KLA Corporation (KLAC) Earnings Call Transcript & Summary

Great. So I'm Joe Quatrochi, the semi cap analyst at Wells Fargo. As we highlighted in our second iteration of a services deep dive note that we published back in June, we think that services is an underappreciated aspect of the semi cap equipment industry and then the increasing recurring nature of services revenue and installed base management revenue stream is something that investors need to focus on. So today, I'm very pleased to feature KLA's Bren Higgins, CFO and Head of Global Operations as well as Brian Lorig, EVP of Global Support and Services to discuss KLA Services business. Before we start the kind of Q&A, I think Bren had a few prepared comments just give us a little bit of overview of where KLA's outlook is and then just kind of where the company is today. Bren?

Thank you, Joe, and thank you for having us. Glad to have Brian here today as well. Just to echo on some themes from earnings, we're a month into the quarter. This year has been a great year for the company. If you just look at where we are for the second half of the year, September was a good quarter. We guided up 12% sequentially in revenue for the December quarter. The half-to-half growth in the the second half of '21 looks like it's somewhere around 18% at the midpoint of guidance. So real strong outlook. As we've gone through the year here, we've seen the forecast for wafer fab equipment grow what seems like 10% a quarter in terms of the growth rates, and we now see the industry growing somewhere around 40%, plus or minus to the mid-$80 billion level. So against that backdrop, our semi process control business, which is the wafer fab business centric -- wafer fab equipment-centric business is -- we talked at earnings about it being up somewhere in the mid-40% range. So against an industry backdrop of 48% plus or minus, we think it's a very good setup in terms of our relative performance. Our Electronic Packaging and Component business, the EPC business of KLA, which is the more than Moore's Law part of the company, is also having a good year. We aren't talking about it as much because of the strength of WFE. But its systems business is up somewhere in the mid-20s. So a real strong growth there in the specialty semiconductor part of the company, printed circuit board, flat panel component inspection. So we're really pleased with that performance. And then the Service business overall somewhere in the mid-teens. So higher than our normalized growth rate and reflective of the strength and diversification of demand of semiconductors. And then the demand we've seen over the last couple of years is those tools that shipped in 2020 start to come off of warranty and move into contracts. So real pleased with the overall. It puts the company in 2021, somewhere in the mid-30s in terms of growth over 2020. I also talked in earnings about our views on the first half of '22. We [ did ] put a point of growth out there for the full year. But certainly, our view of the first half of the year versus the second half of 2021 in the high single digits. And additional commentary that we don't see any slowdowns from there. So we definitely see as we move through the year, sustaining level of business and, in fact, are adding capacity to make sure we're positioned to support our customers. So I think the outlook is pretty strong. Gross margins continue to be strong for the company despite some of the headwind of cost. Certainly, there's wage pressure that we're feeling in COGS. We're also feeling in operating expenses. And then raw materials cost is putting some pressure on our overall cost structure. Talked about a 75 to 100 basis point impact from cost increases in freight logistics, those areas in our COGS as we move into next year, but do expect the company to be performing pretty much in line with the 63% view. We are investing. We're investing in revenue and volume-dependent activities in the company given the growth we've seen over the last couple of years, infrastructure to support our longer-term structural growth thesis for our business and for semiconductor revenue and then next-generation program investments. And our company is and our competitive position is built on a portfolio approach to solving customer problems to giving customers the ability to trade off against their technical requirements and their economic objectives. And so there's significant program investments required to develop the next generation of products and also to address some new market opportunities with new technologies we see that are out there. From a capital structure point of view, I think things are very -- moving very consistently with the way we've talked about things over the years, both our dividend and our share repurchase. So no change there other than continued execution, would expect that we'll return somewhere around 85%, perhaps a little bit more free cash flow to shareholders in '21 and expect our behavior in that area to continue. So I think that sets up where we see things for now, and let's -- I'm sure you have some questions, let's dive right in.

Yes, that is a perfect setup. So Brian, thanks for joining us. So I think maybe first, it would be helpful just to kind of level set things to frame the discussion. Can you give us a few maybe key metrics or statistics just about KLA's Services business that we should be maybe paying attention to closely?

Yes. Thanks, Joe, and thanks for hosting us. Happy to be here. So our service team is a customer-focused organization. And our customers are making large investments in KLA equipment. And the only way that they see return on that equipment is if it's a highly reliable and there's high availability of the systems. And so we've seen over time that the best way for our customers to maximize the value of their KLA asset is to leverage our service teams. So because we've demonstrated that value over time, we do have a very strong and growing business. The Service business makes up about 25% of KLA's overall revenue. And we've talked about a targeted growth rate of 9% to 11%. As Bren said, in 2020, we outperformed that, and we would expect to outperform that in 2021. We've got a very strong installed base, 55 -- more than 55,000 tools. That's about 50% from our Semi Process Control business and about 50% from our Electronics Packaging Components or EPC business. And those tools are located in more than 4,000 customer facilities around the world. So when you think about sort of that, that's a high mix customer base and a high mix installed base. It really is a very diversified business. And that's part of the reason that it's such a stable and predictable business for us. In addition to that, the way that we report Service revenue is a very pure definition. We only include service. We don't include upgrades. We don't include refurbished or remanufactured tools. It is really just a service number. And more than 75% of that service revenue is on subscription-like service contracts. So when you think about recurring revenue stream, a resilient revenue stream, that diversified business, coupled with the fact that it's -- it really is just about a pure definition with high subscription rates. It really is a great business for KLA.

Joe, 1 other point there that's really important is that we think about a lot is the KLA business model is really optimized to drive the service stream as much as the equipment stream. So we deliver differentiated products. We try to make a value proposition for our customers in buying KLA tools and KLA tools driving a return for them. But part of that unique differentiation also creates unique and differentiated hardware and service support IP, matching performance across tools. So as that extends not only from the time that we ship tools early on, but all the way through the service stream allows us to continue -- our tools to continue to provide value, which means they live for a long period of time. And there's some accelerants in that, that we'll probably talk about, but also allows us to maintain, I think, and protect the profit stream, if you will, that's associated with the nature of that custom componentry that drives that differentiation early on. It's not the only thing that differentiates us, but certainly part of that value equation. And so in some ways, it's very linked up from the time we ship the tool to the time it ultimately ends, and there are a lot of tools out there that continue for a long period of time.

Yes. And well, that's a perfect segue just kind of my next question is, I think when people think of services, they mostly think of break/fix or consumable parts, things like that, that's replacing those. But maybe relative to your peers, you don't have as many consumables and just the tools just in the nature of process control tools relative to maybe like an etcher deposition tool. Help us understand just kind of like what are those maybe value services that KLA provides to customers that are so vital?

Yes. So maybe we've just touched on it, but maybe just a little more detail on sort of the backup of our installed base. So we're -- KLA's a high mix, high complexity, low volume provider. So when you compare us, as you just alluded to, Joe, to some of our process peers, the installed base makeup of any given KLA product line at a given customer is going to look very different. And that's going to drive a few things. Number one, the criticality in the customer fab of that particular tool is very high because there isn't a lot of redundancy. So they place a real premium on availability of the tool. And again, we talked about KLA service being the best medium to drive that availability. The other thing is that it's a challenge around the maintaining proficiency of your service engineers and access to parts because we don't have high consumable parts and we don't have hundreds of a given tool with lots of repetitive tasks. You need a very specialized skill set in your engineers and you need to really leverage your entire system to supply those spare parts. So with that as kind of a backdrop, we can then talk about some of the specific value propositions that we have. Number 1 is we are able to tailor our service offerings to meet the customer needs. So we don't have a one-size-fits-all. And that's important because as we see -- we kind of think about customers in a couple of buckets, sort of leading-edge development and high-volume manufacturing and then trailing-edge manufacturing. And you can imagine that the needs of those customers are very different. If you're a trailing-edge, maybe you're producing the same product for the last 10 years, you might have a different requirement than the person who's trying to develop, ramp and fan-out production of a next-generation node. So we're able to tailor our offerings to meet the very specific needs of each customer. We talked about 4,000 facilities around the world, all 4,000 have a little bit of a different need. And the reason -- the second value prop is the reason we're able to tailor our offerings because of our infrastructure. And when you think about KLA service infrastructure, we've been investing in that for the last 40 years, and we continue to invest in it as our installed base grows. And so that's in the form of service engineers. We've got more than 3,000 service engineers around the globe. Many of them with advanced degrees and more than 10 years of experience. We have more than 165,000 unique spare parts, many with very, very low demand. But when that part is needed, wherever it's needed in the world, it has to be ready at moments noticed. And then the ability to train our new CFCs and bring them up to proficiency, both on existing new CFCs to KLA and also existing CFCs on new product. And just 1 more statement on the infrastructure. I think COVID has all challenged us -- has challenged us all in a lot of different ways. I would say it certainly put our infrastructure to the test. But the team has really done a fantastic job stepping up in support of our customer commitments. And I think it really speaks to the maturity of the KLA operating model. which is employed in a great way in the Service business as well as, of course, the amazing work that our team has done.

That's helpful. Maybe sticking with that kind of line of questioning. I think a common topic, obviously, with investors is the rising equipment-related capital intensity. But I'm curious, how do you think about maybe what we call services capital intensity. I mean, are you seeing the rising cost of moving to next-generation nodes, maybe resulting in higher or higher level service engagement and, I guess, a bigger opportunity maybe for you, especially as customers are trying to move from that ramp to yield of production much faster given the higher cost?

Yes, I think that's right, Joe. So again, we go back to this bucket of leading-edge customers or developing next-generation technology, the complexity of their manufacturing processes are increasing and the tools that we're building in support of that manufacturing is also increasing. And there's a direct correlation for service intensity on complexity of the product and our service attach rate. So as we continue to see customers push new technology, it is a great opportunity for us to partner with them. And then as you mentioned, after they develop it in the home location, as we see this trend about a broader geographic footprint, not only are they fanning out the high-volume manufacturing inside of their sort of R&D home location, but now they're crossing borders to try to fan that out. And we play a very important role of course, our equipment, but then the ability to install those tools, ensure that they match the development centers, recipes and then continue to ramp as we move into production.

But Joe, it's important if you just go back to Brian's earlier statement about the lack of redundancy. So if you think about the environment our customers are supporting today. They're adding significant capacity. They've got significant amount of design starts at multiple nodes. They're adding capacity at multiple nodes. Most of our business is very leading-edge centric. And so they're managing process flows at different nodes and a lot of designs that are driving and design starts in very different ways. So as they're speeding their time to results as they're ramping these new fabs, the ability to have these tools up and performing and matching that performance. It isn't necessarily part of the revenue stream yet for a service organization. It's part of the warranty commitments though, that we make. So our ability to take very leading-edge technology where our customers are single-threaded in a lot of cases and keep the tools up and matching performance across different parts of the process flow is a really critical attribute of KLA. And I think where the service organization absolutely helps accelerates our customers' node progression, certainly as they're ramping these nodes in these facilities.

That's really helpful. And I think you kind of touched on it, but kind of the next question I would ask is, I mean, there's -- obviously, there's been a lot of discussions around like government funding for potentially benefiting WFE. But I guess what about opportunities given for the services side just given that there'd be less kind of centralization of fabs globally?

Yes. I think as you mentioned, I think we're kind of in the early innings of some of this regionalization activities we're engaged with several customers and their plans to begin to start up those factories. But if you look at our installed base growth over the last decade, in most cases, it was shipments to established regions and again, in most cases, into sort of mega fabs. And there was clearly a benefit to our customers in terms of time to market, but also cost advantages for our customers and for KLA in terms of just adding to existing infrastructure. And so there is natural leverage in the model. As we begin to expand to some of these new geographies, in most cases, our customers are starting from scratch. And so they are very focused on just getting the shells built and then everything related to getting a factory up and running. So their dependence on KLA service to make sure that we can get the tools shipped, installed and at production levels, even they're really depending on us to do that. And so it is a great opportunity for us. It's a challenge. I mean we have to -- hiring folks in these new locations, potentially moving resources from the home location to the new location to maintain continuity and sort of culture, setting up logistics and warehouses. There's a lot of work to be done. But I think our experience has been that when customers expand out there outside of their own geography, service intensity is certainly equal to, and in most cases, increases as we move into the new location.

Yes, it probably does. Look, we're investing, too, right? We have to invest today, we don't have $1 of revenue from even the most -- the earliest of some of these projects that are being discussed out there that we might see some equipment shipments at the end of '22 in small volumes. And we're investing today to put those resources in place, both in terms of the infrastructure, logistics and so we can actually have parts depots and so on, but also the training of the resources. It's a huge opportunity for a scale provider to be able to help the customer ramp when they're spread more thinly across a broader geography. There is an increased reliance on big providers with scale, I think, to help ramp those facilities. And so I think that there's a share opportunity that goes along with it. It's a differentiator because some of our competitors don't have the breadth to be able to do that. And we're willing to make those investments in advance to ensure that we're positioned to help them execute because that's the expectation. There are other parts of the world like China where we invested for a long period of time in our P&L those investments before we started to see some leverage in terms of top line growth related to those resources. And I think we're going to be in that period of time now moving forward, where we might be in multiple locations, having to reestablish those positions. But in the long run, I think the service organization is a differentiator for us and will translate both in terms of the service reliance, but also, I think, in market share opportunities as well on the equipment side.

That's helpful. Maybe to kind of round out discussion in terms of like you guys have obviously targeted services growth, revenue in the long-term model, I think, 9% to 11%. And clearly, we have been growing a lot faster than that. And I guess, the question is really with record revenue this year in kind of that warranty period where the services still haven't kicked in, I guess, how do you think about the sustainability of growth for this business? And then how do you think about the timing as you kind of hit on it, but investing into that growth to be able to support that services contracts that are going to be coming down the pipeline in the next 12 to 18 months?

Yes, Brian, how do you think about that higher revenue growth?

I clearly think revenue is growing. Right? It has the last 2 years. So I think as you said, first, we're very focused on just supporting the customers' ramps. And that's -- if you think about a positive service event, you need the right people, the right part and the right knowledge and then the infrastructure around it. So we're very, very focused on that, making sure that our customers are successful and the growth will follow. Bren talked about it, I mean, we're having -- and you said we're having a record year. Those shipments, they do take time to install and then move through warranty before they become service revenue opportunities. But it sets up very well, looking into '22 and beyond based on the shipments that we have and the backlog that we have. So that's on the new product. And we talked about the service intensity, certainly scaling with complexity. So again, that sets up pretty well. The other real benefit that we have in the business is, in many cases, when we -- when you introduce a new product, the old product is retired. And so you end up with this sort of zero-sum gain on your install base. And fortunately, for KLA, that isn't that case, the useful life of our -- of the KLA tools, is increasing. If you go back to the year 2000, it was about 4 years. If you look at it today, it's 15 years. And if I -- the conversations that I'm having with customers now are about how are you going to extend that for another 5 years or beyond. So because it's a very profitable -- these tools are running very profitable lines inside of their some of their trailing-edge factories. So it's a great opportunity for us to partner with customers. It's also a big challenge. We've talked the supply chain has been a very hot topic as of late. You can imagine some of the challenges you might have on a 15-year-old tool or a 20-year-old tool. So we have a dedicated team that works on that, not just in solving some of the obsolescence challenges that we have but in also developing upgrades that will extend the life and/or improve performance of those systems. So I think new shipments, that's great. And if the existing installed base is stable and lives are extending that makes for a great installed base growth narrative. And then I think there are some general trends that are positive for the Service business. There's certainly a move toward more data analytics and predictive maintenance, and those are higher service value propositions. We spoke about the geographic expansion of our customers. And then not necessarily on some of the top line, but some of the COVID-related initiatives that we've done have generated some more productivity around driving Morgan region resources leveraging remote assist so that our customer support engineers can access domain expertise at their fingertips with a camera inside of a fab, leveraging AR/VR for training our CSEs and we're hiring at a faster pace than we ever have before. And so being able to get them proficient is incredibly important for meeting customer ramp. So I think all of that in combination sets up well for being able to continue to outperform the stated growth target.

So it sounds like a new target. That's what I take out of that. Brian's organization is great with data. I think when you look at all the accelerants that we've talked about, you talked about some of the trailing-edge dynamics and how the use of the installed base is extending in life, but also utilization rates and then the new tools that will eventually transition. This data, but when you look at 40 years to get to the first $1 billion of service in KLA, we're going to get to the next $1 billion in 4 to 5 years. And I think that gives you some insight into what to expect-- what's really going on in this part of the market and where we think the revenue growth drivers will take us. So it's pretty compelling. It's exciting. It's a bigger and bigger part of the company and there are some unique challenges, but there's some great opportunities out there as well.

Yes, that's really good insight. I mean -- and maybe one of the questions and you kind of touched on it, but as you think about the installed base has grown significantly and it's grown across really just entire WFE, how do you think about just the talent pool of potential service, I guess, people that could join the company. Is that maybe something that you kind of focus on? And then I guess an offset to that, you kind of touched on it again was implementing new types of ways to service your customer that you've kind of come about maybe accelerated or adopted faster because of COVID? I guess how do you kind of think about those 2 things together?

Yes. Good question, Joe. I think the Service business is a pretty complex operation, and we're spending a significant amount of our time just making sure that we can hire people that we get them on board that we can then get them trained, then get them experience inside the customer fab and then, of course, chasing down supply chain challenges. So it's all hands on deck right now. It's -- the distribution of customers doesn't mean that we have to hire so many in 1 particular region, but the numbers -- the rate at which we're increasing in any given region is faster than we've ever done before. So it is a big challenge. We're spending a lot of time on it. But to your point, we're also trying to provide additional support for those engineers that maybe they haven't had in the past. So more of a blended learning model where they have access to training faster than maybe they would have in the past where they would come on site for -- on asset training. We talked about the remote assist capability and then also driving up both second level service engineering support in region and also driving home team development engineering presence inside of regions. All of this should help accelerate the time to proficiency for our engineers.

That's perfect. I think, unfortunately, we're out of time. I think I could ask you more questions for the rest of the day. But I think that's all the time we have. So guys, thank you very much for joining us today.

Thank you, Joe.

Thanks for having us here.

Thanks.