KLA Corp. (NASDAQ:KLAC) is a leading global supplier of process control and yield management solutions for semiconductors, printed circuit boards and flat panel displays. The company’s products play a critical role throughout the wafer manufacturing process as they are used by customers to improve yields, reduce risk and lower costs.
The company has experienced tremendous growth over the past five years, driven primarily by increased customer demand due to the accelerating adoption of EUV technology and large infrastructure investments in China. Going forward, KLA will benefit from some of the tailwinds it has enjoyed in the past. However, several challenges may slow its growth rate over the next five years.
KLA has three reportable segments, with its Semiconductor Process Control segment accounting for more than 90% of total revenue. In this segment, the company provides the industry’s broadest range of inspection, metrology, software products and related services to wafer fab customers. KLA’s customers use its products throughout the manufacturing process to improve yields and reduce costs.
KLA Corp: Great Business, Terrible Prices
KLA Corp: Great Business, Terrible Prices
For semiconductor equipment investors, it’s hard not to notice KLA’s continued outperformance versus two other big players: Applied Materials (NASDAQ:AMAT) and Lam Research (NASDAQ:LRCX). The following chart shows KLA outperforming both companies over several different time periods.
KLA Corp: Great Business, Terrible Prices
One of Warren Buffett’s ( Trades , Portfolio ) favorite quotes comes from his mentor, Benjamin Graham: “In the short run, the market is a voting machine. In the long run, the market is a weighing machine.” When it comes to KLA, it’s clear that the market has properly valued the stock, as its fundamental growth has outperformed Lam Research and Applied Materials over both the short and long term.
As JPMorgan (NYSE: JPM) analyst Harlan Sarr noted at the 2024 JPMorgan 52nd Annual Global Technology, Media & Communications Conference, over the past decade, wafer fab spending grew at a compound annual growth rate of 12%, compared to semiconductor industry revenue growth of 6%. KLA grew its process control systems revenue at a CAGR of 13%. At the 2024 Morgan Stanley Technology, Media & Telecom Conference, KLA Chief Financial Officer and Executive Vice President Bren Higgins also noted that the adoption of EUV and the increasing scaling of devices has driven the convergence of process control, with the optical inspection segment growing at about 1.70x the growth of wafer fab equipment from 2019 to 2022.
The story continues
Over the last decade, and especially since 2019, KLA has had several growth drivers.
First, the adoption of extreme ultraviolet lithography for leading edge logic is driving higher capital expenditures for process control equipment, as evidenced by statistics presented by Bren Higgins at the JP Morgan conference, which showed that process control capital expenditures for logic, as a percentage of WFE, can be in the mid teens, while for memory it can be closer to 10%.
Second, design starts have increased, which is also beneficial for KLA because new integrated circuit design houses typically require greater investments in test and metrology than established design houses.
Third, KLA continues to grow its market share. As revealed in its Q3 ’24 earnings call slide, the company’s process control market share has grown by more than 500 bps since 2018, reaching more than 56% in 2023. Additionally, the company has gained share in the fast-growing advanced packaging market, marking the fifth consecutive year of share gains in the advanced wafer-level packaging process control market, nearly doubling its market share from 2022 to 2023.
Last but not least, KLA’s growth in China was very strong through 2023 due to US restrictions on cutting edge logic and memory.
Not only has KLA grown rapidly, it also enjoys higher profit margins than its competitors.
KLA Corp: Great Business, Terrible Prices
The difference in gross margins is quite significant. It reflects the competitive environment for process control equipment. As KLA management repeatedly emphasizes on earnings calls and at industry conferences, the company’s market share is more than 4.50 times that of its closest competitor.
Another testament to KLA’s competitive strength is its continued dominance in China, even as domestic companies have taken market share from U.S. companies in other semiconductor equipment segments. For example, in the deposition and etch segment of the Chinese market, domestic companies such as Naura (SZSE:002371) and Amec (SHSE:688012) have taken significant market share from Applied Materials and Lam Research. Yet KLA’s largest Chinese competitor still accounts for less than 1% of China’s total process control market, which speaks to the strength and importance of the company’s products.
Although KLA’s gross margins are significantly higher than its competitors, its operating and net margins are not as strong due to inefficient operations. KLA’s selling, general and administrative expenses account for almost 10% of revenue, while Applied Materials and Lam Research both spend only about 6% of revenue on SG&A. I believe this is an area where KLA can improve in the future.
There are certainly many positive aspects to KLA’s business, but it’s important to consider the risks as well.
First, KLA’s largest leading-edge customers, Taiwan Semiconductor (NYSE:TSM) and Samsung (XKRX:005930), already perform test and metrology services in-house, and there is concern that as Taiwan Semiconductor scales and costs increase with node evolution, it will begin to perform more test and metrology services in-house.
Second, over the past five years, smaller companies have supplanted KLA to assume leadership positions in certain niche markets within the inspection and metrology space. For example, Japan’s Lasertec (TSE:6920) has overtaken KLA to become the leading player in EUV mask inspection.
Third, new technology is constantly emerging in the field of inspection and metrology. For example, there has been a great deal of new development in e-beam inspection recently, but this requires significant investment. KLA not only lags competitors such as Applied Materials and Hitachi in the e-beam market, but also new entrants such as HMI, which was acquired by ASML (NASDAQ:ASML).
Last but not least, geopolitics plays an increasingly large role in the global semiconductor industry. This creates unprecedented challenges for global WFE suppliers like KLA. Specifically, beginning in 2022, the U.S. government has issued export controls requiring an export license from BIS for sales to China-based customers engaged in military end uses, certain U.S.-made semiconductor and high-performance computing technology (including wafer fabrication equipment), the use of such technology for certain end uses in China, and the provision of support by U.S. persons to certain advanced IC manufacturing facilities located in China. The export controls are accelerating China’s path to self-sufficiency and could significantly curtail KLA’s China operations if domestic competitors exploit the export controls.
KLA clearly has most of the hallmarks of a great company. Its shareholders have done well over the past five years. Over the long term, its stock has also generated impressive compounding. However, according to GF Value Rank, the company’s current valuation level appears to be very high both relative to its industry as a whole and relative to the company’s history. This suggests that while KLA is certainly a strong and successful company, the market may not be fully pricing in its intrinsic value.
This article was originally published on GuruFocus.