KLA Corporation (KLAC) Earnings Call Transcript & Summary

All right. Good morning, everyone. My name is Robert Ruple. I'm the technology sector specialist here at Credit Suisse, and very excited this morning to host Bren Higgins, Executive VP and CFO of KLA Corp. Bren, maybe just to kick things off, sort of when you think about your company, the core IP, the strategy and the other markets that you address, what are sort of the key priorities and the value proposition for KLA, as you think about for investors and the like?

No, thank you for having us, and it's a good question. And I know we'll probably end up talking a lot about 2023 as we go here. So I do want to take just a step back and look at 2022 has been really good for KLA. We started the year expecting to see sequential growth in our business over the course of the year. We had guided. We thought our revenue levels will be over 20%. And as we sit here today, we feel very good about our position, obviously, with 1 quarter to go and take the midpoint of guidance. And our guidance is shaping up to be pretty consistent with what we thought. So I think it's -- the December quarter looks about as we expected. And so when you look at that, we'll probably be somewhere in the mid-20s in terms of growth. So some upside to that. The profitability model has worked fairly well. We're -- despite some of the cost pressures in the industry, we've been able to maintain, we guided around 63% gross margins, and we're in that range today. We're investing in our business. Our portfolio strategy is fundamental to how KLA goes to market. Our operating margin is expected in low 40s. We did an Investor Day in June and talked about our 2026 plan and our views of our different segments and what we thought '26 would look like we talked about an opportunity set of about $14 billion in revenue, plus or minus $500 million and $38 in earnings. We announced a significant share repurchase authorization of $6 billion, $3 billion of which is in ASR that's ongoing. So we feel like the company has done very well. If you look at the semi PC part of the business, which is our wafer fab equipment, semi process control business. considerable outperformance relative to the market probably in excess of 30% year-over-year against a WFE environment that's maybe mid- to high-single digits. So strong performance there. Our electronics packaging and component business, which is our more than Moore's Law part of KLA, up in the high single digits. In our service business, which is a strong anchor for the company, has had nice growth accretive, obviously, over the long term from a growth point of view in the mid-double digits, so mid-teens type performance. Market share has been very strong. The KLA is a differentiated supplier. We try to do things and deliver capability to our customers that our competitors can't match. We have a portfolio of products that allows our customers to balance technical requirements with economic objectives and driving productivity in a fab. And we gained some share last year. Over the last few years, we've gained about 350 basis points off/on our already strong position and would expect this year to be another year of share gains as well, given the relative performance I talked about earlier. So I think when you look at KLA's model, it's about understanding the value that we deliver and in terms of returns to our customers, sharing in that value with customers that drives the gross margins we have. Those gross margins allow us to invest. We introduce products faster than our competitors. As I said, we have a portfolio approach. And so that enables us to continue to deliver new capability to the market. We have new things to sell, new things for customers to buy and then also throws off a very strong gross margin that allows us to put the capital to work way in different ways. We're strong believers that there's a lot of value trapped in how companies are financed and how cash flows are deployed. And I think our history in those areas, both in terms of leverage levels and our capital and cash returns to shareholders, I think, represents that overall philosophy. So as we move into 2023, certainly, we're facing a year that looks to be a correction year after 3 very strong years of growth, expected some normalization at some point in terms of our longer-term modeling. Given the last 3 years of growth have been so far above trend line, so we would expect to see some changes here in '23 as we move forward. Sure we'll talk more about that.

Yes. We may we'll dig into a few more of those. But as you mentioned on the -- I think on the fiscal Q1 conference call, you revised calendar '22 down from $95 billion to $90 billion, and obviously [indiscernible] to give us some thoughts on '23 [indiscernible] $75 billion. Can you speak to your expectations as it relates to foundry versus logic in the mix there? I think it was like 76-24, and maybe how do you see that unfolding next year in terms of the dynamics between kind of leading and lagging edge logic?

Yes. So this year, between supply constraints and then some of the recent actions from the U.S., inspected some of the WEF investment in China. And I think as a result of that, you've seen expectations for '22 coming down from near $100 billion, let's say, in the middle of the year to low [ 90s ] today. And I think that's pretty consistent as people have reported and guided that, that's probably about where we'll end up. Our business tends to be more levered to logic and foundry investment. And so the overall mix has been probably 60-40 this year, likely higher next year because of the reductions that are going to come in memory. But process control intensity because of the fact that they're designing unique parts and you've got designs moving to fabs, that you have higher levels of process control investment that customers have to spend more to monitor the performance of those designs, the yield given the commitments that they're making and they're running different process flows. They're deploying new technology and then managing a very high mix environment. All that drives a higher percentage as a percent of wafer fab investment in process control than in the memory space, which is good, and we had a very good year this year. But memory has repair, there's redundancy and designs, more commodity-like parts. And so as a result of that, you generally have less overall investment. Now there's been the introduction of EUV lithography and DRAM and that's been a contributor to our business to support that change as you need new infrastructure to support that. So that's been a driver of the business in memory. But in general, foundry logic is kind of our sweet spot and the dynamics around 7-nanometer and 5-nanometer and starting to see 3-nanometer here moving forward have been extremely compelling for us and certainly around certain product types. And I think as we move into '23, where most of the reductions will likely see -- are likely going to happen in the memory space. So I would expect that the mix will be even heavier logic infinity, which tends to help our performance on a relative basis. We've seen, for the reasons I talked about lack of reuse in our customers' capacity that we've seen a significant increase in the KLA share of overall WFE. And I would expect that -- we'll see that increase continue. We'll be able to maintain kind of this mid-7% from the low 6s that we saw last year as we move into next year.

Great. That's a nice update there. I appreciate it. I'm just -- the CapEx budget is obviously not going to be set until next year at some point. But given the elevated spend, can you comment at all just on sort of how we should think about linearity around WFE in '23? And I think it has generally been skewed more towards the second half of the year. Any thoughts you can comment at this point?

Yes. It's an interesting question. And I think the challenge in it is, is a lot of our expectation, we talked about the industry being down about 20% next year, was really coming from what our customers have been somewhat clear in some of the public statements about what they're expecting to invest next year. One of the challenges is we have very strong backlogs, and we've been booking above our billing rate for most of the year. So we've seen the backlogs grow. And we have certain products that are really about enabling customers' technology road maps. We're much more levered to R&D and a ramp of a fab than in production where they have a more predictable environment. Now that environment with a high mix is changing. So there's more participation in production, which has been a driver for growth for the company over the last couple of years. So that's there. But in general, we're much more levered to the road map and the technology evolution and less so to kind of the increment of capacity. So as the capacity plans are being adjusted, it has less of an impact on KLA. So there's a little bit more maybe resiliency around certain product types, and with very long lead times, we still are supply constrained, and I would expect those products to continue to shift into next year even in a weaker overall environment. It's not falling off, right? It's fast. I would expect, as we move into the March quarter, it still feels pretty strong in terms of business levels. And so I wouldn't expect it to fall off kind of dramatically. Whether it plays out -- first, I would expect right now, I think first half is probably higher than the second half based on what we see today. But it's not like -- I think a lot of times people would expect it's just going to fall off like this, and maybe it has historically have been in the industry a long time. It feels like it's more of a moderation. And so what the WFE number ends up being versus maybe a run rate we end up at as we move into the second half of the year, maybe that's a different question. But right now, I think it looks like it's more of a gradual kind of decline to the -- through the year than something more dramatic.

Got you. Got you. You touched on this already, but the process control market, you've gained some significant share. I'm just kind of outgrowing industry. Just how much of the outperformance do you attribute to share gains with process control metrology versus your segment performance versus the overall market?

Yes, that's a good question. I think it's a mix. Look, certainly the overall market and the growth of logic and foundry has been a driver for the reasons I talked about earlier. And in fact, with the -- before EUV was introduced, you had this period of time from about 2012 to 2018 where logic/foundry WFE was actually a negative CAGR. So most of the growth in WFE -- in fact, all of the growth was coming from memory. So as EUV was introduced, you saw a lot of new capability available. You had customers that invested capability. You had new capability that not just leaders, but other follow-on designs kind of migrated to 7-nanometer and then into 5. And so we saw a big ramp in the design environment for 7. And then as customers went to ramp 5, they weren't able to take any of the capacity that they had deployed for 7 because it was being consumed and try to migrate it. There was a period of time where they were able to do that fairly well because the increments of kind of Moore's Law improvement related to multi-patterning were fairly modest. So now you introduce EUV, you've got more compelling Moore's Law attributes. You have more designs that are coming in. You have less reuse because customers are consuming the capacity, but also they have new technical requirements. And so that's been a big driver for our business. I also talked about that, I think that as you look at the -- our participation in production that, that design environment, every design test design rules in different ways. And if you have to deliver a specific volume in a specific product window, you don't want to start too many wafers, you want to start too few given the productivity dynamics. And so you see a lot more process control investment in that environment where they're managing a lot of designs. You also have a lot of different product flow variants that are also at different nodes that are also drivers for the business as well. Share gain, I mentioned 350 basis points. And most of the share gain in our space or share changes tends to be within the relative performance of certain markets. We have a very broad portfolio of products. And so you have the relative growth rates of those individual segments tends to drive some of the share movement. But optical pattern inspection has been a huge business for -- it's largest business for KLA, probably one of the fastest growing markets in overall WFE. And because of the dynamics I just talked about, has really been inflecting in is a product that we continue to have very -- it's really about technology enabling so very long lead times with. But in film measurement, we've had strong results. Reticle inspection is another area where qualifying and inspecting reticles for EUV and increasing EUV layers at each node is also a driver for our reticle inspection business. So these have been, I think, factors that have driven some of the share gain in our markets where we have very strong positions that have also very good overall relative growth. So I think it's a combination of things. And I think, for the first time, given some of these dynamics, you're seeing some incremental investment in new capabilities, and we're introducing new products that are going to get customers to spend more. There's some inflections related to more UV layers, changes that are forthcoming in terms of transistor architecture with gate all around and so on, that gives us some confidence moving forward about the portfolio we have. Our competitors have to compete with certain technology to try to solve all the problems, right? And I think one of the things we do fairly well is we allow our customers to balance their technical requirements where they need more technical solutions, but also there are opportunities for them, as they're managing and driving productivity across a fab to buy things that meet their economic requirements. And I think being able and somewhat agnostic about what they use to try to sort of meet that kind of combined benefit of technology and economics is a unique value differentiator for KLA versus our point product competitors.

Got you. More of a longer-term question. You've kind of given us some thoughts as around direction of WFE for '23. But given increased complexity and the lack of 450-millimeter, do you think we're sort of now kind of a permanent uptrend for WFE, albeit along the cyclical patterns that we see in this industry over time?

Well, we do believe it. It was a sort of fundamental to our 2026 plan that we presented back in our Investor Day, back in June, is that the things you talked about, right, you had significant capital efficiency in terms of reuse. You had wafer transitions. You had kind of inefficient kind of IDM structures that migrated to hyperscale foundries. You had consolidation in the space, drove significant efficiency as a percent of revenue in the overall industry. So capital intensity declined meaningfully really. And so in an environment where WFE really didn't that much. So we had some cyclicality, very modest growth. But that started to end, if you go back to kind of the middle of the last decade. And since then, we've seen capital intensity start to rise. And one of the cases we tried to make was explaining that all those things that have driven capital intensity down are now starting to grow. Now I don't think capital intensity is going to grow that much faster than underlying semiconductor revenue. But since it's sort of flat and up, it will drive WFE to grow faster moving forward. So there's a sort of a structural growth element that has changed in the industry versus over the last number of years versus the previous couple of decades, frankly. And so we think that, that continues. We think that the dynamics around the technology changes and what that means in terms of designs and the changes that have happened to drive more design activity at nodes, TSMC, for example, releasing design libraries, more economic EDA solutions. One of the things the industry got -- I think, got wrong was this view that you'd have fewer and fewer designs at the leading edge because of the cost of design. And for the leaders, it's very expensive to design at the next node. But to drive returns and to drive demand to consume that capacity as the leaders move on, and you've got leaders that aren't just in mobile, but in data center now driving leading edge road maps so you've got players there. That demand has now caused this growth in logic and foundry. And I think we'll see that as a percent of the total. Also, there's been, I think, pretty good price discipline over the years as the cost decrements that come from Moore's Law that were fairly easy and drove maybe a lack of discipline in pricing, have firmed up, and we've seen pricing increase over the last year or so that we'll see semiconductor revenue grow faster. You hear the numbers that McKinsey studies and other numbers that are out there around $1 trillion of semiconductor revenue or more in 2030. All that implies about a 6% to 7% growth rate in semiconductor revenue or 2x GDP. We think WFE grows a little faster than that based on a lot of the things I talked about. Process controls should grow a little faster than that, and KLA should be able to grow a little bit of share, modest share increases we move forward. We're about mid-50s today. In the markets we're in, it's higher. It's in the mid-60s or higher. At some point, there is a limit probably to how much share you can gain, but we still think that if we can deliver the right solutions with the go-to-market approach we have, that there is opportunity for us to gain some share. So when you add all that together, we think that drives kind of a 10% growth rate in our semi business from '21. Our electronics packaging and component business grows about 10% on market growth and some new product introduction and service is at 12% to 14%, and we made it -- we adjusted that 12% to 14% growth rate in Investor Day, talked a lot about the dynamics that are driving that. So all that leads you to the $14 billion with the financial framework in terms of how we run the business, expected profitability levels, cash deployment and so on, $14 billion is in revenue and [indiscernible].

It seems like a pretty solid plan. When you think about -- not a new theme, obviously, but when you think about the supply and logistical constraints that we've seen throughout the industry. Maybe just an update on sort of how you're navigating that. You seem to be navigating better than most of your peers. And any update on some of these constraints as we get towards the end of the year here.

Well, it's gotten easy around certain electronic components in semiconductors. There, for a while, it was [indiscernible]? You beat down an issue and another issue would pop up. And in some cases, I'm dealing with issues today that weren't issues 6, 9 months ago. So we still, in certain products, are constrained by our ability to get supply. I think over the last year, our supply chain is a little bit different than some of the process tool guys where I think they rely on a lot of the same suppliers. They also have higher volumes around common components. And so I think that puts more strain in those businesses we tend have more exclusive relationships with suppliers the kind of inherent lead time on a lot of our components is very long so we have to make commitments significantly in advance. And -- but downside of that is to add more also takes a long period of time. And I know ASML, as an example, struggles with some of the same challenges around optical components. So that sort of establishes, though, what you think you can sell of those products, the actual volume. And then that volume is fairly predictable, both in terms of the actual quantity, but also the timing. And then you go work all the issues that are underneath it to try to get the parts you need to keep up. So I think our supply chain teams have done a great job. Our supply chain management strategy is a lot less about transactional supply and much more about ensuring that we have the capacity of what we need when we need it. And we're willing to make investments in terms of extra inventory. We will hedge long lead time materials. We buy our suppliers long lead time materials. We'll invest in dedicated capacity. And I think all that has helped us through this period of time, although we wished we could ship more. And I have general managers in my business because I run operations coming to me if we could just ship more, we could ship more, I have the demand. And maybe over time, it sort of works its way out and customers rationalize supply and demand. But certainly, that pressure has been in the system. So I think it's a little bit better today. We still have some constraints here and there that are affecting us. And one of the things, if it does sort of slow down and soften a little bit, we'll have to navigate our way through that in terms of maintaining the capability and capacity we have to support this thesis that I just talked about in terms of longer-term growth. But coming off of a higher level and absorbing that increment that was added if we go through a softening period here as we move through '23. So some management of that, but I feel pretty good about how we're positioned, and how we're positioned to support our growth plan.

Great. I just wanted to take a quick poll of the audience if there are any questions. Looks like Chris has a question here. I don't know if we need a mic up front here.

Bren, you mentioned services. And for 2023 on the earnings call, you talked about some growing below the long-term average. The services business is generally a lot more resilient in downturns. So maybe you could speak to that a little bit on what's driving that in 2023. Also, is there any impact that some others have talked about some impact on the China business from service from inability to service tools there. And is that a longer-term impact for the services business?

Yes. So our service business is a little bit different and everybody kind of adds it up a little bit differently. But our service -- and there is -- you have to kind of dig into what's kind of traditional break and fix, spare, service other upgrades, including things like that. So our business is really core kind of traditional service. So upgrades and things like that are not included in the service stream. 80% of the revenue of our service business is service contract. And so it tends to be, I think, a stickier stream and it's a stream that the service contracts vary. And a lot of times, they could be on individual tools. Sometimes it can be a fab-wide. We have the ability, I think, to customize our offerings to customers. We set entitlements. Those offerings are about response times and stocking and things like that. And then we can deliver to that entitlement. We have a perspective on what the revenue opportunity is the commitments we've made. And we can then optimize the cost structure underneath. In a more billable environment, it's hard to get efficient because you kind of have to have the burst capacity in case something goes wrong. So this enables us, I think, to do it fairly efficiently. When you move into slower environment, customers continue to run installed base. But there are periods of time where you'll see it certain, particularly in some of the legacy parts of the installed base where utilizations will drop off and tools won't break as quickly and as often and so that has an effect. Some of the service revenue is denominated in local currencies. And so the strength of the U.S. dollars had some impact, too, on service revenue. So it's those kind of factors would probably drive us. I think service will continue to grow, and our service business has had 1 down year in the last 20 to 25 years, and that was in 2009. It was down about 12% or so. So we've talked about it being mid, maybe high-single digits as we move into '23, below that 12% to 14% that I talked about. And it's really driven by the things I talked about. But really our expectation that we'll see some softening in certain parts of consumer markets, maybe and how that affects some of our customers in their installed base. Long run trends around service compelling. As a percent of ASP, we've seen that increase over time. We've shipped a lot of tools. So those tools now are starting to come off of warranty, and that's a driver in the long term for service. 80% of the tools that KLA and Tencor have shipped kind of history are still in service out there in the field. So there's still a lot of tools that we're supporting that were shipped a long time ago. And now you have a lot of growth in rising semiconductor content in some of these legacy markets, automotive, industrial, IoT, communications, where particularly around automotive, where you're seeing reliability changing -- changes. And so those reliabilities are changing -- reliability requirements are changing how customers are looking at service opportunities. So I would expect it to moderate some in terms of the growth rate. Over time, though, for the reasons I talked about, we would expect it, which is why we adjusted our long-term plan from 9% to 11%, 12% to 14% over time. And the history, I think through '21, has been somewhere in that kind of range. It's been the 11%, 12%. And we think that the drivers I mentioned, will add an increment to growth going forward. China is less developed. So the service streams in China, that all the legacy equipment that we've been driving service on for years and years, the fabs are not that old. And so the service business in China as a percent of the total is smaller. Obviously, we'll grow over time. It's something we've invested in because you have a fairly disparate footprint of fabs. So you've had to put the infrastructure in place to be able to support it. So over time, it will be a positive stream -- a much more positive stream for service. But it has a -- it's a lower percentage than the kind of the systems mix into China, which is about 20% to 25% our semi process control business. So less of an issue there. But certainly, over time, we would expect that to be a growth area. And with all the investment that's happening in the legacy part of China, in the infrastructure and wafer and reticle infrastructure, that even there -- though there have been some new restrictions, there's still a lot of investment that's happened in these other areas, which will be a good driver for long term for service.

A comment you made earlier about next year will be first half weighted, second half slows down. A lot of your customers think about the opposite, first half inventory correction, hopefully picking up second half into the following year. So you could talk about the timing of projects. Was it that they slowed down and that only starts to affect the second half shipments? So just a little more why you see that profile.

Well, it's just what we see today, right? As you just as you work your way through and you go to at and so on. Now a lot of -- we're adding meaningful capacity this quarter, and you'll see that capacity come online. And I think it's the customer's expectations, in some cases, where what they expected supply is at that point relative to the demand environment they're facing. Now a lot of the reductions are in memory, and memory tends to be a business that turns fast because your incremental bit supply is coming from more from new wafers versus shrinks and smaller kind of transistors, achieving a big growth, supply growth through Moore's Law effectively. And so because of that, those turns, I think, tend to be quicker because those capacity investments are bigger investments and are very market-centric. So my point is: a, we're sitting here and we're in late November, and we're talking about what could be 9 to 12 months from now. And I think we're in a very good position to react if that's how it plays out. But as I sit today, I see kind of a -- as I said, kind of more of a gradual reduction through the year as we move forward, and less confidence probably the further out you go, obviously so.

And 1 follow-up to Chris on China. As you look at the impact, could you recall how much you cited would be the impact from the restriction. Is it largely memory? Or do you see meaningful logic getting pulled down by the restriction?

Yes. So we went -- and we talked about gross direct impact of -- from $500 million to $600 million at the low end to about $900 million at the high end. What was incremental to the new regulations in early October was the inclusion of memory in these restrictions. So there was a logic foundry element. It was smaller, but it kind of was there before. And so memory is the biggest factor in driving that. Now, in some cases, you're going to be able to mitigate where you'll be able to ship those tools to others and that assumes that you're able to continue to pull right? But ultimately, there's a WFE number for the year and that's how much capacity we'll ship. And we continue to work through with our customers in terms of requirements, engaging with the Department of Commerce in terms questions about what our customers are doing, what our tools would do to try to mitigate some of that and get some comfort around the licensing process. There -- obviously, there's a lack of predictability there that makes it hard to kind of handicap. But as we see it today, and that was the impact in terms of our impact into next year. And it was -- the incremental increase was really more memory-centric.

I think we have about 30 seconds here. So any final closing remarks or themes or topics that are coming up with investors that we didn't get to that we should focus on?

Like I said earlier, I think we feel very good about the plan we have. We tried to articulate around our businesses at our Investor Day, some of the growth opportunities. We have exposure, and we love to be in process control, obviously, to wafer fab and where our customers are going there to drive new capability in some of those dynamics. Our acquisition of Orbotech and the creation of our EPC Group, Electronics, Packaging and Components Group, has exposed us to more of where are going for new capability. It's too expensive to do everything in the front end like they used to. So we have exposure there. And then, of course, the drivers of service creates a nice sort of accretive growth rate over time but also a profitability stream that gives us comfort in terms of how we're managing the business. The leverage we have in our capital structure, our ability to maintain our dividend and grow it over time. We did raise our dividend a few months ago for the 13th consecutive year. So we think the business is well positioned. We're excited about the plan, and we're happy with where we are.

Great. Well, Bren, we really appreciate taking the time to speak their room today. And thanks, again.

Thank you, Rob. Thanks for having us.

Thank you.