KLA Corp. (KLAC) is an American company that manufactures process control and yield management equipment for the semiconductor industry. It appears the large semiconductor equipment companies have high profit margins, great returns on capital, and barriers to entry. Currently, there seems to be a cyclical downturn in semiconductors in general, so many of the stocks are down quite a bit from their recent highs. Given this background, I want to do a rough valuation on KLA to see whether it is fairly valued or undervalued.
Since I believe KLA has a moat, I will use the growth return valuation method from Bruce Greenwald’s valuation book. With this valuation method, first a sustainable shareholder yield is estimated, then estimated growth rates are added to get expected return from buying the stock.
The first step is to figure out a reasonable steady state revenue. In 2022, KLAC did a record $9,212M in revenue. Since the semiconductor capital equipment industry can be cyclical, I will smooth out KLACs revenue by using a 5 year average. The 5 year average comes out to be $6,108M, which I’ll use for the preceding analysis.
After revenue comes operating margins. KLA has averaged 35% operating margins over the past 5 years. Using these margins, KLA should be able to produce $2,138M in operating earnings based on my estimated go-forward $6,108M revenue figure.
The next step is to get an after tax earnings figure. KLA typically pays an effective tax rate of around 17%. This tax rate applied to the $2,138M in operating earnings produces an after tax earnings of $1,774M.
Now that we have the estimated after tax earnings, we almost have a sustainable shareholder yield. KLAC has 152M shares outstanding, which produces an estimated EPS of $11.67. Looking at past shareholder returns, KLA tends to return most cash back to shareholders. I will estimate that KLAC can sustainably return 70% of their cash flow as dividends and stock buybacks. Applying the 70% to the $11.67 in EPS, we arrive at a distributable earnings of $8.17. With a current share price around $375, KLAC estimated shareholder yield is about 2.2%.
Once we have the estimated shareholder yield, Greenwald adds the estimated returns due to revenue/earnings growth to get the total expected yield of the stock. Revenue growth comes in two forms: organic and through reinvestment.
Thinking about the organic growth rate of the semiconductor equipment industry over the next 10 years, there are many tailwinds with increased semiconductor demand in automotive, cloud compute, Internet of Things, etc. Despite these tailwinds, the semiconductor industry is cyclical, so I want to be a bit conservative with a long term growth estimate. If GDP is usually around 3%, a long term revenue growth rate of 5-7% could be reasonable for the semiconductor equipment industry.
Reinvestment growth occurs when a company reinvests its leftover cash in things such as expanding production, performing research for new product lines, or performing major acquisitions. However if a company is returning a large portion of its cash back to shareholders, then the business is most likely in a mature state. Since KLAC is returning most of its profits back to shareholders, my view is that they are not reinvesting in their business at a large scale. Therefore I will only utilize the organic growth figure when estimating the return in KLAs stock.
Finally we have all the pieces to estimate the long-term returns of KLAC at its current stock price. The estimated shareholder return gives us 2.2%, then we add the growth return of 5-7% producing a total return of 7.2-9.2%. Given these ranges, KLAC seems fairly valued. However, if we re-compute the returns using their current 52 week low of $250 a share, the shareholder yield would be 3.3%, bumping the total return to 8.3-10.3%.
After doing this analysis, I think a decent return could be achieved from buying KLA at the current prices, however as a value investor I would prefer to see it get a bit cheaper. If the stock sells off back around $250 I may consider it. Another point is that my organic growth estimates are quite hand-wavy, so it could be possible that higher returns are realized if revenue growth surpasses my expectations.