Early in September, the U.S. Department of Commerce said it was restricting the ability of top semiconductor designers Nvidia and Advanced Micro Devices from selling advanced AI chips to China. But these restrictions won't just apply to advanced semiconductor designs. The Commerce Department is also putting restrictions on chip fab equipment too, in an effort to limit China's ability to make its own advanced semiconductors.
That's a potentially big issue for top chip equipment maker KLA Corporation (KLAC 2.50%). The company, along with other top fab equipment outfits Applied Materials and Lam Research, was informed earlier this year of restrictions. But a report from Reuters says the Commerce Department is readying new limits on KLA and its peers' sales to China. Is KLA stock a buy given potential geopolitical disruption to its business?
How much does China mean to KLA and friends?
Beijing has been serious about funding the development of its own domestic chip production industry. This incremental investment over the years has been a boon for U.S. technologists like KLA. Specifically, KLA said 29% of its fiscal year 2022 revenue (for the 12 months ended June 2022) came from China, totaling $2.66 billion. This made China KLA's largest geographical market in the last year. The sales figure is up from just 12% of revenue coming from China in fiscal year 2017.
Interestingly, KLA's reliance on China is in spite of its two largest customers being Taiwan Semiconductor Manufacturing (based in Taiwan) and Samsung (based in Korea). TSMC and Samsung each accounted for more than 10% of KLA's sales last year.
The CHIPS Act to the rescue?
Meanwhile, U.S. market share of the chip manufacturing industry has steadily declined for three decades. According to the Semiconductor Industry Association (SIA), chip manufacturing capacity in the U.S. is only 12% of the global total, down from 37% in 1990. This is reflected in KLA's financials too, with North America accounting for just 10% of its sales last year.
The SIA thus applauds the CHIPS Act, which was passed by Congress in July. The plan will dole out some $52 billion in funding over time, specifically for chip manufacturing and research in the U.S. The plan will also provide a 25% tax credit to encourage companies to expand semiconductor manufacturing in the states.
What's this to KLA? Well, if sales to China get throttled, the CHIPS Act could go a long way toward offsetting those losses by fostering new fab equipment spending in the U.S. Other countries around the world are also ramping up investments to domesticate some chip manufacturing for the sake of solidifying supply chains in the wake of the global chip shortage.
KLA has a long road map to further success
Any hardware electronics hardware company, especially one closely linked to manufacturing, is going to be a cyclical business. KLA is no exception. Periods of booming sales can be followed by periods of flat or declining revenue. But the fab equipment industry has consolidated over the years, with revenue growth largely coalescing around KLA, Applied Materials, and Lam Research, as well as the unique equipment made by Netherlands-based company ASML Holding.
As a result, KLA's results have become a steady growth engine for nearly a decade now. Revenue has chugged higher, and free cash flow per share has grown at an even faster rate thanks to share repurchases. A dividend that currently yields just shy of 1.5% a year sweetens the deal.
Data by YCharts.
Most of KLA's revenue is tied to equipment used in process planning and yield management from chip production. In other words, KLA's specialty is making chip fabs more efficient. While it remains to be seen how much of this equipment will be restricted from China, there will be a big push in the coming decade to increase the number of chips produced every year. Chip demand is exploding, especially as modern vehicles and industrial equipment need more silicon, as do data centers powering the cloud and AI.
Despite headwinds from geopolitics, KLA thinks its revenue will grow at an average 9% to 11% per year through fiscal 2026. The company plans to return 85% of free cash flow to shareholders via stock buybacks and dividends, which is significant considering this company generates free cash flow profit margins of upwards of 30%.
As of this writing, KLA stock trades for 18 times enterprise value to free cash flow. Considering the steady growth potential and cash return, it looks like a solid deal, though this will by no means be the fastest-growing story in the chip space. I fhave my money on Applied Materials stock in the chip fab arena. Nevertheless, give KLA a serious look if you're wanting a broad-based bet on the chip industry as chip fabs look to boost production.
