The KLA Advantage: Resilience Amid A Challenging Semiconductor Landscape

In our previous article, we sang the praises of KLA Corporation (NASDAQ:KLAC) for its remarkable ability to outperform its end market and peers. Financial results since we published the article have not disappointed. As we venture into 2023, KLA stands strong like a lighthouse in a storm, confidently navigating the choppy waters of the semiconductor industry. With a potential 20% decline in Wafer Fab Equipment (WFE) on the horizon, one might assume that KLA's journey would become treacherous. However, the company's remarkable resilience, impressive revenue growth, and strategic positioning not only help it stay afloat but also surge ahead in the race. In this article, we will delve deeper into KLA's secret sauce, discussing how the company has managed to weather industry fluctuations and why KLAC stock remains an attractive investment opportunity, even while trading at a premium.

Starting 2023 in Position of Strength

Based on our research, we believe that KLA is well-positioned to navigate the current industry landscape and outperform in the face of a potential 20% decline in WFE in 2023. The company's strong performance in 2022, backed by its robust supply chain management and inventory holding strategy, has set the stage for continued relative strength in 2023.

KLA's lower exposure to the memory sector, where the largest pullback is expected, should help support their market share gains this year. For more information on the memory industry, we recently wrote a bearish article on Micron (MU). This lower exposure, coupled with their ongoing strength in process control, reticle inspection, and EPC, as well as growth in services, puts KLA in a favorable position in a year with declining WFE. Additionally, the company's focus on technology roadmaps, rather than capacity expansion, aligns well with customer spending patterns in this phase of the cycle.

In our judgment, KLA management sounded confident in the sustainability of process control capital intensity, which is expected to benefit from increased EUV adoption and the ongoing transition to new architectures and materials. Moreover, we are optimistic about China's wafer infrastructure investments and KLA's ability to capitalize on these strategic opportunities, as process control intensity is highest at wafer houses.

In the face of China export restrictions, KLA seems to be less impacted compared to some of its peers. The company's exposure to the growth in wafer infrastructure investments in China, particularly at legacy nodes, allows KLA to capitalize on strategic opportunities in the region. The process control intensity in these wafer houses is expected to benefit KLA's market position despite potential export restrictions.

Regarding the CHIPS Act, we believe government funding will focus on equalizing the cost of building in the US versus abroad, thereby limiting the risk of being too dependent on foreign supply. This should provide a net benefit to KLA. Additionally, our research indicates that tool reuse is expected to remain limited, further supporting KLA's position in the market.

Despite the ongoing WFE correction in 2023, KLA seems well-positioned to achieve its 2026 target model. During their January 2023 earnings call, management made the following important statement: "We remain confident that the secular trends outlined in our Investor Day last June are driving long-term semiconductor industry demand, and investments in WFE are durable and compelling." Recall that the company's Investor Day introduced a positive outlook on the semiconductor industry supporting a 9%-11% CAGR from 2021 to 2026, with process control growth outpacing total WFE and capital intensity benefits.

Furthermore, KLA's unique supply chain strategy, focusing on strategic relationships, allows them to optimize their capacity and reduce exposure to supply chain challenges. The company has been actively investing in new capabilities to ensure they can support their long-term revenue goals of $14 billion by 2026.

Financial & Valuation

KLA Corporation has experienced significant growth due to the semiconductor capital equipment boom over the past few years. The company has shown impressive revenue growth with a compound annual growth rate (CAGR) of 23.1% over the three-year period from 2020 to 2022. In 2020, revenues increased by 23%, followed by a 27% increase in 2021, and a 20% increase in 2022. While wafer fabrication equipment (WFE) is expected to decline by around 20% in 2023, KLA's revenues are projected to decline by only 3%, highlighting the company's strong performance and ability to withstand industry fluctuations.

Earnings per share (EPS) have also shown robust growth during the same period, with a CAGR of 34.3%. In 2020, EPS grew by 33%, followed by a 43% growth in 2021, and a 27% growth in 2022. In 2023, EPS is expected to decline by only 6%, which showcases the company's remarkable cost discipline and agility. KLA's ability to maintain earnings growth, even during challenging periods, is a testament to its strong management and operational efficiency.

On a forward 12-month expected EPS basis, KLA is trading at 19 times price-to-earnings ratio, which is at the high end of its 10-year range. However, this multiple can be considered relatively inexpensive given the company's growth track record and demonstrated ability to navigate downturns. Relative to the S&P 500, the company is trading at a mere 6% premium, compared to a 20% discount five years ago. In our view, the rerating of the company is justified by its competitive advantage, increasing stability of its end markets, and its mix shift towards software and services.

Although KLA is trading at a premium valuation relative to its own history, we believe shares are still attractively valued. The company's strong growth, resilience in challenging market conditions, and strategic focus on software and services warrant the premium and present an appealing investment opportunity for long-term investors.

Risks

KLAC is currently viewed as a more secure long-term investment option due to the ongoing need for advanced technology investments and the unpredictability linked to the memory market. In recent times, KLAC stocks have surpassed their counterparts, mainly attributed to the firm's heightened emphasis on foundry and logic operations, as well as reduced involvement in the unpredictable memory sector. Regardless, with the memory sector rebounding, KLAC might not fare as well as competitors like Applied Materials and Lam Research, considering the shifting investor interest towards businesses with higher growth prospects.

The firm has experienced steady annual growth in earnings per share since the 2016 fiscal year, growing almost ten times, from $2.98 in FY15 to a projected $21.38 in FY23. This accomplishment, in spite of the semiconductor sector's struggles around 2018, may cause investors to regard the industry as less volatile, influenced by elements such as increasing chip demand, industry consolidation, and overall maturity. However, a more conservative perspective indicates that this growth phase was facilitated by a stable global macroeconomic climate, negative real interest rates in developed markets, and geopolitical stability following the 2008 financial crisis.

As the present era is marked by escalating interest rates, conflicts, weakening economic expansion, and tense geopolitical connections, KLAC could experience renewed volatility in the Wafer Fab Equipment market. On the geopolitical front, KLAC faces potential hazards as it generates 27% of its income from mainland China and an additional 27% from China's Taiwan province, resulting in a 54% exposure to the Greater China area. The U.S. government's introduction of fresh export rules in October 2022 for semiconductors and high-performance computing technology destined for mainland China poses a problem for KLAC. These regulations require export permits for all KLA products and services aimed at clients in China involved in the production of advanced logic, NAND, and DRAM ICs.

Moreover, KLA confronts limitations on supplying U.S.-origin equipment, software, and technology to Chinese wafer fab equipment manufacturers and mask shops without an export license. A worsening U.S.-China geopolitical relationship might have a disproportionate effect on KLAC's performance.

Conclusion

KLA Corporation remains an appealing investment for long-term investors, given its strong growth, resilience in challenging market conditions, and strategic focus on software and services. Although KLA may face headwinds such as geopolitical risks and cyclicality, we believe that the company's competitive advantage and robust management will help it navigate these challenges. As the semiconductor landscape continues to evolve, KLA stands tall, ready to adapt and outperform its competition.