KLA: This High-Quality Company Looks Cheap
Should you consider an investment in this semiconductor bellwether?
Dear readers,
Welcome back to the Quality Equities newsletter.
KLAC 0.00%↑ KLA Corporation (formerly KLA-Tencor) stands as a cornerstone of the semiconductor industry, providing critical inspection and measurement systems that ensure the quality of chip production in an increasingly complex manufacturing landscape. As semiconductor devices continue to shrink and become more sophisticated, KLA's role in maintaining production yields and quality control has become more vital than ever.
Core Business Model
At its heart, KLA operates a robust business model centered on high-value equipment sales and recurring revenue streams. Their flagship products include wafer inspection systems, reticle inspection tools, and metrology systems. This equipment revenue is complemented by steady income from service contracts, software licenses, and technical support, creating a balanced revenue structure that helps weather industry cycles.
The company's strength lies in its deep integration with customer operations. Once KLA's equipment is installed in a semiconductor fab, the high switching costs and mission-critical nature of quality control create significant customer lock-in. This strategic positioning has allowed KLA to maintain strong pricing power and healthy margins.
Artificial intelligence represents a significant growth opportunity for KLA on multiple fronts. The company is using AI to enhance its core products, improving defect detection accuracy and reducing false positives. AI-powered pattern recognition and predictive maintenance capabilities are creating new value propositions for customers, while also opening doors to new markets and applications.
Furthermore, the broader AI boom is driving increased demand for sophisticated semiconductors, indirectly benefiting KLA as manufacturers require more advanced inspection and quality control systems to produce these complex chips.
Valuation
KLA's stock has experienced significant pressure lately, trading 31.14% below its all-time highs. The decline intensified following industry leader AMAT 0.00%↑ Applied Materials' recent quarterly earnings report. When Applied Materials, the largest US semiconductor equipment manufacturer, provided weaker-than-expected guidance due to softening Chinese demand, the news rippled throughout the sector. As often happens in the tightly connected semiconductor equipment industry, KLA's shares fell in sympathy with its larger peer.
KLA's recent pullback has created a compelling opportunity. The company now trades at an earnings yield and free cash flow yield of approximately 5% on forward-looking basis (an attractive entry point for a market leader of KLA's caliber). Given the company's dominant market position and promising growth prospects in the semiconductor industry, these valuation metrics offer a potential opportunity for long-term investors.
To better understand the expectations currently priced into the stock, let’s use a reverse discounted cash flow model. A reverse discounted cash flow analysis helps illuminate the market's growth expectations embedded in KLA's stock price.
Based on our model, achieving a 10% annual return for the next 10 years would require KLA to grow its free cash flow by 11.30% annually over the next decade. This implied growth rate provides a useful framework for evaluating whether the market's expectations are reasonable given KLA's competitive position and industry dynamics.
If you believe KLA can meet these growth requirements, then you may wish to consider Meta Platforms as an investment. Remember, reverse DCF is not about predicting the future, but about understanding what's priced into the market today. This understanding can lead to better-informed investment decisions and a more disciplined approach to valuation analysis.