Summary
- One year ago, I gave KLA Corporation a neutral rating based on my DCF analysis and it returned exactly 0% since then.
- The margin of safety of KLAC improved, and valuation retraced while operating performance improved. Win, win, and win.
- China has been a significant growth contributor to the semiconductor market, which is why the market is reacting negatively to tech sanctions against it.
- KLAC is very shareholder-friendly and also wary of the market. It bought back shares and increased dividends with its excess profits from 2022.
Exactly one year ago, I wrote about KLA Corporation (KLAC) and gave a neutral rating because my DCF analysis at the time didn't provide sufficient upwards potential. The margin of safety of holding KLAC wasn't large enough to add it as a position to my portfolio.
Many semiconductor stocks retraced from their highs. The hardest hit is ASML , followed closely by Applied Materials Inc ( AMAT ). The Invesco PHLX Semiconductor ETF (SOXQ), which KLAC uses as a comparison in their Annual Report, is down 35% from its highs last year.
KLAC is the least hit because, even at the time, it had the highest margin of safety. We'll look at the valuations in a moment. It doesn't help ASML and AMAT that their stocks became Twitter darlings, which implies that the crowd doesn't care about its valuation.
Before diving into this article, I'd recommend going back a year and reading my thesis - KLA Corporation: A Company I'd Love To Recommend, But I Can't .
KLA Corporation - Keyanoush's Article from 2021 (SeekingAlpha)
The investor takeaway from a year ago was the following:
Looking at KLA's historical price performance, we see that KLA has usually traded anywhere between a PE of 16 and 20. At a current PE of nearly 22, it is more than fairly valued, tilting the risk-reward balance away from reward.
With a sufficiently strong pullback into the PE range of 16-17, I would consider KLA a good investment, but I rate it as a hold until then.
Contrary to what the Twitter folk tries to establish, valuation matters. It matters a lot in the short term and sufficiently in the long term. To quote the words of Warren Buffett: " The three most important words in investing are margin of safety. "
The margin of safety a year ago was not large enough to consider KLAC a good investment, even though it has been experiencing significant tailwinds.
Thesis
The margin of safety of KLAC improved. There are additional geopolitical issues, but for KLAC's instruments, these aren't as impactful as, for example, ASML.
While KLAC's stock price is identical to the price in my last article, its fundamentals did not stay identical. In the graph below, I marked the release of my previous article about KLAC. Usually, it trades between a PE of 16 and 20; at the time, it was 22.
KLAC Historical Valuation Chart - Fastgraphs (Fastgraphs)
KLAC had a great year. Its revenue increased by 33% YoY, gross margin expanded from 59.93% to 61%, operating margin expanded from 35.97% to 39.64%, and net margin expanded from 30.04% to 36.06%.
KLAC's operating performance caught up, and all valuation metrics retraced from their all-time highs.
The margin of safety for KLAC improved while the tailwinds remained steady for the next 3-5 years. The CHIPS act adds a tailwind for the company that counters the headwinds from the geopolitical issues with China.
KLAC's backlog is elevated, and management points to the higher risk of order modifications, rescheduling, or even cancellation of orders.
I rate KLAC as a buy. Full disclosure - I invested in KLAC in the sub $300 area, at which I consider the margin of safety sufficient.
Business and Industry Overview
Asia is expanding its semiconductor footprint, of which China, Japan, Taiwan, and Korea make up 79% of KLAC's revenue. China makes up 29% and Taiwan 25% of its revenue. This geographic concentration is a risk that investors should know.
In his recent article - KLA: Least WFE Company Impacted By Semiconductor Slowdown And US Sanctions , Robert Castellano discusses the geographic concentration of KLAC and its competitors in Asia. The difference in revenue from China between the ASML, AMAT, [[LRCX]], and KLAC is just 3%. China has been rapidly expanding its semiconductor capabilities.
The August/September publication of Semiconductor Digest discusses the increasing number of patent applications from China.
Patent Applications by Publication Year - SK hynix, Micron - US and China (Semiconductor Digest)
China has been a significant growth contributor to the semiconductor market, which is why the market is reacting negatively to tech sanctions against it. On August 26th, the US government told Nvidia (NVDA) about new license requirements for future exports to China, including Hong Kong. Nvidia isn't allowed to export DGX or any other systems incorporating A100 or H100 integrated circuits to China and Russia.
The US has already banned ASML from exporting its EUV lithography systems to China to impede China from developing more capabilities in this realm.
I think KLAC is less prone to these sanctions because its instruments don't fabricate the chips but are used for quality monitoring and metrology.
Another beneficial factor is KLAC's growing service revenue. Metrology and wafer inspection equipment is long-lasting but requires maintenance. In the sub-7nm sector, KLAC is one of the few competitive companies selling equipment capable enough to provide the required services. With manufacturing capacities expanding and more of KLAC's equipment out in the wild, its service revenue is increasing at a constant rate.
KLAC Breakdown of Revenue by Major Product and Regions (KLAC Investors Presentation June 2022)
Valuation
The valuation chart above shows that while the price is identical to when I last published, the valuation metrics, on average, dropped considerably. KLAC has a backlog of $13.11bn in 2022, up 300% from last year. In 2022, KLAC had a record-breaking revenue of $9.2bn. The backlog, considering some cancellations, assures that KLAC's revenue for 2023 will be on a similar level. I am cautious of over-capacity because the semiconductor manufacturing industry experiences counter-cyclical capacity expansion and production cycles.
Meaning we're experiencing lower demand for chips while companies expand manufacturing capacity. That leads to overcapacity and then to lower demand for WFE.
KLAC is doing, in my opinion, the most logical action with excess capital - returning it to shareholders through dividends and buybacks instead of expanding capacity and running into overcapacity in a year or two.
Compared with AMAT, ASML, and LRCX, KLAC has grown revenue and EBITDA faster than its competitors while being moderately valued.
The company's growth and moderate valuation make KLAC the better pick in the semiconductor industry. As mentioned before, its instruments are at lower risk of being sanctioned because they are not manufacturing the chips.
The WFE market growth is tempered. Manufacturers are experiencing elevated levels of inventory and cash conversion cycles. I discussed these higher levels in my previous analysis of Qorvo ( QRVO ) - Qorvo: Around The Sweet Spot - and Skyworks ( SWKS ) - Skyworks Solutions: Cheap? Yes; Cheap Enough? Maybe . In comparison, process control systems are growing faster than the rest of WFE.
KLAC is the market leader in process control systems, especially in the sub-7nm. Like ASML's monopoly on EUV lithography systems, KLAC has a monopoly in the sub-7nm metrology and process control systems.
Conclusion
KLAC is a decently valued semiconductor WFE manufacturer. It's operating in the market's process control system and metrology segment, which has been outgrowing the overall WFE market.
KLAC has a near monopoly in this segment, especially in the sub-7nm inspection segment. Not even ASML or AMAT come close to its expertise in this segment.
Valuation-wise, KLAC is relatively conservatively valued compared to its peers while outgrowing them in revenue and operating cash flow. Using my DCF analysis from last year and updating the numbers, and using moderate growth numbers, we get the following input parameters:
KLAC Growth Projections - Keyanoush (Keyanoush - The Value Bull)
We can then insert these numbers in our DCF analysis and calculate KLAC's fair value:
DCF Calculation for KLAC - Based on Moderate Growth Projections (Keyanoush)
The updated growth projections and a remarkable 2022 provide decent upside potential for KLAC over the next 3-5 years. KLAC is one of the most decently valued semiconductor companies on the market. It outperformed the market since I last wrote about it.
Cautionary Note
The semiconductor market and the companies in it are very interrelated. There are certain geopolitical and recessionary risks that hover over the industry.
Yes, our demand for chips will increase in the long term, but the industry's outlook is murky at best at the moment.
I initiated my position in the sub-$300 area, where I consider the scale tilting heavily towards reward. In the sub-$300 area, the company is trading below intrinsic value.
On the bright side, 0% return since I last wrote means that the stock outperformed the S&P 500 by 10% and the broad semiconductor market by 22%. That's the result of a margin of safety.
This article should only be regarded as the first step in your due diligence process.
I always welcome constructive criticism and open discussions. Please feel free to comment about my calculations and/or sources that I use in my articles.
For further details see:
KLA Corp.: Finest Stock In The Semiconductor Industry