KLA Corporation (KLAC) Earnings Call Transcript & Summary

Okay, excellent. All right, good afternoon, everyone. Thank you for joining us for this session. I'm Vivek Arya from BofA's semiconductor semi-cap equipment research team. Really delighted to have the team from KLA join us. Bren Higgins, Chief Financial Officer. And as usual, I'll go through my fireside questions, but please feel free to raise your hand if you would like to bring something up. But really, welcome to you, Bren, really glad that you could join us.

Yes, Vivek. Good to see you. Thanks for having us.

You as well. Maybe as a start, Bren, just give us a lay of the land, how are you seeing the demand environment versus what you thought at the start of the year, right? There's just been a lot of macro noise over the last few months, and I'm wondering how your demand, right, along the different food groups, how that has evolved?

It's a great question. And there has been noise, but at the same time, we really haven't seen much of a change. Overall, our customers have been very committed. And if you look at what they're investing and what's driving our business today, you can understand why. Certainly, at the leading edge, and we're happy to have a return of growth at the leading edge after a couple of years where things were more legacy centric. But certainly, at the leading edge, a lot of investment at the 2-nanometer node. I think we're pretty well positioned at the 2-nanometer node, we're seeing higher levels of intensity for KLA, KLA share of market at the 2-nanometer node, higher than 3-nanometer as the customer is -- has high designs, a large number of designs, more than they had at 3-nanometer to similar state, advanced design rules, changes in architecture which drives different defect challenges and process control challenges, anytime you have a architecture change, it tends to be very good for process control. If you go back to FinFET, we were approaching 8% of WFE then and we're in that same neighborhood today as we move to a gate-all-around architecture. Large die is a big deal for high-performance compute. And if you just think about large die and what it means to yield with a similar number, if you have a set number of defects and you have large die, your yield is impacted pretty significantly. We have -- we'll call it, 20 die on a wafer versus 100 die on a wafer with the same number of particles. So large die, they are very valuable to our customers. And so the defect challenges, advanced design rules and then the value of the actual chip, very good for process control. Most of the investment that's happening in DRAM is high bandwidth memory focused, high-bandwidth memory chips, are larger than DRAM chips. That's a consumer of capacity. But the company, there's less redundancy in that chip. You have higher reliability requirements because you're stacking multiple ones together. You have a logic circuitry that as you do the base die to program these high-bandwidth memory chips that then feed all the data into the GPU or the custom silicon. So that's all a nice driver for the business as it relates to DRAM and say the intensity of DRAM is also higher, particularly as it relates to high-bandwidth memory. And then the advanced packaging as you integrate the logic device with the high-bandwidth memory has also been a nice driver for our business. We talked at earnings about $850 million of opportunity in 2025, up from about $500 million across the company. About 70% of that in our process control business. And so a lot of momentum both in terms of the intensity as the processing requirements have changed in terms of heterogeneous integration and what that's doing for process control intensity, but also significant share momentum as well. So I think that trend continues. It's interesting, if you look at the advanced packaging market overall it's $9 billion, $10 billion of investment today. You go back 4, 5 years ago, it was $3 billion, $4 billion. So it's grown meaningfully in support of high performance compute markets. And as the technologies become more complex, it's a market that has moved towards higher-value solutions, solutions where we can differentiate. We can leverage a lot of what we've done in the front end to meet the customer requirements there. So that is strong for the business. Our service business continues to operate strongly. We've been impacted a little bit by some of the restrictions that have happened in China, that have limited access to fabs. Over the long run, our service business growth correlates pretty well with semiconductor revenue growth. But in the short run, if you lose access to a fab, it does have a near-term impact. Despite that, I think our service business still grows low double digits in 2025. So overall, if you look at just the drivers of revenue, we feel very good about the ability of the company to outperform relative to the market. We've had a nice trajectory over the last few years in terms of our share of WFE growing. And I think you'll see a continuation of that as we move through 2025 and -- service is functioning well. The P&L is operating consistent with our expectations. Gross margins, we guided at 63%, adjusted our '25 outlook for gross margins to -- in the mid-60s from 62% plus or minus, reflecting some of the, I think, sustainable strength in the margin profile as we go forward. And then our operating income target of incremental operating margin of 40% to 50%, we're performing in excess of that in terms of how things lay out for '25. So I think the company is well positioned from a share point of view. This market is moving to us, we think, in a lot of ways that we couldn't design a better set of applications as what's happening with high-performance compute for KLA and the relevancy of KLA. We think it benefits KLA uniquely. And we think it's constructive as we look at the next several years of opportunity.

Got it. Excellent. So maybe, Bren, just 1 or 2 China-related questions, and then we'll go to some of the longer-term drivers of your business. So first of all, from a China perspective, I know that whether it's KLA or your peers, you have all been kind of on either side of 30% or so exposure. You think that business is now predictable, right? There's enough visibility for the rest of the year? I realize geopolitics is ever-evolving environment. But if there is no big change to restrictions, is that still -- is that a fairly predictable business for you over the next several quarters?

Well, look, as we laid out at earnings, we talked about China for '25 versus '24. '24 it was over 40%, '25 I think it comes down to about 30%, plus or minus, overall for the business. So I think what we've seen so far has been pretty consistent with that. Given our lead times and how we manage our slot plans around customers, particularly, if it's a new customer, where we have flexibility, look, we always want to go after whatever business is out there, and we try to be as flexible as we can. But typically, with customers with -- that are newer to the company or don't have -- aren't as strategic, let's say, as some of our leading-edge customers. They tend to communicate and get into the queue and get slots solidified pretty quickly. So as I look at next year, I don't think that -- or the rest of '25, it looks, I think, fairly predictable. If there's an opportunity out there, I always consider different demand scenarios in terms of extra opportunity. We don't want to lose business because we can't deliver. We have intrinsic lead times that are long. But I feel pretty comfortable with where the forecast is. And look, could it be 30% plus a little bit, it could be minus a little bit, sure, but I think it's going to be in that neighborhood as we go through the year.

Got it. Okay. Is there any concentration of revenue in China to any single customer? I realize the last time we spoke, you mentioned that there's actually a very fragmented set of customers. So is there any concentration issue at all that, that can impact your business?

Not really as it relates to process control, process control gets invested at in chunks as customers are working through R&D, establishing some risk production, trying to become both credible in road map, and credible to potential customers. And so then there's more of a kind of lower level but more continuous level of investment than a more capacity-centric investment on a fab that's ramping its first 10,000 wafer starts. You do have those that happen and we participate in that. But there's a lot of business that is more somewhat just kind of consistent with the way I laid it out. You also have customers that have been more historic customers, I call them more mature customers in China that haven't invested much in the last few years that are now starting to invest again, so it's a mix. We also have infrastructure investment that happens in China, related to wafers and bare wafer capacity, but also reticle capacity. Not a lot of mass shops in China that are accessible was a choke point area where the customers in China need to buy reticles from the merchants, and the merchants haven't invested or don't have either capacity. That's been -- was certainly an issue back in '21 and '22 when there were supply shortages. So you're seeing some establishment of that domestic infrastructure. That's also a driver for KLA that's unique to KLA in that we are a high percentage of the CapEx in those in those operations that others may not be exposed to -- parts of WFE they're exposed to. But I would say it's really across the board. I wouldn't call it anything excessive from an overall certain customer exposure. As you think about multiple quarter time, right.

Given your tools are so proprietary, who services the tools if a customer is restricted?

It's a great question. And it is a challenge. And one of the challenges is that when we're not -- we don't have access to customers, it's hard for us to know what the customer is doing with those tools. But it becomes very, very difficult for them to do it. I'm sure that there's some cannibalization that likely happens. There's probably some third parties that are trying to reverse engineer and replicate certain types of parts to try to keep tools running even if it's not running at its highest performance levels. If you look at our service business, generally, it is unique, and that one of the reasons why our service business has such a high contract percentage, it's about 75% of the revenue stream is because of the complexity of the tools. These are not single use tools. These are very custom precision instruments. They don't have a lot of them. And most of the supply chain and certainly around critical components is custom and so therefore, proprietary to KLA. As a result of that, the customer wants performance. They want availability, they want matching performance across the tools, and they rely on KLA to support those systems. And a contract structure allows them to sign up to very specific requirements and allows us to size our infrastructure to support those requirements and drive as much efficiency as we can. So it's a very unique business, and I think it continues -- it grows every year. We've had 1 down year in the last 25 years. And over time, if you look at service, our service business, if you had asked me when I became CFO in 2013, what was the percent of ASP of a service contract for a tool, I would have said, it's about 4%. Today, it's about 5%. If you would ask me what the lifetime of a tool was, I would have said, lifetime was probably low teens. Today, it's high teens. If you would have asked, what percent of a tool ASP we capture in service revenue over time, I would have said 40% to 50%, today it's 100%. Because the tools are living longer in the field, customers are keeping them up, they're serving markets, if you think about the spectrum of demand for semiconductors, you have a lot of these markets where semiconductor content is growing in industrial and automotive and Internet of Things and so on. And so these tools are running for a long period of time, and so we're able to capture a lot more opportunity off of them and then have those dynamics around the complexity of the system and the challenge for third parties or customers to be able to support the systems that really makes it a nice kind of captive business for KLA over time that generates what we believe are accretive margins and growth. Frankly, over time, faster than the equipment business. So it's a special part of KLA, and I think it's going to be -- continue to be a strong contributor moving forward.

Right. I'm glad you brought up services because your services business is different than the services, right, "services business" that we hear from some of your U.S. peers who also include 200-millimeter tools or might include like refurbs and spares. So what's different about your services business that gives you the ability to grow double digit, right? So it is much less cyclical, right, than anybody else's services business.

Well, there's a few things. I mean, first of all, you're right, it doesn't include anything that's system. So a systems upgrade would show up in our systems revenue. 200-millimeter older system shows up in system driven. So it's classic service. What our customers effectively are buying, they're not necessarily buying just break and fix, we do that. But what they're buying is a certain level of performance out of the system over time because you don't want it to degrade over time. It's got to match the rest of their installed base in terms of overall. And then the availability, we commit to very high levels of availability on these systems. And they -- we have the ability, I think, to customize these offerings to allow us to meet whatever their requirements are delivered to those requirements, but then have good visibility to it so we can structure our business underneath. Very few consumables in our products. One thing on the process tool and we have process businesses is that there is a supply chain for consumable parts. And so customers can get access, third parties can get access. And so there -- as a result of that, you have more billable business and you have parts of the business that are accessible from somebody other than the suppliers of the business. So it behaves very uniquely relative to the process tools. I think because of that, obviously, that influences the top line growth rate opportunity. And so most of what we sell is KLA provide -- even in our billable service, customers buying the parts from us. They're just -- they're paying for the labor and a billable structure. So I think for all those reasons, it drives this very consistent growth rate that's at the level that we talked about. And then the lifetime of the tools, and I think the higher value opportunities of the newer systems, given the complexity of them is a nice tailwind overall.

I had 1 or 2 questions on overall WFE. So this year, right? Most people who have kind of guided WFE, have guided to kind of mid-single-digit growth. But your trend line is double digit, right? A few others of our peers trend line is double digits. So is it that mid-single digit is a conservative number? Or is that some are declining a lot? Or what is the right way to kind of align, right, your double-digit growth versus market itself, that may not be growing as much.

We have a lot more visibility, obviously, to my business than everybody else's. And I think what we do every quarter is we assess what the market is, what our customers are saying, how peers are performing as we go build our forecast. So we'll provide an update as we move into the June quarter and the earnings cycle, I think after people guide, I get decent visibility in the second half. There's also the packaging dynamic and how that translates back into WFE. Historically, I think a lot of companies certainly KLA include, we never really identified advanced packaging as part of the overall market. It was a few billion dollars on what was a $90 billion plus number. And so it was kind of in the margin for areas you thought about trying to provide a directional forecast for WFE. As it's bigger now, it's a bigger part of the overall opportunity. And so I think when you look at our WFE number, we talked about mid-single-digit growth. If you add also advanced packaging, then that's also additional served market opportunity. And that could be a factor in some of this where the numbers relative to where people are performing. Now that it's so significant, I think, continues to be significant over time, given what we expect to see happen in terms of the composition of semiconductor revenue over the next several years, is I think it's got to go into that baseline number in terms of what the overall market. It's not just WFE anymore, it's WFE plus advanced packaging. And the WFE -- or the advanced backwork we tend to 15%, maybe even higher, 20% if it's growing faster of the overall served market. So I think that could be a factor in all of it, but we'll provide an update. And I would expect that at our next Investor Day, as we think about a long-term plan we'll dig into this a little bit more to provide this additional context because it's not just traditional WFE is the opportunity for a company like KLA. We also have this, what is $9 billion to $10 billion today, growing, we think, over time, at a growth rate faster than core WFE. So it's certainly a new opportunity that I think we want to raise the awareness to -- from investors.

All right. Historically, WFE in China has been -- or WFE intensity in China has been a lot higher than overall WFE. So as China starts getting to be a smaller part of the industry because of restrictions and other things. What does that do to long-term WFE intensity for the industry.

No, it's a good question. And you've had some inefficiency from the fact that you've had a number of projects spread out a small number of wafer starts. And so it's pushed. I think the efficiency of that spend has been fairly low. Now if you look at the leading edge, the efficiency of the investment at the leading edge has also been very, very high, right? So I think if you go and look at what's happened with WFE intensity over time from about 2013, 2014 time frame, we've seen the intensity of WFE rise, right? For a long time, it was coming down, wafer transitions, consolidation in the industry, all this drove it down. Since about that time, we've seen a rise. If you -- and if you look at what's happening in the industry today, it's not clear that there's anything that's coming from a tech, there's no more wafer transitions. They're coming from a technical point of view that's going to drive intensity down. I think there's a lot of focus on customers to keep it from growing faster. And if you look at the way we model our business and think about it over the long run is that we assume a pretty efficient market, right? We assume that WFE is going to grow a little bit faster than semi revenue. So semi revenue is growing 7% to 8%, we would expect WFE to grow a little bit faster than that. We think logic/foundry WFE is growing faster, that's more friendly to process control. So that means process control should grow faster than core WFE. KLA's position in process control and in markets we think that will inflect will drive our share opportunities plus some other markets that we're in that we think our share opportunities for us should allow KLA to grow faster than that overall. So that's how we lay out the overall view of the market and how we size the company because our view is, is that, look, it's important for us to size the company, size our investments based on an expectation of the market. If it turns out that there's higher levels of inefficiency over time in the market, either driven by regional investment more competitive dynamics of leading edge or more strategic investment that's happening in parts of the legacy market, although it's hard to understand how that continues at the rate we've seen because how much legacy capacity could you add. But if that happens, that's in my view, upside to the model. And I think we've proven over time that KLA -- if the opportunity is there, we know how to ramp our supply chain, ramp our operations and capacity to take advantage of it. So that's generally how we see it over time. And I think when you look at that and look at what that would translate to in terms of semi revenue and WFE, if you go out several years, add in packaging, we think it's a pretty compelling story relative to where the company is currently operating today.

I see. One near-term question, Bren, you have kind of given a flattish profile for the back half of the year. So what are the pluses and minuses from the different end markets? And what could be potential for upside in that part of the year?

Yes. So it was more of a soft guidance around the second half that we see the business generally operating in and around this $3 billion level. We guided for the June quarter at $3.075 billion. I don't know if I'm good enough to say it's exactly around that number. We have integers that are $20 million to $30 million on some of our systems. But in general, it was a statement to say, "Hey, look, the dynamics that are driving the market today are more or less leading the company at this level." As you look at 2026 and you start to say, okay, well, what drives growth from $3 billion for KLA or drives growth in the industry. I think we continue to see significant investment in the leading edge. I think there could be more competitive investment at the leading edge, not expecting a lot of growth out of China, not expecting growth out of legacy markets. I would expect to see DRAM continue to flash probably a very low levels, invest a little bit more. I think what would drive WFE to be stronger than kind of a mid-single-digit kind of view of growth into next year would be some strength in some of the markets that consume a lot of semiconductors replenishment cycles into PC markets, phones, things that are consumer-centric, AI at the edge and what that means in terms of replenishment of -- or replacement cycles on some of these markets. They don't need a lot of growth, but they consume a lot of semiconductors. So it's an important contributor over time. The 1 market that is really strong right now is high-performance compute. The rest of the markets are kind of, ehh, so I think getting -- or seeing some strength there would be the driver of upside as we move into '26. When that happens, who knows? And hopefully, while we haven't seen any change in customer profiles. I know everybody is watching to see if anything changes from an overall demand point of view given some of the geopolitical dynamics that we're facing today. So far, our customers are committed to their plans and nothing has changed. But I know everybody is kind of at least looking or cautious about what they might see. So we'll see how that plays out.

Got it. And if I had to put you on the spot, if let's say, there is no change in the restrictions on China, right? I mean, who knows what the situation is. Is China WFE up, down or flat next year?

At least in terms of my planning, I think you're already starting to see this normalization. And you've even heard it from certain customers in China about some consolidation efforts. Most of the investment has been in the legacy markets is I expected that we would see it normalize over time. It was at elevated levels for some clear reasons, funding provided new fabs, capacity availability in '23 and '24, where frankly, if I think people had capacity, a lot of some of that business would have shipped in '21 and '22. So at cushion, what would have been a more meaningful downturn certainly in 2023. But over time, I think the percent of business declines down at least for KLA, down somewhere in the 20% range or even thinking about overall legacy maybe 25%, including what's in China, but what's also happening in the other parts of the legacy market. So that's in general, how we're thinking about it over time is that it kind of moves down from where it is today at 30% down into that range over the next few years. So I think like we said earlier, what we see right now looks pretty consistent in terms of our plans for this year. And I'm not relying in terms of my commentary earlier on meaningful growth in China to kind of enable a stronger growth year in WFE in '26.

I see. One question that comes up is that KLA benefits a lot in kind of the upfront validation R&D. But then as we move to high-volume manufacturing, then some of your peers tend to benefit more. So let's say if N2 ramps next year, then is it possible that your share can shift down for some time until they start investing in 18 or 14, right, N2 nodes?

So historically, and a lot of it had to do with the design start environment. A lot of it also had to do with the adoption level of the previous generation node. So if you have limited design starts, and customers, they do their R&D work, they introduce volume. They ramp the fab, the first 40,000 or 50,000 wafer starts. And then they get to a place of stability, then you're right, historically, you'd see focus shift to more productivity-driven investment. So process control tools that go from higher-end tools, more capacity-centric tools. You would also have this dynamic that at the previous generation nodes weren't adopted by follow-on designs that follow the leaders is that there were opportunities to take some of that capacity and leverage and reuse it in the current node. So those were factors that influenced it and certainly influenced it pretty dramatically with the road map for the Moore's Law road map was a slower drive because of the delays in scaling that came from the push out of EUV. One of the things that's about the 2-nanometer node right now is, first of all, we talked about some of the drivers as it relates to new architecture, you still have -- while you don't have more or meaningfully more EUV layers, the EUV layers are more complex layers. There's still desires to shrink the pitch on the reticles to shrink feature sizes it into. So you have good leading-edge design rule drivers. You have a design start environment that's rich. You have an anticipation of products starting to move to some of these higher-value products. You have the 3-nanometer node, the 5-nanometer node very well adopted right now. So the reuse factor is next to nothing and the anticipation of design starts for 2-nanometer are likely higher over the first 4 to 5 years of the node than the previous high, which was 7-nanometer, previous high was 28 nanometers. There's a lot of unique dynamics around expectations for 2-nanometers that I think sustain our business moving forward. You have to remember that lots of designs and lots of process iterations, drive process control in a different way because customers each design is different. Each design brings different defect mechanisms and systematic defectivity issues. So -- and then you have different process, they test design rules in different ways. So it does create, I think, opportunities, and we've seen our customer manage very, very closely. You don't want to start too many. You've got to deliver yielded die at the end, you've got to deliver to a market window. So the process control intensity even in production, we've seen a step-up in it. Then you have what's going to happen with the next node and that investment will start at some point even at kind of R&D and risk reduction level. So you'll have that starting that we'd expect some time and some time in '26 also. And so I would -- my expectations for leading edge investment are higher, I think, from the leader, but potentially from others that invest more next year than they've invested this year.

I see. Are you getting those signals that the strength could be broadening out or...

I'm optimistic.

Okay. That's a good thing. On gross margin, so low 60s, I thought earlier during the -- our chat, you mentioned mid-60s. Did I catch that, right?

Well, look, we guided 63%. If you go back to the 2026 model we presented at our Investor Day in 2022, it was 63% plus, right? So you could argue that right now, the company is in line with my '26 target more or less at roughly $2 billion less, in revenue. So I feel pretty good about the sustainability, both in terms of the product mix dynamics. I think the -- we're shipping more of the latest version of products. I mean 1 reason why KLA has -- not across the portfolio that we invest the way we do is we like to introduce products at a cadence and new capability at a cadence that's much faster than competitors. Reason for -- a couple of reasons. Number 1 is you always want new capability to sell. You try to stay a moving target for competitors, but it also allows you to deal with some of the cost dynamics relative to price and make whatever adjustments you need to make in that. And for a couple of years, we were selling more legacy equipment, older versions of products, and there was inflation across the entire cost structure that, in some ways, we absorbed that I think we're now able to work our way through and recapture as we move forward. So what was a headwind is now more of a tailwind. So our EPC business has underperformed. We had flat panel. We don't have flat panel anymore. That was a margin dilutive business. So we're out of that. Parts of that business are still somewhat sluggish. Frankly, look, be happy with another couple of hundred million dollars of PCB revenue, and if it impacted the gross margins a little bit, fine. My general view is we're optimizing for gross margin dollars. But in terms of the overall percent and how we model the business, I think those factors are positive ones. And I think in packaging, which has been somewhat dilutive for us from a margin point of view, as that -- as we move forward, that market will need more capability, but we've also introduced new capability that we've been able to move the margin profile up in that part of the business. And so while it's modestly below corporate averages, I think over time, it starts to become a tailwind as well. So I feel pretty good about the trajectory of where we are inclusive of our current view of the tariff environment, which I've talked about publicly a fair amount over the last few months. As we look at the next few years. We run the business given the mix of systems and service with a 65% incremental gross margin on revenue growth, plus or minus. So for 63%, there's not a lot of room, but there's room. And so I think as we move forward, a lot of these factors are sustainable.

Got it. Excellent. With that, Bren, thank you so much. Greatly appreciate your time. Thanks everyone.

Thanks again for having us.