KLA Corporation (NASDAQ:KLAC) Q2: Beats On Revenue But Stock Drops

Full Report / January 25, 2024

Semiconductor manufacturing equipment maker KLA Corporation (NASDAQ:KLAC) reported Q2 FY2024 results beating Wall Street analysts' expectations, with revenue down 16.7% year on year to $2.49 billion. On the other hand, next quarter's revenue guidance of $2.3 billion was less impressive, coming in 6.5% below analysts' estimates. It made a non-GAAP profit of $6.16 per share, down from its profit of $7.38 per share in the same quarter last year.

KLA Corporation (KLAC) Q2 FY2024 Highlights:

  • Market Capitalization: $87.03 billion
  • Revenue: $2.49 billion vs analyst estimates of $2.46 billion (1.1% beat)
  • EPS (non-GAAP): $6.16 vs analyst estimates of $5.88 (4.7% beat)
  • Revenue Guidance for Q3 2024 is $2.3 billion at the midpoint, below analyst estimates of $2.46 billion
  • Free Cash Flow of $545.4 million, down 33.1% from the previous quarter
  • Inventory Days Outstanding: 283, down from 289 in the previous quarter
  • Gross Margin (GAAP): 60.7%, up from 59.5% in the same quarter last year

Formed by the 1997 merger of the two leading semiconductor yield management companies, KLA Corporation (NASDAQ:KLAC) is the leading supplier of equipment used to measure and inspect semiconductor chips.

KLA sells the tools used by semiconductor foundries and memory chip producers to inspect semiconductors and measure their precise dimensions throughout the manufacturing process, from the wafers to patterning to final production. Today, accuracy and defect detection in the semiconductor manufacturing process is becoming even more crucial as chip sizes continue to shrink, making it increasingly difficult to find defects. As the cost to create chips has gone up, even a small irregularity early on in the manufacturing process can render a chip useless, costing companies time and money.

KLA is the dominant provider of process control systems, maintaining around 50% market share for more than a decade, or 4x its closest competitor. It works closely with its customers to develop specific tools for specific semiconductor manufacturing processes. In recent years it has looked to expand its addressable market and the 2019 acquisition of Orbotech extended its business into printed circuit boards and flat panel displays.

KLACs primary peers and competitors are Applied Materials (NASDAQ:AMAT), ASML (NASDAQ:ASML) Lam Research (NASDA:LCRX), and Tokyo Electron (TSE:8035).

Semiconductor Manufacturing

The semiconductor capital (manufacturing) equipment group has become highly concentrated over the past decade. Suppliers have consolidated, and the increasing cost of innovation have made it unaffordable to almost everybody, except the largest companies, to produce leading edge chips. The result of the increased industry concentration has been higher operating margins and free cash generation through the cycle. Despite this structural improvement, the businesses can still be quite volatile, as demand fluctuations for the semiconductor equipment are magnified by the already cyclical nature of underlying semiconductor demand. Read More Chip manufacturing is done in "batches" on a single round silicon disk, known as a "wafer". Multiple chips can be fabricated on a single wafer, which itself can cost over $10,000 today for the more advanced nodes. The actual chip fabrication process requires hundreds to thousands of steps that are executed at an atomic scale. From start to finish, including fabrication, testing and packaging, it can take 3 months to make a chip. The process to create a silicon wafer starts with sand, which is melted to extract silicon, then purified and formed into a cylinder, which is then sliced down into discs about 1mm thick that are then polished into wafers. Next, the wafers go to a semiconductor foundry and go through a process where successive layers of insulating, conducting, and semiconducting materials are stacked on top of one another to form many small complex interconnected 3D structures (wires, insulators, etc), with each layer consisting of 15-20 processes such as deposition, lithography, etching, stripping, testing, and cleaning.

Sales Growth

KLA Corporation's revenue growth over the last three years has been solid, averaging 18.5% annually. But as you can see below, its revenue declined from $2.98 billion in the same quarter last year to $2.49 billion. Semiconductors are a cyclical industry, and long-term investors should be prepared for periods of high growth followed by periods of revenue contractions (which can sometimes offer opportune times to buy).

KLA Corporation Total Revenue

Even though KLA Corporation surpassed analysts' revenue estimates, this was a slow quarter for the company as its revenue dropped 16.7% year on year. This could mean that the current downcycle is deepening.

KLA Corporation's revenue growth has slowed over the last three quarters and its management team projects revenue to fall next quarter. As such, the company is guiding for a 5.5% year-on-year revenue decline, but Wall Street thinks there will be a recovery next year. Analysts' estimates call for 4.7% growth over the next 12 months.

Product Demand & Outstanding Inventory

Days Inventory Outstanding (DIO) is an important metric for chipmakers, as it reflects a business' capital intensity and the cyclical nature of semiconductor supply and demand. In a tight supply environment, inventories tend to be stable, allowing chipmakers to exert pricing power. Steadily increasing DIO can be a warning sign that demand is weak, and if inventories continue to rise, the company may have to downsize production.

KLA Corporation Inventory Days Outstanding

This quarter, KLA Corporation's DIO came in at 283, which is 71 days above its five-year average. These numbers suggest that despite the recent decrease, the company's inventory levels are higher than what we've seen in the past.

Pricing Power

In the semiconductor industry, a company's gross profit margin is a critical metric to track because it sheds light on its pricing power, complexity of products, and ability to procure raw materials, equipment, and labor. KLA Corporation's gross profit margin, which shows how much money the company gets to keep after paying key materials, input, and manufacturing costs, came in at 60.7% in Q2, up 1.2 percentage points year on year.

KLA Corporation Gross Margin (GAAP)

Despite declining over the last 12 months, KLA Corporation still retains reasonably high gross margins, averaging 59.8%. These margins point to its solid competitive offering, disciplined cost controls, and lack of significant pricing pressure.

Earnings, Cash & Competitive Moat

Analysts covering KLA Corporation expect earnings per share to grow 6.8% over the next 12 months, although estimates will likely change after earnings.

Although earnings are important, we believe cash is king because you can't use accounting profits to pay the bills. KLA Corporation's free cash flow came in at $545.4 million in Q2, down 8.3% year on year.

KLA Corporation Free Cash Flow

As you can see above, KLA Corporation produced $3.17 billion in free cash flow over the last 12 months, an eye-popping 32.9% of revenue. This is a great result; KLA Corporation's free cash flow conversion places it among the best semiconductor companies and, if sustainable, puts the company in an advantageous position to invest in new products while remaining resilient during industry downturns.

Return on Invested Capital (ROIC)

EPS growth informs us whether a company's revenue growth was profitable. But was it capital-efficient? For example, if two companies had the same EPS growth, we’d prefer the one putting up those numbers with lower capital requirements (usually in the form of balance sheet debt and equity).

Understanding a company’s long-term ROIC (return on invested capital) gives another level of insight because it factors the total debt and equity needed to generate operating profits. This metric is a proxy for not only the capital efficiency of a business but also its management team's decision-making prowess (because they're the individuals dictating what the company invests in).

KLA Corporation's five-year average ROIC was 39.3%, placing it among the best semiconductor companies. Just as you’d like your investment dollars to generate returns, KLA Corporation's invested capital has produced excellent profits. The trend in its ROIC, however, is often what surprises the market and drives the stock price. KLA Corporation's ROIC has averaged 18.4 percentage point increases each year. We think KLA Corporation is a good business, and its rising returns gives us more confidence in the company’s trajectory. It could suggest its competitive advantage or profitable investment opportunities are growing.

Key Takeaways from KLA Corporation's Q2 Results

We enjoyed seeing KLA Corporation exceed analysts' revenue and EPS expectations this quarter. This beat was driven by strong outperformance in its largest division, semiconductor process control. On the other hand, its free cash flow missed Wall Street's estimates, and its revenue and EPS guidance for the next quarter fell short. Overall, this was a mixed quarter for KLA Corporation. The company is down 6% on the results and currently trades at $603 per share.

Is Now The Time?

When considering an investment in KLA Corporation, investors should take into account its valuation and business qualities as well as what's happened in the latest quarter.

There are several reasons why we think KLA Corporation is a great business. While we'd expect growth rates to moderate from here, its revenue growth has been solid over the last three years. Additionally, its powerful free cash generation enables it to sustainably invest in growth initiatives while maintaining an ample cash cushion, and its stellar ROIC suggests it has been a well-run company historically.

KLA Corporation's price-to-earnings ratio based on the next 12 months is 26.4x. Looking at the semiconductors landscape today, KLA Corporation's qualities really stand out, and we really like it at this price.

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