With Quiver Quantitative’s recent institutional holdings data, we can see that hedge funds and asset managers have been increasing their holdings in KLA Corporation (NASDAQ: KLAC). Firms such as T. Rowe Price, Fidelity Investments, and Alkeon Capital Management have all added to their KLAC positions recently. Most notably, Fidelity Investments increased shares held by around 1.5% (as filed on 6/30), bringing their total KLAC holdings to 2,830,623 shares worth around $1.38 billion dollars at current market prices. With this in mind, we took a closer look at some of the reasons why many investors may be bullish on KLA Corporation.
In July, KLA Corporation posted strong earnings results for the fourth quarter of the fiscal year ended June 30th, 2023. In Q4 of FY23, KLA Corporation posted total revenues of $2.355 billion dollars, with a net income of $685 million dollars and a net income per diluted share of $4.97 dollars per share. This is compared to Q4 of FY22, where KLA Corporation posted total revenues of $2.487 billion dollars, with a net income of $805 million dollars and a net income per diluted share of $5.40 dollars per share. While the fourth quarter of fiscal year 2023 was weaker than the fourth quarter of fiscal year 2022, these earnings results exceeded expectations, demonstrating the strength of KLA Corporation’s portfolio, focused operational execution, and high-performing teams in what remains a challenging demand environment for the business.
In addition to these earnings results, KLA Corporation also posted guidance for the first quarter of fiscal year 2024. KLA Corporation is guiding total revenues at $2.35 billion dollars (+/- $125 million dollars), with GAAP and Non-GAAP gross margins being guided at 59% (+/- 1%) and 61% (+/- 1%), respectively. Additionally, GAAP and Non-GAAP diluted EPS are being guided at $5.02 (+/- $0.60) and $5.35 (+/- $0.60), respectively. With these relatively strong earnings results in mind, we believe that KLA Corporation is a compelling investment opportunity currently trading at a fair valuation.
KLA Corporation (NASDAQ: KLAC) is a supplier of industry-leading equipment and services that enables innovation throughout the electronics industry. KLA Corporation provides advanced process-enabling and process control solutions for manufacturers of printed circuit boards (PCB), flat panel displays (FPD), integrated circuits (IC), packaged ICs, wafers, reticles/masks, and chemicals/materials. In addition to these solutions, KLA Corporation also offers comprehensive support and services across their installed base. The business’ suite of advanced products, coupled with their distinctive yield management software and services (in the context of semiconductors, yield management refers to the process of maximizing the number of fully functional chips produced from a batch of raw materials or wafers), allows KLA Corporation to deliver the solutions their customers need to achieve their productivity goals. These products and services significantly improve yields and reduce waste, risks, and the costs associated with chip manufacturing, increasing their customers overall profitability and return on investment.
KLA Corporation was formed in April of 1997 (then known as KLA-Tencor Corporation) through the merger of Tencor Instruments and KLA Instruments Corporation, two long-time leaders in the semiconductor capital equipment industry. Both KLA Instruments Corporation and Tencor Instruments began operations in 1975 and 1976, respectively, bringing decades of experience together to form KLA Corporation. KLA Corporation is broken up into three segments which include Semiconductor Process Control, Speciality Semiconductor Process, and PCB, Display, and Component Inspection.
The worldwide market for advanced process-enabling, process control, and yield management solutions used by electronics and semiconductor manufacturers is highly competitive. Management acknowledges that competitive factors for this industry include system performance, reliability, ease of use, technical service and support, and overall cost of ownership. Management also goes on to further acknowledge that their customers' overriding requirement is for systems that effectively and easily incorporate automated capabilities into their existing manufacturing and development processes to improve yields, enhance productivity, and reduce waste. To remain competitive in this industry, KLA Corporation uses significant financial resources to maintain customer service and support centers worldwide, offer a wide range of products, and invest heavily into R&D capabilities. Additionally, KLA Corporation continuously evaluates strategic alliances and acquisitions to enhance their technology, distribution, and product offering capabilities.
One thing for investors to note before entering a position in KLA Corporation is that the business requires the sourcing of raw materials and parts where supply chains can be shaky. For example, many of the raw materials come from areas of the world where political instability is high, jeopardizing those supply chains. Additionally, management acknowledges that sourcing these raw materials from multiple suppliers can be difficult, further adding to supply chain uncertainty. While this may be a red flag for investors, this supply chain risk is largely mitigated by KLA Corporation, who monitors the financial condition of their suppliers, provides financial support and incentives to encourage vendors to increase capacity when needed, identifies potential alternative suppliers, and ensures adequate inventories of key parts and raw materials are available to maintain manufacturing schedules. Again, while the dependence on raw materials (especially those with a weak supply chain) can be a red flag for some investors, we think that KLA Corporation does a great job of mitigating these risks.
Management is solid and their capital allocation priorities align well with shareholder interests. In June of 2022, KLA Corporation executed an accelerated share repurchase agreement (ASR) with two financial institutions to repurchase the business’ common stock in exchange for an upfront payment of $3 billion dollars. In the fourth quarter of fiscal year 2022, the company received initial deliverables totalling 6.5 million shares of common stock, representing 70% of the prepayment amount. These initial shares delivered from the prepayment agreement were retired immediately. Management acknowledges that share repurchases help reverse the dilutive effect of the business’ equity-based compensation plans. As of June 30th, 2023, there was still approximately $2 billion dollars available for further share repurchases under the business’ share repurchase program. In addition to these share repurchases, KLA Corporation also offers a quarterly cash dividend of $1.30 per share, first announced earlier this month. As we can see, KLA Corporation returns value to shareholders via share repurchases and a quarterly cash dividend offering, reversing the dilutive effect of the business’ equity-based compensation plans and aligning shareholder and management interests well.
As for management incentives, management is incentivized well, with a compensation structure that aligns management and shareholder interests very well. For fiscal year 2022, KLA Corporation’s compensation structure for NEOs pays out 5% of total compensation in the form of a yearly salary, meaning that 95% of the NEO total compensation plan is at risk, incentivizing management to perform very well. The remaining 95% of the total compensation plan includes a bonus (15% of total compensation), restricted stock units (32% of total compensation), and performance-based restricted stock units (48% of total compensation). With a very high portion of total compensation coming from equity rewards, KLA Corporation is able to retain executive talent long-term. Additionally, with executives and management building up equity in the business through their compensation structure, management and shareholder interests are well aligned, as management has skin in the game regarding the performance of the business’ shares. Performance-based restricted stock units are based on a relative free cash flow margin objective, ensuring the business’ ability to efficiently generate cash from its operations. As we can see, management is incentivized well, with a compensation structure that allows management to build equity in the business, further aligning shareholder and management interests. Furthermore, the compensation structure incentivizes performance, with 95% of total compensation being at risk based on factors like a relative free cash flow margin objective that ensures the business’ operational efficiency and ability to generate cash from revenue. With a free cash flow margin objective, management is incentivized to ensure the generation and growth of free cash flow, which can then be used to repurchase shares, increase the quarterly cash dividend, or reinvest back into the business, rapidly compounding intrinsic value and rewarding shareholders handsomely.
KLA Corporation is a very efficient business. KLA Corporation currently operates at a LTM ROE of 156.9% and a LTM ROIC of 42%. With a WACC of 12%, KLA Corporation operates with a ROIC to WACC ratio of 3.5x, showcasing the business’ ability to generate returns on cash far greater than their cost of capital. Furthermore, with such a high ROIC to WACC ratio, the business is able to efficiently reinvest cash back into the business, allowing KLA Corporation to rapidly compound it’s intrinsic value over a long time frame and handsomely rewarding shareholders in the process. Looking further at efficiency metrics, we can see that ROIC has expanded over time, potentially signifying that the business holds a strong competitive advantage within their industry. In 2014, KLA Corporation operated with a ROIC of 17.5%, compared to today where the business now operates at a LTM ROIC of 42%, one of the highest return on capital figures amongst competitors.
Analyzing KLA Corporation’s income statement, we can see some stellar sustained growth in revenue, gross profit, and earnings within the last decade. Since 2014, KLA Corporation has grown revenue at a CAGR of 13.4%, with gross profit growing at a CAGR of 13.2% in that same time frame. The growth in gross profit can largely be attributed to expanding gross margins. In 2014, KLA Corporation operated with a gross margin of 57.9%, compared to today where the business operates with a LTM gross margin of 59.8%. As we can see, KLA Corporation is a high margin business, with an average gross margin of 60.1% since 2014, showcasing the business’ ability to generate profit from revenue. In terms of earnings, KLA Corporation has grown EBITDA at a CAGR of 17.8% since 2014, with EPS growing at a CAGR of 21.3% in that same time frame. The growth in EPS can largely be attributed to share repurchases. KLA Corporation is a cannibal, decreasing shares outstanding by 17.3% since 2014.
Looking at KLA Corporation’s balance sheet, we can see that the business operates in sound financial health. KLA Corporation currently holds around $1.92 billion dollars worth of cash and equivalents and also holds around $1.31 billion dollars in short term investments, bringing their total cash and short term investments to $3.24 billion dollars. In comparison, the business also has around $5.89 billion dollars in long-term debt and no short term borrowings, showing that the business operates at a manageable long-term debt to cash ratio. Additionally, the business operates at an EBIT / Interest Expense (interest coverage ratio) of 13.44x, signifying that for every dollar of interest expense that the business incurs, KLA Corporation generated $13.44 of EBIT, showing that the business has plenty of runway to comfortably pay off its debt obligations.
Looking at KLA Corporation’s cash flow statement, we can see some stellar sustained growth in free cash flow and net income within the last decade, showcasing the business’ ability to generate cash from revenue and the business’ operational efficiency. Since 2014, KLA Corporation has grown its net income at a CAGR of 19.2%, with free cash flow growing at a CAGR of 16.7% within that same time frame. The growth in free cash flow can largely be attributed to expanding free cash flow margins. In 2014, KLA Corporation operated with a free cash flow margin of 24.4% of revenue, compared to today where the business operates at a LTM free cash flow margin of 31.7% of revenue. With expanding free cash flow margins, KLA Corporation is able to generate more free cash flow from revenue, which the business can then use to repurchase shares, increase their dividend offerings, or reinvest back into the business.
After conducting a reverse discounted cash flow analysis, we can see that KLA Corporation is trading at share prices that imply a 8.1% growth rate in free cash flow over the next ten years, using a perpetuity growth rate of 3% (largely in line with US GDP growth) and a discount rate of 10%. We believe that this free cash flow growth rate is a fair growth rate for the business to be trading at, especially considering that they operate within the fast growing semiconductor industry, an industry that has received favorable tailwinds from the rapidly growing artificial intelligence and AI-related technologies industry. KLA Corporation has grown free cash flow at a CAGR of 16.7% within the last 10 years, and while past results do not indicate future performance, we believe that an 8.1% growth rate in free cash flow is very attainable given the business’ expanding free cash flow margins over the last decade or so. Additionally, with Factset placing a 9.1% long-term growth rate on the business (based on analyst estimates), this growth rate in free cash flow implied by current share prices is slightly below analyst estimates, further adding credence to the point that this growth rate implied by current share prices is very fair. Expanding free cash flow margins and the continuation of the AI technology boom will act as catalysts for free cash flow generation and growth going forward, and we believe that these catalysts will provide positive tailwinds for KLA Corporation and the semiconductor industry in general.