KLA Corp (KLAC) — Q2 2022 Earnings Call Transcript

Thank you, Leo, and welcome to KLA's Fiscal Q2 2022 Quarterly Earnings Call to discuss the results of the December quarter and the outlook for the March quarter. With me on today's call is Rick Wallace, our Chief Executive Officer; and Bren Higgins, our Chief Financial Officer. During this call, we will discuss quarterly results for the period ended December 31, 2021, released this afternoon after the market closed. You can find the press release, shareholder letter, slide deck and infographic on the KLA IR section of our website. Today's discussion is presented on a non-GAAP financial basis unless otherwise specified. And whenever we make references to full year business performance, it can be understood to be a calendar year. A detailed reconciliation of GAAP to non-GAAP results is in the earnings materials posted on our website. Our IR website also contains future investor events as well as presentations, corporate governance information and links to our SEC filings, including the most recent annual report and quarterly reports on Forms 10-K and 10-Q. Our comments today are subject to risks and uncertainties reflected in the risk factors disclosure in our SEC filings. Any forward-looking statements, including those we make on the call today, are also 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. Let me now turn the call over to our Chief Executive Officer, Rick Wallace. Rick?

Thanks, Kevin. Before summarizing KLA's results for calendar year 2021 and for the December quarter, I'd like to first acknowledge and thank the global KLA team. The dedication and hard work of our teams never wavered despite challenging conditions, delivering for customers and managing around a complex global supply chain during a period of unprecedented industry shortages. It was the day-to-day drive to be better that drove KLA's market leadership, resulting in record growth and financial performance across the board for the company in the December quarter and for 2021. KLA also delivered record returns to shareholders in 2021 through our dividend and share repurchase programs with returns to shareholders totaling over $2 billion. KLA's strong results demonstrate our track record of relative strength and revenue growth and superior financial performance compared with semiconductor industry peers in a dynamic and growing wafer fab equipment industry as well as the long-term value created by employee and consistently refining our KLA operating model. Since our founding in 1976, KLA's mission has been focused on using our expertise and innovative thinking to overcome monumental technological challenges. KLA is advancing humanity with technologies and ideas that inspire action. Our results in the December quarter and for 2021 demonstrate ongoing success of these strategies. So thank you to all our teams for contributing to KLA's enduring success. 2021 was another year of record growth, profitability and free cash flow for KLA, as we successfully navigated unprecedented challenges in the marketplace, responding to record demand across the vast majority of our markets, while adapting to the evolving operational complexities associated with the global pandemic. Through it all, we remained focused on delivering to our customers' requirements and driving strong returns to shareholders in a rapidly growing industry demand environment. In 2021, revenue grew 34% to $8.2 billion, marking the sixth consecutive year of revenue growth. KLA's strong revenue growth in 2021 was driven by 46% growth in the semiconductor process control systems. Revenue from the services business grew 14% in the year, with over 75% of the revenue generated from recurring subscription-like contracts, reflecting the growing value of added process control systems and services in our product portfolio. KLA also demonstrated strong operating leverage on our revenue growth in 2021 with non-GAAP operating profit and non-GAAP earnings per share growing 54% and 61%, respectively. Incremental operating margin on the revenue growth in 2021 was 57%, consistently above our target operating leverage model of 40% to 50% for the second year in a row. Free cash flow also grew a healthy 43% in 2021 to a record $2.5 billion. Consistent with our long-term strategic objectives, KLA delivered on our ongoing commitment to return value to shareholders, including our 12th consecutive dividend increase announced in July 2021, along with an additional $2 billion share repurchase program. Total returns to shareholders in 2021, including dividend and share repurchases, topped just over $2 billion or approximately 79% of free cash flow. This growth demonstrates success in strengthening our market leadership across our business that we can continue to build upon to drive adoption of KLA solutions in the critical markets we serve. Within the Electronics, Packaging and Component inspection or EPC Group, the Specialty Semiconductor Process segment grew 11% in 2021, and the Printed Circuit Board Display and Component Inspection grew 17% in the year. The strong relative performance for KLA reflects our market leadership and diversification and was driven by secular industry growth trends across multiple end markets. We ended 2021 with an exceptionally strong backlog and began what we anticipate being a seventh consecutive year of growth for KLA. We enter 2022 executing at a high level and operating from a position of strength in our marketplace despite persistent supply chain challenges. This momentum sets the stage for KLA to continue to outperform the market while demonstrating superior financial performance and maintaining our capital returns. Turning now to focus on the December quarter results where we saw diversified strength across our business. Today, demand environment continues to demonstrate accelerated adoption of a broad spectrum of semiconductor and electronic industry growth trends. Technology is transforming how we live and work and the data-driven economy is fundamentally changing how businesses operate and deliver value. This digital transformation is enabling secular demand drivers such as high-performance computing, artificial intelligence, growth in new automotive electronics and strong growth in data centers and 5G communication markets. Each of these secular trends are driving investment and innovation and advanced memory and logic semiconductor devices as well as new and increasingly more complex advanced packaging and PCB technologies. With our market leadership in process control, and growth and expansion in new markets like Specialty Semiconductor Process equipment, PCB and finished die inspection in our EPC group, KLA is essential to enabling our increasing digital world. To make this happen, KLA continues to prioritize and invest in R&D, which totaled $1 billion in calendar 2021, double the level of 5 years ago and growing at a 15% compound annual growth rate. With this favorable backdrop and our demonstrated track record of investing heavily in R&D to drive product differentiation and consistently meeting or exceeding our commitments to customers and shareholders, our performance enabled KLA to outperform the 2023 long-term financial model targets that we set 2 years ago, 2 years ahead of expectations. Moving along to the top highlights from the December 2021 quarter. First, we saw continued strength and consistency in foundry logic customer revenue for both leading edge and legacy technologies in the December quarter. As expected, memory demand also grew in the period. Calendar 2022 is setting up to be another year of strong growth for WFE. We see demand momentum throughout 2022 across our major end markets. The strength in demand we're seeing reflects KLA's essential role in supporting our customers' drive to innovate and continue to invest in future technology nodes. In foundry and logic, simultaneous investments across multiple nodes and rising capital intensity continues to be a tailwind. In memory, demand remains broad-based across multiple customers, and we expect another year of double-digit growth in 2022 with NAND growing faster than DRAM; second, KLA is seeing strong demand across the breadth of our industry-leading optical inspection portfolio as we have maintained our momentum in one of the fastest-growing markets in WFE. Wafer inspection systems revenues grew 54% in 2021, far outpacing the WFE market, which is estimated to have grown 40%. We're experiencing strong growth across our wafer inspection portfolio from broadband plasma, laser scanning, unpatterned bare wafer inspection, macro inspection and e-beam products. This quarter, we highlight macro inspection, which is growing at a pace of 1.5x WFE driven by growth in automotive and other specialty markets where KLA has defensible market leadership with a platform uniquely positioned to address growing technical complexity and tighter design rules; third, success in KLA's strategic growth and market diversification strategies are being demonstrated by growth in EPC. Systems revenue from KLA's Electronics, Packaging and Components, or EPC group, grew 20% in 2021. With EPC, KLA is diversifying our market leadership with a portfolio of solutions addressing fast-growing new markets in the electronics value chain, including RF, specialty semiconductors, automotive, PCB, advanced packaging and display; fourth, service revenue grew 14% in 2021 to $1.8 billion and continues to sustain a growth rate above its long-term target of 9% to 11%. For the quarter, services revenue was $457 million or 19% of total revenue. Annual services revenue is quickly approaching $2 billion and has grown 81% in the past 3 years. This growth has been driven by the rising installed base and increasing adoption of subscription-like contracts. Over 75% of service revenue in the Semiconductor Process Control segment, and over 90% of services in the printed circuit board business come from recurring subscription-like contracts. Finally, the December quarter was another exceptional one from a free cash flow perspective, capping a year in which KLA generated over $2.5 billion in free cash flow and returned over $2 billion to shareholders. In the December quarter, we generated strong quarterly free cash flow of $746 million, which helped drive 43% growth in free cash flow in 2021. We've also maintained focus on returning capital to shareholders via our dividend and share repurchase program, which rose 63% year-over-year on a combined basis. Before Bren gets into greater detail on our financial highlights and guidance, let me briefly summarize. Despite the persistent disruption and continued challenges associated with the pandemic, particularly around the supply chain and component availability, KLA is consistently delivering strong revenue growth, financial results and returns to shareholders. KLA is well positioned at the forefront of technological innovation with a comprehensive portfolio of products targeting the most demanding inspection and measurement challenges in the marketplace. I also want to provide a quick update on our ESG activities. On December 16, KLA announced setting a goal to use 100% renewable electricity across our global operations by 2030. Managing the impacts of our business in terms of ESG stewardship is an integral part of KLA's mission to advance humanity. This includes contributing to creating a more sustainable future. With that, I'll pass the call over to Bren to cover our financial highlights, outlook and guidance. Bren?

Thank you, Rick. KLA's December quarter and 2021 results highlight the continuation of strong execution in a dynamic and challenging market environment. We continue to demonstrate our ability to meet customer needs and expand our market leadership, while growing operating profits, generating record free cash flow and maintaining our long-term strategy of productive capital allocation. The December quarter capped off a year in 2021 that was defined by strong growth and profitability across multiple areas of our business. We also invested almost $1 billion in R&D to sustain our success and $250 million in capital expenditures to grow our global infrastructure to support our industry growth thesis. All this was accomplished while simultaneously continuing to return high levels of capital to shareholders. Total revenue in the December quarter was $2.35 billion, above the midpoint of the guided range of the quarter of $2.225 billion to $2.425 billion and up 13% sequentially versus the September quarter. Non-GAAP gross margin was 63.1%, just above the midpoint of the guided range of 62% to 64%. GAAP diluted EPS was $4.71 and non-GAAP diluted EPS was $5.59, each within the guidance range. Gross margins were 63.1% and in line with expectations as product mix and factory expenses ended the quarter mostly as planned. KLA's gross margin reflects the value we deliver to the marketplace and our competitive differentiation. To improve on our ability to meet our customer needs, we are also making meaningful investments in our global workforce, supply chain and factory infrastructure to position KLA to deliver our products in this growing demand environment. Total non-GAAP operating expenses were slightly below the midpoint of the guided range of $465 million, including $265 million of R&D expense and $200 million of SG&A. Non-GAAP operating income as a percentage of revenue was 43.4% in the December quarter. KLA's innovation is fundamental to our go-to-market strategy focused on differentiated solutions. R&D is at the heart of what we do and remains a key element in driving our portfolio strategy, new product introduction cadence and product differentiation. This in turn helps sustain our technology and market leadership. Given the rapid growth of the business over the last couple of years and our revenue expectations going forward, we expect the company's operating expenses to continue to grow as we invest in global infrastructure and systems to scale the KLA operating model, as well as new product development programs and volume-dependent resources to support our business expansion. Furthermore, we, as most companies are seeing a strong labor market driving cost pressure across our global workforce and within outsourced partners. As a result, we expect operating expenses to grow sequentially to approximately $495 million in the March quarter, and we forecast sequential growth in operating expenses to continue through calendar 2022. While operating expenses are modeled higher going forward as we will make the necessary investments to scale our business to support our long-term structural industry growth thesis, we will continue to size the company based on our target operating model, which delivers 40% to 50% incremental operating margin leverage on revenue growth over a normalized time horizon. Other interest and expense in the December quarter was $39 million, and the non-GAAP effective tax rate was 13.3%. Though we always have some variability in our tax rate, given the timing and impact of discrete items and the geographic distribution of revenue and profit, we believe it remains prudent to maintain our long-term tax planning rate at 13.5% going forward. Non-GAAP net income was $851 million. GAAP net income was $717 million. Cash flow from operations was $811 million, and free cash flow was $746 million. This resulted in a free cash flow conversion of 88% and a very healthy free cash flow margin of 32%. The company had approximately 152 million diluted weighted average shares outstanding exiting the quarter. Revenue for the Semiconductor Process Control segment, including its associated service business, was $2.05 billion, up 49% compared with the December 2020 quarter and up 15% sequentially. Semiconductor Process Control systems and service grew 39% in calendar '21 versus calendar 2020. Foundry logic was 71% of the approximate Semiconductor Process Control system customer segment mix in the December quarter and memory was 29%. Within memory, the business was split roughly 54% DRAM and 46% NAND. Revenue for our Electronics, Packaging and Components Group continues to be driven by strength in 5G mobile and infrastructure as well as continued demand in automotive. More specifically, the Specialty Semiconductor Process segment, which includes its associated service business generated record revenue of $113 million, up 24% over the prior year and up 10% sequentially. Specialty Semiconductor Process systems and service grew 11% for calendar '21. PCB, display and component inspection revenue was $188 million, up 5% year-over-year, but down 7% sequentially. On a full calendar year basis, it grew 17%. Our breakdown of revenue by major products and region can be found in the shareholder letter, so I won't cover those here. Turning to the balance sheet. KLA ended the quarter with $2.8 billion in total cash, total debt of $3.4 billion and a flexible and attractive bond maturity profile supported by investment-grade ratings from all 3 agencies. We remain committed to our long-term strategy of cash returns to shareholders, executing a balanced approach split between dividends and share repurchases, targeting long-term returns of 70% or more of free cash flow generated. In 2021, KLA exceeded our long-term capital returns target, returning over $2 billion to shareholders, including $601 million in dividends paid and $1.4 billion in share repurchases. We believe our track record of delivering strong capital returns is a key component of the KLA investment thesis and offers predictable and compelling value creation for our shareholders. KLA has a history of consistent free cash flow generation, high free cash flow conversion and strong free cash flow margins across all phases of the business cycle and economic conditions. During the December quarter, we repurchased $430 million of common stock and paid $160 million in dividends. As we begin the new year, our view is that the WFE market will grow in the high teens, topping $100 billion off a baseline of approximately $86 billion for 2021. WFE demand is still constrained by the industry's ability to supply. Strong industry growth momentum in 2022 across all end markets is expected to drive growth with the strongest percentage growth coming from foundry logic customers. And memory investment will be led by 3D NAND. Now wrapping up with our outlook and guidance. Looking ahead, our backlog remains strong and sales funnel visibility over the near-term horizon is good. However, rising product lead times driven by increased supply chain constraints is limiting our near-term output. These issues are reducing our revenue expectation by 8% to 10% for the March quarter. Specifically, COVID-related disruptions at a number of single-source suppliers have exacerbated what has already been a difficult supply situation where these suppliers have been challenged to meet demand by running their production at maximum capacity. These disruptions are causing delays in parts delivery timing across multiple product platforms. In addition, numerous electronic component sourcing challenges have become more acute over the past month as these are standardized parts and in demand across multiple industries. We expect that the COVID-related impact will begin to abate shortly and new capacity or supply alternatives are expected to become available as we move through the calendar year. While these issues can be fluid and difficult to predict in the short run, we expect the March quarter revenue to represent the low point for calendar 2022, and we remain exceedingly confident in the sustainability of our current demand profile for the year. Given current expectations for growth in WFE and other electronics markets, we feel confident in our ability to grow throughout the year with total company revenue growth exceeding 20% and semiconductor process control systems revenue to outperform WFE growth again. Our confidence is based on current backlog levels, competitive positioning, strong customer engagement, and steps we continue to take to add capacity to address output constraints in what continues to be a robust demand environment. Our March quarter 2022 guidance is as follows: Total revenue is expected to be in a range of $2.2 billion, plus or minus $100 million. Foundry logic is forecasted to be about 59% of Semiconductor Process Control systems revenue. Memory is expected to be approximately 41%. We forecast non-GAAP gross margin to be in a range of 61.5% to 63.5% as overall revenue levels declined modestly on a sequential basis and product mix dilutes gross margins by roughly 50 basis points versus the prior quarter. To provide some color for the calendar year, given higher revenue volume, product mix expectations across our various segments offset by expected cost pressures within our supply chain, we are modeling gross margins to be approximately 63% for the year, plus or minus 50 basis points. Other model assumptions for the March quarter include operating expenses of approximately $495 million, interest and other expense of approximately $41 million and an effective tax rate of approximately 13.5%. Finally, GAAP diluted EPS is expected to be $4.54, plus or minus $0.45, and non-GAAP diluted EPS of $4.80 plus or minus $0.45. The EPS guidance is based on a fully diluted share count of approximately 151 million shares. In conclusion, we have exceptionally strong and diversified end market dynamics propelling semiconductors and the essential WFE investments required to make them. Furthermore, we are seeing revenue growth opportunities as more innovation occurs and technology complexity increases in specialty semiconductors, advanced packaging and other electronics markets. Finally, our services offerings continue to deliver more value to our customers in our Semiconductor Process Control business, and their evolving opportunities to further expand our value proposition in our acquired businesses. Our record backlog is supported by solid customer demand across end markets and at multiple technology nodes. 2022 is setting up to be the third consecutive year of double-digit growth for WFE and the seventh consecutive year of growth for KLA. The KLA operating model fuels KLA's strategic objectives and positions us to outperform the industry in terms of growth and financial performance. These objectives fuel our growth, operational excellence and differentiation across an increasingly more diverse product and service offering. They also underpin our sustained technology leadership, wide competitive moat and strong record of free cash flow generation and capital returns to shareholders. With that, I'll now turn the call back over to Kevin to begin the Q&A session. Kevin?

Go ahead and queue for questions. Sorry about that.

Rick, as you pointed out in your prepared comments, you guys have been dealing and the industry has been dealing with a difficult supply situation all year, but this is the first quarter that you and others have seen to have a meaningful impact on the business. And I'm kind of curious as to what specifically happened in the last 90 days to make things worse. And I guess, more importantly, as you call March as the bottom, what gives you confidence that these problems won't persist even longer?

John, thanks for the question. Yes, we feel pretty good about how we've navigated through the pandemic. A couple of factors for KLA specific, I think, to think about. One is we were up in the December quarter. And again, huge customer demand, so working to work that off. We talked in the past about securing critical components, critical parts from key suppliers. That actually continues to be in good shape, where we had some challenges in the last few weeks. And right now, as we're actually working through them, had to do with not necessarily our critical supply but just generalized supply across the industry. I think as most companies are talking about. So we're seeing some of that, that are not unique, as Bren said in his comments, to KLA. The reason we feel more confident is even in the last few days, we've seen some pressure being released in that system, that it won't be in time for what we would have preferred to ship in this quarter, we obviously have the backlog, we could have shipped more if we'd had it. But it's being resolved. So we feel pretty good about the go forward after we get through March. And I'll let Bren add some color since he's spending a good part of his time working some of these issues himself.

Hey John, how are you? So just to add to Rick's comments. I think one of the things you have to consider is most of our strategic buffer that we've built, whether we have it in inventory levels at the company, whether it's at inventory or long lead time materials that we've either procured or suppliers have procured. Over the last 15 months or so, given the strength of demand, we have worked through a fair amount of that. And that's one of the challenges we have is we are more dependent today on the predictability of timing, first of all, but also volume of quality. And so I think those are issues that we continue to work through. As Rick said, in our complex systems, we generally have a pretty transparent view of where that demand is, although everyone is struggling to meet the demand environment that we're facing today. But it's in our higher volume but single sourced type products where we've seen some of these pressures. We did not anticipate a COVID variant and what that would do to those factories in terms of people having to leave either because of contact or exposure. So you had facilities that are already running 100% max that all of a sudden had to deal with this disruption in a lot of cases, a pretty meaningful disruption in the first part of the month. We think that, that's abating. And we're getting a sense that that's improving. And this COVID environment, we'll have to figure out and navigate our way through. We don't know what the future holds. But at least in terms of the near-term environment, we feel pretty good about that.

Bren, for my follow-up, you provided specific guidance for operating expenses that will grow sequentially throughout the year, while still fitting within the model of a 40% to 50% incremental operating margin. I assume this year’s supply constraints are leading to some extra costs that may decrease over time as supply improves. There seems to be a bigger mismatch between revenue collection and investment this year. As we begin to recover some revenue with improved supply, should we consider that incremental operating margins might be closer to the higher end of that 40% to 50% range? How should we view this as revenue growth picks up after March?

Yes. No, you're thinking about it right. As we see revenue growth, it should accelerate to the higher end of the range. The commentary was really about how we look and size the company on an annual basis or over a longer-term horizon. And if you look at '19 to our '22 planning, we will have had incremental operating margins given the growth we've seen in excess of 50%, about 52%. So my point was that we would expect revenue to grow. We're also expecting OpEx to grow. But at the end of the day, as we're sizing 2022, we expect to be in our target range of 40 to 50.

Great execution by the operations team. In calendar '21, your Process Control Systems business outgrew WFE by about 8 percentage points. So strong performance there. So as we look at your WFE outlook for this year, right, up 16% to $100 billion, taking into account rising cost of control intensity, your portfolio of new products, how should we think about your Process Control Systems growth profile relative to WFE this year? It's clearly going to outperform, but should we expect a similar type of outperformance like you saw in '21 or maybe even better, just given the customer mix and the complexity challenges? And is it going to again be led by wafer inspection?

Harlan. Good question. Yes, we feel really good about how we performed in 2021. We've discussed several times the extraordinary strength of optical wafer inspection throughout the year. Looking at our order book, there is tremendous interest in those products, and we see great opportunities in 2022 as well. This creates a favorable mix for 2022. Based on the success of our new products and their reception by customers, we anticipate being in a strong position to strengthen our market leadership moving forward. We expect continued growth in market share, albeit at the rate we outlined a few years ago. The combination of these factors along with the ongoing drive in design roles are all positive indicators and drivers for KLA to outperform, which is our forecast. While we can’t predict the exact details at this point in the year, we believe Process Control is well-positioned for 2022, and we are in a strong position within Process Control. Bren can add some additional insights on this.

Yes, Harlan. I expect that foundry logic will grow faster this year compared to the growth rate in wafer fabrication equipment. This should result in a favorable mix, supporting Rick's point that it will be a driver for us. From a market share perspective, we feel confident about our position, especially in wafer inspection, which has been our fastest-growing business. I believe it may be one of the fastest-growing markets within wafer fabrication equipment. We anticipate continued momentum in that overall market. As mentioned in our prepared remarks, we estimated that we were around 46% for semiconductor systems in 2021, which contrasted with a market of 40% or 41%. Looking at growth rates in the high teens for wafer fabrication equipment this year, I expect us to improve similarly over the market, likely in the mid-single-digit range based on our current outlook.

And I appreciate the insights there. And then on the gross margin front, I understand the supply challenges and other logistics-related dynamics that are impacting your shipments here. But relative to your peers, I mean, your gross margins are holding up extremely well, right? I mean you guys are only guiding for roughly a 50 basis point decline sequentially in gross margins here in the March quarter. And it actually looks like that's more mix and volume related, right? And in the midst of all of these potential cost dynamics, you're still guiding full year gross margins to 63%. So help us understand the better sustainability of gross margins in this challenging period. I mean, are you guys just passing along exercising some pricing power and just passing along some of these cost to your customers?

That's a great question, Harlan. I'll start, and Rick might want to add some comments. Our pricing model is based on value rather than cost. We price our products according to the value we believe our tools provide to customers. As we look at the March quarter, the decline is mainly in Semiconductor Process Control revenue quarter-to-quarter. However, we anticipate growth in our EPC business, and service revenues consistently increase each quarter. This results in a mix and volume effect for the March quarter. Moving forward, we are experiencing cost pressures, and I’ve been transparent about a 100 basis point headwind linked to cost increases, as nearly everything is becoming more expensive. Labor costs are rising, and the investments our suppliers are making are adding to costs in our model; however, we have accounted for that. Given the anticipated mix as we enter '22 and the growth rate of Semi PC, we expect margins to improve, even though we are feeling some pressure. I believe we will maintain around 63%, with some variability each quarter. Ultimately, this reflects the value we provide and the differentiation we have in the market.

Yes, I’d like to emphasize the importance of recognizing the value we create for our customers and incorporating that into our pricing. Customers are highly motivated to access our products quickly because the returns are rapid. In a more normalized environment, without supply constraints, an increase in volume would typically lead to better cost dynamics. The slight headwind we’re experiencing is mainly due to some pricing increases, but overall, it’s not significant for our business. Historically, if our revenues rose as they have, we would expect to see volume discounts from suppliers, which would help lower costs, but that’s not occurring in the current environment. However, we’re starting from a strong position, and our new products have been very well received. Not only are we pleased with the margin profile, but our customers are eager to obtain the new products. Therefore, we find ourselves in a favorable position at this moment.

I guess another gross margin question, if we really drilled down just the process control, you grew gross margins there, 64% in 2020 to 65% in 2021. And I'm cognizant of the fact that there's clearly some challenges near term. But as you think about the mix that you're seeing and the value add that you're bringing, where do you think process control gross margins can go in a more normalized environment once the supply chain normalizes?

Yes, it's a great question. You're correct that we're in the mid-65% range for the overall process control segment. As we move into 2022, I would expect that to remain roughly flat, perhaps a bit better, but generally in that range considering our previous discussions. A lot depends on the service mix, as service gross margins have improved over time with business scaling, although it can be dilutive. In the long run, if service grows faster than systems, that might put some pressure on margins. We're fairly comfortable with the current levels and I can see them increasing. We typically talk about 60% to 65% incremental margins on our semi process control business, so I would expect something consistent with that. However, once you approach or slightly exceed 65%, you're nearing the upper limit of potential growth. I believe we are likely to remain in the mid-60s range, possibly inching up slightly from there, but I don't anticipate significant improvement beyond that.

That's helpful. As my follow-up, I guess, can you comment on whether you expect to be constrained in the June quarter? And as we think about kind of second half total revenues versus first half on a calendar basis, should we be thinking kind of low- to mid-double-digit growth half-on-half?

Yes, I think that's the way to think about it. Certainly, the second half will be stronger than the first half. And look, I think we're all constrained right now in terms of the ability to get parts. What we've provided is our expected probability of all the various issues we're managing in terms of an overall view. But given that March will be lower, I would expect sequential growth as we move through the year. And the second half overall for the company, yes, low- to mid-double digits is a reasonable way to think about it.

I actually wanted to ask the last question in a slightly different way. So as you go into June, so I think you're suggesting about a $200 million impact in the March quarter. Are you able to recognize that $200 million in June? Or is that spread into the back half of the year?

Yes. Vivek, it will show up in the June quarter. So these are shipments that slipped out and then are in the June quarter. But when you have suppliers that are running at max capacity in a lot of cases, and they have a disruption, I think the making up of that lost time will take some time through the year, right? I don't think that they'll be able to make it all of it once. So there's a little bit of a cascading that happens whenever you have a disruption in a facility that's already running full out, I mean, equipment is running 24/7, people are working up to legal limits in terms of overtime. Trying to squeeze more capacity in the short run is a little bit harder. But over time, I would expect that we'll see that creep out. We also expect capacity to improve or have alternatives to materialize as we move through the year. So it's a combination of those effects. But yes, I would expect it to move into the June quarter.

We observed that with Omicron, more individuals were affected and lost workdays, although fortunately not to a severe extent, which meant they couldn't be part of the workforce. As Bren mentioned, the factories were already operating at full capacity, making it challenging to compensate for that loss. However, they are beginning to return to normal operations, and we are quite confident that the supply chain will stabilize to support our business moving forward.

For my follow-up, I understand it's very early, but could you share some insights into customer discussions regarding 2023? Historically, WFE has experienced growth for two to three years, followed by a period of stabilization. Now, as we approach the third year of growth, do you think a fourth year of growth is feasible? What are the key factors to consider, so that investors can understand whether this is the peak year for WFE or if there are still opportunities for growth next year?

Vivek, great question. I think, ironically, perhaps the current slowdown in our ability as an equipment industry to provide will stretch this out into '23 anyway. And so you see that plus a number of high-profile projects, which have been discussed recently by our customers don't really order equipment in '22 or maybe they place POs, but we certainly don't see deliveries. So if you think about some of the big new greenfield projects that have been announced, those are '23 projects, not '22. So I think the combination of those that are related to both support from the regionalization efforts driven by things like the CHIPS Act in the U.S. should that come to pass. But even the other projects, which aren't dependent on that, are really much more about '23 than they are about '22. So as we look at it now, we do have pretty good visibility out through the end of the year and even into the first part of next year for the demand to continue to be very supportive of our business.

Yes. Vivek, I would like to add that we have a significant amount of backlog. In many instances, we are already booking slots for customers in 2023. As a result, we feel quite confident about the sustainability of the current trends. I mentioned earlier about the second half of the year and as we plan for the company and our capacity, we expect those business levels to be maintained as we move ahead. While it's still a long way out and circumstances can change, we certainly do not see any indications of a slowdown on the horizon. Additionally, customers are requesting more and quicker delivery.

I had two questions, Bren. One relates to the previous question. It seems that the wafer fabrication equipment in the first half of the year was lower than most of us anticipated as we entered March due to some constraints. However, the second half is projected to be much larger. Based on your numbers, you might have around 18, maybe even 19 process control shipments in the second half of the year. If you consider your share of wafer fabrication equipment, that approximates to an annualized figure of about $110 billion. My question is, when you evaluate that figure and assess the actual demand for wafer fabrication equipment by looking at projects and technology transitions, how do you determine at what point the run rate for wafer fabrication equipment becomes excessive? Furthermore, do you concur with the estimated figure of around $185 billion for the system number in the latter half of the year?

Tim, regarding the last part of your question, based on the guidance we provided for the second half, your estimate is likely close, probably in the 18 range, give or take. We will need to see how things develop. We've spent considerable time analyzing the various leading indicators from our customers, including our discussions with them and their profitability levels. We examine the end markets and the challenges within them. Currently, our customers are spending more than ever and are more profitable than at any time. This gives us optimism about their current situation and demand. We are going to keep monitoring it. At this moment, our customers continue to request systems. As I mentioned earlier, WFE is limited by supply. Over the long term, we anticipate that WFE, due to increasing capital intensity, will grow at a faster rate than semiconductor revenue as a long-term trend. This is the approach we are taking in our modeling and planning regarding supply and necessary investments.

And then just maybe a bigger picture, Rick, I'm sort of curious what your view is. I get a lot of questions around as you go to sort of scaling that's a little more verticalized versus using litho to scale, whether you're talking about indiscernible or 3D DRAM, things like that. It isn't exactly what happened in NAND, but litho does become a little bit maybe less of a driver for actually to scale going forward. Can you just talk about how you think about how that affects you either positively or negatively sort of in terms of your ability to keep on gaining WFE share? And maybe what you're attach to litho is sort of how you think about that bigger picture?

Yes, thanks, Tim. That's a good question. It's interesting to use NAND as an example because there, we actually went backwards in lithography. While the process control intensity decreased slightly, we initially expected a larger decline. This was due to two factors. If we had had the right solutions, it likely wouldn’t have decreased at all because there were other integration issues we could not address at that time. Even so, we observed a backward trend without a significant change in process control intensity, although at lower levels. We're already seeing through discussions with customers that the process control challenges with new device types will be substantial. While defects are a major factor, EUV is creating additional use cases, and there are registration overlay challenges that have led to a considerable market. We also recognize the increasing need for various inspection layers using different wavelengths. The Gen 4 technology is currently being extended; it actually generated more revenue than Gen 5 in 2021, and we expect this trend to persist because of its effectiveness and wavelength advantage. The important question is whether there will be integration challenges affecting our customers. With multiple competitors at the leading edge, it benefits KLA. We previously had a dominant driver and a key end device focusing on logic, but that's changed. We're optimistic about the architectures we're observing, and our process control teams are collaborating with customers. Looking ahead several years, we believe we're well-positioned with ample opportunities and are heavily investing in R&D, as Bren mentioned, to support these advancements. We do not foresee a relaxation in process control intensity moving forward. While we don't expect a significant rise, if it does increase, that would be an upside to our model, although it's not something we're currently factoring in.

Tim, there are two main points to discuss. First, as we transition from planar to vertical NAND, using NAND as a reference, we observed a slight improvement in overall process control intensity, particularly within our metrology sector. Building structures vertically introduces new metrology challenges, and we've noticed an inflection point in that area. Additionally, there are defect mechanisms associated with high-aspect ratio structures. If NAND serves as a benchmark, we are optimistic about the opportunities ahead as these defect mechanisms and metrology challenges evolve, but overall process control intensity remains positive. Our 2023 plan for process control, or KLA's share of the wafer fabrication equipment market, aimed for an improvement in process control intensity, with KLA's share projected to increase by about 75 to 100 basis points compared to 2019. We believe we are on track to achieve this as we move forward. As Rick mentioned, while we do not expect significant growth, we do anticipate continued growth, which should allow us to consistently outperform the market over the next few years.

Rick, maybe just following up on that question by Tim in terms of process control intensity in terms of device architecture. As we look at gate all around, and I know you've talked about it from a big picture perspective of some of the opportunities there. But given the materials intensity, how do you see, I guess, more semiconductor engineering materials type of trends benefiting process control intensity? And especially, I'm just thinking gate all around, the gates now being surrounded by a lot of materials. How do you look at it from both an inspection and probably from an overlay metrology perspective? Do you see one or the other benefiting from these changes on the materials front?

Yes, that's a great question. We have been in discussions with customers regarding advanced architectures and the challenges they encounter. Fortunately, we often have more time than initially expected to prepare our solutions, as these tools usually take longer to enter the market than anticipated. We are in a strong position to deliver the necessary solutions. Specifically regarding gate all around, there are several problems we need to address for inspection. A key issue that often gets overlooked is contrast, which is more critical than resolution. Different materials for gate all around present distinct contrast challenges, making wavelength selection crucial. This is why we are extending Gen 4, and we are seeing positive modeling results from that effort. Moreover, we face challenges related to registration and overlay, which can be significant with each generation. The increase in sampling in this area is substantial. Our modeling capabilities in the company are robust, allowing us to understand how devices will perform and what capabilities they will require. As a result, we are well-equipped to manage this situation. We expect to see growth in both inspection and metrology, although in different ways. In metrology, it's about enhancing the sampling at existing levels, which means more measurement points per die and wafer. In inspection, it involves adding inspection steps during the process, rather than changing the predetermined area to be inspected. Overall, both areas will grow for different reasons. Our relationships with customers have evolved as they recognize the importance of inspection and metrology early in the development phase to successfully ramp up new technologies. Therefore, we are optimistic about our understanding of these trends.

Great. That's helpful. And as a quick follow-up. The current environment obviously is seeing very high utilization across fabs for both leading edge and trailing edge. Given the supply chain issues, and I know not all parts and components are the same for both new systems and your spare parts business, your installed base business. But how are you balancing some of the procurement issues that you're dealing with today in terms of where do I take this component or part? Should it go into the spare parts bucket? Or should it go into a new system? How are you balancing that today?

Yes, Patrick, that's a great question and something we spend a lot of time on internally. Brian Lorig, who manages our service business, always reminds me not to forget about spare parts. It's definitely a balancing act. Fortunately, we have a good idea of when certain components are likely to fail, allowing us to plan accordingly for stocking levels. However, there have been instances where we've had to remove parts from systems to support the field because we’ve made commitments to our customers. Those customers rely on these systems, and it's crucial for us to keep them operational. In most cases, we prioritize service if we can't find a workaround, which we have largely been able to do. It's a continuous balancing act that we monitor very closely.

I wonder if you could talk a little bit more about the supply constraints in terms of how much planning were you able to do around it? Did you get surprised by these component issues? And are you generally just kind of meeting commitments to your customers but the lead times are getting pushed out? Or was there kind of a decommitment because of disruptions in your own supply chain?

Yes. Joe, that's a great question. So I'll say a couple of things here. First, yes, there were some surprises, right? As we were moving through December and into the early part of January, the COVID impact was a surprise in terms of the impact on some of these suppliers. So we also had some issues that materialized, as I said in the prepared remarks around, I'll call them, more lower-value commodity parts that we also procure in a lot of cases, where those are as we have supplier suppliers that are trying to acquire those parts to then send them to us to our direct suppliers before it gets to us. So it's a little bit harder to have visibility down at those levels. Now with enough time, you can typically manage around some of those issues, either by finding alternatives, qualifying alternatives. It does have an impact on on-time delivery, to your point, and so the reason we were able to quantify the impact of 8% to 10% on the results in March was really what we thought we were looking at as we ended the December quarter and where we ended up today. So we had a pretty good visibility to the impact and so we're able to quantify it. On-time delivery is what's suffering though. But we're managing around it to the extent we can. And I think customers, while there's tremendous pressure in the system, there's a reality check of the challenges that I think I can speak for everybody that we're all dealing with here.

Great. Thank you, Joe and thank you, everybody, for joining us. We know it's a busy week of earnings, a busy day of earnings. We really appreciate everyone's time and attention. I'm sure we'll be catching up with many of you throughout the quarter. With that I'll pass the call back over to Leo to end the call.