KLAC- Very Strong Sept & Guide-Foundry up 50%- 5NM & EUV drivers- Outperforming

• KLAC Strong Beat on Both Sept Q & Dec Guide
• Foundry/logic (TSMC) up 50% H2 vs H1
• Gen 5 acceptance and 5NM rollout drive future

Strong beat in Sept results and Dec Guide
KLAC reported revenue of $1.41B and EPS of $2.48 handily beating street estimates of $1.5B and $2.20 in EPS. More importantly the company guided December to be revenues between $1.425B to $1.515B ($1.475B midpoint) and EPS between $2.39 and $2.69 ($2.54 midpoint), substantially higher than street estimates of $1.39B and $2.35.

The company also upped its estimate of WFE spend in calendar 2019 as the second half of the year has obviously turned out way better than the first half.

Foundry/Logic up 50% H2 versus H1
As we had suggested in our preview, the biggest uptick in business is Foundry/logic which is primarily TSMC spending a lot of money. Even Intel doesn’t come close. Memory remains weak and shrinking versus foundry/logic as a percentage of KLA’s business.

KLA’s core remains very strong
The orbotech acquisition hid the strength of the core KLA business which was up 16% sequentially while the Orbotech business was down slightly for a total 12% sequential growth which in our view is very strong considering that memory is still soft. Obviously this is a very strong annualized rate.

Reticle Inspection outperforming
Wafer inspection was up 13% sequentially but “patterning ” (reticle inspection) was up a whopping 31% sequentially which we attribute to some competitive wins mainly against Japanese competition.

Taiwan (TSMC) led the way with 27% of business with China at 24% , Korea (memory) a low 14% …even Japan was bigger at 15%, US was 13% (Intel).

2020 should be a very good year
The spend by TSMC on 5NM looks to be very large going into 2020. One reason we would cite is that there is little to no equipment reuse from 7NM to 5NM that we expect, so spending on 5NM by TSMC and 7NM by Intel will be for a lot of new equipment. We would also expect some sort of at least partial pick up in memory some time in 2020.

EUV transition pays dividends to KLA
As TSMC transitions from a few layers using EUV to most critical layers using EUV we will not only see a significant jump in EUV scanners, which obviously benefits ASML, but also a corresponding increase in KLA tools to support EUV.

This 4X to 5X increase in the number of EUV layers requires a lot of tools.
Intel, which has not put EUV into production will transition to EUV and will follow a similar tool and spending path as TSMC before it.

Industry Outperform
As we had previewed, its clear that KLA will outperform the growth of the overall semi equipment industry as they have historically been most closely tied to the fortunes of Foundry/Logic which is clearly as strong as memory was two years ago, perhaps even more so.

We think that Foundry/Logic leads memory spending over the next 3 to 4 quarters at least, as we still don’t have a solid idea as to the timing of a memory recovery. This suggests that KLA should keep up the industry outperforman as well given its tie to Foundry/Logic.

The Stock
We would continue to be a buyer of KLAC given the strong report coupled with excellent financials and value returns to shareholders which form a complete picture of an attractive value. Dividends and returns to shareholders continue their 15% trajectory with strong free cash flow and gross margins which continue to lead the industry by a very wide margin. We would view KLAC as our top large cap pick in the space.