KLA Corporation possesses several key attributes I look for in an investment. It is a market leader with a high ROIC, indicating a strong competitive advantage. Additionally, it is a compounder and operates in a growing sector. The question, however, is whether now is the right time to add the stock to the portfolio. This is what I will explore in this analysis.
This is not a financial advice. I am not a financial advisor and I only do these posts in order to do my own analysis and elaborate about my decisions, especially for my copiers and followers. If you consider investing in any of the ideas I present, you should do your own research or contact a professional financial advisor, as all investing comes with a risk of losing money. You are also more than welcome to copy me.
For full disclosure, I should start by mentioning that at the time of writing this analysis, I do not own any shares of KLA Corporation. If you would like to view the stocks in my portfolio or copy my portfolio, you can do so on eToro. Instructions on how to do so can be found here. I don't own any stocks in KLA Corporation's competitors either. Thus, I have no personal stake in KLA Corporation. If you want to purchase shares or fractional shares of KLA Corporation, you can do so through eToro. eToro is a highly user-friendly platform that allows you to get started on investing with as little as $100.
The Business
KLA Corporation is a leader in the semiconductor capital equipment industry, providing advanced tools and solutions that enable semiconductor manufacturers to improve production efficiency, quality, and yield. Founded in 1997 through the merger of KLA Instruments and Tencor Instruments, the company supports the entire lifecycle of semiconductor manufacturing, from R&D to high-volume production. KLA's products detect and classify defects during and after chip production, helping manufacturers like TSMC and Samsung achieve higher yields and profitability. As semiconductors become increasingly complex, KLA's tools are critical for ensuring the quality and competitiveness of advanced chips. KLA Corporation's moat is built on several factors. The company is a technological leader in inspection, metrology, and process control, offering unmatched precision and efficiency. Its tools are indispensable for modern semiconductor fabs, which require ever more stringent quality standards. KLA invests billions annually in research and development, creating significant barriers to entry for potential competitors. This scale advantage allows KLA to anticipate customer needs and deliver innovative solutions. Fabs are heavily invested in KLA’s equipment, which can last for decades and integrates deeply into production processes. Replacing KLA’s tools would involve massive financial costs and significant downtime, making it impractical for customers to switch providers. Additionally, KLA works closely with semiconductor giants like TSMC and Samsung to align its solutions with their technology roadmaps, ensuring long-term partnerships and visibility into future demand. The company also offers a broader range of solutions compared to competitors, making it a one-stop shop for process control needs and reducing costs and complexity for its customers. KLA operates in three segments. Semiconductor Process Control, the largest segment contributing 89% of revenue, provides tools to inspect, measure, and analyze chips and wafers during production to ensure quality and minimize defects. Specialty Semiconductor Process, which accounts for 5% of revenue, focuses on unique chip applications such as sensors for cars, power management for EVs, and advanced packaging techniques for combining multiple chips. PCB, Display, and Component Inspection, contributing 6% of revenue, inspects printed circuit boards and other components to ensure quality and functionality in electronic devices. KLA's strong position in the semiconductor industry, coupled with its technological leadership and deep integration into customers’ production processes, makes it a critical partner for advancing chip manufacturing globally.
Management
Rick Wallace is the CEO of KLA Corporation. He joined KLA Instruments in 1988 as an applications engineer and held various roles within the company before becoming CEO in 2005. In addition to serving as CEO and sitting on KLA Corporation’s Board of Directors, Rick Wallace also serves on the Board of Directors at Splunk Inc. He holds a bachelor's degree in electrical engineering from the University of Michigan and a master's degree in engineering management from Santa Clara University. Earlier in his career at KLA, Rick Wallace was assigned a task with a team member to develop a business plan within 90 days. They exceeded expectations by discovering a new product opportunity worth $20 million, which would have otherwise been overlooked by the company. This experience taught him a valuable lesson about the importance of focus and fully dedicating oneself to new initiatives. Rick Wallace leads KLA Corporation with five core values that he expects both the company and its employees to embody: perseverance, a drive to continuously improve, the ability to excel in high-performing, multicultural, interdisciplinary teams, a commitment to honesty and forthrightness, and a dedication to providing indispensable products and unmatched service to KLA’s customers. Considering his extensive experience, leadership qualities, and alignment with these core values, I feel very confident in Rick Wallace's ability to continue leading KLA Corporation successfully.
The Numbers
The first metric to examine is the return on invested capital (ROIC). Ideally, I look for a 10-year history with all figures exceeding 10% annually. KLA Corporation has consistently delivered a ROIC above 10% over the past decade. Since 2017, ROIC has exceeded 20% every year, with the exception of fiscal year 2020, which was impacted by the pandemic. In the last three years, ROIC has reached new heights, exceeding 30% in three of the past four years and nearly hitting 30% in fiscal year 2024 - a very impressive achievement. The slight decline in fiscal year 2024 is attributed to a decrease in net income. Management has noted that fiscal year 2024 was affected by weaker conditions in the Semiconductor and Wafer Fabrication Equipment industry but has expressed optimism about future improvements. Given that ROIC remains nearly 30% even in a challenging year, I do not find the decline in fiscal year 2024 concerning. This continued high level of performance underscores KLA Corporation's strong operational efficiency and competitive position.
The following numbers represent the book value + dividend. In my previous format, this was referred to as the equity growth rate. It was the most important of the four growth rates I used in my analyses, which is why I will continue to use it in the future. As you are accustomed to seeing numbers in percentage form, I have decided to provide both the actual numbers and the year-over-year percentage growth. The numbers are highly variable, with some years showing significant declines and others experiencing substantial increases. One factor influencing this variability is the numerous acquisitions made by KLA Corporation. Over the past decade, the company has completed five acquisitions and also invested in constructing a new headquarters. Despite this variability, it is encouraging to note that equity has increased over the past two years, reaching its highest level ever in fiscal year 2024.
Finally, we will analyze the free cash flow. Free cash flow, in short, refers to the cash that a company generates after covering its operating expenses and capital expenditures. I use levered free cash flow margin because I believe that margins provide a better understanding of the numbers. Free cash flow yield refers to the amount of free cash flow per share that a company is expected to generate in relation to its market value per share. It is not surprising that KLA Corporation has consistently generated positive free cash flow every year over the past decade. Examining the numbers, we observe a pattern similar to ROIC, with a significant increase in free cash flow in recent years, which is highly encouraging. However, free cash flow declined slightly in fiscal year 2024. Management has attributed this decline to reduced consumer demand in the semiconductor sector. As demand rebounds, free cash flow is expected to follow suit. As free cash flow increases, shareholders stand to benefit significantly, as the company has committed to returning 85% of free cash flow to shareholders through dividends and share buybacks. While the levered free cash flow margin decreased slightly in fiscal year 2024, it remains high, with management noting that KLA Corporation ranks among the top tier of S&P 500 companies in this metric. That said, the free cash flow yield reached a ten-year low at the end of fiscal year 2024, indicating that shares are trading at a premium valuation. This aspect will be revisited in the valuation section of the analysis.
Debt
Another important aspect to consider is the level of debt. It is crucial to assess whether a business has manageable debt that can be repaid within a three-year period. This is calculated by dividing total long-term debt by earnings. After performing the calculation for KLA Corporation, I found that the company has 2,13 years of earnings in debt. This falls comfortably within the three-year range, so debt is not a concern for me. Notably, KLA Corporation has not had a debt-to-earnings ratio exceeding three years since 2016. This consistent management of debt levels suggests that it is unlikely to become a concern in the future either.
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Risks
Macroeconomic factors pose a significant risk to KLA Corporation due to its reliance on the global semiconductor and electronics industries, which are highly sensitive to economic conditions. The demand for KLA’s products is ultimately driven by global demand for electronic devices. During periods of economic uncertainty, reduced consumer and business spending on electronics can lead to lower demand for semiconductors. This, in turn, may prompt KLA’s customers to delay or cancel orders for capital equipment, directly affecting the company’s revenues. Many of KLA’s customers depend on access to credit to finance large capital expenditures, such as purchasing KLA’s high-cost equipment. When credit markets tighten or interest rates rise, customers may face difficulties in securing financing, resulting in delays or cancellations of orders. Additionally, the semiconductor industry is cyclical, with periods of rapid investment followed by downturns. Economic slowdowns can intensify these cycles, as semiconductor manufacturers may halt capacity expansions, further reducing KLA’s sales pipeline. KLA’s strong ties to the semiconductor industry make it particularly vulnerable to shifts in global economic conditions. Any broader economic slowdown or financial instability has the potential to harm its business, either directly through reduced sales or indirectly through tighter credit conditions and weakened customer demand.
Export restrictions, particularly those targeting China, pose a significant risk to KLA Corporation due to the country’s importance to the company’s revenue and the semiconductor industry's global supply chain. China is one of KLA’s largest markets, accounting for 43% of its revenue in fiscal year 2024. Restrictions on selling certain semiconductor manufacturing equipment to Chinese companies could significantly impact KLA’s ability to generate revenue from this region. The U.S. government has implemented increasingly stringent export controls, including the 2022 and 2023 BIS Rules, which limit the sale, shipment, and support of equipment to specific China-based entities or for advanced semiconductor manufacturing. These restrictions disrupt KLA’s operations by requiring export licenses. If denied, these licenses could delay shipments, impair the fulfillment of contracts, and force the return of customer deposits. Moreover, the inability to service existing equipment in China could harm long-term customer relationships. Compliance with evolving and complex export regulations also increases operational risks, as violations could result in fines, export bans, or reputational damage. The Chinese government may retaliate with countermeasures, further complicating KLA’s ability to operate in the region. Given that China contributes such a significant portion of its revenue, losing access to this market would force KLA to rapidly identify alternative customers - a challenging task that may not fully offset the loss. Additionally, these restrictions threaten supply chains by limiting access to Chinese-made components, introducing further operational challenges.
Customer concentration poses a significant risk for KLA Corporation due to its reliance on a small number of large customers for a substantial portion of its revenue. This reliance arises from consolidation within the semiconductor industry, where mergers, acquisitions, and business closures have resulted in fewer, larger players dominating the market. While this concentration allows KLA to focus on key relationships, it also exposes the company to several critical risks. Dependence on a limited number of customers means that sales can fluctuate significantly based on the purchasing decisions of just a few entities. Variations in the mix, type, and timing of customer orders can create considerable volatility in KLA’s quarterly and annual financial performance. For instance, if a major customer delays or cancels orders, replacing that business with other customer orders may prove challenging. This is particularly problematic given the customized nature of KLA’s products, which can result in non-recoverable costs. Foundry and logic customers account for a significant portion of KLA’s orders, increasing the company’s exposure to trends and shifts within this segment. Technological or business changes in this concentrated market could have an outsized impact on KLA’s financial results. Furthermore, as these customers consolidate, their larger market share gives them greater leverage in negotiations. They can demand more favorable pricing, payment terms, or other commercial conditions, potentially putting pressure on KLA’s margins.
Reasons to invest
Favorable industry trends in semiconductor process control make KLA Corporation an attractive investment, driven by increasing complexity in chip manufacturing and rising demand for advanced tools. Foundry and logic manufacturers are pushing the boundaries of scaling and adopting new technologies, necessitating precise process control to improve yields and support production. This trend serves as a long-term growth driver for KLA, as its tools are essential for managing these advanced processes. The memory market, which has traditionally been less reliant on process control, is also becoming more complex with advancements such as high-bandwidth memory (HBM) and NAND bonding. These technologies, driven by AI and high-performance computing, present significant manufacturing challenges that require more sophisticated inspection and metrology solutions. With memory investments expected to increase in 2025, KLA is well-positioned to benefit as process control becomes increasingly critical in this segment. As chip designs grow more intricate, maintaining high yields and efficiency becomes paramount, further reinforcing KLA’s vital role in the semiconductor industry. These industry trends not only support KLA’s near-term growth but also enhance its long-term potential as a key enabler of cutting-edge technology.
The Specialty Semiconductor Process segment presents an exciting growth opportunity for KLA Corporation. Although it accounts for just 5% of the company’s revenue, this segment focuses on tools for advanced packaging and specialized semiconductor markets, such as chips for automotive, industrial, and communication applications. It plays a critical role in KLA’s strategy to expand into new markets beyond its core business. In FY24, this segment demonstrated resilience despite challenges in the automotive and consumer markets. A key highlight was advanced packaging, which is experiencing robust growth driven by rising demand for AI chips, advanced memory technologies like high-bandwidth memory (HBM), and increasingly complex chip designs. KLA’s revenue from advanced packaging grew significantly, and the company expects this momentum to continue as customers adopt new packaging methods that require greater precision. This segment also benefits from broader trends, such as the transition to electric vehicles and the adoption of smarter industrial technologies, both of which are driving demand for specialized chips. As these markets recover and expand, KLA’s targeted solutions position it well to capture future opportunities. By diversifying into areas like advanced packaging and specialty semiconductors, KLA not only broadens its revenue base but also strengthens its long-term potential as a key player in the evolving semiconductor industry.
KLA Corporation's Service segment is a compelling reason to consider investing in the company, given its strong performance, consistent growth, and strategic importance. Service revenue increased by 14% in fiscal 2024, a particularly impressive achievement considering it builds on a larger revenue base than many of KLA’s peers. This growth underscores KLA’s ability to consistently outperform the industry. The Service segment benefits from multiple drivers. First, the expanding installed base of KLA systems, driven by robust equipment sales in prior years, has created a steady pipeline of service opportunities. Tools shipped in 2021 and 2022 are now coming off warranty and converting into service contracts, with an impressive 95% contract renewal rate. This high conversion rate provides visibility into future revenue and highlights the stickiness of KLA's service business. Second, increasing equipment utilization rates across customer segments have boosted demand for service offerings. Customers rely on KLA to ensure their systems operate at peak performance, particularly as semiconductor manufacturing becomes more complex. KLA’s advanced capabilities, which often surpass those of its competitors, make its services indispensable to customers. These services also enable system upgrades over time, aligning with evolving customer needs. Additionally, the subscription-like nature of the Service segment’s revenue is a key strength. More than 75% of service revenue comes from recurring contracts, providing predictable income and mitigating the impact of industry cyclicality. The long-term growth prospects for the Service segment are robust. Service revenue has more than doubled since 2019 and is on track to grow at the upper end of KLA’s 12-14% compound annual growth rate (CAGR) target through 2026.
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Valuation
Now it is time to calculate the share price. I perform three different calculations that I learned at a Phil Town seminar. If you want to make the calculations yourself for this or other stocks, you can do so through the tools page on my website, where you have access to all three calculators.
The first is called the Margin of Safety price, which is calculated based on earnings per share (EPS), estimated future EPS growth, and estimated future price-to-earnings ratio (P/E). The minimum acceptable rate of return is 15%. I chose to use an EPS of 20,58, which is the one from fiscal 2023. I have selected a projected future EPS growth rate of 15%. Finbox expects EPS to grow by 17% in the next five years, but 15% is the highest number I use. Additionally, I have chosen a projected future P/E ratio of 30, which is twice the growth rate. This decision is based on the fact that KLA Corporation has historically had a higher P/E ratio. Lastly, our minimum acceptable rate of return is already set at 15%. Doing the calculations, we come up with the sticker price (some call it fair value or intrinsic value) of $608,40. We want to have a margin of safety of 50%, so we will divide it by 2. This means that we want to buy KLA Corporation at a price of $304,20 (or lower, obviously) if we use the Margin of Safety price.
The second calculation is called the Ten Cap price. The rate of return that an owner of a company (or stock) receives on the purchase price of the company is essentially its return on investment. The return should be at least 10% annually, and I calculate it as follows: The operating cash flow last year was 3.309 and capital expenditures were 277. I attempted to review their annual report to determine the percentage of capital expenditures allocated for maintenance. I couldn't find it, but as a rule of thumb, you can expect that 70% of the capital expenditures will be allocated for maintenance purposes. This means that we will use 194 in our calculations. The tax provision was 451. We have 133,819 outstanding shares. Hence, the calculation will be as follows: (3.309 – 194 + 451) / 133,819 x 10 = $266,48 in Ten Cap price.
The final calculation is called the Payback Time price. It is a calculation based on the free cash flow per share. With KLA Corporation's Free Cash Flow Per Share at $22,51 and a growth rate of 15%, if you want to recoup your investment in 8 years, the Payback Time price is $355,35.
Conclusion
I believe KLA Corporation is an intriguing company, and I have great confidence in its management. The company has a strong moat and has consistently delivered a high ROIC. Over the past three years, KLA has increased its free cash flow and now boasts one of the best levered free cash flow margins in the S&P 500. That said, macroeconomic factors pose a significant risk to KLA due to its dependence on the semiconductor industry, which is highly sensitive to economic conditions. During downturns, reduced demand for electronic devices and tightened credit markets can lead customers to delay or cancel orders for KLA’s equipment. Export restrictions are another significant risk, as China, which accounts for 43% of KLA’s revenue, is a critical market. Tightened U.S. export controls, such as the 2022 and 2023 BIS Rules, could delay shipments, disrupt contracts, and harm customer relationships. Customer concentration is also a concern, given KLA’s reliance on a small number of large customers for much of its revenue. This dependence makes its financial performance vulnerable to fluctuations in orders, delays, or cancellations. Additionally, industry consolidation has given these customers greater negotiating power, which can pressure KLA’s margins and profitability. On the positive side, favorable industry trends, such as increasing chip complexity and rising demand for advanced tools, are key growth drivers for KLA. Its process control solutions are essential for improving yields and supporting production, reinforcing its critical role in the semiconductor industry. The Specialty Semiconductor Process segment also presents a promising growth opportunity, focusing on advanced packaging and specialized semiconductor tools for markets like automotive and industrial applications. Strong performance in this segment, driven by trends such as AI, high-bandwidth memory, and electric vehicles, positions KLA for future growth while diversifying its revenue streams. Additionally, KLA’s Service segment is a strong investment driver, with robust growth fueled by an expanding installed base, high contract renewal rates, and recurring revenue streams. This segment provides predictable income and reduces exposure to industry cyclicality. Overall, I believe there is much to like about KLA Corporation. I plan to open a position at the intrinsic value of the Ten Cap price of $532, as it provides a discount to both the Margin of Safety price and the Payback Time price.
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