KLA-Tencor Set To Substantially Underperform Competition In 2018

Summary

• KLA-Tencor recently reported its quarterly earnings, and its QoQ revenue growth was the lowest among a group of four competitors.
• With lackluster quarterly revenues, its YoY revenue growth was also the lowest among the group of four competitors.
• While KLA-Tencor should retain its #1 position in the semiconductor metrology/inspection market, it will lose market share to these competitors in 2018.

KLA-Tencor (NASDAQ:KLAC) has had a long history of dominating the semiconductor metrology/inspection market. According to The Information Network’s report "Metrology, Inspection, and Process Control in VLSI Manufacturing," KLAC’s share of the market has increased from the mid-40%'s in 2004 to nearly 55% in 2017, as shown in Chart 1.

Chart 1

On April 26, the company reported FY Q3 revenues of $1.02 billion. But in its earnings call, there are several points that came out that raises concern that although the company’s dominance in the sector is solid, it stands to lose appreciable market share in CY 2018. I present a closer analysis.

CY Q1 Revenue Growth Comparison

I noted in a February 28, 2017, Seeking Alpha article entitled “The Semiconductor Metrology/Inspection Market Dominated By Just 5 Companies,” that:

• Five companies dominate the $6 billion Semiconductor Metrology/Inspection market - KLA-Tencor, Applied Materials (AMAT), Hitachi High Tech (OTC:HICTF), Nanometrics (NANO), and Rudolph Technologies (RTEC).

• These companies had a combined share of 87.0% in 2017, up from 75.3% in 2002, as the market has consolidated from 37 companies to 20.

Chart 2 shows QoQ for five top companies in the metrology/inspection sector for the recent quarter. I have added Nova Measuring Instruments (NVMI), and excluded AMAT because it hasn’t reported yet.

However, as I reported in a May 2, 2018, Seeking Alpha article entitled “Revenue Pull By Japanese Competitors Could Distort Market Sentiment For Applied Materials,” I projected AMAT’s QoQ semiconductor equipment revenue growth of only 1.4%. And since the company’s metrology/inspection revenues represent less than 7% of its total semiconductor equipment revenue, I will defer the complex revenue breakout until the end of the year.

Chart 2

According to Chart 2, KLAC’s QoQ revenues grew only 4.6%, compared to HICTF’s 55.6%. NANO’s revenues were similar to KLAC’s, but RTEC’s revenue growth rose a substantial 21.6%.

Full CY 2018 Revenue Analysis

KLAC CEO Rick Wallace noted in the FY Q3 conference call:

“Turning to the overall industry environment for calendar 2018. Coming off an exceptionally strong year in 2017, the investment landscape in each of the major customer end markets today is solid, supporting a WFE industry growth outlook that is currently expected to be in the high-single digits to low-double digits in 2018. In terms of our view of the end markets, we see memory once again comprising 70% or more of WFE investment in 2018, led by the ongoing ramp in 3D NAND, capacity expansion in DRAM and continued investment from China memory.”

I agree with his first sentence that the WFE industry will grow in the “high-single digits to low-double digits in 2018.” I noted in a March 22, 2018, Seeking Alpha article entitled “Watch For Positive Signals For Semiconductor Equipment Companies With SEMI Billings Report,” that:

“While the semiconductor equipment industry is forecast to grow 9%-11% in 2018, growth will only be a quarter of the 38% growth exhibited in 2017.”

In CEO Wallace’s second sentence, he said:

“we see memory once again comprising 70% or more of WFE investment in 2018, led by the ongoing ramp in 3D NAND, capacity expansion in DRAM and continued investment from China memory.”

I interpret several takeaways:

1. The 70% or more WFE spend is KLAC's customer mix, which is a bit vague from his comments, because according to The Information Network’s above report, memory represented 54% of overall WFE (wafer front-end) spend in 2017, which was up from 45% in 2016. The report also notes that for 2018, memory equipment growth will be 13% YoY, compared to 4% for logic.
2. The 70% memory customer mix may actually have been a detriment to KLAC. If we look at Table 1, except for HICTF there is almost an inverse correlation between memory customer mix and QoQ growth.

Table 1 - Comparison Between Customer Product Mix and QoQ Growth
	KLAC	NANO	NVMI	RTEC	HICTF
Memory %	71%	89%	50%	36%	52%
QoQ Growth	4.6%	5.0%	14.5%	21.6%	56%
Source: The Information Network

Click to enlarge

Indeed, KLAC CFO Bren D. Higgins commented during the conference call:

“And as you know, the process control intensity and foundry logic tends to be closer to 2x what it is in memory. So not every dollar of WFE is created equal when it comes to our business, and so certainly if you see a pickup in that segment so that's a significant positive for us.”

For the next quarter, CEO Wallace noted:

“I'll turn now to the income statement. Revenue was a record $1.021 billion in March. We expect revenue to grow sequentially and be in the range of $1.02 billion to $1.08 billion in the June quarter, and for revenue in the second half of calendar 2018 to be in accordance with our outlook for full year revenue growth of 10% or greater.”

Chart 3 presents YoY growth for CY Q1. While growth rates are different compared to QoQ growth in Chart 2, KLAC still registered the smallest growth.

Chart 3

The $1.02 billion to $1.08 billion in the June quarter means QoQ revenue growth should be in the range of 0-5.8%. If I calculate KLAC’s CY 1HoH rate using this guidance, 1HoH growth will be between 10.4% and 13.6%.

Investor Takeaway

Unless serious headwinds crop up, KLAC CEO Wallace’s guidance for the year for revenue growth is probably correct. Its #1 position in the semiconductor metrology/inspection market is also guaranteed due to its dominance in the sector.

What is probable is that KLAC’s market share in the sector will drop in 2018. That should impact stock performance in the future. Why? Go back to Chart 1. KLAC’s market share has been steadily increasing over the past 15 years, except for a few pullbacks. This is because when an equipment company sells a product to a customer, part of the decision is based on a “best of breed” evaluation. In other words, the company has demonstrated technical prowess.

But subsequent "capacity purchases" by the customer to increase capacity means the customer buys more of the same tool. These represent lost sales to a competitor, and market share decreases. When the customer makes “technology purchases,” i.e., moving to the next technology node, as long as the company continues to make “best of breed” equipment, it will win the contract. Market share increases. New technology nodes are a staging point for additional purchases as production increases, and eventually, for more “capacity purchases” as needed.

I wrote a March 29, 2018, Seeking Alpha article entitled “KLA-Tencor Needs To Break Up Orbotech And Re-Open Talks With Lam Research.” The acquisition of Orbotech (NASDAQ:ORBK) probably won’t be approved until the end of 2018, so no revenue for KLAC would be generated, and CEO Wallace’s guidance would be solely based on legacy products.

In the article, I reported that:

“Once the acquisition is finalized, KLA-Tencor would be better served by breaking out the semiconductor business segment and sell it.”

Semiconductor products include CVD and PVD equipment used for advanced packaging, such as wafer bumping, wafer-level packaging (WLP) and through-silicon vias (TSV). I suggested Lam Research (LRCX), which would be a good fit.

On April 4, 2018, I learned that Tokyo Electron (OTCPK:TOELY) was divesting TEL NEXX, its consolidated subsidiary, and selling the company to ASM Pacific Technology Ltd. (OTCPK:ASMVF). NEXX developed electrochemical deposition (ECD) and PVD equipment for WLP, and was acquired by TOELY in 2012.

And so, I suggest that KLAC, if it were to take my advice and divest the semiconductor division of ORBK, consider ASMVF as an alternative buy to LRCX.

On another point, but still within the metrology/inspection sector, I’ve continuously come across new companies and technologies over the 37 years since I started The Information Network. Back in 2011, a young man, Alon Raphael, a student at University of California, Santa Barbara, contacted me about our above-referenced metrology/inspection report. I recently learned he went on to form a company called FemtoMetrix, and he is now president and CEO. The company uses Optical Second Harmonic Generation (SHG), a non-destructive, contactless, optical characterization method to characterize surfaces, interfaces, thin-films, as well as bulk properties of materials. Already, FemtoMetrix has completed its first round of equity financing in a deal led by Samsung's (OTCPK:SSNLF) Venture Division, and announced a license agreement with Boeing (BA). This type of new technology will eventually compete against KLAC.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.