KLA - Q2 2024

Transcript

Operator (participant)

Good afternoon. My name is Chelsea, and I will be your conference operator today. At this time, I would like to welcome everyone to the KLA Corporation December quarter 2023 earnings conference call and webcast. All participant lines have been placed in a listen-only mode to prevent any background noise. After the speakers' remarks, there will be a question and answer session. If you would like to ask a question at that time, please press star one on your telephone keypad. If you wish to remove yourself from the queue, please press star two. Please also limit yourself to one question and one follow-up. Lastly, if you should need operator assistance, please press star zero. Thank you.

Kevin Kessel (VP of Investor Relations and Market Analytics)

Thank you for joining the earnings call to discuss the December 2023 results of the March quarter outlook. I am joined by our CEO, Rick Wallace, and our CFO, Bren Higgins. We will discuss today's results, released after the market close and available on our IR website, along with supplemental materials. Today's discussion is presented on a non-GAAP financial basis, unless otherwise specified. Our full-year references all relate to calendar years. A detailed reconciliation of non-GAAP to GAAP results in the earnings material posted on our website. KLA's IR website also contains future investor events as well as presentations, corporate governance information, and links to our SEC filings, including our most recent annual report and quarterly reports on 10-Q and 10-K. Our comments today are subject to risks and uncertainties reflected in the respective disclosure in our SEC filings.

Any forward-looking statements, including those we make on the call today, are subject to those risks, and KLA cannot guarantee those forward-looking statements will come true. Our actual results may differ significantly from those projected in our forward-looking statements. Rick will begin the call with some comments and quarterly highlights. Bren will conclude with our financial highlights, including our guidance and outlook. I will now turn the call over to our CEO, Rick Wallace. Rick?

Rick Wallace (President and CEO)

Thank you, Kevin. I will briefly summarize KLA's performance for 2023 calendar year and the December quarter, and then set up our view for 2024. For 2023, KLA revenue was almost $9.7 billion, down 8% versus the prior year. This was higher than our expectations coming into the year as strength from legacy node customers and semiconductor infrastructure offset weaker than expected leading-edge investments in both logic and memory. While overall WFE spending was down for the year, there were areas of growth in KLA business segments, including the infrastructure business supporting wafer and mask manufacturers, automotive, and specialty semiconductor process equipment. KLA's service business grew 7% to $2.2 billion for the year. The company continued to deliver strong industry-leading margins, with non-GAAP gross margins of 62% and a non-GAAP operating margin of 39%.

Free cash flow grew 6% in 2023 to a record $3.2 billion. Moving to KLA's December quarter results, which were ahead of expectations as revenue grew 4% sequentially to $2.49 billion. Quarterly non-GAAP net income was $839 million. GAAP diluted earnings per share was $4.28, and non-GAAP diluted EPS was $6.16. We saw sequential growth in all three of KLA's business segments. You can find specific details in our shareholder letter released earlier today. Additional highlights in the quarter include growing adoption for KLA's 8900 Series platform for high throughput macro inspection. Increased demand in the legacy node and advanced packaging categories made the platform one of the best-performing product lines in our optical inspection portfolio in 2023.

Continued growth in AI enables KLA's differentiation and helps drive industry growth. We continue to deploy deep learning and physics-based algorithms across KLA's inspection and metrology product portfolio. This has improved signal and noise recognition and reduced process learning cycles as customers resolve critical yield challenges. KLA's service business grew 1% on a sequential quarterly basis to $565 million, and remains on track to resume the targeted 12%-14% annual revenue growth trajectory in calendar 2024. As we look at CY 2024, we're encouraged by recent reports from many of our customers that the demand environment is expected to continue to gradually improve throughout the calendar year.

Through collaboration with customers, KLA is focused on preparing our teams for our return to growth at the leading edge and leveraging the KLA operating model to ensure readiness to support our customers' needs as the demand environment improves. For the near term, we see the March quarter as the low point for the year. We expect business levels to improve as we progress throughout the year. The KLA team will, as always, prioritize commitments to our customers in executing on our product roadmaps. I'll now hand the call over to Bren to provide more specifics around the financials and our guidance.

Bren Higgins (EVP and CFO)

Thanks, Rick. Our results demonstrated the consistent execution of our global team. Despite the challenges and complexity of the current industry environment, KLA continues to show resourcefulness and the ability to adapt to meeting customers' changing and fluid requirements. Revenue was $2.49 billion, slightly above the guidance midpoint of $2.45 billion. Non-GAAP diluted EPS was $6.16, above the midpoint of the guided range of $5.26-$6.46. GAAP diluted EPS was $4.28. GAAP EPS was negatively impacted by $1.59 for goodwill and purchased intangible asset impairment charge.

Non-GAAP gross margin was 62.6%, just above the high end of the guidance range of 60.5%-62.5%. Non-GAAP operating margin was 40.7%. Quarterly non-GAAP net income was $839 million. GAAP net income was $583 million. Cash flow from operations was $622 million, and free cash flow was $545 million. As I just mentioned, during the quarter, KLA recognized a goodwill and purchased intangible asset impairment charge of $219 million for the PCB and Display Reporting unit, attributed to a weaker long-term outlook, primarily for the flat panel display business. We have begun investigating strategic alternatives for this business, which accounted for 1.4% of total revenue in calendar 2023.

The breakdown of revenue by reportable segments and end markets, and major products and regions, can be found within the shareholder letter and slides. Turning to the balance sheet, KLA ended the quarter with $3.3 billion in total cash, cash equivalents, and marketable securities, debt of $5.95 billion, and a flexible and attractive bond maturity profile, supported by strong investment grade ratings from all three agencies. In December 2023, Fitch Ratings upgraded KLA's debt rating to A from A-minus with a stable outlook. Moving to our outlook. Looking ahead to calendar 2024, the exact timing of a meaningful and sustainable resumption in WFE investment growth continues to remain uncertain. Though there are signs of improvements in some end markets, this improvement is off low levels, impacting our customers' profitability and cash flow generation in the near term.

KLA's overall demand is stabilizing around current business levels, plus or minus the guidance ranges. As of now, this translates into KLA revenue bottoming in the March quarter, driven mostly by a customer project delay occurring in the last couple of months. Based on current fab schedules and our June quarter shipment plans, we expect sequential growth to return in the June quarter and continue for the remainder of the calendar year. For calendar 2024, we currently expect WFE demand to be in the mid- to high $80 billion, roughly flat to modestly up from the anticipated level in calendar year 2023. We expect that the second half of the calendar year will be stronger than the first half for WFE investment.

This WFE estimate reflects our current top-down assessment of industry demand as follows: In memory, we expect WFE investment to be slightly up from low levels, with investments focused on High Bandwidth Memory capacity, and leading-edge node development. Both NAND and DRAM fabs are still at low utilization levels, as consumer markets have not yet returned to the growth levels needed to bring factory utilization back to the high levels seen in recent years. Once customers consume this excess capacity and focus on node migration, we would expect to see new investments. Foundry Logic is expected to be slightly up, with leading-edge investment returning to modest growth levels, legacy investment declining versus 2023, and China legacy node investments remaining relatively flattish to current levels.

As for guidance, KLA's March quarter guidance is as follows: Revenue is expected to be $2.3 billion ±$125 million. Foundry Logic is forecasted to be approximately 60%, and memory is expected to be 40% of Semi-process control systems revenue. Within memory, DRAM is expected to be about 85% of the segment mix, and NAND, the remaining 15%. Non-GAAP gross margin is forecasted to be in a range of 61.5% ±1 percentage point, as product mix weakens quarter to quarter due to lower overall semiconductor process control systems revenue. For calendar 2024, based on current industry outlook, top-line growth expectations, higher forecasted growth in services and expected systems product mix, we are modeling gross margins to be relatively stable around the mid-61% range to what we delivered in 2023.

Variability quarter to quarter is typically driven by product mix fluctuations. Operating expenses are forecasted in the March quarter to be approximately $545 million, relatively flat with the December quarter. For calendar 2024 operating expenses, we expect $5-$10 million incremental growth per quarter beyond the March quarter, in line with expected sequential growth in revenue. Prototype material purchases can drive variability quarter to quarter. For the calendar 2024 tax rate, based on current forecasts, we do not expect material changes. You should continue using the 13.5% effective rate for modeling purposes. Other model assumptions for the March quarter include other income and expense net of approximately $45 million.

GAAP diluted EPS is expected to be $4.93 ±$0.60, and non-GAAP diluted EPS of $5.26 ±$0.60. EPS guidance is based on a fully diluted share count of approximately $135.6 million shares. In conclusion, we are optimistic that most end markets are showing signs of improvement. KLA will remain focused on supporting customers, executing on our product roadmap, and positioning the company for a return of growth at the leading edge. Though visibility into the precise timing of a sustainable demand recovery is still unclear, KLA is running the business to ensure delivery of a differentiated product portfolio that meets customers' technology roadmap requirements, and to execute our business in line with our longer-term growth expectations.

The KLA operating model guiding best-in-class execution, KLA continues to implement strategic objectives which are geared to drive outperformance. With a focus on customer success, delivering innovative and differentiated solutions and operational excellence, KLA is able to deliver industry-leading financial and free cash flow performance and return capital consistently… The past few years have strengthened our confidence in the increasing importance of process control and enabling technology advancements and optimizing yield in a high design, mixed volume production environment. This bodes well for KLA's long-term growth outlook, despite still challenging near-term demand trends. In the meantime, KLA business continues to stabilize, and the long-term secular trends driving semiconductor industry demand and investments in WFE remain very compelling. That concludes the prepared remarks. Kevin, let's begin the Q&A.

Kevin Kessel (VP of Investor Relations and Market Analytics)

Thanks, Brian. Chelsea, if you can just give the instructions and set up the queue.

Operator (participant)

At this time, if you would like to ask a question, please press star one on your telephone keypad. If you wish to remove yourself from the queue, you may do so by pressing star two. We remind you to please unmute your line when introduced, and if possible, to pick up your handset for optimal sound quality. In the interest of time, we ask that you please limit yourself to one question and one follow-up. We'll take our first question from Harlan Sur with JP Morgan. Your line is open.

Harlan Sur (Managing Director and Equity Research Analyst)

Good afternoon. Thanks for taking my question. It looks like relative to your prior view, the March quarter came in lower by roughly about $200 million. I know you talked about a customer project delay that materialized just over the last couple of months. It looks like based on your December quarter end market mix and expected March quarter mix, that it's a Foundry Logic customer. Was that a leading edge or mature node customer? Was the delay more technology related or just weak demand trends? And does the sequential growth outlook beyond March assume that this customer comes back this year?

Bren Higgins (EVP and CFO)

Hey, Harlan, it's Brian. So yes, yes, as, as we said in the prepared remarks over the last couple of months, we had a project that we were planning to ship, roughly $200 million of business to, that, that had a pushout that's extended, I think, somewhere around 12 months. So could we see it at the end of 2024, maybe? Could be early 2025 as well. So it was more leading edge centric. And as a result of that, as we backfill that business, with other business, we did see the, the percent of China go up a little bit higher than we had, thought we would see-

Harlan Sur (Managing Director and Equity Research Analyst)

Mm-hmm

Bren Higgins (EVP and CFO)

... when we were giving guidance at the beginning of the quarter. So it's late in the quarter, obviously affected, didn't affect Q4 because of the moving around of other customers in slots, but certainly had an effect on Q1. As we think about sequential improvement into the June quarter, we also have, you know, part of our revenue recognition policy is that when we ship to new customers, we have to go to acceptance to demonstrate that our tools are meeting specifications around reliability and matching and so forth.

There are some shipments that we shipped at the end of Q4 and we're shipping in the March quarter that are aligned with a couple of projects for new customers, where the fabs are opening late in the quarter. So our ability to get those acceptances and complete that process could be potentially constrained. So we'll see that revenue shift into the June quarter. Once you get the established performance, then that revenue happens at shipment going forward with that customer. But we do have some unique dynamics that are affecting us here in the first half. So it does give me some comfort about the sequential growth guidance as we move into June, but it is affecting what we ultimately guided for the March quarter, consistent with our revenue recognition policy.

Harlan Sur (Managing Director and Equity Research Analyst)

No, I appreciate the insights there. Your total process control systems business outgrew WFE yet again, right, in calendar 2023. Within that, inspection significantly outperformed, right? It was only down 5%, but your patterning business was down almost 20%, which is actually worse versus WFE, right? And it looks like most of that full year underperformance was due to the sharp drop-off in patterning just in the December quarter. So was that tied to the customer pushout dynamics, as you mentioned, or is it just the lumpy shipment trends in patterning? And I guess, do you guys expect, you know, process control systems business to outgrow WFE this year?

Rick Wallace (President and CEO)

Yeah, great question, Harlan. I think, if you think about our business and the composition and how it moves with customers, inspection, especially the leading-edge inspection, is much more tied to development of new technology, whether it's in pilot or even ramp. And some of the metrology business is more tied to capacity. So when you see a falloff of capacity, it impacts metrology more than it would impact inspection, and that's what we saw in 2023.

Bren Higgins (EVP and CFO)

Hey, Harlan, it's Bren. On the relative performance, we do feel pretty good about the performance overall when you think about how much legacy business was in the year and how the leading edge fell off, which typically drives higher process control intensity.

Also, in WFE this year, it was a little unique in that there was a lot of carryover WFE from 2022, for a number of peers, and so that showed up in 2023. It was really, you know, activity that we started in 2022. So when you take into account those factors and look at how well we performed in 2022 relative to the overall market, where we were, our growth rate was 4x what the market was. The fact that we're mostly, I think, in line, maybe a little bit better than the overall market in 2023, is I think a pretty good indicator of the growing process control intensity that we're excited about here at KLA.

Operator (participant)

Thank you. Our next question will come from Joe Quatrochi with Wells Fargo. Yeah, thanks for taking the question. I just wanted to go back to the pushout. So just so I understand, if we were to adjust for the couple hundred million that's now pushed into the June quarter and assumed it was still in the March quarter, I guess, would you still expect that the June quarter would be up quarter-over-quarter? Or would it be more flattish, like we were thinking or talking about, you know, last quarter of just the first half kind of still being a similar run rate of the business?

Bren Higgins (EVP and CFO)

Yeah, I think it's more the latter, right? We've obviously got a lot of moving parts in how it affects the quarters, but as we had talked about when we last quarter, we saw the business generally continuing at guided level. Guided was $245 million, right? We ended up outperforming by, you know, $40 million or so. So, it would have been probably flattish, more or less. But this adjustment coming out obviously, you know, has the kind of impact, and I sized it earlier. So, flattish, and then we would expect to see the second half start to improve a little bit.

Joe Quatrochi (Director and Equity Research Analyst)

Got it. That's helpful. And then just as a follow-up, I know you're gonna, you'll file your 10-Q probably tomorrow, but any color on where the RPO stood at the end of the quarter?

Bren Higgins (EVP and CFO)

Yeah. So RPO was down about $200 million. I expected you to ask that question, Joe. So yeah, $200 million quarter-over-quarter and with about 50%, so that takes you to about $10.6 billion, 45%-50% of it to ship beyond 12 months. And then within that, we have about just short of $800 million in customer deposits.

Operator (participant)

Thank you. Our next question comes from C.J. Muse with Cantor Fitzgerald.

Christopher James Muse (Senior Managing Director and Senior Equity Research Analyst)

Yeah, good afternoon. Thanks for taking the question. I guess first question, can you speak to domestic China? And I guess, you know, to what degree 2023 was helped by bare wafer and reticle inspection, and your thoughts on how that progresses in 2024. And I guess with mix shift to perhaps maybe incrementally more DRAM and, you know, I don't know, in terms of the really core legacy, some shifts there, how you're seeing your kind of implied market share at 2024 versus 2023.

Bren Higgins (EVP and CFO)

So for China, CJ, I think overall for China looks pretty flattish year-over-year. We did benefit from the infrastructure investment that I talked a lot about over the course of the last year or so. I would expect that part of the business to come down some, as some of the digestion is happening, more so on the wafer side than the reticle side. And so that obviously will get made up by what I would expect to be, you know, slightly higher foundry. I think the memory piece will shift to potentially shift to another customer. So I could see that being flattish overall. So feel pretty good about the trajectory of China.

There is some lumpiness, given our ASPs, but I think through the year it'll be relatively consistent across the quarters, notwithstanding the timing of certain fab projects and construction schedules complete and so on. And then I think we'll start to see the percent come down as we move into the second half, as you see other customers drive our expected growth as we move through the second half of the year. What was the second part of the question?

Christopher James Muse (Senior Managing Director and Senior Equity Research Analyst)

No, you covered it. I guess for my follow-up, as you think about kind of second half stronger than first half, how would you kind of rank order leading-edge foundry logic versus DRAM in terms of the key drivers for you?

Bren Higgins (EVP and CFO)

I think leading-edge will be, you know, we'll see some growth in the year. It'll be, I think, you know, fairly modest growth as we continue through the year, here. I would say I'm just kind of looking quickly here. I would say that it is reasonably balanced across the year, so I would think that we'll see, you know, I'd, I would expect to see, you know, DRAM probably be a, actually, I think it's going to be pretty balanced as well, from a leading-edge DRAM point of view. So I think it's pretty balanced on both fronts, and then just, you know, ticking up a little bit as you move into the second half.

Christopher James Muse (Senior Managing Director and Senior Equity Research Analyst)

Thank you.

Operator (participant)

Our next question will come from Krish Sankar with TD Cowen.

Krish Sankar (Managing Director and Senior Research Analyst)

Yeah, hi. Thanks for taking the question. I have two of them. Two, one is I was just kind of curious, like if you can kind of give color on how to think about China revenues this year, ex EPC.

Bren Higgins (EVP and CFO)

Well, Brian just covered that, but in the last question, essentially flattish. I mean, that's the general view for China this year. Flattish, a little less infrastructure than we saw, especially in wafer. CapEx continues to, you know, remain reasonably stable at the current run rate.

Krish Sankar (Managing Director and Senior Research Analyst)

Got it. Got it. And then, just as a quick follow-up, you know, if, if I look at kind of like Broadband optical inspection, and you said that, you know, revenue should start improving over time, where is the lead times today for them today versus, let's say, three months or six months ago? And where do you expect them to go, you know, over the next few months?

Bren Higgins (EVP and CFO)

Yeah, I'll start on that one. On optical inspection, so we're still constrained on Gen 4 in terms of demand relative to our supply. I would expect to see supply increase this year, and that's part of our business I would expect to do better than overall market as we move into 2024. We have right now, I think, you know, we've seen some normalization around Gen 5 lead times, which tend to be, you know, somewhere between seven and 9 months. But Gen 4 is still out over a year or so, but new capacity coming online. I think not enough for what we expect over the next, you know, year to year and a half.

But, but then we have another, another tranche of capacity that'll come online as we move into the 2026 time frame. So we feel pretty good about what we have in terms of overall capacity, both within the, within KLA and our facilities, but also within our supply chain, to support the growth that we expect as we move into 2025 with more meaningful WFE growth. And then as we, as we target the, the 2026 financial plan that we laid out back at our Investor Day in 2022.

Krish Sankar (Managing Director and Senior Research Analyst)

Thank you very much.

Operator (participant)

Our next question will come from Brian Chin with Stifel.

Brian Chin (Director and Equity Research Analyst)

Hi there. Good afternoon. Thanks for letting us ask a few questions. Maybe just to—I think someone might have tried to ask this earlier in the queue, but you know, taking your WFE sort of outlook for you know, flat to modest, based on your 2023 base level, flat to modest growth this year. It you know, relative to sort of the pickup in maybe your revenue and WFE being sort of in the second half, but kind of modest, right? You probably would need to see an acceleration in the back quarters of the year in order to kind of get to say, you know, even towards the mid, the low- to mid-single-digit kind of growth that you're talking about for WFE at the moment.

I'm kind of curious, do you see process control intensity type of profile spending this year, sort of, neutral in terms of WFE? Do you think intensity is higher or lower relative to, again, that profile of spending this year, and then how does that reflect in your revenue?

Bren Higgins (EVP and CFO)

Yeah, no, you're right in terms of the math, right? As we look at the first half of this year, which is, you know, we'll call maybe, you know, slightly down versus the second half of 2023, and then an acceleration in the second half, which puts you somewhere in the, you know, I'll call it, high single digit growth. That assumes that WFE is marginally up, more or less from 2023. And so against that backdrop, with slight improvement in memory, I would expect our process control intensity to be roughly flat. So we were in the seven, you know, depending on, you know, your WFE number, but assuming $87 billion-$88 billion in WFE in 2023, about 7.6% or so.

So I would expect it to be similar as we move into 2024. And as we expect to see, you know, more growth in leading-edge investment as we move into 2025, then we'll start to see, you know, favorability in terms of leading-edge dynamics that tend to drive our business and higher process control intensity overall. So, I think that's how to think about it right now.

Brian Chin (Director and Equity Research Analyst)

Okay, thanks. And then just, you know, given that emphasis this year on memory conversions, and upgrade activity, can you comment on the areas where KLA benefits and also how meaningful a benefit that this sort of spending represents?

Bren Higgins (EVP and CFO)

You mean in terms of just where we benefit in memory investment, or where we expect to see it? I mean, certainly you've got the, you know, in DRAM, with more DRAM investment, with the introduction of EUV, that's tend to be a positive dynamic, for our business. We saw Process Control intensity increase as we saw EUV introduced into DRAM. So that's probably one of the bigger positives for us. So you're right, as you start to do technology conversions, instead of new capacity, it'll be a little bit more muted investment. But we would expect to see our customers continue to invest in their leading-edge development for the next nodes, and so I think that will be the biggest driver for our business.

Brian Chin (Director and Equity Research Analyst)

Okay. Thank you.

Operator (participant)

Our next question will come from Chris Caso with Wolfe Research.

Chris Caso (Managing Director and Senior Equity Analyst)

Yes, thank you. Good evening. I guess the first question is, you know, kind of looking beyond to 2024, and obviously don't expect you to provide any guidance there, but, but take any opinion that you have. You know, some of the other equipment suppliers that have had longer lead times were starting to express a little more confidence on, you know, a turn on 2025. You know, I don't expect that you've seen that in your order book yet, but interested to see what your customers may be talking about.

Bren Higgins (EVP and CFO)

It's a great question, and we have definitely had those conversations. I think that, you know, customers are looking at it from a couple perspectives. One, we do have long leads on the most advanced optical tools, but there's also a lot of development that we're doing right now to make those tools even better for the advanced logic ramps that are coming. So we're actually engaged quite a bit in R&D and in pilot with those customers. So we have a pretty good sense. They're all bullish about 25. I can't think of a customer we have on the leading edge that isn't bullish about 25. But as you say, we're not going to see the orders for those yet, but we're certainly having those conversations. But more importantly, we're seeing the discussions happen around capability that we're demonstrating as they do pilot.

The other thing is we're seeing a trend toward more designs, and we talked about this for the past several years. One of the leading indicators for us is the advanced designs, because that's an indicator of how broad a node is going to be. We're seeing that continue, and that'll drive both reticle business, but also as a good leading indicator for the strength in 25. That's why, you know, one of the objectives for the company is to prepare for growth in leading edge, because that's what we believe will happen over the next 24 months. As Bren indicated, not the next six months, we should start to see the green shoots of that toward the end of the year, and then we'll see it in 25, is the way we're modeling the business and our investment right now.

Chris Caso (Managing Director and Senior Equity Analyst)

Got it. That's very helpful. As a follow-up, with regard to the foundry logic business, would you characterize, and I guess what you talked about in your WFE assumptions as some kind of slight growth this year? Is it safe to say that growth is either tied to, you know, new node deployments and kind of technology upgrades and such, as opposed to, you know, capacity at this point?

Bren Higgins (EVP and CFO)

It's a little bit of capacity, too. I mean, it, it, you know, 2023 was down, right? And so we're seeing some expansion of capacity. The big node ramps aren't really happening as much this year, which is part of why the WFE gets driven up. And you heard TSM's call, and I think, you know, they're fairly bullish on their forecast, but we'd have to see what happens in the early parts of 2025 for those ramps on especially the newest technologies. And we would expect the legacy business, non-China, to be lower in 2024 than 2023. So there's so it's being offset. You've got some improvement with the leading edge investment, offset by some of the non-China legacy falling off a bit. So that's how we get to our forecast.

We'll see as we start to, we're having these conversations with customers. We're certainly planning for it from a capacity point of view, and we'll see as we progress through the year, as we start to firm up, you know, when those shipments will actually start to take place.

Operator (participant)

Thank you. Our next question comes from Joe Moore with Morgan Stanley.

Joe Moore (Managing Director and Head of US Semiconductors Research)

Great. Thank you. You talked about memory utilization remaining low, and I guess I feel like you guys kind of talked about that relatively early, and then you saw it kind of static. We've heard from memory customers, all kinds of things about different times that they brought it down, and it looked like someone brought it up. But I just want to confirm that you're seeing that as kind of a steady trend, and then can you talk about how that affects your services revenue you can get from those guys?

Bren Higgins (EVP and CFO)

Yes, but having met with a number of memory customers recently, there's a marked difference in their tone right now. And so when we talked to them last year, you know, it was a lot of downcast looks about the—because they had been ready for a much bigger, you know, much bigger consumption of memory, and now I think they're starting to turn the corner on that. We do see conversion technology, but utilization hasn't really changed much. Service continues to be higher than historically. Our utilization rates on our equipment are higher than historically, but because I think customers, even those that have the ability to flex down their utilization on our systems, have chosen not to.

And so that's been a real strength for us and why services for KLA did so well in 2023, and we expect that growth to resume to the numbers we targeted a couple of years ago for 2024 and beyond. So I'd say the posture is different, and we're going to, and we expect to see that continue to strengthen throughout the year. Yeah, yeah, the customers don't have the same level of redundancy with what they buy from KLA versus a lot of process equipment. And when you're focused on trying to be as efficient with your capital as you can, you'll tend to really focus on trying to drive yield. So the way they buy process control, they don't buy a lot of extra, so they take capacity offline for a process.

They, they tend to run, process control much more consistently. The customers that cut more in terms of utilization earlier, have come back more. I think overall, to Rick's statement, it's been fairly flat, overall. I think DRAM has tightened a bit because of some of the AI drivers for that. But on the flash side, I think it's been, been fairly stable. And like I said, some improvement from folks who, who cut, more aggressively early on.

Joe Moore (Managing Director and Head of US Semiconductors Research)

Great. Thank you very much.

Operator (participant)

Our next question will come from Atif Malik with Citi.

Atif Malik (Managing Director of Semiconductors and Semiconductor Equipment Reseacrh)

Hi, thank you for taking my question. And Bren, you talked about strategic alternatives for the display business. Can you help us out how big the display business was last year? And then in general, on the ETC business, mobility is getting better. Can you just talk about how you're looking at the ETC business excluding display?

Bren Higgins (EVP and CFO)

You're breaking up a little bit there, Atif. So, in regards to the comments on display, it's about 1.5% of the revenue of the company, and it. There are parts of display that are more commodity-based, and there's aspects of that industry structurally, where profitability is more challenged. And then there's some interesting parts of it, too, in terms of some of the future roadmap opportunities and where some of the higher-end customers are moving. So we'll have more to say about that as we assess the alternatives we're considering. The rest of EPC is kind of a tale of two businesses overall. The especially semiconductor business has done exceptionally well. As we talked about in the shareholder letter, really outperforming...

WFE overall, I think it's a combination of customer engagement, more applications, new products. So we're really pleased with where we're performing there and the ability to differentiate, and I would expect that to be roughly flat and with some mix shift. It has some diversity in terms of end markets between automotive and mobile and Advanced Packaging. So you could see a shift where automotive weakens, we'll see more investment on the Advanced Packaging side. So we're pretty positive on that. ICOS, we're already starting to see some improvement there, which tends to be a little bit of a leading indicator in terms of finished components. And so we're more optimistic about how that will translate back into the other parts of our business, given that that's a short lead time, more capacity-centric business.

So again, back to our views of some improvement as we move into the second half. PCB has been more mobile centric in terms of, and more consumer, you know, consumer markets, more capacity centric. So, that business has been weaker, but I would expect it to be a little bit better this year as well. And there are some product offerings that we have coming that start to take advantage of opportunities in high-end PCB and in substrates as those integrate into heterogeneous packages. So we expect the APC business overall to be up. We'll call it, you know, mid, maybe high single digits. A little less lead time over there, so a little harder to forecast, off of the year we had in 2023.

Atif Malik (Managing Director of Semiconductors and Semiconductor Equipment Reseacrh)

Great. Then as my follow-up, Rick, you talked about uncertainty in leading edge with some pushout. If your foundry customers decide to focus more in putting these investments of fabs in Japan versus U.S., is there an impact to your business?

Rick Wallace (President and CEO)

Well, the work that they're doing in Japan is not at the leading edge, but it is part of their overall investment, with the exception of the Japanese company that's investing there. So I would say yes, of course, you know, that's a different kind of business for us. It's important. But the leading edge business that's being done in the foundries isn't being done there right now, with the exception of one. So we're talking about what we're seeing and hearing is the development is going on for the leading edge work. The question is, at what point will they be in a position to ramp that?

The reason we're confident of the growth that's coming is because of the engagements we've had, the design starts that we see, and the plans that we know that they've been, they've been discussing. So we feel pretty good about the setup as we go toward the end of the year and into next year.

Atif Malik (Managing Director of Semiconductors and Semiconductor Equipment Reseacrh)

Thank you.

Operator (participant)

Our next question will come from Charles Shi with Needham.

Charles Shi (Senior Analyst of Semiconductors and Semiconductor Equipment Research)

Hi, thanks. Now, first off, I really want—just wanna ask for some clarification about the service business expectation for calendar 2024. I think you talked about higher forecasted growth in service. Is it higher than what you thought, at the 12%-14% this year, or you're just talking about higher growth than compared with your systems business? Just a quick clarification. Thanks.

Bren Higgins (EVP and CFO)

Yeah, more, more in line with the long-term target model of 12%-14% and closer to the high end of the target range. And that's really being driven by, we talked about some of the improving utilizations that we expect to see as we move through the year, which, if you think about our customers, their businesses get better, they have more demand, they start to consume the capacity they have. They have sustainability in that, and then as their profitability improves, then they start to invest in new equipment. So we would expect to see that play through as we move through the year. But we also will start to benefit from the tools that we shipped in 2021 and 2022, as they move from warranty into contract.

That should be a driver for service growth as we move into next year. We'll be back in line with the overall target model in terms of how we're planning for the business next year. The great thing about service is this growth that happens, you know, pretty continuously. It does have a little bit of a dilutive effect on our overall margins, which is one of the factors in the 2024 gross margin color that I provided. So even if we would expect to see revenue increase a bit, I do think that you'll see a little bit of pressure on margins. Now, it tends to be based on the way we do the accounting, accretive to operating margins.

So, it's at that level, it's pretty positive, but it does have an effect on the puts and takes within gross margin.

Charles Shi (Senior Analyst of Semiconductors and Semiconductor Equipment Research)

Thanks, Bren. Maybe another question, maybe a little bit longer term. I think in the past, you talked about particularly some of your leading-edge customers reusing their capacity in the past and may put a little bit of pressure a few cycles ago on your overall growth. Your largest customer, I think, last week talked about maybe converting some of the 5 nm to 3 nm. We don't know whether they're going to continue to do that, but have any thoughts there? And looking a little bit ahead, do you expect any sort of a negative impact going forward? Thanks.

Bren Higgins (EVP and CFO)

You're right. I mean, historically, customers have always tried to reuse whatever they could. There's a couple factors that impact it going forward. One is the technology that they're going to need for three and then for two is upgraded from what they have at five. And the second one is they still have volume at five. So the question will be, and historically, when this was the most pronounced, was when there was a great falloff in an existing node going to a new node. So in our conversations with them and our modeling of it. We see it pretty consistent from what we've seen in the last few years. Not as, not as high as the reuse was what it was several years ago.

But that factor drives us to continuously provide more capability in the tool to give them incentive to go to the new technology or to upgrade the existing. So there's nothing specifically new about this upcoming next generation of new technology, but it is definitely something customers are always trying to optimize their footprint.

Operator (participant)

Thank you. Our next question will come from Timothy Arcuri with UBS.

Timothy Arcuri (Managing Director of Semiconductors and Semiconductor Equipment Reseacrh)

Thanks. Bren, I wanted to ask about book-to-bill. So, it's below 1 for the fifth quarter in a row. It's up a little bit. It's up to, like, 0.9. So you're reaching some sort of, like, steady state. But it's a much different dynamic, what's sitting in RPO than what used to sit in backlog, because you used to have 4-5 months worth of backlog, and now, you know, if you assume half of this stuff is parked outside of 12 months and half is inside of 12 months, you, I mean, it's not, I guess, that different than it was before, but you still have this, you know, $5 billion plus it's parked beyond 12 months, and that was never there before. So as we look pre-COVID and post-COVID, what changed?

Why is there this $5 billion worth of bookings or, you know, RPO just parked beyond 12 months? Because it, it isn't like your lead times have gone out, out that far. And I understand that, you know, litho's long lead times, but litho's always been long lead times. So what's kind of changed for you?

Bren Higgins (EVP and CFO)

Yeah, no, I think the easiest way to think about that part of it is it's related to customers giving orders that are tied to facilities that they're planning, greenfield projects. And so the schedules are driving the orders, and so it's one of those where it isn't lead time centric, it's, you know, the customer has a project that's going to open in 25. They want their tools when they have that scheduled planned opening. And so they've given us orders. In a lot of cases, you have some China business where you've given us orders and deposits that are tied to those schedules. So that's the biggest factor in the piece that's out.

And you're right, it is a bit of a new phenomenon, I think that we started to see after the massive ramp that we saw from 2019 to 2022 or so. So, and you know, each quarter it's been pretty consistent, and we've been, you know, cleaning up a certain amount of that backlog every quarter, but it's been pretty consistent, and it's been roughly 50% or so. So, in the quarter we just completed, if you notice, if you look at the balance sheet, you'll see the deferred systems revenue is actually a little bit higher, and that's related to the dynamic I talked about earlier, where shipments were higher than revenue levels. And that drove down the RPO.

But the book-to-bill relative to the revenue was actually positive. So, I don't think that changes the nature of your question in terms of the trend line. It was a little bit better, more consistent, it's kind of consistent with what we thought, and a little bit positive in the December quarter.

Timothy Arcuri (Managing Director of Semiconductors and Semiconductor Equipment Reseacrh)

Yeah. Yeah. I mean, it was up, definitely. But I guess just to my follow-up on that is, what's the advantage? If I'm that customer, and if your lead times are well inside of that, what's the advantage, if I'm a Chinese customer, to booking something that's going to sit in your backlog or sit, you know, be, like, parked beyond 12 months? I mean, unless I'm worried about export control, and maybe I think because I have something, I've given you a down payment that entitles me to get the tool. Like, is that part of it? I still don't know why I would, you know, park something, like, way beyond your lead times.

Bren Higgins (EVP and CFO)

Well, if you're a new customer and you have new relationships with us, the demonstration of credibility in terms of, "Hey, we want this, we want to engage, we want you to put resources in place to support the fab," and that takes some time to do so. And then in a lot of cases, that also comes with deposits for a portion of the orders. So I think it comes down to, you don't want. If you're one of those customers, you want to ensure that when your fab opens, that this isn't a bottleneck or an obstacle to your ramp and your plan.

So, in a lot of cases, if they're newer customers to us, these aren't our— You know, I wouldn't say that the customers you know are booking orders that far in advance. But there are certain customers that want to make sure that we're prepared to support their plans, and so they give us orders to ensure that they're credible on those plans.

Timothy Arcuri (Managing Director of Semiconductors and Semiconductor Equipment Reseacrh)

Wow, that's a, you know, ton of, you know, a ton of customers that we actually never heard of before. So okay. Okay, Bren. Thanks.

Operator (participant)

Our next question will come from Toshiya Hari with Goldman Sachs.

Toshiya Hari (Managing Director of Semiconductor Research)

Hi, thank you so much for taking the question. I have two as well. The first one's on High NA. There seems to be, you know, a bit of a disconnect among some of your customers in terms of, I guess, their appetite to take tools and to, you know, develop using those tools. Curious how you're thinking about, you know, potential insertion of High NA over the medium to long term, and how should we think about the positive impact to your business from an intensity standpoint?

Bren Higgins (EVP and CFO)

Our views haven't really changed in terms of the timing for High NA. You know, we're encouraged to see the shipments of the tools that were well-publicized, and that I think that's great. It is going to take a while, of course, as with any new technology, to get those up and into production. So really haven't changed in terms of our view of when that turns into pilot and then when it turns into high volume. But one thing that's clear is the increased adoption of NA, of, of EUV is good for KLA, and the broadening of it, as we see it being more applicable in memory also creates more opportunities, not only just in the reticle space, but because we're now dealing with the defectivity challenges are greater as they start printing smaller features.

It drives both the number and intensity of the tools that we need, but also how they're run. So you need to run, for example, a BBP tool at a higher sensitivity, which, as you know, requires, you know, we keep adding capability, but it does require more capacity to cover the same amount of silicon to support that. So it's a very good trend for process control and ones that we're encouraged by. But from our standpoint, no change, which I guess is really good news because, you know, if we look back at EUV, it did delay several times. High NA seems to be on track with the schedule that has been out there for some time now.

Toshiya Hari (Managing Director of Semiconductor Research)

That's very helpful. Thank you. And then as my follow-up, maybe one for Bren. Just on the display business, so one and a half percent of revenue last year. I'm curious if you could speak to the profitability of that business. I mean, to the extent you do end up, say, selling the business, how should we think about accretion to gross margins and bottom line earnings? Thank you.

Bren Higgins (EVP and CFO)

Yeah, profitability is less than 1.5.

Toshiya Hari (Managing Director of Semiconductor Research)

Okay.

Bren Higgins (EVP and CFO)

1.5% of KLA. So it's 1.5% of revenue. The profitability is less than 1.5% of KLA profitability.

Toshiya Hari (Managing Director of Semiconductor Research)

Okay, I figured that much, but thank you.

Operator (participant)

As a reminder, that is star one to ask a question. All right, we have no further questions in the queue, so I'll turn the floor back over to Kevin Kessel for any additional or closing remarks.

Kevin Kessel (VP of Investor Relations and Market Analytics)

Thank you, Chelsea, and thank you again everyone for your time. We know it's a busy day of earnings, a busy week. We appreciate it. We'll be in touch with, I'm sure, all of you, over the coming days and weeks. With that, back to you, Chelsea, to provide any final instructions. Thank you.

Operator (participant)

This concludes the KLA Corporation December-

Toshiya Hari (Managing Director of Semiconductor Research)

Goodbye

Operator (participant)

...quarter, 2023 earnings call and webcast. Please disconnect your line at this time and have a wonderful day.