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KLA Corporation (NASDAQ:KLAC) Exceeds Q2 Expectations But Quarterly Guidance Underwhelms


Full Report / January 26, 2023
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Maker of equipment for semiconductor manufacturing, KLA Corporation (NASDAQ:KLAC) reported Q2 FY2023 results beating Wall St's expectations, with revenue up 26.8% year on year to $2.98 billion. However, guidance for the next quarter was less impressive, coming in at $2.35 billion at the midpoint, being 5.95% below analyst estimates. KLA Corporation made a GAAP profit of $978.7 million, improving on its profit of $717.5 million, in the same quarter last year.

KLA Corporation (KLAC) Q2 FY2023 Highlights:

  • Revenue: $2.98 billion vs analyst estimates of $2.82 billion (5.5% beat)
  • EPS (non-GAAP): $7.38 vs analyst estimates of $7.10 (4.01% beat)
  • Revenue guidance for Q3 2023 is $2.35 billion at the midpoint, below analyst estimates of $2.49 billion
  • Free cash flow of $594.6 million, down 35.8% from previous quarter
  • Inventory Days Outstanding: 191, down from 210 previous quarter
  • Gross Margin (GAAP): 59.4%, down from 61.3% 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 strong, averaging 26.1% annually. And as you can see below, last year has been especially strong, with quarterly revenue growing from $2.35 billion to $2.98 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

This was a decent quarter for KLA Corporation as revenues grew 26.8%, topping analyst estimates by 5.5%.

KLA Corporation' appears to be headed for a downturn. While the company is guiding to growth of 2.67% YoY next quarter, analyst consensus sees 13.3% declines over the next twelve months.

Product Demand & Outstanding Inventory

Days Inventory Outstanding (DIO) are an important metric for chipmakers, as it reflects the capital intensity of the business 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 inventory days came in at 191, 11 days below the five year average, showing no indication of an excessive inventory buildup at the moment.

Pricing Power

KLA Corporation's gross profit margin, how much the company gets to keep after paying the costs of manufacturing its products, came in at 59.4% in Q2, down 1.9 percentage points year on year.

KLA Corporation Gross Margin (GAAP)

KLA Corporation's gross margins have been stable over the past year, averaging 60.7%, and remains well ahead of most of its semiconductor peers, indicative of a potent competitive offering, pricing power, and solid inventory management.

Profitability

KLA Corporation reported an operating margin of 44.9% in Q2, up 1.3 percentage points year on year. Operating margins are one of the best measures of profitability, telling us how much the company gets to keep after paying the costs of manufacturing the product, selling and marketing it and most importantly, keeping products relevant through research and development spending.

KLA Corporation Adjusted Operating Margin

Operating margins have been trending up over the last year, averaging 41.9%. KLA Corporation's margins remain one of the highest in the semiconductor industry, driven by its highly efficient operating model's economies of scale.

Earnings, Cash & Competitive Moat

Wall St analysts are expecting earnings per share to decline 24.2% over the next twelve months, although estimates are likely to change post earnings.

Earnings are important, but we believe cash is king as you cannot pay bills with accounting profits. KLA Corporation's free cash flow came in at $594.6 million in Q2, down 20.2% year on year.

KLA Corporation Free Cash Flow

KLA Corporation has generated $2.98 billion in free cash flow over the last twelve months, translating to 28.4% of revenues. This is a great result; KLA Corporation's free cash flow conversion was very high compared to most semiconductor companies, in the last year. This high cash conversion, if maintained, puts it in a great position to invest in new products, while also remaining resilient during industry down cycles.

KLA Corporation’s average return on invested capital (ROIC) over the last 5 years of 78.5% implies it has a strong competitive position and is able to invest in profitable growth over the long term.

Key Takeaways from KLA Corporation's Q2 Results

Sporting a market capitalization of $59.8 billion, more than $2.86 billion in cash and with positive free cash flow over the last twelve months, we're confident that KLA Corporation has the resources it needs to pursue a high growth business strategy.

We were very impressed by the strong improvements in KLA Corporation’s inventory levels. And we were also excited to see that it outperformed Wall St’s revenue expectations. On the other hand, it was unfortunate to see that the revenue guidance for the next quarter missed analysts' expectations and gross margin deteriorated a little. Overall, this quarter's results still seemed mixed. Investors might have been expecting more and the company is down 3.43% on the results and currently trades at $414 per share.

Is Now The Time?

When considering KLA Corporation, investors should take into account its valuation and business qualities, as well as what happened in the latest quarter. We think KLA Corporation is a solid business. We would expect growth rates to moderate from here, but its revenue growth has been solid, over the last three years. On top of that, its impressive operating margins are indicative of an highly efficient business model, and its high return on invested capital suggests it is well run and in a strong position for profit growth.

KLA Corporation's price to earnings ratio based on the next twelve months is 23.4x. There are definitely things to like about KLA Corporation and looking at the semiconductors landscape right now, it seems that it doesn't trade at an unreasonable price point.

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