Good afternoon, and thank you for attending JPMorgan's fortieth Annual Technology Media and Communications Conference. My name is Harlan Sur. I'm the semiconductor and semiconductor capital equipment analyst for the firm. Very pleased to have the team from KLA here today. Rick Wallace, President and Chief Executive Officer Brent Higgins, CFO Kevin Kessel and Ed Lockwood of the IR team.
I've asked Rick to kick us off, with some opening comments, and then we'll go ahead and start the Q and A. Be sure to click the Q and A button on your Zoom window if you want to ask a question. With that, thanks, guys, for joining us. And with that, let me turn it over to Rick.
Good afternoon, everyone. Thank you, Harlan, for the introduction. This is obviously quite different than prior conferences, but one thing that hasn't changed is I have to start with a safe harbor statement. So everything I say will be, covered by that, and we will make some forward looking statements. I think the theme of the day for KLA or for the month is really it's about our resiliency.
And I think what you've seen in the last couple of months, we announced our earnings last week, is how we were able to perform in a in a really unprecedented environment. And I attribute that to the ability that we've had as a company to really hone our operating system, the KLA operating system, which is really the driving factor for managing all our businesses. And of course, we had challenges early on to navigate the supply chain. We talked about that at our call. But what was really gratifying through the March, and we're seeing extended now, is the support by our customers and the interest in our equipment and and really the partnership we've had with our customers around the world to enable them to continue to make their investments in their technology transfer and their ability to to work on new technologies and advance their road maps in addition to support their capacity needs.
So we had a strong quarter. We talked about at the earnings call, we left the March with record backlog. And, we felt feel really good about where we're positioned. We also had a strong market share in 2019. The Gartner report came out, and we gained share.
And we attribute that to our engagement with our customers and, the technology innovation across the company. So we feel well positioned. There are certainly gonna be additional challenges in this, COVID world that we're all dealing with. But thanks to the outstanding work of all our employees across KLA, and I'd really like to recognize them as well as, our interactions with our customers. We feel like we're gonna be in a strong position to be able to support our customers as they navigate these, these choppy waters.
Great. Thanks for the opening remarks there. On resiliency, I think we should start up there because I think it's very, applicable here. Gale team seems to be navigating COVID nineteen relatively well, drove better earnings in the March, strong free cash flow, putting forth a relatively strong forward guidance. Although the range of the guide was rather large, you did mention, you know, more logistical personnel related impacts, installs, and qualifications and the likes.
Maybe you can just help us understand what cost impacts you're occurring due to COVID nineteen, whether it be related to social distancing, logistics, freight, and so on. But, specifically, my question is, I would have expected a bigger impact to the gross margins, but the team is still holding gross margins at a very strong 60% plus level.
Yeah. I'll let Bren take that one.
Yeah. Hey, Harlan. Nice to see you. It it it is, I think we've done a pretty good job with things overall. We are incurring costs related to some of the things you talked about.
There are expedite fees. There are logistical costs. So those are things that we're we're dealing with. I would not classify them as as at a material level overall, and they're embedded in how we're thinking about our guidance. From a resource perspective, we are running our factories as we generally always have.
And so what that means is is that we build our our tools and bays, and we're able to comply with social distancing and other protocols. Clean rooms are very safe spaces to be in general. And and given the way the tools are built, we haven't had to add excess resources to, to comply. We are adding some extra resources into the field, teams locally as we deal with quarantine periods and travel restrictions, and we can't leverage our centralized teams to support customers. So all that's embedded in the guidance.
We're dealing with it. I I would say that, you know, it's probably, you know, less than 5,000,000 in in aggregate impact in a given quarter. But, like I said, it's it's contemplated in our guidance. And our our margins tend to move around mostly by by product mix type factors more so than than any sort of period type expense like this. So we're dealing with it.
And, ultimately, those resources get absorbed in the into either our our service business or or absorbed just into our factory teams as we manage our growth moving forward. One thing that is also contributing, I think, to the good performance of the company is the strength of the service business. We continue to see growth in service. Service provides an accretive revenue stream to the company. And so we've been pleased with the ability to continue to execute that.
And given the global infrastructure we have and resources and staffing that we're able to continue to support our customers as they they run their facilities even in the impacted areas where the facilities continue to run.
Great. Yeah. I mean, strong execution on the, supply and operations side. On the demand side of things relative COVID nineteen, has the team seen any customer spending time line starting to push out?
The the, we noted this on the call. I think, by and large, it's been remarkable in terms of our customer behavior. And I let me quantify that. Really, our large customers that are driving, most of the spending are sticking with their plans, and we're certainly seeing strong demand. We've talked about exiting with record backlog.
And they also talk about continuing their plans as they look forward for new technology node and transition. Obviously, there's a softness in the semiconductor supporting the automobile industry, which would be the one sector that we think we were hoping in 2020 was going to resume growth, and now that's going to be deferred. But it's almost been made up by the other drivers. And I think the work from home and virtual world that we're in now has driven a lot of our customers to being supported in those efforts, which is driving demand at at a level that's really remarkable, given everything else that's going on in the environment. So no, we have not seen that.
We've had conversations. We widened the range mainly because of how much we just don't know about how this is gonna this health crisis is, of course, gonna be common has already become an economic impact to the the world economy, and we just don't know how to how to handicap that, and hence, the the prudence around the range. But, no, our conversation with customers continue to be very positive. We've had a lot of interactions. They were quite happy and surprised, frankly, at our ability to support them.
And
we got a lot of positive feedback from them on that, both in terms of service, but also new tools installation. And I I think it has, we've strengthened our partnership with them because we're really helping them in a time where, they're, of course, trying to keep their factories running. As Bren said, they they're doing that. But, no, so far, demand looks good. We haven't forecast the year, as you know.
And and we'll have to see how the quarter develops in terms of, I think, the economy in general before we're able to really weigh in on on how the second half will look.
If you break it down by segments, Harlan, I think if you look at logic and foundry and the breadth of investment that's happening there, a, that business tends to be pretty focused on certain nodes, supporting certain customers. And so we've seen some breadth of that investment, and, we continue to expect to see that over the course of this year. As we move into the second half, you know, the memory business is interesting in that. It's really been somewhat soft since the 2018. So we're coming into 'twenty after pretty significant corrections in that part of the of the overall semiconductor environment.
And so I think our customers are in a place where they can continue to invest. Certainly, they're gonna do things to progress their road maps. And as we look at the second half of the year, I think that's probably the part of the business that might be more sensitive to demand changes for them that might influence their plans. But they've been very disciplined for a long period of time. They have facilities.
So, I think it's been fairly well managed so far. So I think that's why we're seeing the signals that we're seeing. But, clearly, with the caveat that the second half is is a bit of a question for everybody. But internally, you know, we see things holding up. And as we said, not much different today than what we thought three months ago overall with the exception of the couple markets that Rick talked about.
And so let's go with that. So if we if we look at the the profile that you see today, you've described this year's WFE spending profile, as you mentioned, fairly balanced on the foundry and logic side with strength here in the first half continuing into the second half. You've discussed the potential for improved memory in the back half of the year, obviously, with the caveat that macro weakness could result in lower investments there. First question on the sustainability of foundry and logic into the second half. Is it being driven by a broadening of spenders beyond your large foundry customers?
And then second question is on the second half bias on memory spend, is that more NAND or DRAM biased?
So so yes, to answer your question, it is a broadening of investment into the second half. And there are product cycles that tends to drive leading customers to invest the way that they do. But you are seeing a broadening of investment that gives us some confidence around how that will play out in the second half. Pretty balanced. I think that certainly to Rick's earlier point, the drivers around work from home has influenced, I think, the DRAM space a little bit more.
So I think that that that part is a little bit more insulated from some of the consumer dynamics that you might see on the NAND side. So as I look at it, I I probably handicap it a little bit more that way, but but pretty balanced into, into the second half.
Great. And then something that you touched upon on the earnings call, but we wanna kinda revisit based on the environment. Could be your interpretation could be changing. But with the recent Department of Commerce, BIS, initiative on licensing requirements for equipment shipments to China, that could be used for defense purposes, your interpretation last week was that it would probably only impact tools that are manufactured in The US, which would include sort of your some of your flagship products like your broadband plasma and mask inspection based platforms that are manufactured here in the Bay Area. Again, it's only been a week, but I'm sure that you've gotten more clarity.
Any any changes to your prior view?
Let me, start, and then Brent can can fill in some of the details because he's got a lot of the specific about what we already have to do. I I think in aggregate, we're getting a little bit more clarity, but it's still pretty vague in terms of the the way to interpret it. And as we work through the details of that, I think, the the intent is is clear, but the implementation is the part of that that we're still working through. But I would note a couple things. Our leading edge tools, by and large, are not shipping into China.
What we're shipping is is, tools in in the most part. Take even the flagship, the VPP that you talk about. We're really talking about tools that are several years old in terms of when they've been introduced, that that, model into the market. And and that's you know, the example in lithography would be EUV isn't being allowed to be shipped into to China, and so our tools that would be on a level of that. So that's a very small part of of what we're looking at.
So if you're talking about really leading edge enabling, which historically has not been the focus has been on concern about selling directly to the military and also enabling leading edge tools. I would say in aggregate, that's not a big part of what the Chinese customers have been buying from us. And then we can already talk we can talk to the military implications, shipping the military based on what we already have to do, and that's an area that Bren's very plugged into.
I mean, we we already have to to to assure that that our tools aren't being used to to build military products. The definition in the most recent order are is broader about just military customers. And and and to the earlier point, we'll see how it ultimately, plays out over the next few months as some of these issues are surfaced, we work with our peers to to to bring up some of the complexity that's that's in, that's in the order. But so we're already at that place already. And so what you would have to do is you go through a diligence process of of seeing if if if customers are are selling to military customers or not.
And if that diligence process says yes, then you have to get a license. If it doesn't, then you then you can continue to ship as as normal. So now we'll see if any of this changes or not, but that's generally how what the what the rule says, and we'll have to see. I think there's a couple points also that when you think about the composition of of the investment that's happening in China today, There's there's the memory composition, which is more commodity like products. To Rick's point, in all cases, everything more trailing edge versus leading edge.
And then on the foundry logic side, more application specific, most of it more trailing edge. And then there was also materials investments, investments in wafer capacity and reticle capacity to support, the overall infrastructure. In a lot of those cases, those are new facilities, and, so don't really have customers So there's a lot of dynamics there that we'll have to understand. Obviously, we're gonna do everything we need to to comply, with, with the regulations.
And, you know, we'll we'll see where we end up in a couple and and then we'll have a better visibility in terms of the impact both near term and long term. Could be just an administrative dynamic, but but we'll have to just see how it plays out.
Great. And, you know, the team does have fairly large operations in Singapore. Whether it's because of trade or just overall good business continuity planning, how feasible is it to move production of some of your, you know, high value add reticle and EBP optical tools to this location if need be?
Let me let me take the first part and then, let Bren fill it in again. So years ago, we started to, we made an effort, I'd say probably fifteen years ago, to make our ability to produce products both in The US was where we originally were almost everything was produced. And we built out Singapore, to your point, but also Israel. So we have a large operation in Israel and in Singapore. And what we demonstrated over time is very efficient ability to transition products and even subsystems to the different factories around the world.
So our process and our procurement process is one that really enables us to do that. And it's really a matter of choice of a number of factors that determine where we do that. There are already aspects of BBP, of the BBP tool that are there are parts of that subsystems that are built in Singapore. So it's not a major, effort to transition because those factories are up and running in both cases, and it's been a pretty standard practice. And then Bren can, fill that out a bit.
Yeah. They're they're mature operations. And and if you look at what we do, I would say that the level of there was probably a time where, you know, what we moved to Singapore was and and even to Israel was was less complex products. But we started those operations about fifteen years ago and and certainly in Israel, like, in that case, lot a lot longer ago than that. And so I would say that today, we are capable of building the most complex systems in the company just about anywhere in the world.
So if you look, for example, we're building the new Axiom three d metrology tool. We're gonna build that in Israel. So there are a lot of factors that go into why we build what we build where. And to Rick's point, we do subsystems in certain places, and it's typically, there's there's cost elements, but there's also capability, and there's, there's supply chain and proximity to customer aspects of of of those, I'd call them, more operational drivers for why we do what we do. So, certainly, we we have the flexibility to do that, and and we're always looking to optimize our footprint, about what we do where.
And so it's not stuff that's that's transferable overnight. But certainly, to Rick's point, we we've demonstrated the capability to be able to, to move and pour products if if we decide to do that.
Great. Thanks for that. Rick, you know, on the earnings call, you expressed high confidence on sustained process control intensity this year. In your foundry logic market, clearly, leading foundry supplier has steadily moved down the path of Moore's Law, and the equipment industry and KLA has certainly benefited from the aggressive technology migration cadence. Now it looks like one of your large logic customers is finally executing on getting back to a two, two and a half year cadence on node migrations after almost a four year pause and probably much reuse.
Now now that you have multiple large customers, boundary and logic, moving at an aggressive cadence over the next few years, is this contributing to your confidence on sustained process control intensity, not just for this year, but going forward?
It is. Those are those are really good observations, Harlan. I think if you look at the, the delay, this kind of lithography holiday where there was no real advancement in the wavelength and and there was no EUV for a number of years, scaling, even though there was progress made, scaling has kind of resumed to your point. And on top of that, because of the cost effectiveness of the advanced nodes, I think you're seeing more customers, more design starts happening, which is what's driving, I think, these players to to invest and provide more than having just one supplier of that. And, of course, the combination of more advanced designs, new lithography technology, and higher mix, all is good for process control.
And it's been coupled with the successful introduction of our new capability, not just VBP, which I'm sure we can talk more about, but also the other tools that we've had. And I think that's what's been driving it. We did see a strong year in market share in 2019. And a lot of that was associated with some of our new capability winning some early decisions at customers that we think will then scale as we go forward into larger share and also higher process control. So we feel very good about being validated on those investments that we've been making over the years.
Great. And then on the market share front, I mean, the team had another solid year in 2019, gaining nearly 300 basis points of share in core process control. You're now almost five times larger than your second largest competitor. How should we think about share over the next few years, especially considering new pool offerings such as EVM inspection, X-ray metrology, and just the overall r and d scale that KLA has over its competitors?
I I think it's a very interesting question. I mean, this industry is made up, in general, with the large players over time and, often get bigger because they have this natural flywheel advantage of R and D spend and innovation driving, and and you have a you have a disproportionate amount of available money to spend on R and D. And I think that we last year, really, the big story last year was not just the strength of reticle inspection, which was significant because it was part of all the new designs that were happening at the advanced nodes, but also the resurgence of BBP and the broadening of the Gen five customer base to more production areas, which was driving, I think, a lot of questions people had. And we could talk about optical e beam too, I'm sure. But this was a real demonstration of early innings of the broadening of BBP.
And I think we feel good about where that can go because that product is still new in terms of it's a couple years in, but the general lifetime of a generation like that could be ten years, and and it's been longer for Gen four. So we feel like we're in really good position. Our customers are excited because we're giving them capability that they didn't know was gonna be available at the kind of cost of ownership. There was that concern in the industry a few years ago that to support these nodes, you'd have to be on e beam. And we've demonstrated that, e beam continues to be a niche part of that segment.
And in in our case, we'll use it to guide some of the more advanced optical inspections, but that's been largely why. And then you mentioned the metrology. The metrology challenges aren't getting easier either. And that's not just logic. That's also in memory.
So we feel good about both of, both our metrology and inspection business. And I think there's a long way to go in terms of customers continuing to have confidence. I have to say that these last few months, we've heard from a lot of customers. I think it reinforced their confidence in dealing with KLA, and I think that's a positive going forward because we were able to deliver when others didn't, and I think that that was very important to them.
Let's, along those same lines of share, I mean, EUV, EUV mask inspection has been a great story for the team, driving strong investments in your mask inspection business as well as your wafer inspection for EUV mask print check. Your reticle inspection business grew almost 40% last year. You gained 500 points of share. You own 60% of this market. And despite your share gains, your R and
D
scale, your leadership in the mass shop, there still seems to be quite a bit of competitive noise out there. Help us understand your road map for EUV mask inspection over the next several years and your plans to bring an at wavelength, a kinetic inspection platform, to the market.
Yes. That that's a well put. I think we we had success. I I think we early on in in our, maybe as we grew up as a company, I remember before the Tencor deal, you know, we tried to push really hard on Brightfield inspection for every application. And and Tencor had Darkfield inspection.
And and really the story that that told us is once we had both, we really recognized the customers really have to have the best cost of ownership solution to solve the problem that they can have. And once we became a portfolio company, we quit trying to push just the latest technology that may or may not be appropriate for the job. And I think what we're seeing, and this is a recurring theme, is if you're only doing e beam inspection, what you have to do is tell the world that the world only needs e beam inspection. And so if you're only doing actinic reticle inspection, of course, you're gonna tell the world that that's what they need, and you can create some buzz around it. The truth is what our customers need is the most cost effective way to solve their problems that you can possibly get.
And the benefit of a portfolio is we don't have to dictate a point solution for any application. So the reticle inspection is a great example. If today people had an actinic reticle tool for EUV, it would be overmatched and overpriced, and the cost of ownership would be too high for the job that needs to be solved. And the job that can be solved can be solved with a six x x and a print down to verify the with the Gen five that you're really finding the defects that matter. There will be a time when we need actinic inspection for EUV, but it'll be concurrent with high NA EUV.
That's not gonna be for at least three years in in mass production. So right now, the customers the reason they're choosing to buy from KLA, it's the most cost effective solution for them. So we keep trying to we we end up historically, we've always battled a point answer that looks to be a leading disruptive technology. But and and even our customers might get excited about that idea, but they keep coming back to what's the most cost effective way to to solve the problem. And that's why, you know, back to the optical e beam example, If you can do it optically, you'd much rather do it optically than by e beam.
If you can measure a mask and with a six x x and a and a print down with a Gen five, that's a better solution until it's not, until it doesn't work. And when it doesn't work, that's when we will have the Gen five or the EUV reticle. But before that, we'll have a multibeam e beam tool to measure the reticles in the mascouse because that's the next best solution in terms of cost of ownership. So so I really think the portfolio solution allows us to think more along the lines of the economic buyer and our customers and less about just the technologist that wants the latest generation.
We have a appreciate that. We have a question from, one of, one of the investors. Question is Intel has petitioned the US government to expand the semi industry in The US, potentially at the expense of maybe some of the offshore foundries, how does that theoretically shift or impact the share or potential economics to KLA?
So we're we're in the fortunate position, that our market share is nominally the same everywhere in the world. It really doesn't matter where a factory has been built. Now I would like to believe that, we could compete anywhere in the world. So if it was in The U. S, we do very well here.
The issue is for doing that, unless it's a very large investment, it won't have the efficiency and the scale that you would need to be competitive with some of the operations in Asia. And so in aggregate, I think it's at worst case even for KLA because we will fight and win the business either place. In some cases, it might actually be better because the efficiency of that fab is unlikely to be as efficient as what it is in in those mega cluster of fabs that are happening right now in Taiwan.
Got it.
And then Carl, a lot of a lot of efficiency over the years has come from the consolidation of customers and scaling to big mega fabs. And that's what's kept WFE from growing all that fast. And all that efficiency has played out. You introduced this. This turns to make it maybe a little less efficient, which means less, you know, less efficient, which means more WFE growth associated with it.
And to Rick's point, given our market position, that's a a positive for for KLA from that point of view.
That's on the product side. You know, in your flagship, optical pattern wafer inspection franchise, it it does appear that, again, you know, the bare case thesis on optical inspection being overtaken by e beam really isn't playing out. In fact, you know, the team continues to strengthen its hold on the optical market with advanced systems like Gen five, for example. In the meantime, PLA did introduce first time in five years. How is the team going to capitalize on your leadership in Optical to drive synergies with your new e beam platform, either sustain or potentially even grow your leadership in the overall wafer inspection market?
It's a great question. And we said all along, we always felt there's a market for e beam inspection. We were always clear on on the the challenge we thought that that market had. There was a size of that market, but it was not going to overtake optical, partly because of you can continue to improve the optical tools. And I can tell you, there are several generations or at least, improvements we can continue to make to optical to make sure that that, continues to be the primary tool.
However, a directed e beam tool that has, the capabilities that we have in this one and some of the same algorithms that we have can help in terms of some of the engineering analysis and a few layers in the application, specifically for some certain defect types. And that will be why I think we're seeing early success. We have a, we think, a superior e beam architecture, but also it's the coupling that will enable us, to optimize further the optical tool and then also give feedback to the e beam tool with especially leveraging the algos that we have. So we think that will be a place, and that's part of the growth story that we laid out, the relatively modest growth story we laid out in terms of our overall process control portfolio for the 2023 timeline. And I know Bren has spent a lot of time looking at this as the CFO to make sure that investment was rational.
What's old you?
Well well, one thing I think you have to even if you even further segment down within e beam inspection, you have a electrical defect test voltage contrast that happens within e beam and also small physicals. Our our tool is focused on the physical defect part of it because we think that's how we enable and increase the relevance of of the optical capability. So in a scaling environment where smaller defects matter, we can use this connectivity across the tools, and some of the machine learning algorithms that are built into the tools to try to use that to point the optical inspectors to make them even more valuable to customers. So you couple that that higher signal to noise, if you will, with production level throughputs, and it's pretty compelling from a from an overall high end pattern inspection point of view. So so it's really about enabling that part of the market opportunity for us.
And we certainly saw some of that momentum in 'nineteen, and I would expect to see even more in 'twenty based on just what we're seeing with optical. And that doesn't include the print check application that Rick talked about earlier, which is about reticle qualification for EUV. So it's created some opportunities for us, and we think ultimately will drive the relevance of optical inspection, which is the strongest market or biggest business in the company.
Let's talk about capital return. When I think about KLA, lots of different differentiators, right? Look the financial profile, 60% plus gross margins, you know, well north of 30% plus operating margins, high twenties free cash flow margins. You've got the leadership in the plus control. But, also, capital return has been a big differentiator for the team.
Right? You have the stated goal of returning 70% to 75% of free cash flow to shareholders. Your payout ratio was over 100% in the March on 28% free cash flow margins. Very strong, I would argue, in a very tough environment. How should we think about the buybacks and dividends as we move through the year even if fundamentals do weaken in the second half of the year?
Well, if you back up, I mean, we've been pretty consistent for the last ten years in terms of how we think about deploying the capital of the company. And to your point, we either deploy it back into our business, which is our number one priority or achieving our growth objectives from an inorganic point of view. And then and then putting what what is unallocated back to work in terms of returning to shareholders. We have a pretty deep understanding of what it takes to run this business, how much liquidity we need, why we have the level of debt we do in the capital structure. And so that allows us to really to have a long term perspective and think about different different demand environments about how we think about deploying cash and returning to shareholders.
So the dividend, the dividend, we target a payout ratio through cycle of about 35%. We have a goal to to grow the the dividend payout at the rate of the growth of free cash flow for the company. So with our expectations for top line, the operating leverage in our model, we should be able to grow our dividend payout over 10%. And our our track record's been higher than that, over the last ten years, but that's generally our our target. And with the payout ratio we have, that even in difficult environments, we can still, maintain a regular cadence.
It gets valued if it's predictable in terms of, the growth plan and how it's managed, and so we try to be fairly explicit about that. Certainly, times like this, there you you do have the ability to turn on and off, share repurchases. We do believe that we will consistently deliver over 70%. We're being more prudent today, obviously, with some of the questions overall in the market and and the general economy about, our share repurchase activity. As you said, it was pretty high in March.
It was also pretty high in December. And most of our free or our share repurchases are funded out of ongoing cash flow from the business just given the level of cash we have. So, we'll continue to be prudent, but the long term strategy is intact, and and, we don't think about it any differently because of the situation we're in because we built it in a way that tested it against good and bad or potentially bad environments.
We're just about out of time. Rick, Brent, Kevin, Ed, appreciate the insights. Keep up the great execution, and thank you for participating in our conference.
Thanks for having us, Harlan.
Glad to meet you.
Thank Take care. Stay safe.