KLA Corp (KLAC) — Q1 2023 Earnings Call Transcript

Thank you, and welcome to KLA's Fiscal Q1 2023 Earnings Call to discuss the results of the September quarter and our December quarter outlook. Joining me is Rick Wallace, our Chief Executive Officer; and Bren Higgins, our Chief Financial Officer. During this call, we will discuss our results released today after the market close in the form of a press release, shareholder letter, and slide deck, which can all be found on the KLA IR website. Today's discussion is presented on a non-GAAP financial basis unless otherwise specified. Whenever references are made to full year business performance, they are calendar year references. A detailed reconciliation of GAAP to non-GAAP results is in the earnings material 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 our 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 factor 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. Our CEO, Rick Wallace, will begin the call with some brief quarterly comments and highlights before discussing the semiconductor industry demand environment, including our business in China. Bren Higgins, our CFO, will conclude with the financial highlights as well as our guidance and outlook. I will now turn the call over to our CEO, Rick Wallace. Rick?

Thank you all for joining us today. I'll spend some time sharing highlights of KLA's performance in the quarter, touch on our business in China, and provide a brief perspective on the overall semiconductor demand environment. Before we get into details, I'd like to first acknowledge our global KLA teams who have continued to demonstrate perseverance in navigating dynamic challenges to deliver for our customers. Their commitment is evident in our results. KLA's September quarter demonstrates strong customer demand across major product groups. Specifically for this quarter, record revenue of $2.7 billion was at the top of the guidance range, growing 31% on a year-over-year basis and 10% sequentially. Quarterly non-GAAP net income topped $1 billion for the first time. GAAP earnings per share was $7.20 and non-GAAP EPS was $7.06, each above guidance ranges. Our performance is a reflection of the increasingly essential role Process Control plays in the development of enabling technology and the long-term product road maps of our customers. As drivers for semiconductor demand continue to diversify beyond traditional PC and consumer-facing markets, Process Control is considered critical in enabling customers to execute on node and technology transitions. As this demand backdrop continues to evolve, our KLA operating model ensures focus on delivering for our customers, navigating supply chain challenges, and continued investment in R&D. Now I will quickly summarize key highlights for the quarter. First, KLA continues to deliver strong relative outperformance versus peers and is positioned to be one of the fastest-growing Tier 1 WFE equipment suppliers in calendar 2022, substantially outperforming expected overall WFE market growth. Second, our Patterning systems revenue grew 49% sequentially and 67% on a year-over-year basis. Third, KLA delivered strong quarterly revenue in our SPTS segment. KLA has intensified efforts in advanced packaging and automotive electronics, leveraging the combined portfolios of both the Semiconductor Process Control and EPC groups. Fourth, the KLA Services business grew to $529 million in the September quarter, up 16% year-over-year. Finally, operating cash flow topped $1 billion for the first time, and we generated quarterly free cash flow of $927 million and free cash flow margin of 34%. For the 12 months ended September 30, 2022, total free cash flow grew from 37% to $3.14 billion. Total capital returns in the quarter were $278 million, comprising $90 million in share repurchases and $188 million in dividends paid. Total capital returns over 12 months ended September 30 were $5.2 billion or 166% of free cash flow and included $4.6 billion in share repurchases and $664 million in dividends. Early in October, the U.S. government issued new regulations to control aspects of the U.S. semiconductor industry trade with China. Specific to KLA, a meaningful amount of our business in China is focused on legacy node investment, which is not the focus of the recent export constraints. However, our system and service revenue will be adversely impacted going forward as we are unable to provide systems and support to certain customers for certain end users. We are assessing the broader implications and engaging collaboratively with the U.S. government to provide the necessary information about our products and services to fully determine the impact on our business operations moving forward. As we look at the industry demand environment, growth for the semiconductor industry has evolved to be more strategic with more diverse end market mix. For the near term, the recognized excess inventories driven by a slowdown in consumer electronics markets, such as PC and mobility, is having an impact on semiconductor device pricing, particularly in Memory. As a result, semiconductor customers are adjusting CY '23 CapEx budgets lower, with the largest impact to date coming from Memory customers. However, long-term growth for the semiconductor equipment industry continues due to the prioritization of R&D investment at the leading edge, continued investment in legacy nodes, and growth in enabling technologies such as advanced packaging. Considering all factors, KLA's long-term targets announced at our Investor Day in June remain intact. In summary, KLA's September quarter results demonstrate sustainable outperformance and highlight the critical nature of KLA's products and services. Our teams continue to navigate and execute against dynamic challenges, and KLA remains well positioned with a comprehensive portfolio to meet evolving customer requirements. The KLA operating model and our strategic objectives are the foundation for our sustained technology leadership, wide competitive moat, leading financial performance, strong free cash flow generation, and consistent returns to shareholders. Now our CFO, Bren Higgins, will review our September quarterly financial highlights and outlook. Bren?

Thank you. As you heard from Rick, KLA's September quarter results were strong, better than expected, and demonstrated our consistent successful execution. While supply chain challenges continue in certain areas and are still limiting output, we have seen marginal improvement as new supplier capacity has come online to meet our requirements. Our continued focus on meeting customer needs while expanding market leadership, growing revenue, sustaining industry-leading growth and operating margins, generating strong free cash flow, and maintaining our long-term strategy of assertive capital allocation is what makes us successful. Quarterly revenue was $2.724 billion at the top of the guided range of $2.475 billion to $2.725 billion. Non-GAAP diluted EPS was $7.06, above the guided range of $5.70 to $6.80. GAAP diluted EPS was $7.20. Non-GAAP gross margin was 40 basis points, above the midpoint of guidance at 63.4% at Semiconductor Process Control systems, which carry stronger gross margins delivered virtually all the revenue upside from the guidance midpoint. Non-GAAP operating expenses were $526 million, slightly below our expectation of $530 million for the quarter. Non-GAAP operating margin was strong at 44.1%. Quarterly non-GAAP net income topped the $1 billion level for the first time ever. GAAP net income was $1.03 billion. Cash flow from operations was $1.01 billion. And free cash flow was $927 million, resulting in a free cash flow conversion of 92% and a free cash flow margin of 34%. The breakdown of revenue by reportable segments and end markets in major products and regions can be found within the shareholder letter and slides. Switching to the balance sheet, KLA ended the quarter with almost $3 billion in total cash, debt of $6.3 billion, and a flexible and attractive bond maturity profile supported by strong investment-grade ratings from all three agencies. Our balance sheet offers a unique capability to fund our growth strategies, both organic and inorganic, and provides ongoing attractive capital returns to shareholders. Over the last 12 months, KLA has returned $5.2 billion to shareholders, including $4.6 billion in share repurchases and $664 million in dividends paid with total capital returns amounting to 166% of free cash flow. Turning to our outlook. KLA continues to deliver sequential growth and strong relative financial performance. Based on the midpoint of our December quarter guidance, KLA is positioned for mid-20% revenue growth for the total company in calendar '22, with Semiconductor Process Control systems growing several points faster than the company average. Furthermore, this business is expected to significantly outperform the overall WFE industry growth, which is currently projected to be up mid- to high single digits to the low $90 billion range. Looking ahead, we expect industry spending to slow. Though early, we are planning our business based on the expectation of CY '23 WFE declining approximately 20% based on increasing global macroeconomic concerns and recent public statements from several customers, particularly in Memory, and the impact of the new U.S. government regulations on native China investment. This WFE estimate reflects our current top-down assessment of industry demand as follows. In Memory, we expect WFE investment to decline by more than the market as Memory customers respond to lower consumer demand by cutting production and factory utilizations to bring device supply in line with demand. We expect Foundry/Logic to decline less than the overall market. Specific to KLA, we are still assessing the impact of the new China export regulations. Our preliminary assessment for the combined gross direct impact on our revenue based on our existing backlog and sales funnel forecast is in the range of approximately $600 million to $900 million in calendar '23. This reflects systems and service impact with service representing approximately 10% to 15% of the total. This estimate is before any potential system reallocation for products where supply is meaningfully below current demand, which has resulted in significant lead time to other customers. Given our backlog and forecast, we expect that we will be able to reallocate certain tools to other customers as we move through next year. KLA's unique broad portfolio differentiation and primary value proposition is focused on enabling technology transitions, which our customers continue to invest in regardless of business environment. While capacity plans can change, technology roadmap investment tends to be more resilient. This adds additional confidence in our business expectations as customers align shipment slots with roadmap requirements. In this environment, we will continue to focus on meeting customer requirements, maintaining a high level of investment in R&D to advance our product roadmaps and KLA's market leadership and delivering strong relative revenue growth and financial performance. Our December quarter guidance is as follows. Total revenue is expected to be in the range of $2.8 billion, plus or minus $150 million. The gross direct impact of the new China regulations on the December quarter revenue guidance is approximately $100 million. Foundry/Logic is forecasted to be approximately 76%, and Memory is expected to be around 24% of Semi PC systems revenue. Within Memory, DRAM is expected to be about 55% of the segment mix and NAND 45%. We forecast non-GAAP gross margin to be in the range of 61.5% to 63.5% due primarily to expected product and segment mix. Looking ahead, KLA will continue to balance investments in technology and infrastructure to support our long-term growth objectives with the expectation of a softening near-term outlook. As a result, operating expenses will grow to approximately $550 million in the December quarter with growth in quarterly operating expenses expected to flatten out as we move through calendar '23. Other model assumptions for the December quarter include other income and expense net of approximately $66 million and an effective tax rate of approximately 13.5%. Finally, GAAP diluted EPS is expected to be in the range of $5.94 to $7.34 and non-GAAP diluted EPS in the range of $6.30 to $7.70. EPS guidance is based on a fully diluted share count of approximately 140 million shares. In conclusion, although the CY '23 outlook for WFE demand has softened, we remain confident that the secular trends driving long-term semiconductor industry demand and investments in WFE are durable and compelling. Broad-based customer demand, the increasing strategic role semiconductors are playing in influencing national industrial policy, and simultaneous investments supporting growing semiconductor content across technology nodes remain important trends. These are long-term secular growth drivers for the industry as technology investment and node transitions reflect the value that semiconductors in our industry have in lowering costs for our customers and enabling a broader application universe for semiconductor-based technology across multiple end markets. For KLA, considering our strong track record of execution and the power of our portfolio strategy, we have confidence in our ability to continue to deliver sustainable relative outperformance. We will continue to maintain a high level of investment in our product development roadmaps to enable market share expansion and support customers' technology roadmaps and multiyear investment plans. This provides an element of stability that shores up our confidence in the demand outlook for the future. These factors, combined with the KLA operating model that guides our execution, positions us to continue to deliver strong relative performance as we execute our strategic objectives. These objectives fuel our growth, consistent operational excellence, and differentiation across the diverse product and service offering. They are also the foundation of our sustained technology leadership, wide competitive moat, industry-leading financial performance, history of robust free cash flow generation, and consistent and growing capital returns to shareholders. And with that, I'll turn the call back over to Kevin to begin the Q&A session. Kevin?

Thanks, Bren. Operator, can you please queue for questions?

Congratulations on the solid quarterly execution and strong free cash flow. As you mentioned, the team has been outperforming WFE and Process Control spending growth for the last few years. No different this year, right? I mean it looks like given your December quarter guidance, your Process Control systems business is going to be up like 30% to 35% when WFE is only up high single digits. I know in the last downturn, like 2019, not as severe, but potentially 2023 is, but you guys actually grew your Process Control and services revenues when WFE was down back then. So kind of given all of this, like do you think you can provide some sort of rough framework for thinking about the team's revenue and earnings power potential with industry spending down about 20% next year?

Thank you for your comments, Harlan. I'll start, and Rick can join in later. When considering KLA's performance, it's important to note that in the past, most of the volatility we've observed in WFE has been in the Memory sector. Process Control demand in Memory is significantly lower compared to Foundry and Logic. Historically, we have outperformed WFE in every down year it has experienced, which has always been a strong point for us. We also tend to support customers who are investing in their strategic plans. Even when they reduce their capacity investments, they continue to invest in technology, resulting in a steady flow of business for KLA, regardless of their revenue levels. Additionally, customers typically continue to maintain their installed base, leading to ongoing service operations. A significant portion of our revenue, more than 75%, comes from contract agreements. Despite cutbacks in capital expenditures, customers still invest heavily in maintaining their existing systems. Given how they purchase Process Control—buying what they need and relying on us to ensure system uptime—this also helps stabilize our business during downturns in Capital Expenditure.

Great. And then on my follow-up, good to see the strong EUV mask inspection shipments and Patterning segment was up almost 70% year-over-year. I think that's reflective of the strong EUV adoption this year. And despite the weaker WFE backdrop for next year, I think that the EUV lithography outlook continues to be strong, right? I mean continued penetration of EUV into Memory and Logic and Foundry, and so this should bode well or continue to bode well for your mask inspection demand. But I know last year the mask inspection segment underperformed positive control on growth. What's the team's outlook for your mask inspection business this year and next year, given the relatively better fundamental outlook in lithography?

So yes, Harlan, you have it right. So this year is actually a very strong year for reticle inspection. I would expect reticle inspection to outperform the overall Semi PC business within the company. So a very strong year and certainly driven by EUV as 90% plus of EUV reticles in production are running through KLA systems. As we look at next year, I think that there will be continued demand there as you start to see more investment in the 3-nanometer node. So I would expect the business to probably continue to perform better than Semi PC. There's also some investment in infrastructure that's happening in some of the legacy mask inspection and new infrastructure that's being built in China to support the legacy reticles, and so there's also an aspect of investment that's happening there as well. So I would expect it to have another good year this year, a strong year in '22, but also a strong year '23 as well.

Yes. I believe that one of the factors contributing to our success is the increase in market share due to new capabilities in our products. We have been working on enhancing the 6xx product to better serve the EUV market. As a result, we've experienced some improvements in performance. Overall, the segment is performing well, and we have also benefited from gaining some market share.

Rick, just wanted to follow up on the earlier question. I understand you guys typically outperform Process Control like a normal cyclical downturn. But if you overlay the fact that some of your peers had supply issues, which you of course did not, and Process Control tends to be more early cyclical. If you overlay those two components, do you still expect your Process Control revenue to outperform WFE next year? And then I have a follow-up.

We have two reasons for our expectations. First, it’s true that some competitors faced greater challenges than we did, although we faced our own issues. We could have shipped more if we had the capacity, as we built up our backlog. Second, the decrease in WFE will primarily be influenced by Memory rather than Foundry and Logic. This factor positively affects our mix. Overall, I believe we are well positioned to outperform WFE. However, it's uncertain what 2023 will look like. Given this setup, we are in a good position.

Got it. Got it. Very helpful, Rick. And then just a follow-up on services. What percentage of your services is from China or domestic China? And also if WFE is down 20%, what do you think happens to your service business next year?

Yes. I don't believe we have that specific breakdown. I would estimate that if our systems business in China and Semi PC is around 20% to 25%, I would anticipate the service stream is lower because it is less developed. It is newer regarding the investments made, and therefore it would be a smaller percentage of service revenue compared to system revenue. I expect service will continue to grow next year, although it will likely be slower than our long-term growth target of 12% to 14%. I think it will probably be in the single digits. There is also some foreign exchange pressure affecting service, as the strong dollar impacts service revenues that are in local currencies. While there is some degree of natural hedge due to costs being in local currencies as well, there is still a headwind impacting service revenue growth from foreign exchange. However, I believe we will see mid-to-high single-digit growth in services given the expectations of WFE, which is projected to decline by 20%.

Krish, when we set the plan at our Investor Day, we didn't know when, but we anticipated there would be this digestion period of WFE just based on the historic growth, so we're still modeling the targets that we set out for '26. And we didn't know when, but it seems like it's coming in '23, and we weren't sure if it was '23 or '24, but it was going to be in that period. But overall, we feel pretty good about where we are positioned relative to that longer-term trend line. And as Bren said, we'll go under it, but then we've got a lot of systems that are shipping now, for example, that will come off warranty. And so they'll be going into services as we move forward, and feel pretty good about where we are relative to the long-term services plan.

I guess first question, I was hoping you could speak to changes in backlog over the last 3 months, how you're kind of incorporating the changes around domestic China embargo. And when are you expecting to get back to kind of your normalized lead times of 6 to 7 months?

It's a good question. We'll have the specific numbers in the 10-Q, which we plan to file by the end of this week. We did experience a slight increase in our backlog, so remaining performance obligations will likely be in the mid-13 range, with a modest growth to 13.1 as a reference point for the June quarter. We made some adjustments to the backlog due to the new China regulations, and I believe there's more work to be done as we approach the December quarter. The situation is still quite fluid, and we are evaluating the new regulations and communicating with the government on various aspects. I anticipate that we'll see some adjustments, and while we grew the backlog a bit this quarter, I expect a bit more growth as we enter the December quarter.

So I think from a lead time point of view, it's been very across certain products. And we have certain products that are high-end sort of technology-enabling products like broadband plasma inspection, our reticle inspection tools, our Voyager laser scanning system, SP7 Surfscan products. Those lead times remain very extended. I think it will take some time because we're dependent on incremental capacity to come online to be able to work through some of that backlog. And I would expect those customers to stay in the queue given the long-term sort of demand dynamics around those particular products. But as it relates to some of our more capacity-centric products, I would expect some normalization as we move into '23. I think certainly, we're still constrained today in a lot of areas, and I would expect that we'll see that continue for a little while. But I think as we move through '23, we'll get up with a little bit more flexibility and more normalization on certain more capacity-centric product.

Very helpful. As a quick follow-up, you mentioned a gross risk of $100 million related to the impact in China for December. What does the net figure look like? Should we consider taking out about $10 million to $15 million from service to account for that, suggesting you're perhaps reusing the remaining tools so the net effect is significantly lower? How should we approach this?

Yes, I think the easiest way to think about it is that without the new regulations, our guidance would have been approximately $100 million higher. The mix of service versus system remains relatively unchanged this quarter compared to the longer term. However, reallocating those systems in the short term is somewhat more challenging. Moving into next year, I believe we will be able to reallocate more, including some of what we anticipated here, but in the short term, it's certainly more difficult. So, the simplest way to consider it is as I have described.

Just one more on China. Can you help us put this $600 million to $900 million in context with what you're currently doing? In the last 12 months, China sales were about $2.8 billion. Obviously, it's both domestic and multi. So is this $600 million to 900 million derisk enough? And how much is left and what is left once the $600 million to $900 million goes out of your addressable opportunity next year?

Yes, I think we have mitigated the risks. We aim to provide a range to offer you some perspective. While there is some forecasting involved, it is part of the process. We examined our backlog and what we anticipate booking in 2023 for the affected customers, tool by tool, to develop the range I shared. Service accounts for approximately 10% to 15% of that. We'll see how things progress. We are still in the early stages of navigating regulations and engaging with customers. There may be opportunities to recover some of that as we proceed, but we will need to see how it unfolds. As mentioned earlier, it is connected to the legacy components of our business, which are largely unaffected by the new regulations. Most items classified as 14-nanometer and below have already been de-risked from our plans since we were addressing similar guidance back in the June quarter. The main change relates to restrictions on the Memory business. Therefore, we feel confident about the range we provided, given our current circumstances.

And just as a follow-up, I had a longer-term more conceptual question. I know we are far away from '24. But as people look forward and especially this topic of WFE intensity, in the last 2 years, it grows about 15% to 16%. But before that, the industry used to be around the 13%, 14% level. Do you think as the industry recovers, we kind of stay at the 13%, 14%? Or do you think there's a case to be made that WFE intensity can start to recover back to the levels that we have seen in the last 2 years?

Yes, when we consider the longer term, it's an important question that we've been focusing on. The intensity is influenced by several factors, notably the challenges associated with advanced technology nodes. One reason for the recent increase is that scaling has resumed in both Logic/Foundry and Memory sectors. I believe it will trend slightly higher than it did in 2023, but whether it returns to previous levels is uncertain. There will be pressure on those trying to advance technology. Even if there's a capacity slowdown in 2023, we won't see a slowdown in technological advancement, as companies understand that launching new products is key to overcoming downturns. Hence, I foresee a trend upward, but while it's unclear if it will fully recover, I expect some improvement in capital intensity. We are confident that the gains made in Process Control intensity will be maintained and potentially enhanced as we introduce new products.

Yes. A key part of our thesis is that we expect semiconductor revenue to grow, with wafer fabrication equipment (WFE) growing at a slightly faster rate. This means we anticipate a flat to upward trend in WFE intensity that outpaces semiconductor revenue, based on the factors Rick discussed, as well as the changes in the industry that have significantly improved efficiency in WFE. Specifically, issues like wafer transitions and industry consolidation are important factors. We believe customers will feel pressure to prevent WFE growth from outpacing semiconductor revenue, but discussions with various customers indicate their focus is on managing growth rather than reducing it. Overall, we maintain a straightforward view of the long-term assumptions we have regarding this situation.

Yes. And there's one additional fact. When you look at the regionalization efforts and you think about new fabs around the world, they will tend to be slightly less efficient, which will drive up the efficiency, and those numbers are not really in anything in calendar '23.

Great, I wonder if you could talk a little bit about the export restrictions. You guys have talked about seeing the Logic restrictions coming, I think, before, and I heard from anyone else. Where were you surprised on the Logic side? And then as a bigger picture question. The fact that this could affect the multinationals, but the multinationals immediately have a license for a year, do you think that gives any kind of pause to investing in Chinese fabs for the multinationals, who could find themselves with large assets that they're unable to upgrade if there's a change in policy? Just can you kind of assess how your customers are talking about all of this?

Yes, Joe. This is not an area where we're going to provide much insight. I think from the standpoint, I think what you meant is that we see the Memory restrictions coming, right, because we talked about the Logic ones. We were not surprised by the export controls that were implemented. And as we've mentioned, we've been working with the government officials as they've implemented those. So we're not surprised by that. When I talk to customers about their plans in China, I think a lot of what they're doing is trying to figure out what are the implications of those extensions and what's the long-term viability. So I would say that it's a much better question to ask them than us. And ultimately, from our standpoint, frankly, it doesn't matter that much because if they choose not to invest there, what they're doing is investing to support demand and they'll move that investment to where they could do it. So that's kind of the way they're talking about it and what we're seeing. So I think from our standpoint, now that this has happened, we're in a much better position to not speculate but support as we move forward.

Last quarter, you had talked about productivity, your manufacturing staying relatively similar rates in the second half into the first half of next year. Is that still how you're thinking about? And maybe in that context, how do you think about that relative to gross margin?

Yes. As you can see from the guidance, we expect to see an increase in output from our factories and are working to meet our targets for the early part of the year. We've noticed some customer turnover, and most of the adjustments to our outlook stem from a broader overview regarding engagement with certain clients and public data. We'll need to see how this develops, but at this moment, we're pushing our factories to fulfill our customers' requests. We'll have to monitor how things progress, but we are observing some rescheduling as we transition into 2023. There are still uncertainties, especially considering the current macroeconomic dynamics and feedback from our customers. However, our perspective on the early part of the year remains largely consistent with previous comments. I will provide more insights regarding the second half in the March guidance when that time comes.

That's helpful. And then just as a follow-up. Maybe going back to the Investor Day. Now with the new China export restrictions in limiting some of the emerging China customers, how do you think about that maybe changing the long-term growth CAGR that you outlined at the Analyst Day in terms of WFE, your capital intensity? Does it change given those guys are maybe trying to ramp up on the technology front and so spending a little bit more than say some of the more mature customers?

It really goes back to a good question regarding the rationalization of Wafer Fabrication Equipment in support of the overall industry. Most of our customers have strict investment forecasts based on their perceptions of the capital intensity they can manage, which, when aggregated, reflects the industry's outlook. This ties into assumptions about semiconductor industry growth, capital intensity, and Process Control. All of these factors were considered when evaluating expected investments. There may have been instances of investment without corresponding revenue, but rationalization was inevitable. Belief in semiconductor growth and capital intensity continues to be integral, and we think these aspects are factored into our projections. We anticipated a digestion period, which we are currently experiencing, while also acknowledging potential investment opportunities in regionalization that might have positively impacted our plans. If you believe in semiconductor growth, capital intensity is unlikely to decline, and we are confident in our Process Control capabilities and market share, which support our outlined figures. Additionally, the services aspect remains significant as discussed earlier. In summary, we believe we are still on track for our 2026 plan.

Yes, you overlooked the EPC aspect as well. I believe that area is experiencing pressure this year, and we anticipate more volatility in that segment due to its closeness to consumers. However, we still expect that through SAM growth, we will achieve similar growth rates there. We discussed our projections from '21 to '26 overall. Rick mentioned that we have accounted for some softness in between, but we remain confident in the underlying assumptions we've established.

So I have two questions. The first one is the near term. If I look at your December quarter guidance, can you help us with the growth difference between SPC and EPC? And I know this EDC was down quite a bit quarter-over-quarter, maybe just seasonality in Q1. And then related to that, if you can unpack the guidance for gross margin a little bit, it's down about 100 basis points at the midpoint, can you talk about the pluses and minuses and specifically related to revenue impact of the China regulation? Does that have a gross impact on gross margin? And I have a follow-up.

Oh, good question. So in terms of guidance for December, all the incremental revenue is coming just about all that's likely to come from our Semi Process Control business. I would think there'd be some impact from the new China regulations on service and the ability to grow service quarter-to-quarter. EPC was down. I think it will be up modestly quarter-to-quarter, but the bulk of the revenue increase will come from Semi PC. So I think in terms of gross margin in the September quarter, it was most of the upside, and I think we did better overall in Semi PC than we expected, and EPC was a little bit weaker on the margin than we thought going into the quarter. So we had a very strong mix of business. We had a significant sequential growth in Patterning. Patterning includes reticle inspection, which tends to be a richer product line from a gross margin point of view. So that was the biggest impact that drove the upside. I think as we look at December, again, it will come back to mix dynamics in terms of how we model the business. We're kind of operating in line with the long-term range that I've talked about is somewhere between 63%, plus or minus 50 basis points or so, and we've been operating fairly consistent with that if you look at the broader picture of calendar '22. So we'll see how it plays out. We've certainly been driving the business at a higher level in terms of output expectations. If you just go back to June, what was the consensus expectation for WFE both this year but also into '23? So that's certainly been a factor in terms of how we've been sizing our business in terms of our ability to support and to ship. And as we move into '23 and we see some of that, it could create a little bit of inventory exposure from an excess inventory point of view. So it could have some incremental reserve exposure there as well that we contemplated as we thought about December. So those are the puts and takes. I think the China regs in terms of impact on gross margin, it's more of a revenue impact. I don't think there's anything incremental from a gross margin point of view one way or the other.

That's helpful. Great. My follow-up question is about the cycle again. In previous downturns, KLA typically performed better at first because customers sought increased yields and continued investing in research and development. However, the downturn would eventually impact performance after several quarters, often with Memory seeing capital expenditures first and then Foundry/Logic following later. Can you remind us why you believe this time could be different? Also, what kind of visibility into 2023 do you currently have based on cancellations and rescheduling?

We have not experienced any cancellations. There has been some churn in our backlog management due to rescheduling, but our backlog has grown from quarter to quarter. I anticipate that we will see more cancellations as we move into 2023. Based on our guidance, the industry is projected to decline by approximately 20%, and considering our expectations for the business mix and our historical performance, we expect KLA to perform well in this environment regarding our share of wafer fab equipment. To address your other point, the duration of these soft periods influences how customers adjust and the demand drivers that emerge afterward. As I mentioned earlier, we are more closely tied to our customers' technology roadmaps than to the increase in capacity. Our capacity investments are currently better than they were in the past, influenced by higher design starts and reduced reuse, among other issues we covered at Investor Day. These factors are positive for us in terms of capacity. Ultimately, the core of KLA's business is focused on development and ramping up production. Therefore, as long as technology roadmaps remain intact, we feel confident about our positioning.

Yes. And let me add to that. I mean, at Investor Day, we talked more about our exposure, as Bren said, and the ability we have to scale when there's capacity. I think the other thing that's changed, particularly with EUV is we're actually more an enabling technology now. And before, we might have been more about yield management. And now with some of our products, particularly in BBP and in rapid, those are the tools that our customers have repeatedly said, 'No matter what happens in this downturn, keep us on your list. We want those tools.' So I think that we've broadened from being primarily a company associated with ramping yields to one of enabling technology, particularly around EUV and then in capacity. So I think we have better exposure, which is why we feel pretty good about how our products are holding up and the fact that we are getting very clear signals from customers that are saying, 'We understand we're slowing overall, but please do not take us out of the list. We need those tools, and we need them as soon as we can get them.'

Bren, I also had a question on Process Control systems. And I ask because 2023 is going to be kind of a weird year because there's about $4 billion to $5 billion worth of deferred WFE just from 2 of your peers that should have been WFE this year but really is going to become WFE next year, and that sort of optically creates maybe like a little bit of a headwind for your WFE share. So I'm wondering if you can sort of help sift through that and maybe size what your PC systems would be for calendar '23. It seems like $6 billion is a pretty reasonable bogey, but I'm wondering if you like that number or not.

Tim, I prefer not to provide guidance for 2023 at this stage. You are correct that the deferred revenue situation may affect the figures somewhat. However, considering our backlog and technology positioning for 2023, we are confident in maintaining our share of WFE. Additionally, we feel optimistic about our market share in Process Control and see potential advantages there as well. Given your assessment, if WFE is estimated to be around $75 billion, the numbers you mentioned seem reasonable. I expect to offer more clarity on this as we head into our 2023 guidance in January.

Cool. I have a question for you, Rick. There was earlier discussion about WFE intensity. The China restrictions are expected to reduce WFE by approximately $7 billion to $9 billion for next year, although some of that might be offset elsewhere. Given the situation with wafers and yields, would you agree that domestic China WFE has perhaps inflated WFE intensity to an extent over the past couple of years? Would it be fair to consider a 50% adjustment? I'm not asking for an exact number, but the idea that there should be some sort of adjustment for WFE dollars, as the productivity of those dollars isn’t comparable to those spent outside China. I'm curious about your perspective on that.

Yes, Tim. No, I think that's true. I think that is absolutely the case that you have a situation where there was additional WFE. But it's interesting because that investment didn't really utilize EUV, so that wasn't particularly capital-intensive investment on a relative basis. So in fact, they were prevented from it. So I think over time, there is going to be more pressure on everybody that stays on the technology road maps to invest in technology that leverages, frankly, more to KLA, whether it's in Logic, Foundry, or Memory. And so that's why, as we said, we modeled that. It is true that will come out, but it will over time be replaced. So I think, sure, the capital intensity was probably running a bit hot because of that, but that's going to get reset. So I don't think we go back into where we were, but I don't think we go all the way down either. I think it's somewhere in between, and that's how we modeled our 2026 plan.

It's more efficient now than it was in 2016 when we saw a significant rise in investment. There has been some maturation in the market compared to five or six years ago. Additionally, we need to consider the investments in infrastructure that support ongoing domestic consumption. This includes investments in wafers and reticles. When examining these factors, we need to differentiate between real demand and strategic investment. There will be some adjustments, but the situation is somewhat different than it was five years ago. In terms of Process Control intensity, we generally see favorable performances in legacy nodes when facilities begin operating. However, the Process Control intensity in trailing-edge technologies is not as high as at the leading edge unless driven by significant changes. For Foundry and Logic in trailing-edge processes, the situation resembles that of Memory technologies, with perhaps a slight edge in China, but it doesn’t match what leading-edge investments yield. Thus, the environment from KLA's perspective is distinctly different.

I had two questions as well. Bren, on the China impact, in calendar '23, which you sized at $600 million to $900 million, I think that was a gross number. So just curious, given the fungibility of your tools and based on your current pipeline, roughly what percentage of that do you think you can repurpose and ship to other customers, at least on the systems side?

Yes, I think it's too early to tell. What we try to do is look at the situation carefully. As we move forward, there are certain products we can repurpose easily, while others may present more challenges depending on their capacity and technology. I will have a clearer understanding as we progress. I assessed our backlog and forecasted revenue without the new regulations to determine the range I provided. We'll need to see how things evolve and engage with customers for a clearer view as we move forward. Right now, I believe that for higher-end products with extended lead times, we should be able to reallocate some of those tools.

Got it. That's helpful. And then as my follow-up, I wanted to get your thoughts on OpEx into calendar '23. I think it's fair to say that the WFE outlook has deteriorated over the past 3 months or so given Memory weakness and the export controls, your business is going to be a lot more resilient than the overall market. But just given how the trajectory has potentially changed from a revenue perspective, I'm sure you're sort of thinking through and revisiting your footprint into '23. How should we think about OpEx? I think you talked about on a quarterly basis, things moderating into Q1. But for the full year, if you can provide some context, that would be helpful.

Yes, I think the easiest way to think about it right now is the flattening out. So as we get a clearer picture on what the revenue profile looks like for '23, I'll have a better level of sort of quarter-to-quarter guidance. We've invested a lot over the last couple of years to support the revenue growth and to continue to invest in driving innovation and differentiation, which is so critical to KLA's go-to-market, and so we've made those investments. We want to get returns on those investments. So we'll be careful and judicious about how we think about it. Obviously, the reality of the business environment is a factor, but also ensuring that we have the right products to meet our customers' roadmap requirements over the next few years is really critical. And I think the history at KLA has shown that in a soft period, our ability to invest and deliver what our customers need when they need it. It's been fundamental to our ability to go-to-market to have the portfolio and to share the value that we deliver. So it will be a balancing act across all of those kinds of dynamics. But I think from a modeling point of view, you've got a model that it flattens out. There's also inflation pressures, right? We'll have a merit cycle, so we'll have to work through all of that as well, but my expectation right now is that you will see it flatten out.

First, I just want to clarify if you and your peers cannot ship the spare parts and services to these projects, will these projects kind of like halt sometime next year as they run out of spare parts? And then I have a follow-up.

The ability to support the tools, I can't speak for the peers. But I can just say for KLA systems, given the nature of our tools and the maintenance that's required to support them and the supply chain, which is fairly custom, that the ability to do maintenance is important to keeping the tools up and performing as designed and expected. So without service, it becomes very hard to utilize the tools that we've shipped.

Great. And then the team talked about very nice bookings momentum on auto-related products on advanced packaging and silicon carbide at the Investor Day. Can you update us on what you're seeing in the auto market that end market seems to be holding quite well right now and into next year?

Yes. In the automotive sector, we've experienced significant growth, not just in our EPC group but also across various areas. We have a presence in our SPTS business, which serves process, power, and semiconductors, as well as our Semi PC business. We've tailored several offerings to meet the demands of this market, leading to positive growth. We're optimistic about the increasing semiconductor content in vehicles, including both basic components and advanced EUV enhanced features and assisted technologies. While I don't have the precise figure, I estimate our automotive revenue exposure for this year is around $700 million, and we anticipate that will continue to grow. We're working closely with our customers, which is prompting a new approach to Process Control, considering the reliability standards required in the automotive industry, along with the costs associated with defects and recalls.

All right. We thank you, and we appreciate. Yes. Thanks so much for the questions, everyone. I appreciate your time on a busy earnings week, and we will be in touch. I'll turn the call back over to the operator to conclude.