Great. Thank you. Welcome back. I'm Joe Moore from Morgan Stanley. Very happy to have with me today, Bren Higgins, the CFO of KLA. Bren, let's just jump right in. Can you talk a little bit about process control in a kind of more challenging environment like we're seeing now? You guys have traditionally seen process control generally rising over time anyway, and certainly in these types of environments accelerates. Can you talk about the drivers of that and, you know, You've talked about this year as a kind of 20% WFE decline. You know, how are you guys feeling about your prospects around that?
Sure. Sure. Thanks, Joe, for having us. Appreciate being here. I'll make forward-looking statements, and those are covered by our safe harbor statements. You can find our risk factors on our website. I encourage you to take a look at them. 2022 was a strong year, and if you just look back at what was really the strongest upturn we've seen over the last few years. You look at WFE growth rates that were 21% CAGR, you know, from 2019 - 2022. Against a backdrop of an overall industry, even with semiconductor revenue at, you know, 2x GDP, you would expect to see, you know, some normalization.
We had a great year in 2022 as a company. I know a lot of focus here going forward. As we look back and we effectively took the company from $5 billion - $10 billion from 2019 - 2022, I think it's a testament to the scalability of the operating model. Over that timeframe, our incremental operating margins were 51%. We saw a nice leverage in drop-through. Our relative performance last year was very strong. Our service business continues to grow and all this new equipment and all the demand at the legacy nodes is driving more service utilization, which is also good, and that's been good for service as well.
Our EPC business, which is the more than more part of KLA, I like to call it, and it includes our specialty semiconductors, but our packaging businesses, our flat panel business. We had a decent year in 2022. It's closer to consumer, so we felt some of the softness that we're experiencing now a little earlier there, but we still had growth near double digits in the system, part of that part of the business. We saw overall share of WFE grow pretty meaningfully over the course of 2022. To your point, over the last couple of years, we've seen it move. Part of our Investor Day presentation we did last June was talking about the drivers of how we would see that continue to grow.
We're ahead of that pace, and we certainly saw again the strong performance last year. As we look at 2023, though, we're in a more challenging environment, WFE down roughly 20% or so. We feel pretty good about our ability to maintain our share of the overall market. If you look at in down environments, first of all, every down WFE year, KLA's generally done better than the overall market 'cause customers in all segments continue to invest in their technology roadmaps. They adjust their capacity plans, they invest in technology roadmaps, that tends to be good for us. What cycles more is memory.
We have less exposure overall to memory, you start to see the process control intensity tick up because it's more logic foundry-centric in terms of WFE, with roughly 70% of WFE is logic foundry. The introduction of EUV and the scaling that is being driven by that is driving certain products within KLA that are very strong products in reticle inspection and optical pattern inspection that are also inflecting through this time, and so that's certainly a driver for us as well. Lots of talk about China and China export restrictions. The impact on KLA versus some of our peers is, I think a little bit less, and we'll see how that ultimately plays out, and there's a range of impact that we've talked about.
Finally, we also are seeing investment in wafer capacity and reticle capacity in China, and these are for legacy nodes. That's a part of WFE that we're exposed to. I know there's a fair amount of noise with some of the challenges around supply chain last year with some of the companies around, the deferred revenue and how that pulls forward or fast shipments and how that pulls forward. In some ways, it's kind of the same aggregate amount of business over a two-year period, but there's some timing elements that are part of all that. Because of the reasons I cited, I feel pretty good about our ability to maintain this share of overall WFE somewhere in the mid-sevens. It depends again on your denominator, but we feel pretty good about that overall.
Our service business will continue to grow. It'll grow this year. It'll be impacted by some of the China restrictions. It's also impacted by some lower utilizations in memory. So we'll still see growth in service. I would expect the EPC business, because it was weaker in 2022, strength in semiconductor or especially semiconductor because of power semi, I think EPC will be down less than the overall WFE level. When you aggregate it all, I think, you know, we set up to, you know, somewhere, if you look at our consensus estimates, somewhere in the high eights and a share of WFE that's, roughly consistent with what we saw last year.
Mm-hmm. Great. Well, there's a lot to unpack there. Maybe starting with the tactical stuff around supply chain, and hopefully we're getting close to the end of having to ask about this stuff. But, you know, you guys have a lot more semiconductors in your supply chain than really anyone in equipment, and yet you were more unscathed by these challenges than everyone. I guess, you know, why is that? And to the extent that, you know, we do see, I think, other companies benefiting materially from the deferred that they built up. You know, you probably have a little less of that in the first half. Can you just talk to, you know, how you've navigated the supply chain so effectively compared to others?
Well, We have different supply chains in a lot of cases, and our supply chain strategy historically, and I spent some time on this at the Investor Day, has been much more about strategic supply chain versus transactional. We have a lot of suppliers that we're single source through, that work with just us in our space, that allows us to, you know, in some ways optimize it. We're not sort of trading capacity with some of our competitors, which tends to be a positive. We're sometimes trading capacity across KLA products, which can always be a challenge, particularly if you're a general manager who's not getting your allocation and somebody else is. We, you know, in most of these cases, it's fairly clear about what we're gonna get in terms of volume.
At that point. The lead times are incredibly long. If you think about optical components, you can go have lead times that can be two years.
Mm-hmm.
When you start thinking about lead time on raw material, calcium fluoride, the lead time on equipment, and then through a full production process. You get to a place where it's fairly predictable. Adding increments beyond that is a challenge, but what you're gonna get is fairly predictable. We start procuring material for shipments sometimes 12 months in advance, and we do a lot to hedge that. Set those volume levels, and then we do all the work that everybody else does to go and figure out all the different short, more commodity-like parts that you need. There's a lot of semiconductors there. My ASPs are higher than some of my peers, so I need maybe fewer sets of the core electronics, mechatronic equipment, wafer handling equipment, and the components that are within that.
I need less of it. You could argue maybe I'm a little less exposed than some of my peers. As it relates to high-end image computing and data processing, AI and machine learning capability, we weren't challenged all that much in those areas, right? Of course, that's our high-end systems. Again, there's a volume aspect to it. The biggest challenges we had was just trying to go and find all those microcontrollers and some of those parts that drove a lot of the subsystem movement in mechatronic systems.
Hey, look, we did not ship what we wanted to ship, and we still have huge gaps in some of our key products, some of our enabling products, like high-end wafer inspection, but also in reticle inspection, where we have this fundamental gap, and we're trying to resolve it. We're getting new capacity, but it's gonna take some time to come online. It is a driver of our business today, and it's a part of the business that I would expect to grow even in this weaker environment where you feel pressures in your more capacity-centric parts of the company. In those areas, the supply chain challenge is more limited. To your point, we are working through it. We've invested a lot to add new capability.
Part of that capability was, you know, we were hoping, you know, if you just go back to early or the middle of 2022, we thought 2023 would be a much stronger year. We knew there was a, an adjustment year out there somewhere, but it wasn't quite clear. We've been making investments to try to position us for this 2026 plan. We wanna be able to get to $14 billion in revenue, ± $500 million. A lot of investments that we're making in the supply chain to ensure that we have the capacity to be able to support that over the long run. A, I think it validated through 2022 some of the things that we do.
At the same time, we also need to make sure that these relationships, we nurture them, they're important to us, we need these suppliers to be there. We, you know, we take the parts, we plan ahead. I always go back to, you know, what are you optimizing for and what are you accepting? I'm optimizing for our business model.
Mm-hmm
... our differentiation, and the custom nature of the parts that feeds that. I'm accepting that I'm gonna carry more inventory. I'm not the company with high asset turns.
Right.
Right? High inventory turns, and I never have been. It's part of sort of enabling the model that what we are optimizing for versus what we accept, and we accept that. There's also the service streams, which is also part of that.
I think everyone in equipment's gonna hold a lot more inventory after the last 24 months too. Maybe you could talk to China a little bit. You mentioned that up front that it maybe affects you less than others. I was quite surprised by a couple things you guys have said. One, the original impact of the export controls was probably bigger than I might have thought, which probably speaks to how much those guys were planning on spending. You said more recently that China probably grows despite the impact of those controls. What's going on in China? Like, where is the relative strength coming from to offset the impact of those controls?
Yeah. What I've said is that I still expect it to be a decent year and down less than the overall market.
Okay.
I don't know if it'll grow, and we'll see, depending on where we fall in the range that I laid out.
Mm-hmm
... of $500 million-$900 million in terms of impact from the October export control announcements. There are some cases where we're working with the government on potential licenses where it might create an opportunity for us to ship to some of the areas of the business that wasn't caught in the where the technology lines were drawn.
Mm-hmm.
There's a lot of legacy activity that's happening in China, and there's also a lot of investment in infrastructure in China. I mentioned it earlier, right? Where you have wafer capacity that's being added, where getting capacity's been hard for a lot of the Chinese suppliers. Reticles, a lot of reticle houses are captive. The reticle, the customers rely on merchants to supply those reticles. In a lot of cases, the merchants haven't invested as much, and so there's a desire to invest in reticle capacity. Now, these are for legacy nodes.
Mm-hmm.
These are for 28 nanometer and above technologies. When you add that up and you add up, you know, the legacy investment that's happening across a huge variety of projects, a lot of greenfield projects that I would expect that we'll continue to see, you know, see strong demand in those areas. The impact is. What changed in October was more clarity around the logic restrictions, and the impact in logic was less and kind of had already been contemplated.
Mm-hmm.
There were new rules that around US citizens and so on in terms of their ability to support tools. In general, the overall impact didn't change. There's a service component, and we're losing some service, which is a drag on service. About five points of service growth this year is, you know, if you lose roughly $100 million of service, which I've said 10%-15% of the total range. So there's some impact there also. You know, the rest is the memory impact.
Some of that is pretty clear that it's unlikely it'll ship, and then some of it, you know, there might be a path forward, and we're working collaboratively with the government, with our peer companies about, you know, trying to understand where the design rules are, where the rules are in terms of where the lines are drawn. Is there a path forward where there's the clear assurances that we're not supporting anything that would be beyond where the technology lines are drawn?
Yeah. Yeah, okay. What is the role generally of this kind of reshoring activity? You know, when you see obviously the CHIPS Act in the U.S., comparable subsidies that are happening in Europe and in multiple regions in Asia. Clearly, China government policy continues to favor investing in the areas where they're allowed to. You know, is the government subsidy the key aspect there, or is it the motivation of the customers to have domestic capacity, and then that money is helping them to pay for what they were gonna do anyway? Just how do you, how do you view that? Do you view that as something that's incremental to the equipment industry or something that was kind of already?
Yeah, it's more the latter. It's building the capability here and bridging the cost offset between being able to build in the United States or Europe versus alternatives. Semiconductors are fairly cheap to ship. Where you build them doesn't matter that much, just generally. It really is motivated by cost. You know, how do you bridge that cost delta to build here? Look, the industry's gotten a lot of efficiency over the years out of consolidation and consolidation into these, you know, big projects and tighter geographic areas. That's certainly been a driver of lower capital intensity. As you move forward with more projects that are more disparate, it's harder to optimize across all that supply.
There's a period of time where you're scaling potentially multiple facilities, and so you have inefficiency at one period of time. Ultimately, our view is that supply-demand over time is generally gonna balance. There might be an increment here of capital inefficiency because you're spread across multiple facilities and multiple geographies, and there's a spread of talent too. I think it's in the long run, it's probably in the best interest of the industry generally to have supply-demand mostly balanced over time. I don't necessarily see it as this, it's certainly not factored into our plan, that it's a huge driver of incremental spend over a broad period of time. Again, it could be episodic as you're ramping certain facilities and you're scaling.
It's really about bridging this cost offset to build the capability in the United States or Europe versus where it might have been built before. We're not planning for it. It could happen. I've heard some numbers thrown around out there that there's some permanent tier of inefficiency. You know, when we look at it, is if I've got the right products, we're sizing our business in the way that we talked about it, if it's there, it's not like we won't participate if we've got the right products to solve our customers' problems. That's how we're running the company in terms of how we think about that.
Looking at, more specifically at Foundry logic, you know, the market conditions seem pretty challenging for your customers. You know, you're certainly seeing logic companies with low utilizations, foundry companies at 7 nanometer and below, those utilizations have continued to come under pressure. Do you see that changing the spending pattern? I mean, the companies have kind of given their CapEx guidance, doesn't seem like it is. At some point, do you think there's a risk that it does?
Well, I think CapEx levels or WFE levels are gonna be lower-
Yeah
... in the leading edge, right? There are adjustments in capacity. We're not seeing adjustments necessarily in technology roadmaps, that's where KLA tends to participate. We're much more exposed to that than the incremental capacity beyond an entitled yield level. Because at that point, customers have a comfort, they have yield learning, they have yields, they tend to invest less in process control because they kind of know what to manage through those environments. We do see adjustments that are happening. We modeled in that we think leading edge is down. You know, if you think of the foundry part of the business, it's down less than the overall market, I'll call, you know, maybe low double digits.
I think there are pockets within trailing edge of continued investment, probably down somewhere similar. You know, in those parts of the market, I think between automotive, which has held up fairly well, and then the China stuff that we talked about earlier, that's driving that trailing edge part of the market overall. It's less process control intensive, sort of at a mature state than-.
Yeah
... than the leading edge. In terms of activities, you know, in terms of technology roadmaps and expectations in, you know, at N3 and even potentially some investment at the end of the year in N2 development, you know, I feel pretty good about where we are from a technology roadmap. Customers are absolutely adjusting their capacity plans here.
You mentioned the N2 development. I mean, it seems like that's a pretty compelling narrative. I mean, you now have three companies pushing on, you know, 2 nanometer-ish technologies in 2025, where historically you had kind of 1.5 . You know, do you see that activity remaining strong? Is there any area where people are pulling back on the sort of more advanced arms race?
No, not pulling back on the roadmap part of it.
Yeah.
Right? Again, you know, you're seeing some adjustments, you know, in leading edge investment from a capacity point of view. You have the, you know, increasing EUV layers, which drives the scaling dynamic, which is great for the reticle business, but also great for pattern inspection. As you move to new architectures, the gate-all-around architecture creates new metrology challenges. It doesn't create necessarily new small defect problems, but also creates some buried defect challenges. Across the portfolio of products that KLA offers, you know, we have the metrology capability. We think, for example, you know, you'll see Gen4 needed more for an optical inspection for gate-all-around than Gen5, 'cause it isn't as much of a small defect problem as much as the buried defect.
You got a wavelength challenge or wavelength opportunity through the Gen4 product that you can help measure and manage that defectivity. I think it's a pretty healthy environment at the leading edge in terms of.
Yeah
... the arms race, from a, from a technology point of view.
Okay
You know, we'll see how it plays out.
The role of VPC as you think about high-end foundry versus low end. I mean, I guess I think of it as more skewed to consumer, like you said, but when I look at the most important silicon at the cutting edge, stuff that's used in HPC, there's an awful lot of advanced packaging and an awful lot of stuff that makes your EPC initiatives look really important. You know, should I think of EPC as kind of helping the whole foundry logic business or one piece versus another?
It's an interesting question. When you think about EPC, you've got specialty semiconductor, which is being driven by.
Mm-hmm
... advanced packaging and RF, although RF is weaker now with the weakness in some of the handsets. When you think about silicon carbide and gallium nitride, that's been drivers for the specialty part of the business. You also have products and packaging in etch and deposition, but also wafer singulation and dicing. Within the PCB part, you're seeing the substrate part of the business where the substrate's integrating into the package. What you're effectively doing is just adding a lot more value.
One of the value prop as we thought about the Orbotech acquisition was the inflecting that we're seeing in these specialty markets and our ability to go take the KLA operating model, engage with customers at a higher level, and drive process tools as much as process control. Also to expose the company more to areas where we were seeing our customers go for value, right? That it wasn't just about front-end semiconductor manufacturing, but also how you integrate, package the chips. There are new products that are coming that address this sort of substrate market and how the substrate integrates into the package, into the PCB board. We'll see that, you know, grow over time. Most of the spending in the packaging market tends to be in traditional methods.
You know, overall across the company, you know, we were, I think in 2022, somewhere around, you know, $300 million-$400 million of what I'll call advanced packaging. Certainly, the ability to get chiplets, which drives design costs down at the leading edge, allows customers to only drive the leading-edge capability where they have to, be able to integrate it in a heterogeneous package. Sort of creates a more robust design environment at the leading edge, which is good because that's an important part of our business. Then, you know, more value shifting the package and the value that's in that package, driving the need for more inspection 'cause you start failing things that carry a lot more value with connecting layers and things like that, creates some of these challenges.
It's in some ways it's validating the thesis we had and.
Yeah
Why we needed to move, and we thought it was a good use of shareholder capital to go that direction and position the company to be able to go to all the areas where our customers were going for capability.
That acquisition looks better each passing quarter, given silicon carbide, given the importance of advanced packaging.
The specialty semiconductor part of it has certainly inflected...
Yeah
... a lot more than we originally thought.
Right.
I think our ability to engage with customers, and we've developed the channel, and we can get meetings as KLA that maybe smaller players couldn't. The service business creates another opportunity that it has, you know, the right place designed for markets. They're differentiated. If you look at the gross margins, which is the clearest sign of differentiation in that business, we segment reports, you can see it relative to general process businesses. Sort of highlights that they're able to address these opportunities uniquely, it's a nice growth opportunity for us moving forward. We've got some new products in development that hopefully will allow us to expand our SAM in that area.
Okay. If we could talk about memory. You mentioned that being an area where you see more concentrated weakness. You know, my thinking has been we would get to the bottom of spending fairly quickly just because, you know, the margin went away for your customers so quickly. It's continuing to get worse. I mean, even as a kind of bearish person on memory, I've been sort of shocked at where gross margins are going. You know, do you think there's risk of incremental compression as you move through the year in the memory space?
Well, we aren't leaning into it, right? In terms of our assessment and how we size the year and how we're, you know, thinking about that part of the business. You're right, it continues to be a challenging environment. You know, one of the challenges in that market is that, you know, there's more capacity adds to meet long-term bit growth supply. Historically, shrinks were able to address most of it. So these our customers have the balancing act of moving technology roadmaps, but also having to be in position to supply when growth resumes, and they're kind of thinking about it in different ways, certain customers. Yes, it's weaker than I thought it would be.
I don't think it's impacted our business all that much, given we're less exposed to memory and the technology investment still seems to happen and should happen. I'm having more payment term discussions as a CFO than you might imagine, you know, in this kind of environment. You know, look, we try to do what we can to support our customers.
Makes sense. Okay, I have one more question, and then we'll open it up to the audience, just see if there are any. In terms of services, you know, you talked about that being an area of kind of relative stability. I think when we look across all of the top five equipment companies, you know, the services is growing faster than the installed base of tools. Obviously, a lot of that is content, a lot of that is you're building new services capabilities on top of that. What's happening? What does that all look like from the standpoint of customer spending? Is this idea that services can be, you know, continue to grow, relative to the size of the installed base, is that something?
Yeah. It's been almost 3x, right?
Yeah.
If you just go back about five years for us. In our service business, we all kind of roll it up differently.
Mm-hmm
Our service business is traditional service.
Right.
There's no equipment in our service, reported service revenue. About 75% of it is contract, which is service contract. You know, a lot of cases, they're tool-specific contracts. In other cases, it's fab-wide contracts. The other part about it is not just the growth, but also provides a more predictable stream of revenue.
Mm-hmm.
It's a stickier stream. It carries a profitability level we believe is, you know, accretive to the overall. You know, it's a nice anchor for the company over time. It's only had one down year in revenue in the last, you know, 20, 25 years, and that was in 2009, which was a unique.
Mm-hmm
... environment. Even then, it was only down about 12%. You're seeing it in a couple ways. A, the value of the tools and the complexity of our tools, and so the percent of ASP that's tied to service contracts is slowly rising a little bit. You're seeing the install base of tools live longer, and that's been a driver. Then you've got the growth of WFE, how much we've shipped, and then those-
Mm-hmm
... tools go into service. All that got us to a point where, and we talked about it at Investor Day, going from a nine-11 long-term growth rate to 12-14, and we were at the top end of that in 2022, despite some of the China headwinds and some FX headwinds. Over the long run, we think, you know, 12-14% CAGR and with the profitability stream I mentioned to continue. Because of all that's certainly been a factor for us for decades in getting more and more comfortable about not only our dividend strategy, but the how we finance the business in terms of our leverage strategy as well.
Yeah, no, it's a great business. Can we have questions from the audience?
Thank you for taking my question.
Sure.
Quick one. How are you thinking about, you know, investing in the product and also investing in new areas in terms of thinking that there's more competition in the industry, definitely from, one, your pure plays like Lasertec, but also ASML, AMAT, all been investing a lot into metrology, et cetera. How are you thinking about the overall portfolio? How are you thinking about making more investment into these areas?
Yes, it's an attractive market, right? Our margin profile does a couple things. First of all, highlights, you know, the value that we bring, and also, I think, highlights the differentiation the company has. We're 4X our nearest competitor in our space. The relative growth of process control over the last few years is certainly attractive to anyone in the space. We go to market with a portfolio approach. I mean, one thing that's great about KLA, which drives our investments is that we are in some ways agnostic to which tools we allow our customers use for meeting their either technical requirements or their economic requirements, which change as they're moving from defect discovery and development. They're going through a ramp cycle and then monitoring long-term capacity.
Most of our competitors are point product competitors, they've got to sort of come up with ways that, okay, depending on where roadmaps move or the maturity of processes and designs move, that this solution has to try to meet multiple application requirements. It, I think, validates the fact that having the portfolio allows us to compete in a way that's unique in the market. We also have the ability to leverage a lot of the data that comes out of those tools to have a network effect across the tools, which creates a competitive advantage for us. We do have a competitor in a market where, you know, we're investing in the long run.
You know, we think that there's a portfolio approach to solving the challenges today. This is in the, the EUV reticle part of the market. It's a market in reticle inspection that we'll probably gain seven or eight points of share in over the last year because what's available in the market today that meets technical, given the density of the transistor design on the reticle and the layers of the pitch of the lines and spaces, and the economics of running the fab is playing to our optical solutions and our wafer inspection solutions to validate reticles in the fab environment. Clearly that's playing out in the EUV space. 90%+ reticles are running through KLA systems.
We have new capability in the market that as they start to shrink feature sizes, that's an E-beam, electron beam-based capability that should meet those higher end post-writing inspection requirements. We feel pretty good about the strategy and the introduction of new capability similar to what our competitor is offering and trying to engineer today. When you move into a high NA environment, 'cause high NA requires, you know, that you'll see more reticles, you'll see more pellicle, which is a factor driving reticle inspection. lot of investment in the company to meet that timing. If you look at the reticle space for EUV, the company, I think at the end of this year, I was adding up the numbers. As CFO, you kind of roll your eyes, you go, "Holy.
Wow." Over $1 billion across multiple products to solve the reticle challenge in terms of R&D investment. This is a core market for the company, and we have some unique capability. We have, you know, capability that allows our customers to balance. We feel pretty good about our roadmap.
Great. Unfortunately, we're out of time. We'll have to wrap it up there. I apologize. Thank you, everyone.
Thank you, Joe.