• KLA Corporation is a leading semiconductor equipment provider with strong financials, negligible net debt, and high returns on capital, making it a high-quality equity.
• Despite its strengths, I recommend a Hold due to significant revenue exposure to China and potential impacts from US-China trade tensions.
• The stock has retrenched 30% from its all-time high, and investors should await clarity on support levels and upcoming earnings before taking action.
• KLA’s valuation is reasonable, but geopolitical risks and trade restrictions could materially impact future earnings, warranting cautious monitoring of the situation.

Introduction

KLA Corporation (NASDAQ:KLAC) is a leading American semiconductor capital equipment provider. KLA is a market leader in systems for advanced inspection, metrology and computational analytics in the chip manufacturing industry. The firm as it is currently constructed is the result of a merger in 1997 between KLA and Tencor.

The firm holds a leading position in process control systems which are responsible for ensuring the quality and yield of the manufacturing process. In layman terms, their machinery checks for defects in chips, which helps their large customers such as TSMC (NYSE:TSM) ensure quality control and hence boost yields of processed silicon wafers. Given the highly competitive nature of the business it is imperative for firm’s like TSMC to ensure the highest quality control for customers to continue winning orders.

KLA has all the traits of a high quality equity I would be interested in owning. It operates in a market which is cyclical but which has exhibited significant growth over time, in particular as the chip manufacturing business has become more complex as chip sizes continue to shrink. KLA boasts negligible net debt and has a rock solid balance sheet rated A- by S&P (NYSE:SPGI). KLA has very high returns on capital and better profitability metrics when compared to its closest peers. When adjusting for growth the firm’s valuation looks quite attractive.

Despite this host of positive factors I am recommending a Hold for the present moment. My rating is based on concern regarding the huge revenue exposure KLA has to China and the associated uncertainty that further trade restrictions or tariffs between the US and China might have on KLA’s prospects.

Secondly the stock have sold off significantly in the past six months and now the price action is making a second attempt at a key support level for the stock. With an earnings release due in January and a new incoming US administration, I would exhibit caution on KLA , at least in the near-term, despite the clear quality of the underlying business.

Technical Analysis

Looking at the long term price action for KLA we see the stock made an all time high just short of $900 in July this year and the stock has retrenched by over 30% since then. Recent sell off looks as though it may form a double bottom but we are still awaiting confirmation of this.

Zooming into a daily time frame we see a clear bottom has been forming just above the $600. This is the second attempt at this important price level in the last few weeks, with a wedge pattern loosely forming from the high side. I would caution investors to hold fire on any further action in KLA until this near term struggle between buyers and sellers is resolved. A break below the $600 support level would leave a situation where the next major support level is all the way down at $500.

Conversely if buyers hold the line at $600 and we get incrementally better news for the stock, potentially on their earnings call in January. The holding of support coupled with better than expected earnings might serve as the appropriate buy trigger for those investors comfortable with balancing the quality of KLA’s business with the risks associated with high sales volume in China. My recommendation is not to rush at this time and await greater clarity before either initiating a position or topping up existing ones.

Profitability and Balance Sheet

The quality of a business will shine through over time in its financial metrics and KLA is a classic example of this. Looking below at KLA vs two of its closet peers in large cap semiconductor equipment Applied Materials (NASDAQ:AMAT) and Lam Research (NASDAQ:LRCX), we see meaningfully better profitability for KLA.

Another trait I always like to see in a stock is the use of capital to reduce the outstanding share count. Over the past decade KLA has deliver about a 2% annual share count reduction which has been a helpful boost to the bottom line. Additionally, the firm has balanced its capital allocation between dividends and buy backs, providing benefit also to those investors with a preference for cash returns.

KLA’s cash generation is best in-class for the industry as the firm has consistently delivered a FCF margin in mid-20s and above. The company management have committed to returning over 85% of this FCF generated to shareholders through buy backs and dividends. I see this as exactly the type of attitude a management team should have, at the end of the day shareholders as owners in the business have the ultimate claim to cash generated by the company and management teams should recognize this. Too often ambitious CEOs engage in vanity project M&A which research shows destroys value more often than not.

Valuation

Taking a brief look at the current valuation, we see that KLA trades just shy of 21x forward earnings having fallen from a frothy 35x earlier this year. While the current valuation is a premium to the company ten-year average, when we adjust for growth using the PEG the stock looks to be trading at a reasonable level but not outright cheap.

When I run my own DCF analysis on the stock I see the current pricing as anticipating roughly a 12% return for the stock. For the first stage of growth, I use the analyst consensus and stage two growth I reduce to 10% which is significantly lower than the firm’s current ten-year EPS CAGR of 21% and more in-line with the S&P 500 index average. I use a terminal earnings multiple of 20x which is in-line with the firm’s 5-year average, while it is higher the the firm’s ten-year average I see this as justified given the structurally higher ROIC the firm now generates.

As always we need to consider the risks and shortcomings to a DCF analysis. KLA’s future earnings growth will be impacted in large part by developments in the global semiconductor trade situation. If trade restrictions have already peaked, then it is highly possible my second growth stage is significantly underestimating the growth potential for the business. On the flip side, a ramping in trade restrictions to include many of KLA’s products would materially hamper future earnings and likely justify a lower terminal multiple.

Risks

The most obvious risk KLA faces as a business is its position at the cross roads of geopolitics between China and the US. In its most recent fiscal quarter KLA generated over 40% of its revenue from selling equipment to Chinese fabs. Thus far export controls on semiconductors have been limited to the most advanced equipment which has had a greater impact on firm’s like ASML (NASDAQ:ASML) with their EUV lithography machines and more recently export controls pertaining to high-bandwidth memory or HBM.

One could make the case that KLA shouldn’t face the same level of risk given the nature of their product portfolio but given the ramping of trade tensions I think the environment is uncertain enough at present to give investors meaningful pause. The recent story of China opening anti-trust action against Nvidia (NASDAQ:NVDA) is the first example of them hitting back and potentially trying to damage western companies. KLA will need to navigate the current environment with great caution.

Conclusion

I am recommending investors adopt a Hold position on KLA at present. As laid out above the company has extremely attractive financial metrics and the firm’s valuation seems reasonable. With the stock price making a second attempt to push lower below a long term support level I see no reason for investors to jump the gun, with a preference for watching the price development closely ahead of upcoming earnings and any news from the incoming US administration.

KLA might warrant an upgrade to buy if we get more information regarding the geopolitical situation. If new US administration looks set to be pragmatic vis-a-vis the Chinese and work out a deal, that could give comfort that KLA’s portfolio focused on process control will be exempt from any semiconductor trade restrictions. On the other hand, if trade and technology hawks desire to completely derail Chinese efforts in semiconductor manufacturing then its possible KLA could find its China sales seriously at risk which I would see as thesis changing for the stock.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Seeking Alpha’s Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

The post KLA Corporation: Great Business But China Risk Looms Large appeared first on Up2info.com.

• After a robust first 9 months, KLA Corp. is now underperforming the Nasdaq by a significant margin.
• KLAC’s largest region – China is likely to see a slowdown in WFE spending, even as the US expands export controls.
• Despite Chinese market woes, the North American region driven by leading-edge chip momentum and advanced packaging demand offers some optimism for KLAC’s future performance.
• KLAC’s forward P/E valuations are now in line with its long-term average of 21x, but from an FCF yield and dividend yield perspective, it is still not attractive.
• On the weekly chart, the stock has broken a two year trendline, while momentum indicators on the daily chart don’t look good.

A Disappointing Close to 2024

The stock of KLA Corporation (NASDAQ:KLAC), a semiconductor capital equipment entity, noted primarily for its expertise in semiconductor-related process control work, hasn’t had the most dazzling of years. In fairness, up until October, KLAC was on a roll, outperforming both its peers from the semiconductor terrain, as well as the Nasdaq, but it all appears to have gone pear-shaped from mid-October, so much so that on a YTD basis, KLAC is now not even generating half the returns of the benchmark index, while underperforming its close peers by ~250bps.

Could 2025 see a reversal in fortunes, or is this bout of underperformance here to stay?

China Market Woes

Well, it’s difficult to expect the market to view a company in a positive light, when that company’s largest regional exposure is likely to face challenges. In KLAC’s case, that is the Chinese region, which contributed a mammoth 42% of total group topline in Q1-25.

For the current quarter (Dec 2024), KLAC management had first suggested that the Chinese contribution to the overall pie would dip to the mid-30s levels, with further attrition next year, closer to the 30% levels (with a +/-200bps variance). To be clear, KLAC management initially didn’t believe that the dollar value of Chinese sales would fall of a cliff (the Chinese share in the overall mix was likely to be impacted by a pickup from other areas), and were actually guiding to a flattish development there, buttressed by “pretty stable” investment levels.

However, last week, we saw the US come out with further export controls on various chipmaking tools and equipment to China, which could likely send the contribution of Chinese sales in KLAC’s mix down to the low 20s percentage. This is still a very fluid situation, and the eventual outcome could be a lot worse or better (the concerned licensing terms with its Chinese clients may still offer opportunities for KLAC to provide support services) than initially expected, but in last week’s Wells Fargo TMT event, the CFO of KLAC pegged the “preliminary” FY25 calendar impact of this development at around $400-$600m (there won’t be any immediate negative impact in the current quarter which is still expected to be the 3rd straight quarter of sequential revenue growth for KLAC as a whole).

As things stand, consensus is largely sitting on the fence, and has only brought down next year’s sales estimates by less than -0.5%, whereas a $400-$600m impact potentially represents a 2-5% negative impact on KLAC’S annual topline.

Even before this news came out, some members of the sell-side community were already suggesting that YoY spending on Chinese WFE (Wafer Fab Equipment) was likely to slow by 5% to $41bn in FY25 (mainly on account of a pull-forward of spending in recent years), leaving a mark on overall WFE spending. However, note that the official semiconductor industry body – SEMI, which came out with a forecast just today believes that despite a slowdown in the Chinese WFE investments, the overall global WFE spending for the global market could still grow by an impressive 7% (at $107.6bn), better than the 5.4% growth that will be seen by the end of FY24.

Nonetheless, we feel it would be too soon to believe that the Chinese market weakness has been digested by the markets, as the Trump regime hasn’t yet got going, and under his stewardship, things are unlikely to get better.

Leading-Edge Chip Momentum, And Advance Packaging Demand, Could Serve As Mitigating Sub-plots

The Chinese market may be on the way down, but investors can take heart from the fact that the North American region, which only accounted for 10% of KLAC’s total revenue last year, has doubled, and is now the second-largest region after China (contributing 18% of Q1-25 sales or over $0.5bn). Much of this is driven by AI-related momentum and High-Performance Computing (HPC) requirements, which are innately more complex and will necessitate the need for even more process control intensity.

We would expect this region to continue to build clout, given the impetus by the US to cultivate a leading-edge logic chip manufacturing hub (from no exposure last year, the US is now targeting 20% market share in leading-edge chips by 2030). In fact, KLAC management highlighted that in Q1-25, this was the chief driver of sales for their North American segment, and that the quarter was characterized by requests from their leading-edge customers for “more systems than they’d originally planned for”.

Besides the tailwinds from leading-edge momentum, investors may also be comforted by KLAC’s competence in advanced packaging, a tech which is going to see a lot of takers, given how effective it can be in bringing down chip manufacturing costs and power consumption even as design costs on smaller semiconductor nodes get more prohibitive.

This advanced packaging business, which accounted for $300m of KLAC’s annual sales last year, is currently growing at a pace of 67% YoY in FY24 (at $500m), and next year, it could end up growing by another 50%, while also crossing the $750m mark! $250m of additional sales could be a great boon when the Chinese exposure is expected to take a $500m hit next year.

Valuations Are A Mixed Bag

What the sell-off in KLAC has made the forward valuation picture a look more palatable. 6 months back, this was a stock priced at over 35x P/E, but now it is priced at just a marginal premium over its long-term average of 21x. Crucially, it is no longer one of the priciest names in the semiconductor industry, where the current forward industry average multiple of 29x is around 38% higher.

Investors may also be enthused to note that for the current multiple of 21x, they are still getting an attractive cadence of earnings growth over a two-year duration. The image below showcases reported earnings as well as earnings estimates two years out, and what we can infer is that is a business that will likely provide 2-year earning CAGR of 27%. This would translate to a lowly forward PEG (Price-to-Earnings Growth) of just 0.77x.

Having said that, investors may want to note that on an FCF yield basis, KLAC still doesn’t look too attractive relative to what it has traditionally yielded (currently roughly 100bps lower than the 5-year average of 4.58%).

Don’t get us wrong, FCF generation is still robust enough (they are currently converting an impressive 33% of sales and 95% of net profits to free cash), but what it tells us it that the market-cap is still at a relatively high threshold. There’s still scope for KLAC to get better on the FCF front, as the number of days that cash is tied up in working capital work is still quite high by historical standards (11% higher than the 5-year average)

Then we’ve previously talked up KLAC’s stellar dividend profile, but despite an impressive hike of 17% recently, the current yield is still lagging the 4-year average of 1.08% (which once again is a reflection of a steep share price/market-cap effect)

What Do The Charts Suggest?

If you’re someone who takes a cue from the charts, you’d note that it’s probably not the best time to exhibit some bravado, even if the P/E valuations are in a better place.

Firstly, note the developments on the daily chart, which suggest a shift in momentum indicators. Since November 2022, KLAC had managed to defend the psychologically key 200DMA (the blue line), but that is no longer the case. Now it is trading below all three key moving averages, with even the death cross taking place in November (usually a catalyst for further bearish pressure). What may also be rather dispiriting to note is that during the sell-off in November, KLAC’s CEO decided to sell some of his holdings to the tune of $9.5m (the first time any insider has resorted to any selling since August).

On the larger time frame weekly chart, also note that from the start of Q4-22 through Nov 2024, the price had been bouncing against an ascending trendline, every once in a while, but we’ve finally seen this give way, with the price not quite able to recoup the old trendline.

Finally, the relative strength charts, which capture KLAC’s positioning versus it semi peers, tell us that, whilst it no longer looks like one of the most overbought stocks in this universe, the current relative strength ratio still has further scope to normalize, given that it is still around 22% higher than its two-decade old mean value of 2.4x.

Closing Thoughts

To sum up, at current price levels, where the valuations are a bit more palatable than six months ago, we don’t feel an investment in KLAC will be a disaster, but considering the uncertain Chinese market risks, which is their largest region, (which could prompt more earnings revisions going forward), we would prefer to sit on the fence. KLAC is a HOLD for now.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Seeking Alpha’s Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

The post Is KLA Corporation A Good Buy For 2025? appeared first on Up2info.com.

• Wafer Fab Equipment faces multiple tailwinds as semiconductor demand and complexity are bound to increase over the medium to long-term.
• Both, ASML’s and KLA’s, dominant market position and strategic advancements make it a compelling investment proposition in the semiconductor sector.
• While a multitude of risks remain, I rate KLA a “Strong Buy” and ASML a “Buy”.

After comparing the three Generalists Applied Materials (AMAT), Lam Research (LRCX), and Tokyo Electron (OTCPK:TOELY) in a previous article, I found it appropriate to also compare the two Specialists, ASML (NASDAQ:ASML) and KLA Corporation (NASDAQ:KLAC).

Investment thesis

ASML dominates the lithography process. KLA is the undisputed leader in semiconductor metrology and inspection.

As semiconductor demand and complexity increase rapidly and yet face a long runway, WFE demand is bound to increase over the long term. In the endless struggle to achieve higher performance from smaller chips, both are uniquely positioned to benefit from this in their own way.

While risks remain, I believe KLA to be the better deal at the current valuation. That is, despite ASML also seemingly trading around fair value.

Sector and Company Overview

Semiconductors are small “chips” that enable complex tasks inside our phones, cars, and communication hardware but also less prominent places like defense and medical technologies.

Affected by end-consumer spending, economic cycles, and often low visibility into future demand, the semiconductor industry is generally cyclical. Yet it faces long-term tailwinds as a) volume grows through a growing amount of technological applications (i.e. Apple Vision, EVs, Robotics) and b) complexity increases with a growing need for higher performance on less space (i.e. computers/phones processing faster without growing in size).

To make a single semiconductor, dozens of companies have to perform highly complex tasks with extreme precision, often quite literally pushing what is possible physically. The, for me, heart of the semiconductor supply chain, is the mission-critical Wafer Fab Equipment (WFE) sector.

These large machines are installed at customer “Fabs”, the factories in which semiconductors are manufactured, and are essential to making semiconductors. Yet, this also means the WFE sector is reliant on Fab building, expansions, and customers upgrading their equipment. In other words, Foundry and IDM capex.

The “big 5” (ASML, AMAT, KLA, LRCX, TEL) dominate this sector:

AMAT, LRCX, and TEL, which I covered in a past article, are rather diversified, hence I consider them the Generalists.

ASML and KLA on the other side have carved out niches in very specific sectors, thus I consider them the Specialists of the quintet.

ASML

ASML, with a market share of ~90%, towers over the lithography sub-sector. Lithography is critical to semiconductor production as we know it. Lithography, put simply, is the process of drawing a specific pattern on the wafer. This is necessary to later be able to etch the pattern into the wafer, which is a disc cut from a large ingot usually made out of silicon. Making these, increasingly small, patterns as precise as possible is what enables advancements in semiconductor designs. This part of ASML’s business is the “System” segment, where the company sells large machines (see picture below) to customers.

ASML’s Installed Base Management (IBM) made up 20.3% of revenue in the latest quarter and provides a largely recurring revenue profile by supplying customers with spare parts, as well as software, services, and training.

As is visible above, a large part of ASML’s revenue comes from China and generally Asia. Although China’s revenue share is expected to fall to ~20% next year, depending on the downside scenario, this potentially still carries significant risks as I will cover later. Besides China, it is unlikely the geographic allocation will change much in the medium term, as most Fabs are located and being built in Taiwan, China, and Korea.

At its recent Investor Day, the company reaffirmed its 2030 medium-term guidance of revenue between $44B and $60B (13.2% CAGR at midpoint). Unfortunately for the stock performance, besides reiterating the growth story, it was a relatively unexciting event.

KLA

KLA manufactures equipment used to inspect semiconductors throughout and after production. These machines, a picture below, are bought by customers like Intel (INTC), Micron (MU), or TSMC (TSM) to increase their production yield and ensure quality.

To understand the relevance of production yield we need to understand how Fabs operate. Fabs require astronomical amounts of capital to set up, often in the 10 to 11-digit range. Additionally, they require a lot of power and water, which can mean quite high fixed costs. All of this means that Fabs are required to constantly run (most operate 24/7) to be profitable and generate a return for their operators. This makes efficient production mission-critical – and that is what KLA makes possible with its inspection and metrology equipment. As semiconductors become smaller and more complex, controlling their quality and achieving high production yields becomes increasingly harder. Through their leading inspection and quality control equipment KLA is indispensable to any Fab that desires to be competitive.

Similar to what Applied Materials and Lam Research focus on, KLA also provides deposition and etch equipment through its “Speciality Semiconductor Process” segment.

Although not its own reported segment yet, recent strides into semiconductor packaging, due to customer demand, provide further runway. I am positive about this development as it further deepens customer relationships with the broader offering.

Beyond that, KLA also offers “Services”. This segment, similar to ASMLs “IBM”, provides spare parts, services, and software, and provides downside protection and insulation against the cycle.

Similar to ASML, KLA’s geographical revenue distribution is heavily influenced by Asia and especially China, although Europe has a higher share of revenue. As explained in ASML’s paragraph, I don’t expect this to change materially.

While the picture below is now outdated (as Mrs. Polanich joined as CCO), it shows an, in my opinion, very important part of KLA. The majority of management active today is responsible for making KLA the industry leader it has become over the last 20-30 years:

Moats

Scale

By investing billions into research and development annually, the barriers to entry have become immensely high, effectively making it impossible for new competitors to enter the field from a financial perspective.

Switching Costs and Customer Relationships

Due to both companies’ large installed bases, combined worth hundreds of billions, it would be financially impossible for customers to replace their equipment with a competitor’s solution. This is more so true as both company’s equipment has a useful life of up to two decades. In line with their customers’ large investments into their Fabs, customers have close ties with all large WFE companies to coordinate fab building and expansions, often planning together with them. This creates significant relative visibility into demand as well as very high barriers to entry for potential new competitors.

The services and support the companies provide for its machines further increase switching costs as, with these machines costing 7 to 9 digits and downtime being extremely costly for Fabs, customers want to make sure trained technicians service the machines. Further both companies of course supply spare parts and even software for their machines.

Technology

Both KLA and ASML are the technology leaders in their subsectors. As explained in the KLA paragraph, Fabs require remarkably efficient operations to be profitable. A key advantage that makes them incredibly valuable to their customers is maximum throughput and high repeatability, as well as unmatched precision:

…the accuracy of EUV lithography is like shooting a laser gun from the moon to hit a coin on the planet earth.

Technological dominance is further evidenced by them being the only players in their spaces who are and have been experiencing a growing market share and the only “pure-plays” in their sectors.

As technological and scale advantages go hand in hand and enable switching costs and sticky customer relationships, these moat sources reduce effective competitive risks to a minimum. Making it close to impossible for new competition to enter, let alone displace, the incumbents. Additionally, customers depend on them and can not afford to switch from their installed equipment even if a competitor or peer were to out-compete them in technology, which, in turn, is unlikely due to scale. This combination of moats provides tremendous operational downside protection over the medium and long term, despite cycles making operations appear unpredictable at times. I therefore rate both a very wide moat.

Financials

I will use $ for all numbers, except for the company’s guidance which is reported in €.

Despite its sector, ASML had seemingly defeated the cycles, growing each of the past 10 years at a 10y CAGR of 17.4% (when assuming the last quarter’s revenue).

Similar to ASML, KLA had seemingly defeated the cyclicality, but, has also experienced a very normal, cyclical revenue drop-off recently. The reason we see this in the graph this pronouncedly is that KLA’s fiscal year 2024 has already been reported. Yet, KLA grew at a 15.4% CAGR over the last decade. ASML’s revenue for the year, at the midpoint of guidance, will be €28B (~1.5% higher than 2023 revenue).

When looking closer, by looking at trailing twelve-month revenue, both seem to just be rebounding in line with the up-cycle and their Generalist peers:

When taking into account ASML’s guidance for FY25 being below previous revenue estimates (€30-35B vs ~€36B), this implies the upcycle is not as explosive for ASML. This is what likely led to the recent sell-off of ASML’s stock. That is not necessarily a bad thing for ASML, as it will still grow while its peers are experiencing contracting revenues or stagnation. But it was likely unexpected (and not priced for) by the market, which had seemingly forgotten that the WFE sector is cyclical and hardly predictable by nature.

I also want to note that, historically, the two specialists have been growing faster and with less volatility than AMAT, LRCX, or TEL, which I had a look at in my last article. However, I would not rely on this being the case for the next decade, despite the market being more confident in the two companies – expressed by a higher valuation.

When looking at (stock-based compensation adjusted) free cash flow per share and earnings per share metrics, it becomes apparent that ASML has either lost much of its profitability or invested a lot through capital expenditures. The latter is the case. To expand capacity, ASML has invested billions into new facilities in the Netherlands. I expect this to normalize over the medium term and follow a growth path similar to revenue and EPS.

KLA on the other hand has had much less capex in the last years. Subsequently, its FCF/share has, within the volatility of the cycle, consistently grown.

ASML’s EPS have seen a constant increase, compared to its volatile FCF/share, and grew at a compounded annual growth rate of 19.9%.

Meanwhile, KLA grew its EPS at a CAGR of 24.6% over the last decade.

ASML’s and KLA’s operating margins, despite the cycles likely weighing on pricing and operating leverage, have reliably increased, with ASML’s margins only slightly behind KLA’s.

Even with much higher debt than ASML, I think KLA’s balance sheet is fine. I don’t consider debt a relevant risk for either company, due to extreme stickiness and their mission-critical offerings. Beyond that, both generate more than enough cash flow, even in a downcycle, to service their debt.

Shareholder Returns

Click to enlarge

With an average of 2.5% and 3.8% in annual shareholder returns, despite heavy reinvestment into R&D and capacity expansion, I believe both companies distribute adequate amounts of capital to their shareholders. This should support strong stock returns, as both face a stellar long-term outlook and are valued fairly reasonably.

Valuation

Click to enlarge

Calculated with prices and analyst estimates as of the closing of 11/15/24. For the Generalist average, I used the average ratios of AMAT, LRCX, and TEL.

When looking at the past performance of these companies, and the sector, those estimates are not unrealistic. Although the cycles can be very hard to forecast for anyone, including analysts.

This is why, as part of my relative valuation analysis, I like to look at a company’s track record of meeting the market estimates, as it provides an additional data point for how predictable the company might behave in the future.

ASML has beaten 15/16 of the last quarter’s EPS estimates, and 13 of the last 16 annual estimates:

As for KLA, we can see that the company has consistently beaten the market EPS estimates over each of the last 16 Quarters:

The same holds true when looking at the annual beats of the last 16 years, with the exception of 2014:

With the amount of cyclicality given in their sectors and rather lumpy revenues, I consider both of their earnings track records as excellent.

When assuming a 1yPEG ratio of slightly above 2x for the S&P500 (SPY) (30P/E with expected growth of ambitious 14-15%), both seem fairly valued relative to the market. In the case of KLA, valuation even seems undemanding.

Yet, given the higher predictability and lower competitive pressures, investors need to pay a premium over the Generalists. I believe this to be warranted.

Risks

Endmarket Demand

For the vast majority of the semiconductor industry, personal electronics is the underlying end market. While this market is generally subject to broad economic woes, the long-term growth of electronics, communications, and automotive demand is critical to the entire semiconductor growth story.

China

As China aims to advance its own bleeding and leading-edge semiconductor production, the US has increasingly tried to limit China’s access to the advanced tools required for this. While ASML gets much more publicity regarding these trade restrictions, the same goes for KLA, limiting both companies’ potential customer bases.

While this has been ongoing for years, an increase in restrictions could further hurt the top and bottom lines of both companies. This is particularly true as non-EUV equipment has lower gross margins and China mainly buys less-advanced equipment (non-EUV), leading to possible margin compression.

As both companies’ supply chains are highly diversified across all geographies, tariffs could potentially also increase costs and shrink margins. However, it has to be noted that, at least in an upcycle, both companies wield pricing power.

Taiwan and Korea

Taiwan and South Korea are potential targets of invasions by China and North Korea.

Should their threats be made true, it would make shipments from and to Taiwan and South Korea impossible, leading to all WFE companies instantly losing a large part of their revenue.

AI

Much of the expected semiconductor demand (about 15% according to TSMC’s last numbers) is to come from massive AI adoption, this creates risk in the form of an unproven market, as many AI-focused companies yet have to generate meaningful revenue let alone realize profits.

Production Changes, Competiton, and Customer Concentration

Should the way semiconductors are built change on a fundamental level, it is possible for highly specialized companies, especially ASML, to become irrelevant. However, due to immense switching costs, I believe it to be in the Fab owner’s best interest to utilize existing equipment, providing at least some downside protection.

Yet, for example, TSMC has used older equipment to make advanced chips instead of buying new High NA EUV machines. While I don’t believe this has produced sufficient yields at scale, I view it as a warning towards ASML. In the words of the Vice President of Business Development at TSMC, Kevin Zhang:

I like the technology but I don’t like the sticker price.

This is significant because ASML’s (as all WFE companies) sales are highly concentrated into a few large customers, above all TSMC.

Competitors like Canon (OTCPK:CAJPY) and Nikon (OTCPK:NINOF) as well as all three Generalists (AMAT, LRCX, and TEL) are looking to profit from TSMC pushback by making equipment that helps reduce the workload of lithography equipment – essentially reducing medium-term demand for ASML.

So while it is very unlikely any company can directly displace ASML and its technology, reducing customer reliance on its new equipment still hurts the company as it misses out on possible revenue. A fitting analogy might be that; a castle has a deep and wide moat with sharks in it, making getting across impossible. But the besiegers have crossbows – potentially still becoming dangerous for the castle’s population.

As for KLA; both ASML as well as Applied Materials, among other, smaller competitors, have developed process control and metrology equipment, potentially increasing competition for KLA. When looking at market share development over the last decade, however, KLA was the only company in the sector to sustainably grow market share.

So while both do face competition of some kind, it’s everything but easy to compete with, let alone displace, either.

Mitigation

Defense

With geopolitical conflicts at a multi-decade-high, defense exposure is likely the best hedge against the risks Taiwan and South Korea face.

Position Sizing

The best hedge against most uncertainty is prudent diversification. Here, while confident about the future of semiconductors, I think it makes sense to monitor the total China, Taiwan, and South Korea portfolio exposure and allocate accordingly.

As I don’t see competition as a substantial risk I don’t think positioning against peers (by taking a position in them) makes any sense here, as most are so far behind technologically or in scale that they are more likely to underperform. Although, as laid out in my last article, I do believe TEL and LRCX to be a good buy at the moment. Both of these could help against possible risks from reduced lithography demand for ASML shareholders.

Selling

A continuous declining market share, pointing to an erosion of their competitive advantages, would cause me to sell either company. The same applies to abrupt changes in manufacturing processes, potentially making the equipment provided irrelevant, although this would have to be evaluated on a case-by-case basis. An invasion of Taiwan or South Korea would likely take the entire WFE sector multiple years to recover, create tremendous opportunity costs, and might make selling to Taiwan (and China) impossible over the long term. This would be the worst-case scenario for both companies and warrant a sale as well, in my opinion.

Trade restrictions would not necessarily be a reason to sell in my opinion. However, immense restrictions, to the point of making business in China impossible, would make even market returns unlikely at the current valuation.

Conclusion

As could be seen in my valuation comparison, investors would need to pay up for the increased dominance, lower operational volatility, and lower competitive threats compared to the Generalists (which is already a very high base). For investors focused on value, I suggest taking a look at Lam Research and Tokyo Electron, which I have covered and rated as “Buy” and “Strong Buy” here, together with Applied Materials.

As both ASML and KLA enjoy, in my opinion, equally (very) wide and deep moats, both being mission-critical and able to show higher, more resilient growth than the three Generalists, it is a very hard decision which company to pick.

One thing that I dislike about ASML, the stock not the company, is the high media coverage and subsequent crowding. This is likely the cause of a higher valuation – due to sentiment, instead of (prospects of) increasing fundamentals and moat.

In a situation where I perceive two companies that provide the same exposure as equally predictable, I generally pick the company with the lower valuation. This leaves more room for returns as multiple compression is less likely. Of course, the more growth is priced in/the higher it is valued the less likely it is investors can earn excess returns. Further, it has less volatility of earnings performance, though this can largely be attributed to less lumpiness from lower average prices per machine.

So, while I prefer (and am a shareholder of) KLA and rate it a “Strong Buy”, I also like ASML a lot and believe that, relative to an expensive market, it is approximately fairly valued. With such high-quality companies, expressed by immense dominance and medium-/longterm predictability, rarely being valued (relatively) reasonably, I also rate ASML a cautious “Buy”.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of KLAC either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Although I aim to always give actionable recommendations based on doing my research to the best of my abilities, this should never be seen as investment advice – please never skip doing your own research.

Seeking Alpha’s Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

The post ASML And KLA: Which Equipment Specialist Is The Better Investment? appeared first on Up2info.com.

• KLA leverages cutting-edge semiconductor inspection tech, partnering with industry leaders like TSMC and Samsung. This positions them to capitalize on the growing demand for 2nm and 3nm chip manufacturing.
• Holding a 50% global market share in process control, KLA benefits from the surge in AI-driven GPU demand and significant investments by major foundries, driving revenue growth.
• With a 9% Q4’24 revenue increase, high profitability, substantial share buybacks, and an undervalued stock post sell-off, KLA is poised for a potential 10-20% upside.

Investment Thesis

I rate KLA Corporation (NASDAQ:KLAC) stock as a Buy. Backed by the company’s cutting-edge technology, the billion-dollar company KLA has some of the most advanced technologies, such as 29xx broadband plasma, which can redact a defect in the most advanced chips, 2nm, 3nm, and 5nm. Its defect inspection and review technology are used in varied substrate and chip manufacturing applications for line monitoring and wafer qualification. With TSMC (TSM) net sales projection of $23 billion in Q3 ’24, after the company recorded a 40% revenue increase in Q2’24, I expect KLA revenues to upscale as a TSMC supplier at a high percentage of 5.13%. The high demand for TSMC’s 3nm and 5nm semiconductors, which KLA has the technology to measure the quality and detect any defect, positions KLA for more business. Despite the recent plunge of major semiconductor players, especially the declining ASML bookings leading to a 15.7% share plunge, KLAC is at a better bullish entry point. The recent plunge by the major player ASML (ASML) was recorded after geopolitical tensions halted its bookings. However, the demand for EUV is still high, with a sales increase from 36% in 2024 to a projected 58% in 2028. A short-term overlook at 2025, China sales are expected to plummet from 25% to 30%, but with a 58% sales increase in the long-term overlook, I reiterate my bullish rating.

Company overview

KLA is in the semiconductor wafer fabrication industry. The company specializes in process control and process enabling, which helps chip manufacturers achieve cutting-edge chip performance. For example, KLA facilitates 2nm and 3nm chip process control and process-enabling solutions to produce the iPhone 16 series. KLA has machines like broadband plasma patterned wafer defect inspection systems that inspect wafers and verify accurate measurements. The company is a large customer or supplier for the biggest chip manufacturing companies, such as TSMC and Samsung Foundry.

KLA’s position in the semiconductor supply chain

The foundry manufacturing process includes design, fabrication, assembly, testing, and packaging. Unique technologies and equipment achieve quality and high yields at each stage.

Throughout the wafer fabrication process, rigorous inspection and testing ensure the final product is functional and meets the expected quality. However, KLA’s advanced metrology techniques and tools, such as the Puma Laser Scanning Patterned Wafer Inspection System, are best used in the fabrication stage.

Inspection at this stage is critical to capturing defects before moving to assembly. In the current advanced fabrication of 5nm, 2nm, and projected 1nm wafer manufacturing processes, KLA inspection technology such as 39xx, 29xx, C30xx, Voyager, puma, 8 series, Castor, Surfscan, Surfscan SP Ax, eSL10, eDR7xxx, and CIRL are used in a full range of yield applications.

This control process and process enabling ensures wafer qualification and line monitoring. KLA super-resolution broadband plasma technology patterned wafer defect inspection system allows engineers to detect, monitor, and resolve critical yield issues, leading to a high production yield and fast yield ramp. This explains why Major leading semiconductor manufacturers such as TSMC and Samsung use KLA as a significant process control and process-enabling supplier.

I am confident in KLA’s position regarding the supply chain; its cutting-edge technology remains the most significant to its customer’s capability to manufacture advanced chips.

Maintains a firm market position

In the technology world economy that depends on chips in smartphones, personal computers (PC), data centers, high-performing computers (HPC), and the recent artificial intelligence (AI) general processing units (GPUs), KLA has a 50% market position in facilitating chip manufacturing process control and process enabling. This tells me that with a 50% global market position, KLA has the advantage of benefiting more in the 7% global fab forecast in 2025. It is expected that the wafer fabrication will hit 33.7 million per month. TSMC and Samsung, the primary customers of KLA, are projecting to produce 2nm chips at scale, hitting 17% capacity growth by 2025.

KLA’s supply to TSMC is 5.13%, a considerable percentage for a leading semiconductor manufacturer selling 90% of the world’s chips. Therefore, we can relate that a 25% increase in Nvidia (NVDA) Blackwell orders for its GB200 NVL36 server cabinets using 2nm chips increases TSMC’s spending. KLA is, therefore, expected to gain from this increasing demand for GPUs with the rise of GenAI data centers.

It is right to say that TSMC relies on KLA’s process control and process-enabling technology to manufacture high-end AI chips for NVIDIA. This benefits KLA when Nvidia increases its orders. Nvidia does not manufacture its semiconductors. With NVIDIA commanding 98% global market share of data-center GPUs, more GPU sales will demand more chips, which is the work of KLA to ensure the quality of those chips. I am confident that TSMC will continue to record more chip demand, increasing its spending on its suppliers, where KLA is positioned to benefit.

KLA’s business model is irreplaceable

Here, we argue that KLA’s irreplaceable business model is due to its active role in advanced chip manufacturing, strategic partnership, and position to benefit from domestic foundry support.

First, KLA positioned itself for success by meeting the high demand in the foundry sector for process control and process-enabling technologies. Its advanced technology, such as metrology, encompasses systems such as Archer ATL, which are capable of process control for the high-volume manufacturing of 7 nm chips and 1 nm.

The technology enables the accurate detection of errors for varied device types, process layers, patterning technologies, and design nodes. Compared to its close competitors, such as Lam Research (LRCX), I believe that KLA’s cutting-edge metrology technology shows its irreplaceability. For instance, LRCX’s current stock price is $80.85, with a larger market share in TSMC supplier score of 6.32%.

On the other hand, KLA’s current stock price of $774.80, compared to its lower TSMC supplier percentage of 5.13%, shows the quality and uniqueness of its much-needed inspection technology. LRCX supplies innovative fabrication equipment with its expertise in deposition and etch processes, which is a solution for chipmakers.

Secondly, TSMC’s strategic partnership with KLA is based on its critical, cutting-edge technology, which allows TSMC to manufacture the most advanced chips in the world. Therefore, TSMC is leveraging ON KLA metrology to meet 2nm and 1nm chip manufacturing capability. With the AI narrative continuing to receive more recognition, the demand for advanced chips is increasing for efficient and quick processing speed.

Lastly, introducing the CHIPS & Science Act has attracted the attention of KLC customers, such as Samsung and TSMC foundries in the United States. Samsung has invested roughly $45 billion in its under-construction foundry in Taylor, Texas. The fab is expected to start producing 2nm chips in 2026.

TSMC is also investing $65 billion in a fab in Phoenix, Arizona, and is expected to produce 3nm and 2nm by 2028. With the government’s support and subsidies to ensure the companies soar in semiconductor production inside the USA, KLA revenues are also poised to increase as foundries demand more KLA technology.

KLA’s customers are top world chip manufacturers, such as Intel, Samsung, and TSMC, which received the most 7 subscriptions, which signifies future revenue growth. KLA is domiciled in the US, which offers a proximity advantage to supply its process control and process systems to companies manufacturing in the US.

Implication on the Company’s Growth

I annex KLA’s process-control and process-enabling systems technology to its growth and profitability to indicate how the company has gained. Beginning with growth projection, advanced packaging, known as heterogeneous integration, performs multiple functions from varied technologies and is integrated into a single package. This innovation brings up a mix-and-match chipset solution.

This technology is used in AI GPUs driven by AI. In the last 10 years, GPU memory has topped 12 GB, but now it has topped 192GB, achieving efficiency and speed with high-bandwidth memory (HBM). KLA offers solutions for heterogeneous integration architecture in chip packaging, which will assist chip manufacturers in building advanced, high-yield, efficient, and quality devices.

As more complex packaging manufacturing increases, metrology solutions derived from front-end semiconductors that require customized packaging solutions will be demanded. Using its PCB market expertise, KLA is prepared to meet advanced packaging requirements, especially substrate and panel-level.

Rosy financial highlight – Latest earnings

In Q4 ’24, the company recorded a 9% revenue increase to $2.57B YoY. 90% of the revenues were generated from its semiconductor process control, which was $2,308M, a 10% increase YoY. Wafer inspection is a major KLA revenue generator under the product category, with 46% growth and 23% YoY. This indicates an increasing demand for KLA’s wafer inspection as the demand for chips continues to soar. Specialty semiconductor revenue decreased by 7% QoQ and 6% YoY to $121M due to delayed capital expenditures of its key customers and cyclical market conditions.

However, I am opportunistic about specialty semiconductor revenue, as TSMC capital expenditures are set to increase by 15.6% YoY to $37B by 2025. This increase is driven by the demand for 2nm chips accompanied by high production capacity, where KLA technology is positioned in the supply chain. Printed circuit board (PCB) and component inspection soared 9% YoY to $140M.

The company’s profitability was positive in Q4’24 at 62.5%, and there was an increase in non-GAAP diluted EPS by 41.0%. This culminated in a $6.18 earnings per share from $4.43 in Q3’24

The company has shown strong performance by recording over $1,735M from Q3’24 and $1.65M as share buybacks in the last 12 months. This strong share buyback reveals the company’s commitment to boosting shareholder earnings, which explains why earnings per share scored $6.18 in Q4’24, despite an increase in share buyback from $372M in Q3’24 to $470M in Q4’24 and a dividend payment increase from $197M to $198M. Additionally, the company maintained a high free cash flow of $832M from Q3’24 at $838M, showing the strong cash available for its balance sheet.

Valuation and Target Price

First of all, I would like to stress that the almost 20% plunge in October is a completely macro and industry factor, not an idiosyncratic nor company-specific one. The plunge is primarily caused by the scandals and underperformance of an industry downstream peer, Super Micro (SMCI). In other words, my first price target will at least be at $800 where KLAC is traded at before the price action affected by a peer.

Secondly, to be fair, a P/E ratio of almost 45x is an extremely high valuation multiple based on the company’s historical level and industry level. KLAC usually trades in the range of 15x – 30x P/E, depending on market sentiment and industry hype – like 2018, it is traded at the lower end when the market took a dive. As such, under the current AI demand and computing chips frenzy, KLAC should be trading at around 25x – 28x which is the higher end, closer to it peers like TSMC’s valuation.

Full-year earnings, as provided by KLAC in the full-year guidance, is between $26.5 to $27. Therefore, this indicates the stock’s target price will be around $750.

In other words, KLAC is undervalued after the recent sell-off with 10 – 20% of upside, therefore a Strong Buy.

Investment Risks

• More intense competition – KLA’s metrology and wafer inspection systems face competition from Israel Vision and Semilab that offer advanced wafer-level packaging solutions.
• Macroeconomic uncertainties – The business faces interruption from geopolitical tensions, specifically between China and Taiwan. U.S. sanction on China for the sale of ASML EUV deems KLAC an opportunity to expand its services.
• Technology advancement and the inability to catch up – KLAC must keep up with the latest technology to meet the standards of TSMC 2nm and 1nm chips inspection services.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Seeking Alpha’s Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

The post KLA Corporation: Defect Inspection And Review Among Key Drivers To The Growing Industry appeared first on Up2info.com.

• The increasing complexity of the industry through HBM and N2 could benefit KLA Corporation and widen the moat.
• KLAC’s robust balance sheet, with $4.5 billion in cash and manageable debt, ensures financial stability and high interest coverage.
• KLA’s high ROIC of 29% versus a WACC of 8.46% demonstrates significant value creation, supported by ongoing share buyback programs and strong growth in the coming years.

The KLA Corporation Investment Thesis

KLA Corporation (NASDAQ:KLAC) is a solid company in one of the hottest sectors right now that has a lot of momentum for the next few years. And since they are going to be a big part of that growth because they are going to supply the manufacturers with their equipment, I expect continued strong growth rates for years to come.

Sector And Business Overview

KLA is one of the companies operating in the semiconductor industry, and its role is to supply other companies in the segment with the equipment they need. In particular, they offer measurement and inspection equipment, while most of their competitors specialize in process equipment.

Broadly speaking, KLA’s systems are used to identify defects and improve accuracy so that customers can achieve their target yields. And here they are the leader in wafer inspection, which also means that KLA is very dependent on the CAPEX spending of the semiconductor industry.

In particular, TSMC (TSM), which accounts for more than 10% of sales, is a very important customer. So if TSMC increases its CAPEX and has more capacity, it will also have a positive impact on KLA’s revenues. Samsung also had a revenue share of more than 10% in 2023 and 2022, but this fell back in 2024. However, this could change again in 2025 as Memory and especially HBM will probably have a higher revenue share than the 18% in Q4/24.

HBM, which has more dies and therefore more opportunities for errors, could be an opportunity to strengthen KLA’s competitive position. This is all the more true as greater complexity in this sector also means that the competitive advantage can be increased.

In general, KLA has very good customer relationships that have been built up and maintained over many years, which is also reflected in the cooperation with TSMC for N2. But I think TSMC still has some leverage because they are by far the largest and most important customer. However, N2, which is expected to be launched by TSMC in 2025, should have a positive impact on revenues.

But it is not only HBM and N2 that should drive growth in 2025, as KLA is positioned at every corner of the semiconductor market.

KLAC’s Balance Sheet

KLA has a strong balance sheet with credit ratings of A, A2 and A- from the three major rating agencies and $4.5 billion in cash and cash equivalents. This is offset by $6.6 billion of debt, of which only $750 million is due in calendar year 2024. So the debt obligations should be manageable.

Also, the interest coverage ratio of 23x is well above the average of the S&P 500 (SPY), which is around 10x for non-financial institutions. In addition, there is a backlog of $9.8 billion, of which 59% to 64% is expected to be realised within the next 12 months. Therefore, I believe that the liquidity situation is satisfactory.

KLA’s Capital Allocation

KLA bought back more than $11 billion of shares at an average price of $296. And with the stock currently hovering around $770, these buybacks have been value-creating.

In addition, the dividend has been increased for 14 years and has a CAGR of 15% since 2006. So I think it is safe to say that KLA’s management is shareholder-friendly and likes to return capital to shareholders.

KLA’s ROIC is also excellent, with a 10-year average of 26% and a current value of 29%. If we now look at the cost of capital in the form of WACC and compare it to ROIC, we can see that KLA has an excellent ROIC-WACC spread.

ROIC: 29.79% – WACC: ~8% = ROIC-WACC Spread: 21.79%

As a result, we can clearly see that KLA’s investments are also creating value.

The previously mentioned $11 billion in share repurchases can be seen here in comparison to SBC and the extent to which they have reduced shares outstanding. Plus It is impressive that the current market capitalization is close to $104 billion and the $11 billion used for buybacks represents almost 11% of the current market cap.

And there is still $2 billion of the share repurchase program outstanding, which means that almost 2% of the market value could be bought back in the near future.

Valuation Via Reverse DCF

My favorite way to do a valuation is a reverse DCF, where you look at what the market is pricing into the current stock price. And right now, based on TTM diluted EPS of $20.28, the market is pricing in an EPS growth rate of 13% over the next 10 years.

However, KLA has historically achieved the following annual EPS growth rates:

• 3Y: 14.90%
• 5Y: 22.04%
• 10Y: 19.31%

So it is probably safe to say that KLA shares are currently undervalued from a historical perspective, especially considering that the semiconductor market will continue to be in high demand in the coming years. So I think the combination of buybacks and double-digit earnings growth in 2025 and 2026 is very likely to drive EPS above the 13% that is priced in.

Risks

My attitude is always that the risks you don’t have on your radar are the ones that can really hit you. And so I don’t think the China risk is really that big because everybody knows about it and there are always ways to get the tools you want if they’re really that important. For decades, trade restrictions have been circumvented by going through other countries and companies.

But on another note, KLA is kind of suffering from success because they have tools that they delivered in the ’90s that are still in service. As a result, their equipment – and ASML Holding N.V. (ASML) has partly the same problem – is so robust that customers do not need to make new purchases.

Conclusion

Both ASML and TSMC have often talked in their earnings calls about 2024 as a transition year and that 2025 will be a year of strong growth. In addition, 2026 is likely to be a strong year as well, if we can believe the current forecasts that were also voiced in the earnings calls.

And since both ASML and KLA are benefiting from the high CAPEX in the semiconductor industry, we can currently assume that the semiconductor frenzy should continue to generate rising sales for equipment suppliers for at least the next few years.

Therefore, I believe that growth is secured for the next 3 years and that KLA is undervalued at this stage of the cycle. But over the long term, I think there are companies in the semiconductor space that have a stronger moat than KLA. This could change, however, if KLA’s ability to detect errors becomes even more important to its customers due to the expected increase in complexity.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of TSM, ASML either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Seeking Alpha’s Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

The post KLA Corporation: Complexity Could Increase The Competitive Advantage appeared first on Up2info.com.

• KLA’s defect inspection and metrology equipment are essential for economically manufacturing advanced chips.
• The company returns value to investors through dividends and highly accretive share repurchases.
• KLA’s current P/E ratio of 39.15 is significantly above its historical median, indicating potential overvaluation.
• A rebounding semiconductor equipment market, product demand, and KLA’s leadership in its segment make it a buy.

KLA Corp (NASDAQ:KLAC) benefits from new technology that requires more powerful, power-efficient, and complex chips, driving increased demand for process control solutions. The company’s two most important products are defect inspection and review systems, which identify flaws in a chip early in the manufacturing process, and inspection and metrology machines, which precisely measure the physical properties of a chip, such as the size and shape of patterns, thickness and alignment of different layers, and electro-optical properties. These tools help improve chip yield, the percentage of working chips divided by the total number of possible chips. If a semiconductor manufacturer’s chip yield is too low, it can negatively impact its profitability — a reason KLA’s equipment is vital. The market knows KLA’s importance in the chip manufacturing industry; the stock has been up nearly 400% over the last five years.

The company reported its fourth quarter fiscal year (“FY”) 2024 earnings on July 24. Despite delivering a beat-and-raise quarter and its potential upside in the generative artificial intelligence (“AI”) era, some worry about the company’s valuation, as the stock price has been lackluster post-earnings. KLA closed July 24 before earnings at $754.39; the stock’s closing price on September 27 is only up 3.7% to $782.40.

This article will discuss KLA’s growth drivers and business fundamentals. It will also review a few risks, the valuation, and why the stock is a buy despite valuation worries.

Growth drivers for KLA’s business

Chip manufacturers primarily use two wafer circumferences to make chips: 200 mm (~8 inches) and 300 mm (~12 inches). The move toward the 300 mm wafer started decades ago, motivated by lower costs and more chips per wafer. Still, 200 mm wafers may be more cost-effective for some components and applications that do not require the most advanced manufacturing processes. For instance, manufacturers make many power and analog chips, MEMS (Microelectromechanical Systems), IoT (Internet of Things) sensors, radio frequency (“RF”), and automotive devices on 200 mm wafers.

The increased electrification of autos and the proliferation of 5G, IoT, mobile, the cloud, and AI-powered devices have driven the need for more 200mm and 300mm wafer semiconductor manufacturing plants. Semi’s 200 mm Fab outlook forecasts the number of Fabs (semiconductor fabrication plants) rising from 236 at the end of 2024 to 254 at the end of 2027. All new Fabs will require equipment to manufacture the chips, benefitting semiconductor equipment manufacturers like KLA.

Generative AI, high-performance computing, cloud computing, and sophisticated AI-powered mobile devices have driven demand for advanced semiconductors. Semi’s 300 mm equipment spending outlook forecasts spending rising from 4% in 2024 to 24% in 2025. KLA’s process control equipment is vital for semiconductor companies to manufacture 300 mm wafers. Larger wafer sizes often mean more defects and potentially higher costs, driving the need for inspection equipment to find defects early and help prevent low-yield wafers. If Semi’s forecast is valid, demand for KLA’s process control should rise significantly in 2025.

Additionally, chip manufacturers have moved to increasingly smaller process nodes (the size of features on a chip). Samsung has a 3-nanometer (“nm”) process node chip on the market. Taiwan Semiconductor (TSM) also introduced a 3-nm process node in 2022 and is currently working on a 2-nm process node chip due for a 2025 release.

KLA Semiconductor Process Control President Ahmad Khan said at the Goldman Sachs Communacopia + Technology Conference 2024 (emphasis added):

For N2 [2-nm chips], there’s a pretty large inflection in the transistor architecture change. You go from planar or FinFET to gate all around [GAA]. And these are very difficult transistors to make. Very, very few companies have been able to patent them and make them defect-free. It’s a stack of silicon, silicon germanium stack. And then after that, you have these recesses where you could have very, very small defects like 20 nanometers to 5-nanometer defects that can kill the entire device. So we worked about three to four years ago, seeing this inflection, we worked with imec, we worked with International Business Machines (IBM), we worked with TSMC [Taiwan Semiconductor] and everybody else to determine what is required, and we developed two new systems to characterize it.

As Ahmad Khan mentioned, smaller process nodes have driven semiconductor manufacturers toward different chip structures. The image below shows the evolution from planar FET (Field-Effect Transistor) to FinFET to Gate-All-Around (“GAA”) FET. Each move to a new structure raises the potential for creating defects on a wafer, driving the need for KLA’s defect inspection and metrology solutions.

Chief Financial Officer (“CFO”) Bren Higgins said on the company’s fourth quarter FY 2024 earnings call:

If you look back to the last local high and KLA share WFE, it was when the industry transitioned from planar to FinFet structures. So typically, architecture changes do drive [revenue growth] because of just the change that’s happening and the immaturity of the change, it does drive process control intensity to a higher level. So historically, it is proven. So Rick talked about not only inspection opportunities, but you are depositing a lot more layers, 20% to 30% more critical layers on the metrology side.

In less technical language, the above statement means that when chip architecture changes, demand for process control equipment goes up because new, immature technology often produces more defects. The CFO gave an example of the industry shift from planar to FinFet driving demand for defect inspection and metrology equipment. Since FinFET requires more thin film layers deposited on a wafer (20% to 30% more critical layers) and more layers drive the need for more precise measurement of the thickness and roughness of each layer, demand for KLA’s metrology tools rose during the evolution from planar to FinFET. The company expects a similar rise in demand as chip architecture moves from FinFET to GAAFET.

Last, the chip industry’s downturn in 2023 provided stiff headwinds to revenue growth industry-wide. The overall revenue of the top five semiconductor equipment (including KLA) slumped in 2023. Those headwinds have turned into tailwinds in 2024, and experts expect significant growth in 2025. Management is bullish on KLA’s prospects next year.

Company fundamentals

Semiconductor Process Control, which accounts for 90% of revenue and includes inspection, metrology, and software products, rose 10% year-over-year to $2.30 billion. Specialty Semiconductor Processes, accounting for 5% of revenue, consist of advanced vacuum deposition and etch process tools used by specialty semiconductor customers, such as manufacturers of MEMS, RF semiconductors, and power semiconductors. It declined 6% year-over-year to $121 million. The likely culprit for the segment’s decline in 2024 is that power semiconductors often wind up in Electrical Vehicles (“EVs”), which had slowing growth in 2024. Additionally, RF semiconductors end up in mobile and IoT devices, which have decelerated growth in recent years and are due for a rebound. Last, the PCB (printed circuit board), Display, and Component Inspection segment, accounting for 5% of revenue, consists of products and services for inspecting, testing, and measuring PCBs, IC (integrated circuits) substrates, FPDs (flat panel displays) and packaged ICs. The segment’s revenue rose 9% year-over-year to $140 million.

KLA’s second quarter 2024 revenue was up 9% year-over-year to $2.57 billion, beating analysts’ estimates by $54.93 million.

KLA’s June quarter GAAP (Generally Accepted Accounting Principles) gross margin is 60.65%, the highest among its WFE peers.

KLA’s investor presentation emphasizes non-GAAP (Generally Accepted Accounting Principles) metrics. Its non-GAAP gross margins rose 130 basis points (“bps”) to 62.5% over the previous year’s quarter, and its non-GAAP operating margins rose 290 bps to 41%.

KLA’s fourth quarter FY 2024 non-GAAP net income grew $150 million year-over-year to $893 million. Non-GAAP diluted earnings-per-share (“EPS”) was $6.60, beating analysts’ expectations by $0.50. Its GAAP diluted EPS was $6.18, beating analysts’ expectations by $0.45.

The following table shows GAAP to non-GAAP reconciliation. Since KLA has many one-time and non-cash expenses, non-GAAP metrics give a clearer picture of its core profitability.

KLA’s TTM cash flow from operations (“CFO”) to sales is 33.71%, the highest among its semiconductor equipment peers. A higher percentage means a higher potential to turn sales into cash flow.

Click to enlarge

The following chart shows KLA’s annual and TTM free cash flow (“FCF”) and FCF margin.

Please note at the bottom of the above investor slide that the company has committed to returning 85% of FCF to investors through dividends and share repurchases.

The company has an impressive history of dividend growth. The bar chart on the right in the image below shows a 15% compound annual growth rate (“CAGR”) over the last 17 years.

Notice that most buybacks occurred in 2022 when the stock price ranged from $250 to the low $400s throughout the year. The chart shows that the average price per share at which it bought back shares since 2019 was $288. Those share repurchases were highly accretive since the stock price ended September 27, 2024, at $782.40. The following chart shows the stock buybacks have reduced diluted shares outstanding from nearly 160 million at the beginning of 2020 to 135.46 million at the end of the June 2024 quarter.

Investors can loosely use the buyback yield, the repurchase of outstanding shares over the company’s market cap, to determine a stock’s valuation. If a stock’s historical buyback yield is historically high, the market may undervalue it. If a stock’s buyback yield is lower than its historical mean, the market may overvalue it. The company’s buyback yield at the end of June 2024 is 1.88%, compared to its mean buyback yield of 2.42% over the last five years, suggesting the market overvalues the stock. KLA sold above its buyback yield mean between its March 2022 and December 2023 quarters, hitting a high over the last five years of 8.61% in its December 2022 quarter — an excellent time to purchase KLA. Remember this metric when we get to the valuation section.

KLA’s debt-to-equity ratio is 2.03, which means it aggressively funds its growth with debt. Its debt-to-EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) ratio is 1.51, indicating moderate debt relative to its core operating profits. The company’s credit ratings are upper medium grade, meaning its debt has a moderate risk level.

The midpoint of revenue guidance beat analysts’ estimates of $2.62 billion, and the midpoint of EPS guidance beat analysts’ estimates of $6.51 a share.

Risks

Competition is a significant long-term risk. Onto Innovation is a company in the inspection and metrology market that has the potential to challenge KLA. Over the last several years, Onto has taken market share in metrology and inspection for next-generation transistor architectures. Onto ended 2023 with 220 customers, with its two most significant clients being Samsung Semiconductor and Taiwan Semiconductor, each accounting for over 10% of its revenue.

The company has significant Chinese exposure, which is a major risk. China accounts for 44% of KLA’s revenue, and Taiwan accounts for an additional 20%. A severe conflict between China and Taiwan could disrupt 64% of its revenue. Even without an open conflict between China and Taiwan, all Chinese revenue is at risk due to political disagreements between the Chinese and the U.S. governments. The U.S. Bureau of Industry and Security has created complex export rules over the last several years that have hurt KLA’s Chinese business. Besides, the U.S. rules making it harder to do business in China, management risks misinterpreting the rules, which could result in significant civil and criminal penalties if it accidentally steps over the line. Last, if relations between the U.S. and China worsen, either country could create additional rules or restrictions that could significantly harm KLA’s business.

Valuation

KLA’s price-to-earnings (P/E) ratio is 39.15. Its five-year P/E median is 23.71, and its ten-year median is 21.02. Because the stock is trading well above its median, some might conclude that the market is overvaluing it.

KLAC’s one-year forward PEG ratio is 1.93 (one-year forward P/E of 23.99 divided by analysts’ EPS estimated growth rate of 12.42%). Typically, growth investors will allow a growth stock to reach a PEG ratio of 2.0 before considering it overvalued. Consequently, some may consider the stock on the high end of fairly valued.

Let’s look at KLA’s reverse discounted cash flow (“DCF”) to determine what the September 27 closing price implies about the stock’s cash flow growth rate over the next ten years. This DCF uses a terminal growth rate of 3% because the company should continue steadily growing its cash flow above the market average after the ten-year analysis period. I use a discount rate of 10%, which is the opportunity cost of investing in KLA, reflecting a moderate risk level. This reverse DCF uses a levered FCF for the following analysis.

Reverse DCF

Click to enlarge

Considering that the proliferation of AI should create higher demand for KLA’s process control services over the long term, it should maintain a 31% FCF margin over the next ten years. Its median FCF margin over the last ten years was 28.51%, and its maximum was 32.63%. So, KLA would need to grow revenue at 14.7% annually for the next ten years at an average FCF margin of 30.9% to justify a September 27, 2024, closing stock price of $782.40 — a growth rate that may be a bit of a stretch. Over the last ten years, the company grew its annual revenue at a 12.85% compound annual growth rate (“CAGR”). It may not be able to replicate a similar double-digit rate over the next ten years.

KLA’s 2023 Annual Shareholder Letter states:

The latest 2022 Gartner market share analysis published in April 2023 shows Process Control was the fastest-growing WFE market segment in calendar 2022, growing 30% year-over-year to $13.5 billion. Within Process Control, KLA increased market leadership in most major segments, resulting in an overall market share gain of roughly 300 basis points in 2022 to over 57%, or greater than 4x the nearest competitor.

Global Market Trends estimated that the semiconductor process control market was $14.5 billion in 2023. At the end of its FY 2024 (June 30, 2024), the company generated $9.81 billion in annual revenue, capturing 67.65% market share. However, CSI Market claims KLA has an 89.39% market share in process control, with Onto Innovation as a distant second with a 7.74% market share. If those claims are valid, KLA’s total addressable market is only $10.97 billion. Regardless of which market size estimate is valid, KLA has already captured a significant chunk of the market, and it is hard to believe it will grow much faster than the overall process market. Two analysts’ reports on the internet estimate the growth rate of the process control market at around 6.6% to 7.6% annually to 2032. Since it’s unlikely that KLA will capture much more market share than it already has, it’s likely to grow around the rate of the process market. Assuming KLA and the semiconductor market grow at the same 7% growth rate over the next ten years, KLA will maintain its current market share, and the estimated intrinsic value of the stock is $447.03. Assuming the process market grows a very aggressive 10% annually over the next ten years, its estimated intrinsic value is $561.78. Investors that buy today make very aggressive revenue growth or FCF margin assumptions over the next ten years.

No one should assume that KLA will hit these exact numbers, as they are ballpark figures with many assumptions that may not pan out fully. The takeaway from this exercise is that the current stock price assumes aggressive revenue growth rates or that the company can average an FCF margin meaningfully above its median for the last ten years. If you factor in the fact that the company’s buyback yield is at the historically low end of its range, the market likely overvalues KLA in the long term. Only investors comfortable investing in an “overvalued” stock should consider buying it.

KLA is a buy

Aggressive investors who buy stocks with short-term time horizons may want to buy KLA and hold it over the next year or two. It has solid potential upside as the semiconductor equipment industry rebounds, new fabs come online, and chip manufacturers shift to new architectures. Industry experts expect a significant rebound in 2025 that may last into 2026. However, beyond 2026, downside risks rise substantially.

If you are an investor with a long-term mindset, you can still buy it. However, the ideal time to buy KLA was in 2022, when the buyback yield rose to well above its median. The company could potentially enter an industry downturn in 2027. The second quarter 2024 Market Data Pulse Newsletter states (emphasis added), “200mm fab equipment spending is expected to decline by 15% in 2024, recover in 2025 with 43%, and 21% in 2026. 2027 is expected to slow by -2% YoY, which may be due to a lack of visibility.” The following table shows that analysts expect KLA’s revenue growth to drop substantially in FY 2027 and FY 2028.

However, the secular demand for more efficient and powerful chips may help the industry and KLA grow well above analysts’ forecasts. There is also a possibility that the industry will become far less cyclical and may not dip in 2027. So, long-term investors who buy today count on revenue growth rates higher than analysts’ forecasts, while risking that those growth rates fail to come to fruition. I rate the stock as a buy for short-and long-term growth investors.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Seeking Alpha’s Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

The post Understanding KLA Corp: A Deep Dive Into Growth Drivers And Business Fundamentals appeared first on Up2info.com.

• KLA Corporation’s 47% stock price increase is justified by strong growth drivers like advanced packaging, GAA architecture, and high NA EUV technology, boosting revenue forecasts by 3.3%.
• Despite a slight underperformance in 2023 due to TSMC delays, KLA is poised for recovery with TSMC’s Arizona plant on track for 2025 production.
• We expect the closure of KLA’s FPD division to contribute to margins minimally, increasing the total weighted average margin by only 0.3%.
• Our updated DCF valuation with a higher price target reflects the higher growth forecasts, which support current price levels.

In our previous analysis, we highlighted KLA Corporation’s (NASDAQ:KLAC) strong profitability with a 5-year average FCF margin of 24.24% and forecasted the forward average of 28.7%. We expected KLA to maintain a stable market share in legacy nodes, with consistent revenue exposure to China over the last three years. We also expected a semicon equipment market rebound in 2024 (12.7% increase in semicon process control equipment), to bold well for the company’s growth outlook.

In this analysis, we focused primarily on examining whether the substantial 47% increase in the company’s stock price since our last review was justified. We first assessed KLA’s revenue growth by segment and compared it with our previous forecasts to determine if it was in line with the actual performance in 2023. Additionally, we explored key growth drivers in the semicon process control segment as a whole, to determine if they could substantially boost the company’s growth outlook. Finally, we considered the impact of the closure of the company’s Flat Panel Display Business, analyzing whether this could drive a positive growth outlook.

Expected Growth Recovery

In the first section, we analyze the company’s revenue growth breakdown by segment and compare it with our previous forecasts to determine whether our forecasts were in line with its actual performance in 2023.

We compiled the company’s revenue breakdown by segment below and updated it with the latest FY2024 figures and our previous forecasts.

Click to enlarge

* Financial years ending in H1 are considered the previous year

Source: Company Data, Khaveen Investments

From above, our previous FY2023 forecast of the company is fairly in line with the actual, where we projected a growth rate of -3.1% with the actual being -6.5%. In terms of the PCB, Display and Component Inspection segment, the segment had the second-largest decline by -23.1%, but the segment only accounts for 5.4% of total KLA revenue, this is fairly in line with our projection as management mentioned in its latest earnings briefing that the PCB “market has been relatively sluggish”. However, the segment with the biggest difference between our forecast and actual was patterning (-26.4% vs -4.5%). On the other hand, services revenue experienced a positive growth rate in 2023 at 10%, as well as demonstrating a consistent growth rate averaging 12.1% from 2019 to 2023. This surpasses our forecasts of 3.5%. According to management, this is due to the utilization rates which have “steadily improve(d) across all segments in the course of this year”, indicating that equipment is still under operation despite the slowdown in market demand. In our previous analysis, we projected KLA’s full-year segment revenue based on the sum of the actual Q1, Q2 guidance, and H2 revenue based on market forecast CAGR as we expected a market recovery.

The revenue growth for the patterning segment fell nearly 22% below our expectations. While the inspection subsegment surpassed our forecast, this was not enough to offset the strong decline in patterning. Management noted in the Q2 FY2024 earnings transcript that this decline is due to customer pushout, specifically mentioning the “hundred million dollars of business” that has been postponed by approximately 12 months. Additionally, a Reuters report from September 2023 also indicated that “TSMC has been forced to push back production at the Arizona plant by a year to 2025,” primarily due to workforce shortages. Given that TSMC accounts for more than 10% of KLA’s revenue in the Semicon Process Control segment (as stated in the annual report), we believe that the pushout could be a major factor behind the significant decline in patterning revenue as this 10% translates to TSMC’s revenue contribution to the segment being $638.8 mln. If the project was not delayed, we estimate the segment revenue for patterning would be at $2,693 mln, which would then show a -3.5% growth rate, closely aligning with our projection of -3.8%.

In terms of the growth outlook, management expects an improvement in the memory market due to HBM demand increase. This outlook aligns with the analysis from our previous coverage, where we compiled the capex for leading companies (Micron (MU), SK Hynix, and Samsung (OTCPK:SSNLF)) and derived an expected growth in the memory market of 23% YoY by 2024 as well as in 2025 at 31%. We believe that this growth is primarily driven by the expected increase in demand for leading-edge memory due to AI. Additionally, in terms of logic/foundry (59.7% of KLA’s revenue in FY2024), management also claimed to see a tailwind due to customers’ “continuation of scaling and incorporation of new technologies and slowly rising capital intensity”, such as the adoption of the upcoming plans for High NA EUV technologies as mentioned in our previous analysis of ASML (ASML), which aligns with our projection of the capex for foundry companies (TSMC (TSM), Samsung, Intel (INTC)) to be averaged at 20.2% growth by 2025.

Subsequently, our revenue growth forecasts for the company are fairly in line with the actual as we had anticipated a decline in 2023 due to market contraction. However, the actual revenue fell slightly below our expectations, primarily due to the underperformance in patterning caused by the customer pushout, which we believe refers to the TSMC delay in its production at the Arizona plant. Following the update in TSMC’s Q1 FY2024 earnings briefing, the company stated it is “well on track for volume production in the first half of 2025” at its Arizona fabs. We believe this also reflects a positive outlook and recovery for KLA together with both the logic/foundry and memory markets to rebound across 2024 and 2025.

Upward Revision of Growth Projections

In the first section of our analysis, we observed that the segment revenue of Semiconductor Process Control (65.1% of KLA’s total revenue in FY2023) deviated the most from our full-year projections, primarily due to a substantial decline in patterning due to the pushout of TSMC orders. Thus, in the second point, we shifted our focus to examining the growth outlook for the company’s Semiconductor Process Control-related segments, which include Wafer Inspection and Patterning. We foresee the segment’s outlook growing positively given that TSMC is on track for volume production as well as after identifying several key growth drivers that KLA could capitalize on.

Additionally, we observed several bullish factors that could propel the segment growth even higher than we previously forecasted. This includes the key growth drivers for the segment as highlighted during the latest earnings briefing such as advanced packaging, the transition to GAA architecture and high-NA EUV.

Click to enlarge

Source: Company Data, Khaveen Investments

We updated our projection for wafer inspection and patterning based on the global semicon wafer inspection equipment market and the e-beam wafer inspection market respectively. Overall, after the adjustments, our 4-year forward revenue growth rate for KLA now has an average of 12.9%, in contrast with our previous forward average of 9.6%. One of the key growth drivers is the transition to GAA architecture, which based on management, has increased the complexity of semicon manufacturing processes, leading to increased demand for more sophisticated patterning and wafer inspection technologies.

Based on the slide above, KLA claimed that the “Transition to GAA Architecture Brings Additional Process Complexity” due to a “50% increase in the number of critical inspection layers” and a “30% increase in high-end film metrology layers”. Additionally, major IDMs like Samsung and Intel are also transitioning from FinFET to the new Gate-All-Around (GAA) transistor design, similar to TSMC as the company plans to “shift to GAA technology for their N2 process node”. KLA has reported that during FY2021, FY2022, and FY2023, both TSMC and Samsung each contributed over 10% of its total revenues within the Semiconductor Process Control segment. This serves as a growth driver for KLA as the company provides essential technologies to manage and optimize this complexity. For example, this includes the company’s 29xx series for “Broadband Plasma Patterned Wafer Defect Inspection Systems”, which are specifically designed to support the complex manufacturing requirements of GAA transistor production.

Moreover, our previous analysis highlighted that high NA EUV supports the demand for KLA’s systems targeting EUV applications. We noted that companies including TSMC and Samsung, have ordered advanced EUV systems from ASML, which are KLA’s two largest customers contributing over 10% of its revenue. TrendForce reported that as the production capacity for advanced chips continues to expand, “ASML’s delivery volume in 2025 is expected to grow by more than 30%”. This forecast includes TSMC’s substantial order of EUV machines as well as orders from companies like Samsung and Micron. Hence, as the production capacity for 2nm chips increases, which requires “extremely high precision and complex process flow”, the need for KLA’s advanced inspection solutions such as the Voyager and Surfscan series positions the company well to capitalize on this growth driver.

In terms of advanced packaging, KLA released an investor presentation showing a 25% historical CAGR in its packaging revenue, with management projecting the segment revenue to reach $500 mln by the 2024 calendar year. Management claimed it to be primarily driven by AI, which “is driving higher volume wafer manufacturing, more complex designs, larger die and chip size, and growing advanced packaging demands”, thus enhancing the intensity of the process control segment. Furthermore, management also indicated that of the forecasted $500 mln revenue, approximately 60% is attributed to the “classic semiconductor process control” segment and 40% to the specialty semiconductor process business.

From KLA’s official website, we identified systems tailored for advanced wafer-level packaging. Which include the Kronos 1190 for “advanced wafer-level packaging (AWLP) applications including 3D IC and high-density fan-out,” and the CIRCL-AP system for “high sensitivity including 2.5D/3D integration.” Additionally, the SPTS Delta PECVD system is designed for etch and deposition processes for packaging processes in low-temperature environments. Semicon Taiwan also highlights the “increasing need for high-precision inspection” in chip technology, noting that “2D-based inspections can no longer satisfy the needs for quality control where 3D inspection is becoming essential”. With its advanced technologies and partnerships with major OSATs like ASE, we believe KLA is well-positioned to capitalize on the substantial growth (25%) in the advanced packaging market.

Click to enlarge

Source: Company Data, Khaveen Investments

Overall, we believe KLA’s total wafer inspection and patterning segment revenue is well-positioned for future growth recovery given the key drivers. The transition to GAA architecture and the increased adoption of high NA EUV technology is driving demand for KLA’s advanced patterning and wafer inspection systems, with higher complexity and precision required in semicon manufacturing. Additionally, the significant growth forecast in the advanced packaging market, with a projected 25% CAGR provided by management. The increasing integration of AI also reflects a growing demand in the memory market, coupled with orders from major semicon foundry companies like TSMC, Samsung, and Intel, which we believe indicates a robust outlook for KLA’s revenue growth. After adjusting the growth rate and factoring in advanced packaging’s forecasted growth rate of 25% based on its historical CAGR, our projection for the company’s total revenue growth increases by 3.3%.

Minimal Profit Margin Impact from FPD Division Closure

Furthermore, following management’s claim of a weaker long-term outlook for its PCB, Display & Component Inspection segment due to challenges in the flat panel display business (1.4% of total revenue, 26% of segment revenue) and that they have “begun investigating strategic alternatives for this business”, we analyzed whether the company could benefit from the closure of its FPD division.

Firstly, we compiled the company’s revenue and gross margin breakdown by segment, focusing on the PCB, Display & Component Inspection segment’s performance relative to KLA’s total revenue. We then analyzed the impact of the closure on KLA’s total weighted average margin (segment revenue share multiplied by segment gross margin).

Click to enlarge

Source: Company Data, Khaveen Investments

According to the above, the PCB, Display & Component Inspection segment has shown the worst performance in revenue growth, with a 4-year historical average growth of -10.7%, lower compared to the total revenue average (14.9%). In 2022, the PCB, Display & Component Inspection segment saw a significant decline of -32.8% in growth, primarily due to a “softness in the mobile market,” as stated by management. This downturn aligns with Canalys’ reporting the global smartphone shipment with “a 12% drop in annual shipments” for the same year. In 2023, management described the market as “relatively sluggish,” as Canalys reported a slight recovery in smartphone shipment in H2 2023, though shipments were still down by 4% compared to 2022. Furthermore, given that the segment also includes Flat Panel Display products, DSCC also reported an oversupply in 2022 and 2023 where “FPD demand area decreased”, hence also driving a low utilization rate with the fab utilization rate for 2022 to be around 55% (a decrease from ~90% in 2021) and 2023 being below 50%. Additionally, the 2023 decline in the PCB, Display & Component Inspection segment could be also attributable to “the cancellation of a significant new technology project by a major customer” in Q3 FY2024, which led to the company’s decision “to exit the Company’s Display Business”.

Click to enlarge

Source: Company Data, Khaveen Investments

Given that management stated in the Q2 FY2024 earnings transcript that the FPD business “accounted for 1.4% of total revenue in calendar 2023,” we analyzed the impact of its closure. By removing $137 mln in the revenue from PCB, Display, and Component Inspection segment, we calculated the revenue share to decrease by 1.4% and correspondingly increased the revenue share for the semicon process control and specialty semicon process segments. We then calculated the weighted average margin before and after the closure by multiplying each segment’s revenue percentage by its gross margin. Following the closure, we observed only a slight increase of 0.3% in the total weighted average margin.

Overall, we believe the closure of the company’s FPD business is a good decision, given that this could improve the weighted average margin for the company’s largest segment of semiconductor process control. Besides, the global flat panel display market size is also observed with a relatively low market CAGR of 3.5%, aligning with the mature state of the consumer electronics market. However, given that the FPD business only represents 1.4% of the total revenue, the overall impact is minimal as the total weighted average margin is projected to only increase by 0.3% after the closure. Hence, we believe that the benefit of the FPD division closure is not significant enough to justify the company’s surge in stock price.

Risk: Inspection Equipment Product Development

ASML, the leader in the overall semicon equipment market in 2023, has announced its recent advancements in collaboration with IMEC. These developments focus on the High NA EUV specific solutions within the field of patterning, “including the development of advanced resist and underlayer materials, photomasks, metrology and inspection techniques”. We believe this could pose a risk for KLAC, which specializes in inspection solutions, as ASML may attract customers within segments where KLAC has held a strong market presence.

Verdict

All in all, we believe KLA is poised to capitalize on the semicon market recovery, particularly due to the tailwind in the memory segment driven by AI and in logic and foundry given the continuous investments from major companies such as TSMC and Samsung. Additionally, we expect minimal impact from previous delays by TSMC going forward with the progress of its expansion in Arizona guided to be on track for completion by 2025. Furthermore, we raised our growth outlook for the company’s process control segment growth, highlighting key growth drivers such as advanced packaging, GAA architecture and high NA EUV technology which could bode well for demand for the company’s process control equipment, leading to a 3.3% higher average revenue growth forecast for the total company. Finally, we believe the FPD division’s closure would benefit its margins, with a slight increase of 0.3%.

We updated our DCF valuation for KLA, factoring in our revised revenue and margin projections, with a discount rate of 10.7% (company’s WACC) and terminal value based on the top semicon equipment competitors’ 5-year historical average EV/EBITDA of 18.44x. Despite a higher price target of $810.13 compared to our previous analysis of $651.46, our model shows an upside of only 0.7%. Therefore, while we believe the strong run up in the company’s stock price by 47% since our previous coverage is justified, we rate the company as a Hold with a price target reflecting our higher growth forecasts (5-year average of 12.6% vs 7.1%), given the limited upside from current price levels.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of KLAC either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

No information in this publication is intended as investment, tax, accounting, or legal advice, or as an offer/solicitation to sell or buy. Material provided in this publication is for educational purposes only and was prepared from sources and data believed to be reliable, but we do not guarantee its accuracy or completeness.

Seeking Alpha’s Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

The post KLA Corporation: Growth Recovery Supports Current Stock Price Level appeared first on Up2info.com.

• My initial bullish thesis on KLA Corporation aged well, with a 52% total return since September 2023.
• Recent quarterly earnings show strong performance, but the stock is slightly overvalued and faces substantial geopolitical risks.
• Moreover, long-term seasonality trends suggest that August and September are historically the weakest months for the stock.

Investment thesis

My initial bullish thesis about KLA Corporation (NASDAQ:KLAC) aged extremely well since the stock outperformed the broader U.S. market since September 2023 with a 52% total return.

A lot of time has passed since I covered the stock, and today I want to update my thesis. I believe this will be useful for readers, especially in light of the recent quarterly earnings release. Despite strong quarterly performance, I tend to think that buying the stock at current levels is risky. My valuation analysis suggests that the stock is slightly overvalued, which looks risky to me in the short term. Historical seasonality trends suggest that August and September are the weakest months, and the company’s massive revenue exposure to China is a warning sign in the current complex geopolitical situation. All in all, I downgraded KLAC to “Hold”.

Recent developments

KLAC released its latest quarterly earnings on July 24, when the company surpassed both revenue and EPS consensus estimates. FQ4 2024 revenue grew by solid 9% YoY. The adjusted EPS expanded notably, from $5.40 to $6.60.

I pay a lot of attention to the quality of the EPS expansion. In KLAC’s case, the EPS expansion was of high quality, as it was achieved with a solid operating leverage. The operating margin expanded YoY from 34.87% to 38.74% while the outstanding shares count was approximately flat.

Strong operating performance allowed KLAC to generate $614 levered FCF during the quarter. The company continues aggressive stock buybacks, with half-a-billion spent on repurchases during FQ4 2024. Dividend yield is still shallow at 0.77%, but there is an impressive 13.5% dividend CAGR over the last five years. I have to give credit to the management for its robust capital allocation as it successfully balances between fueling growth, keeping the balance sheet healthy, and returning money to shareholders via buybacks and dividends.

The company’s Semiconductor Process Control segment, which represents 90% of the sales, demonstrated a 10% YoY growth. I consider this to be a strong sign, as the company’s core business appears to be healthy. Two other segments, each representing 5% of the total, approximately offset each other.

Wafer Inspection is the company’s core revenue stream, and it appears to be on fire, with a 23% YoY and 18% QoQ growth. Services are the second-largest revenue stream, and it also demonstrates solid dynamic, both on a YoY and sequential bases. KLAC’s revenue mix is well-diversified, and other revenue streams approximately offset each other.

Despite overall strength across core streams, I want to remind investors about a few negative moments as well. The company generates more than 40% of its total revenue in China. That means KLAC faces substantial geopolitical risks related to tensions between the U.S. and China. The company has already faced a ban on exporting some of its products to China. Given complicated relationships between the world’s two largest economies, having such a massive exposure to the Chinese markets is an apparent risk for KLA Corporation.

Generating almost 90% of its sales outside North America also means the company faces significant foreign exchange and international trade risks. Unfavorable fluctuations in foreign exchange rates might significantly undermine the company’s earnings. Changes to international trade regulations and tariffs can also potentially be a big disruptor to the company’s operations.

Short-term seasonality trend also looks unfavorable for KLAC in late July. August and September are historically the weakest months for the stock. Therefore, historical patterns suggest that there likely can be a pullback in the next two months. On the other hand, the last three months of a year are historically quite strong.

Valuation update

The stock outperforms the broader market over the last twelve months with a 64% rally. KLAC is also strong in 2024 with a 31% YTD rally. Seeking Alpha Quant assigns KLAC a low “F” valuation grade due to its high multiples compared to the sector median and historical averages. That said, the stock is overvalued from the valuation ratios perspective.

On the other hand, the company’s financial performance is still expanding notably; therefore, let me simulate the discounted cash flow [DCF] model. I use a 10% WACC for discounting, which aligns with the range recommended by valueinvesting.io. I have revenue consensus estimates available up to FY 2029 and project a long-term 10% CAGR for the years beyond. The mix of consensus estimates by FY 2029 and a 10% CAGR for the years beyond gives a 9% CAGR for the entire decade. This looks like a fairly conservative revenue growth assumption for the DCF. For the FCF margin, I use the last five years’ average, which is 21.45%, and expect it to expand by 50 basis points as the business continues scaling up.

As shown in the above scenario, the business’s fair value is around $86 billion. This indicates that the stock is overvalued at current levels. To demonstrate which revenue growth rate for the next decade justifies KLAC’s valuation, let me simulate the second scenario below.

Playing only with revenue growth rate and leaving other assumptions unchanged suggests that the current market cap is justified with an 11.3% revenue CAGR for the next decade. While consistently delivering double-digit revenue growth for a decade is a challenge, it does not look impossible either. Therefore, I would conclude that KLAC is approximately fairly valued at current levels and maybe even slightly overvalued.

Risks to my rating downgrade

Despite the recent pullback in the biggest semiconductor names, the industry is still on fire. The sentiment looks quite optimistic around the prospects of semiconductor companies due to the massive data center spending from the largest U.S. tech corporations. The current pullback in semiconductors might be just a temporary event before Nvidia and other prominent players start conquering new highs. As a notable player in the industry, KLAC might rally as well despite its already generous valuation. Moreover, KLAC’s momentum is impressive and the solid latest earnings report might help to sustain the rally for longer.

Wall Street analysts are quite bullish about KLAC. I can see it from the robust track record of consensus quarterly earnings revisions, which is usually a positive catalyst for the stock price. Moreover, the consensus target share price for KLAC is notably higher than the current price. This positive sentiment is also likely a positive catalyst for the stock price.

Bottom line

To conclude, KLAC looks like a “Hold” at the moment. I think that the stock is currently fairly valued and there is a slight overvaluation. Paying a premium over the fair value does not look like a good idea considering massive geopolitical risks and historically weak stock performance in August and September. There likely will be better entry points during the upcoming two months.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Seeking Alpha’s Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

The post KLA Corporation: I Am Downgrading Despite Robust Earnings appeared first on Up2info.com.

• KLA Corp. is poised for growth as semiconductor manufacturing capacity increases domestically with the assistance of the CHIPS Act.
• The company is expected to benefit from the construction of regional AI factories, automotive ADAS systems, and AI-enabled smartphones and PCs.
• Investments in EUV lithography and advanced packaging will benefit KLA Corp. during the next cycle of investments for 3nm and 2nm chips.

KLA Corp. (NASDAQ:KLAC) is nearing a cyclical upswing as customers are nearing their major capital allocations to semiconductor manufacturing equipment as they finalize the construction of their domestic foundries. The Semiconductor Industry Association, in partnership with Boston Consulting Group, projects that the domestic capacity for semiconductor manufacturing will grow by 3x from 2022 figures with the assistance of the CHIPS Act.

In addition to this, I believe the design cycle for advanced nodes will accelerate as competition for faster and more energy-efficient chips becomes fiercer, providing more room for KLA to growth across their products and services segments. I anticipate that much of the growth will be driven by the construction of regional AI factories, automotive ADAS systems with more content per vehicle, and AI-enabled smartphones and PCs. I rate KLAC shares with a BUY recommendation with a price target of $1,057/share at 27.60x eFY25 EV/aEBITDA.

Be sure to read my initial coverage of KLA Corp. here:

KLA Corp. Will Benefit From CHIPS Act And The Infrastructure Supercycle

KLA Corp. Operations

KLA is well positioned for a major cyclical upswing as the next generation of 3nm chips begin to ramp up with 2nm chips to follow. Much of the demand is associated with nearshoring the supply chain to the domestic fabs being built out as part of the CHIPS Act. As such, over half of the dedicated funding for foundry buildouts has been allocated to select semiconductor manufacturers in order to bolster the domestic production of advanced chips.

According to IEEE, the US will produce 28% of the world’s advanced logic chips by 2032. Intel Corp. (INTC) is expected to invest $100b in new fabs with the goal of becoming the go-to foundry for advanced semiconductors. Though I’m hesitant to buy into Intel’s strategy as the firm is playing catch-up with its competitors in advanced chip design and production, Mr. Gelsinger remains optimistic in attaining business from competing chip designers. Intel will be building fabs in Arizona, Ohio, New Mexico, and Oregon as part of their $100b investment. One of the differentiators Mr. Gelsinger plans to bring to the table is providing EUV lithography as well as packaging to enable 2.5D and 3D chip tile-based designs.

Taiwan Semiconductor (TSM) is also investing a significant amount into US-based chip manufacturing, which will likely maintain their chip design relationships with firms like Nvidia (NVDA). TSMC will be building their fab in Arizona to manufacture 4nm chips. Management at TSMC mentioned in their q1’24 earnings call that the firm doubled their advanced packaging capacity from the previous year and is leveraging their OSAT partners to cover excess capacity demand. On the earnings call, management discussed that their customers are working with the chip manufacturer on N3 & N2 designs as power consumption remains a major challenge for AI factories.

Micron Technology (MU) will be investing $50b through 2030 to construct fabs in Idaho and New York, which will likely bolster their DRAM & HBM production capacity. Management guided in their q3’24 earnings call that the Idaho fab will meaningfully ramp in 2027 with New York in 2028 or later. Management also mentioned that the firm will be enabling EUV in Japan to ramp the 1-gamma node.

Management anticipates their foundry & logic business to experience tailwinds going into CY2h24 as the next cycle of capital investments ramps up. This will impact their process control products & tools and services business as demand grows for their metrology systems and advanced packaging systems as chip designers seek to bolster their advanced chips to support the demand driven by AI infrastructure. Management anticipates advanced packaging to have a $400mm run rate in 2024 and is expected to meaningfully grow faster than WFE.

The growth opportunity for KLA may be well beyond foundry buildouts given the rate of change for advanced nodes for AI applications and infrastructure. This may include upgrading systems, which should improve services revenue as well as new systems as advanced packaging further expands beyond the China-dominant market. Despite the -1% decline in market share as KLA decouples from the China market, the firm may have ample opportunity to turn this around as chip manufacturers nearshore operations.

Memory is expected to account for 18% of semiconductor process control systems revenue, of which 78% will be DRAM. This aligns with guidance provided by management at Micron as the firm builds out capacity for DRAM and HBM. Memory and storage will likely be a major contributor for KLA as large regional AI factories are built out to cater to localized demand. This is a factor I discuss extensively in my report covering Oracle Corp. (ORCL).

I believe the build-out of regional AI factories will drive demand for more advanced nodes as competition for speed and power consumption becomes more fierce. Many of the hyperscalers, including Microsoft Azure (MSFT) and Amazon AWS (AMZN) are designing their own accelerators in order to provide more tailored services in relation to data consumption and power efficiency. Despite the drive to bring AI to the edge on smartphones and PCs, I do not anticipate as much capacity to be catered to this area as consumer demand remains muted.

In March 2024, KLA made the decision to exit the display business and will wind down operations by the end of the calendar year. KLA will continue to provide services to their installed base. The total goodwill impairment charge for the PCB & Display segment was $192.6mm with the remaining value being distributed between two separate segments for PCB and Display. On a relative basis, the PCB & Display segment has been a low-margin business when compared to KLA’s other segments. The reported segment figures for q3’24 showed the impact post-exit of the business with a -1% gross margin.

Looking at financials, I anticipate modest improvement to margins going into the end of eFY24 and eFY25. I expect growth to accelerate throughout eFY25 as capital investments begin moving to KLA for lighting up domestic foundries. Growth verticals that KLA can cater to reside in AI infrastructure as customers require more advanced nodes with better power management, automotive as ADAS requires more content per vehicle, AI-enabled smartphones and PCs for when consumers upgrade to the next generation of devices, and industrial automation. I believe KLA will realize strength in their wafer inspection systems as more advanced nodes become more and more complex. I anticipate KLA will also realize strength in their testing & packaging segment with the same rationale. As more customers push the boundaries across 3nm and 2nm and gate all around with steeper ramp ups, KLA should realize continued growth. I believe the shortening of the chip cycle will benefit KLA as competition for more powerful logic and memory chips heightens.

Valuation & Shareholder Value

KLAC shares currently trade at 29.25x TTM EV/aEBITDA, a relatively low multiple when compared to its peers Applied Materials (AMAT) and Lam Research (LRCX). Using KLAC’s historical trading multiples, I believe the shares have some room for growth as the firm realizes their cyclical upswing in the coming year. Using a probability-based approach weighted to the upside potential, I believe the internal value for KLAC shares should be priced at $1,008/share at 25.91x eFY25 EV/aEBITDA.

Taking into consideration mean reversion, the enterprise value-weighted trading multiple for unadjusted EV/EBITDA is closer to 37x, providing significantly more upside potential for KLAC shares with a price target of $1,106/share.

Given the growth opportunity ahead for KLAC and the relatively limited risk as it relates to business in China, as referenced in my initial report covering KLAC, I believe there remains some upside potential for shareholders. I rate KLAC shares with a BUY recommendation with a price target of $1,057/share, the average of the internal and company comparison price targets.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of KLAC either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Seeking Alpha’s Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

The post KLA Corporation: Is Positioned For A Cyclical Upswing Driven By AI appeared first on Up2info.com.

• KLA Corp is expected to benefit from long-term growth trends in chip manufacturing, process complexity, and the advanced packaging market.
• The stock price may be overvalued due to industry momentum, and FCF and ROE growth need to be monitored.
• Initiating coverage with a Hold rating due to KLAC’s slowing growth rates and potential overvaluation.
• My analysis specializes in identifying companies that are experiencing growth at a reasonable price. Rating systems don’t consider time horizons or investment strategies. My articles aim to inform, not to make decisions.

Investment Thesis

KLA Corp (NASDAQ:KLAC) CFO Bren Higgins was at the J.P. Morgan (JPM) Global Technology, Media, and Communication Conference at the beginning of this week. At the conference, he discussed how the company is expected to benefit from several long-term growth trends, including rising capital intensity in chip manufacturing, increasing process complexity at advanced nodes, and growth in the advanced packaging market.

KLAC has a strong market share, financial reports show a focus on R&D, and a resilient services business position it well to capture this growth. According to the company’s latest guidance, financial targets for 2026 are $14 billion in revenues, 63% gross margins, and $38 in EPS remain achievable despite a recent industry slowdown, according to Higgins. This would represent a high-growth rate from current numbers. As you can see below, that would be an approximate 40% jump in revenue and 57% increase in EPS.

However, I believe there are some factors to consider. The recent industry slowdown and potential macroeconomic headwinds could impact revenue growth. KLAC has acknowledged this, with forecasts showing a slowdown to only a 6.51% growth on a forward-looking basis. To achieve their ambitious $14 billion target by 2026 they would need a higher growth rate.

The stock’s current valuation might not fully reflect the company’s growth prospects. The stock seems to be hitting new all-time highs constantly, potentially due to momentum created by accelerated demand in the semiconductor space.

Another area of concern is KLA’s high debt level, which has been used to fund R&D and capital expenditures. While these investments appear to be paying off in the form of maintaining market share, and that I consider their debt under control according to their latest earnings presentation, a bad year could be problematic. This increase in debt has already impacted their ROE growth, resulting in a decrease of -12.93% on a YoY and is expected to continue decreasing. On the positive side, FCF has been increasing, which helps mitigate concerns about the high debt level.

Given the momentum factors in the semiconductor industry, the market might have gotten ahead of itself, dragging the price of KLAC to overbought territory. This is further supported by their PEG ratio, which is higher than the industry average on a forward-looking basis (2.76 vs 2.0) and the Seeking Alpha valuation grade. For these reasons, I am inclined to start coverage with a Hold until I see some price correction.

Management Evaluation

Rick Wallace is a seasoned executive with over 30 years of experience with the company. He currently leads KLA Corp as both CEO and President, and sits on their board. Wallace started his career at the company as an application engineer in 1988 and steadily climbed the ranks through various leadership roles. He is also on the board of other companies in the industry. I believe he has a very “high alignment ratio” given his tenure with the company and that 88% of his compensation is in the form of stock awards.

CFO Bren Higgins, with over 25 years at KLA in various senior finance roles, oversees the company’s financial health. The company has been increasing debt to fund investments, with a current D/E with over 200% that’s impacting ROE. This raises concerns, but it’s also important to consider the company’s current strong momentum. This high debt level might not be an immediate threat, but it warrants close monitoring to ensure sustainable growth.

Overall, I believe KLA Corp Management team seems committed to be the company’s long-term success, as evidence by Wallace’s alignment and positive employee sentiment on Glassdoor. However, there’s room for improvement in managing the company’s financial structure, particularly regarding the high debt level and ROE. Considering all the factors, I am inclined to give KLA management team a “Meets expectations”.

Corporate Strategy

KLA enjoys a dominant position in yield management, a crucial stage in chipmaking that ensures high-quality water production. This dominance is built upon their leadership in process control. KLA’s tools and expertise enable chipmakers to monitor and optimize their manufacturing process in real-time, minimizing defects and maximizing yield. This leadership translates to strong customer relationships and a reputation for innovation, taking on smaller competitors like Onto Innovation (ONTO) and Camtek (CAMT) that have more niche markets. Their strategy leverages this dominance to expand into new areas like advanced packaging and emerging technologies, aiming to solidify their position as a leader in the evolving semiconductor landscape. However, dependence on mature markets and high debt levels remain challenges.

I have created the table below to compare their strategy to bigger competitors:

Click to enlarge

Source: From companies’ website, presentations, SeekingAlpha

Valuation

KLA Corp currently trades at around $780 and has appreciated around 20% after reporting earnings in late April.

Employing a conservative 11% discount rate (r). This represents a hurdle rate that an investor expects to receive, considering time value and inherent risk of that investment. To calculate it, I used a 5% rate for time value in addition to a 6% average market premium.

Then, using a simple 10-year two staged DCF calculator and I reversed the formula to obtain its implied FCF growth rate, which is around 20%.

$780 = sum^10 FCF (1 + “X”) / 1+r) + TV FCF (1+g) / (1+r)

*I added Book Value in the calculation

That is, the market currently anticipates KLAC FCF to grow at 21.5% this year. However, KLA Corp expected FCF growth is 6.68%. So, valuation seems to be overvalued

Technical Analysis:

The stock price has positive momentum and seems to be hitting all-time highs since the last earnings report due to the positive momentum in the semiconductor industry. However, the company expected growth rates as described above are not reflecting that now. For this reason, I believe the stock might still continue to see positive momentum; however, I will stay off until there is a sign of weakness. I believe in the long-term story just not at this price. I will consider a sign of weakness as an opportunity for buying and consider it to start looking attractive around $700.

Next earnings report is estimated to be July 26.

Takeaway

KLA Corp. shows promise for long-term growth in the chip industry, but there are concerns. Strong market share, R&D focus, and a resilient services business position them well. Ambitious 2026 targets seem achievable. However, a recent industry slowdown and high debt raises need to be monitored. The stock price might be inflated due to industry momentum. While management seems committed, FCF and ROE growth require monitoring. Considering potential overvaluation and headwinds, I am inclined to start coverage with a Hold and would reconsider once the price becomes more attractive.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Seeking Alpha’s Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

The post KLAC: Hold Despite Long-Term Chip Growth Potential appeared first on Up2info.com.