -- most of them tend to go into contract at a very high percentage, 90% plus that end up in a service contract structure after a warranty period. The utilization of the installed base has been accelerating. I think customers are looking for getting more out of the installed base as we've seen more demand in those parts of the market. You've also seen changing reliability specs around certain products that are in that market, automotive, for example, where you have to be very -- where customers are having to evolve how they think about process control to ensure better reliability because recalls can be expensive. And if semiconductor content is increasing, that creates an opportunity for that part of the business, not just to drive pure service, which is really what our -- when we disclose service, it's really a classic service revenue stream versus some of our peers. I know they include some upgrades, and there's other parts of that. So it's a little bit harder to look at them from an apples-to-apples point of view. But it drives that, but it also drives enhancements. And so the other aspect of our Service business is that most of the revenue, 75% of it, is service contracts, so it's very subscription-like. And that allows us to do a couple of things: a, deliver to an entitlement that's expected by the customer; but also optimize the resources and asset commitments that we're making to support that contract. And so I think that, that drives a profitability profile on the Service business that's attractive as well. And so we're seeing 9% to 11% type -- that's our growth model for Service, and we're seeing that kind of growth right now and that's our expectation moving forward, but also pretty good operating leverage on the overall business: a, from the contract dynamic; but also from -- with consolidated customers, it creates opportunities for us to get more -- better utilization of our own resources in those areas. So I think Orbotech creates some opportunities. Orbotech's PCB business had a very good service model, and there's some opportunities for us to learn from that, where their contract penetration is even higher than ours. And it gives you some sense of the importance of the imaging capability they have to those customers. But we think that with other parts of it, whether it's in the flat panel business or even in specialty semiconductors, that there's more opportunities for us there. So it's very important to the company because it's a nice, consistent, predictable cash flow stream, and it gives us -- you can have volatility around CapEx, but at the end of the day, customers are still going to continue to run their installed bases, and that's going to drive a predictable revenue stream out of Service. From a capital structure point of view, we've been, I think, pretty explicit that -- in our belief that capital needs to be deployed productively, and we either put it to work back in the business or through different M&A considerations. In some cases, some of our M&A is small, make-versus-buy-type things, and we've done a little bit of that over the last few years, or returning it to shareholders. And we've got a balanced approach. We think that the dividend ought to -- you don't have a dividend unless you're going to grow it, and our goal is to continue to grow it every year. We've grown it 11 years in a row. And we govern it really with 2 ways, a payout ratio that we target of right around 35%, sort of over time. Some years, it can be lower, and some years, it can be higher. But that enables us to ensure that we can raise it every year. And then we're going to ultimately grow it with the growth in our free cash flow. So given the asset-light nature of our business, if we can grow our top line, our top line model to 7% to 9%, our bottom line model is to drive 1.5x that revenue growth rate in terms of drop-through leverage, that we ought to be able to grow our dividend 10% to 15% in a dividend payout. And so that's our model and how we think about that. And ultimately, the rest of the cash flow will be deployed in either in share repurchase. And I think, at a minimum, we're going to return about 70% in any given year, other investments, like I talked about, notwithstanding. So I think that's probably a low watermark, but that's going to be, I think, pretty consistent for us, that it's going to be at least 70%, and we're going to drive it the way that I described.

Great. I could keep going, but we are out of time. Bren and Ahmad, thank you so much for joining us. Good luck with everything, and hopefully, we get to do this in person next year.

That would be great. Toshiya, thank you for having us.

Thanks, guys.

Thank you.

Take care. Thank you.