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KLA Corporation: A market leading compounder operating in a growing sector.

Opdateret: 16. jan.


KLA Corporation possesses some of the key attributes I seek in an investment. It is a market leader with a high ROIC, indicating a competitive advantage. Additionally, it is a compounder and operates in a growing sector. The question, though, is whether now is the time to add the stock to the portfolio. This is what I will investigate 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.


Since attending the workshop with Phil Town, I have decided to make some changes to the layout of my analyses. I will perform additional calculations and also provide a brief explanation of why the company is significant to me. If you want to learn more about my company evaluation process, please visit the "MY STRATEGY" section on my website.


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 start your investment journey with as little as $50.



KLA Corporation was founded in 1997 through the merger of KLA Instruments and Tencor Instruments, two long-time leaders in the semiconductor capital equipment industry. KLA Instruments started operations in 1975, while Tencor Instruments began in 1976. KLA Corporation manufactures equipment for the semiconductor industry. KLA Corporation's systems can detect and classify defects at various stages of production. Thus, with the help of KLA Corporation's products, semiconductor manufacturers can identify and address issues that could impact yield. KLA Corporation manufactures equipment that can detect and classify defects, relying heavily on the research and development (R&D) investments made by their customers. KLA Corporation's largest customers are Taiwan Semiconductors and Samsung Electronics. They have three reportable segments: Semiconductor Process Control, which contributes 88% of the revenue; Specialty Semiconductor Process, which contributes 6% of the revenue; and PCB, Display, and Component Inspection, which also contributes 6% of the revenue. Their largest market is China, where they generate 30% of their revenue. Followed by Taiwan (21% of revenue), Korea (18% of revenue), North America (13% of revenue), Japan (8% of revenue), Europe (6% of revenue), and the rest of Asia (4% of revenue). KLA Corporation is the dominant company in its sector and holds a global market share of approximately 57%. KLA Corporation has established a competitive advantage, or "moat," by offering a wider range of products compared to its competitors. This means that they offer a wide range of solutions, which makes it more convenient and cost-effective for customers. Some of KLA Corporation's largest competitors are Applied Materials and ASML Holding.


Their CEO is Rick Wallace. He joined KLA Instruments in 1988 as an applications engineer. He held various positions until he became the CEO in 2005. Besides serving as the CEO and being on the Board of Directors at KLA Corporation, 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 Corporation, Rick Wallace was assigned a task along with a team member. They were given 90 days to develop a business plan. Rick Wallace and his team member exceeded expectations by discovering a new product worth $20 million, which would have otherwise been overlooked by KLA Corporation. This task taught Rick Wallace a valuable lesson about the importance of focus and dedicating oneself full-time to new initiatives. Rick Wallace leads by five core values that the company and employees need to have: perseverance, a drive to be better, the ability to work well in high-performing, multicultural, interdisciplinary teams, the willingness to be consistently honest and forthright, and the desire to provide indispensable products and unmatched service for KLA Corporation's customers. Rick Wallace has also been great for investors. If you had invested $10.000 when he became CEO in 2005 and reinvested dividends, you would now have $197.000 It is a compound annual growth rate of 18%. Thus, considering everything mentioned above, I feel very comfortable with Rick Wallace leading KLA Corporation moving forward.


I believe that KLA Corporation has a moat, and I also hold a high opinion of their management. Now, let us analyze the numbers to determine if KLA Corporation meets our criteria for possessing a strong competitive advantage. In case you want an explanation of what the numbers represent, you can refer to "MY STRATEGY" on the website.


The first number we will investigate is the return on invested capital, also known as ROIC. I would like a 10-year history with all figures exceeding 10% for each year. KLA Corporation has delivered a ROIC (Return on Invested Capital) of over 10% in the past decade. And it has been above 20% since 2017, except for fiscal year 2020, which was impacted by the pandemic. ROIC has taken another notch up in the last 3 years as KLA Corporation has delivered a ROIC above 30% in the past three years, which is very impressive. All in all, I am very impressed with the Return on Invested Capital (ROIC) of KLA Corporation. Not only have they consistently met the requirements, but it also appears that they are consistently increasing their ROIC every third or fourth year.



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 experiencing significant declines and others seeing substantial increases. One factor that has impacted the numbers is the numerous acquisitions made by KLA Corporation. Over the past ten years, they have completed five acquisitions, in addition to constructing a new headquarters. Thus, I don't mind that numbers are a bit mixed throughout a ten-year period.



Finally, we will investigate 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. Levered free cash flow is the amount of money a company has remaining after paying all of its financial obligations. I use margins to enhance clarity and improve understanding. Free cash flow yield refers to the amount of free cash flow per share that a company is projected to generate in relation to its market value per share. It is not surprising to see that KLA Corporation has consistently generated positive free cash flow every year for the past decade. Looking at the actual numbers, we observe the same pattern as with ROIC. KLA Corporation appears to have experienced a significant increase in free cash flow after a few years, which is highly encouraging. KLA Corporation consistently delivers a high levered free cash flow margin, which is another positive aspect. Free cash flow yield is also higher than I would expect, which indicates that KLA Corporation may be trading at an attractive price. However, we will revisit this later in the analysis.



Another important aspect to consider is the level of debt. It is crucial to determine whether a business has manageable debt that can be repaid within a three-year period. We calculate this by dividing the total long-term debt by earnings. After performing the calculation on KLA Corporation, I found that the company has 1,74 years of earnings in debt. It is within the three year range, thus debt is not something I worry about.



Based on my findings thus far, I believe that KLA Corporation is an intriguing company. However, no investment is without risk, and KLA Corporation also has its fair share of risks. One risk is macroeconomics. KLA Corporation relies heavily on semiconductor production. If there is a prolonged slowdown in the global economy, consumers will purchase fewer products that utilize semiconductors. KLA Corporation has already experienced the impact of the slowdown in the global economy, as their customers have started adjusting their capital expenditure plans for calendar year 2023, which were previously focused on capacity expansion. If the slowdown in the global economy continues, it could result in customers choosing to modify, delay, or cancel their orders, which would negatively impact profits. The China Risk. The relationship between the United States and China seems to be deteriorating, which has led to export restrictions on semiconductors to China. It means that KLA Corporation requires an export license to ship products to China. There is no guarantee that KLA Corporation will be granted export licenses, and if they are not granted, it would have a significant impact on the company as they generate 30% of their revenue from China. Customer Concentration. Taiwan Semiconductors and Samsung Electronics each account for more than 10% of KLA Corporation's revenue. KLA Corporation does not provide the exact number, but it could be significantly above 10% as they generate 21% of their revenue in Taiwan and 18% of their revenue in Korea. If KLA Corporation does not successfully maintains satisfactory relationships with these customers, and one or both decide to use products from a competitor, it will significantly hurt the business of KLA Corporation.


There are also numerous reasons to invest in KLA Corporation. One reason is that they are operating in a fast-growing market. The semiconductor industry is expected to grow at a compounded annual growth rate of 12,2% until 2029, which will benefit KLA Corporation. Furthermore, the process control segment is one of the fastest-growing segments within the semiconductor industry, having grown by 30% year over year. KLA Corporation makes 88% of the revenue in the process control segment, which may result in KLA Corporation growing faster than the market. KLA Corporation is also gaining market share, as they achieved a 300 basis point increase in market share in their last fiscal year, and now hold a market share that is four times larger than their closest competitor. Service revenue is growing. KLA Corporation's service business has been experiencing consistent growth, doubling over the past four years, from $1 billion in fiscal 2019 to $2,1 billion in fiscal 2023. Management believes that service revenue will reach $3 billion by 2026. The constant increase in service revenue is driven by the growing number of installed KLA Corporation products. Something to really like about the service revenue is that over 75% of it comes from subscription-based contracts, making it recurrent revenue. Shareholder-friendly. KLA Corporation has an ongoing commitment to returning value to shareholders. KLA Corporation has just announced its 14th consecutive dividend increase, demonstrating its commitment. The other part of the commitment is to repurchase shares. In June 2022, management announced a $6 billion share repurchase program, and this program was increased by $2 billion in July 2023. In fiscal 2023, KLA Corporation utilized 61% of its free cash flow for dividends and share repurchases. Furthermore, the management has set a goal to return 85% of the free cash flow to shareholders in the long run. Thus, dividends and share repurchases could accelerate in the future.



Now it is time to calculate the price of shares in KLA Corporation. I perform three different calculations that I learned at a Phil Town seminar. 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 24,15, which is the one from fiscal 2023. I have selected a projected future EPS growth rate of 10% (management expects to grow between 9% and 11% per year). Additionally, I have chosen a projected future P/E ratio of 20, 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 $309,67. 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 $154,84 (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 3.670 and capital expenditures were 342. 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 239 in our calculations. The tax provision was 402. We have 136,75 outstanding shares. Hence, the calculation will be as follows: (3.670 – 239 + 402) / 136,75 x 10 = $280,29 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 $24,26 and a growth rate of 10%, if you want to recoup your investment in 8 years, the Payback Time price is $305,18.


I believe that KLA Corporation is an intriguing company, and I also have great confidence in its management. KLA Corporation may face some short-term headwinds due to macroeconomic factors, but this doesn't concern me much, as I believe that macroeconomics will eventually improve. Customer concentration is always a risk, but KLA Corporation currently holds the largest market share. There doesn't appear to be any compelling reasons for their customers to switch to another provider. The China risk is very real, as the relationship between the United States and China continues to deteriorate. If we encounter additional restrictions in the future, it could have a substantial impact on the profitability of KLA Corporation. Thus, it would be something worth monitoring. However, I believe that the potential far outweighs the risks. KLA Corporation operates in a growing market and is gaining market share. As more KLA Corporation products are installed, there will be an increased need for service, resulting in the growth of their recurring service revenue. Furthermore, KLA Corporation has a very ambitious goal of delivering value to shareholders. Not only will they return a larger share of the free cash flow, but the free cash flow has also been growing. I will definitely purchase shares in KLA Corporation if it reaches the intrinsic value of the margin of safety price at $309,67, which is slightly higher than the discounted Payback Time price. I may consider adding KLA Corporation to the portfolio at a higher price.


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