Let’s start with a few quotes that highlight new revenue growth opportunities (and even a new serviceable addressable market) and the high margin profile of the company…
“Growth of advanced packaging supporting heterogeneous chip integration has led to a new meaningful served market for KLA. What was once a rounding error in wafer fab equipment is now, according to KLA internal estimates, an approximately $11 billion market, growing faster than core WFE. This is particularly true as chip density shrinks and the processing required for packaging increases risk for our customers. For KLA, this creates a new served available market that will augment the company’s revenue growth over the next several years. The market and technology road map for leading-edge WFE supporting high-performance compute is driving relative inflections for process control. This opportunity, coupled with the evolving complexity of advanced packaging, supports an even broader market opportunity for KLA.” – Bren Higgins, KLA Corp CFO
“We’ve seen service actually pick up a little bit here. It’s been a little stronger than we expected. Obviously, we’ve had some FX benefits, but we’ve also had some strengthening as utilization rates have gone up, we’ve seen some strengthening in some of our billable business. So I think our service growth will be in our target range of 12% to 14% this year. And I would expect right now, as I look at next year, that we’ll be in the same range as well. So I think we feel pretty good about where that is, both based on the growth expected in the installed base, the lifetime increase in the tools, the incremental value that’s coming from the complexity in the systems and how that’s affecting the pricing as it relates to contracts, the opportunities in the acquired businesses that we’ve acquired over the last few years to drive their service business and new requirements that we’re seeing, this is a factor in ’25 as well. But as you think about packaging, a different service model for packaging, but also for DRAM, where the utilization rates to some of the earlier questions have been higher and higher expectations of performance of our system. So I think there’s some new opportunities for growth there that, frankly, if you go back a couple of years, I don’t think we fully anticipated, both on the [advanced] packaging front but also on the high bandwidth memory front supporting HPC.” – Bren Higgins, KLA Corp CFO
“I think the semiconductor industry has been prudent in terms of adding capacity. And right now, when we talk to — when we try to reconcile the external discussions about CapEx [for AI data centers] and what that translates into in terms of wafers, not enough wafers will be available to achieve those objectives in the time frame. And our view is that it’s not necessarily a bad thing. It means it’s not going to — it’s unlikely to overheat if those forecasts remain intact because there’s more gating factors than there are people making announcements. It’s easier to make an announcement about investment in the data center than it is to build a new fab. So I think it’s going to take some time for the industry to absorb and support the capacity demands implied by all the public announcements.” – Rick Wallace, KLA Corp CEO
“In terms of how we were thinking about running the company and over the long run, certainly our 40% to 50% long-standing incremental operating margin target does drive how we size the company. Gross margin obviously is a factor in that. And so we have to think about where gross margins are trending as we consider that. We outperformed that target pretty significantly as revenue has grown in the mid-teens. I’d call it above trend line growth in 2025. So as we move forward, I think the easiest way to think about that is if you’re more or less a trend line, we’re more or less in the middle of the target range. And if [revenue] growth levels are above that high single-digit trend line, we should outperform it. If growth level is below, we’ll probably underperform the target a bit. But that’s how we’re going to size the company over time, and our performance over longer periods of time is obviously very consistent with that.” – Bren Higgins, KLA Corp CFO
“Gross margins for KLA are generally impacted, I’d say, almost exclusively impacted by what we sell, not so much who we sell to and where we sell it [for example to China]. So it really is a factor of how it’s impacting certain product types. But we have a pretty extensive portfolio of products, the broadest in our segment of the industry. And depending on what you’re buying, it can carry different margin profiles. Certain parts of the market, like [advanced] packaging tend to carry a more dilutive [margin] stream. As I mentioned earlier, I think, over time, that goes from being a headwind to a tailwind. Service tends to grow and has a dilutive gross margin, but we believe an accretive operating margin. So you do have some of the moving parts.” – Bren Higgins, KLA Corp CFO
KLA Corporation’s (Nasdaq: KLAC) first quarter fiscal 2026 revenue increased 13%, its non-GAAP operating margin expanded 170 basis points to 43.2%, and its non-GAAP EPS grew 20% year-over-year. KLA is clearly an incredibly profitable business, which is supported by its industry leading gross margins and incremental operating margins in the 40% to 50% range.
Free cash flow (FCF) increased 14% to over $1 billion, resulting in an FCF margin of 33% and FCF conversion on non-GAAP net income of 91%. KLA’s FCF growth of 14% is especially impressive because its CapEx increased 59% from the same quarter in the prior year. It generated a trailing twelve month (TTM) return on equity (ROE) of 99%.
I think investors could search an entire career and maybe only find a handful of other businesses with (1) such high quality growth and profitability fundamentals that is (2) also riding a massive wave of technological revolution and that (3) is also poised to return lots of capital to shareholders each year through a growing dividend and buybacks.
Increased semiconductor complexity is driving rapid demand for advanced packaging solutions, which is stacking and integrating hundreds of different logic and memory chips and interconnects onto a single larger semiconductor package. Each layer in the stack, which is connected by tens of billions (and soon to be trillions) of transistors, presents a potential point of failure, and even one flaw at one layer could render the larger package of chips useless. This is driving strong demand for KLA’s process control (wafer inspection) and advanced packing portfolio.
KLA leadership says that advanced packaging has emerged as a “new meaningful served market for KLA” beyond its traditional process control market opportunity. In other words, advanced packing has expanded KLA’s total addressable market, which is what KLA CFO Bren Higgins means when he says that advanced packaging “supports an even broader market opportunity for KLA.”
KLA’s management estimates that it currently has about 6% market share in advanced packaging. They estimate the total advanced packaging market that KLA can serve is about $11 billion and expects it to grow about 20% in calendar 2025. But KLA management expects that its own advanced packaging sales will grow 70% in calendar 2025 to over $925 million, implying that it could end the year with about 8% market share. So, while KLA only has an estimated mid-to-high single digit percentage market share in advanced packaging today, its advanced packaging business is growing faster than the overall market, implying that it is taking significant market share.
And importantly, KLA’s management thinks that as its advanced packing business continues to scale, it has the potential to generate margins above KLA’s current corporate-level margins (which as you know are already incredibly high). So, KLA’s advanced packaging business has the potential to provide both a growth and margin tailwind to the business over time.
Management also reiterated that wafer fabrication equipment (WFE) industry growth is being partly driven by more semiconductor foundries opening outside of Taiwan and South Korea, and Intel possibly trying to establish itself as a third major advanced semiconductor outsource manufacturer (or foundry). Remember that it is the semiconductor third-party foundries like Taiwan Semiconductor and Samsung (as well as vertically-integrated semiconductor companies that do in-house manufacturing) that purchase semiconductor capital equipment (or wafer fabrication equipment) machinery, software, and services.
Additionally, KLA’s services revenue increased 16% year-over-year and accounted for 23% of KLA’s total revenue in the quarter. Please read my note from last quarter for a deeper dive into KLA’s services business and my overall investment thesis in KLA.
And for even more on KLA Corporation, please check out my recent podcast with Morningstar senior technology analyst, Will Kerwin.
Sources:
Key quotes from the earnings call and letter to shareholders…
(note: bold and underline are my own)
“KLA’s advanced packaging systems revenue continues to gain momentum through a combination of market share improvement across all customer segments and intensity gains. As we enter the last quarter of the calendar year, we continue to see momentum in our product offerings versus our competition and expect advanced packaging-related revenue to exceed $925 million in calendar year 2025, rising approximately 70% year-over-year.”
“The growth of advanced packaging supporting heterogeneous chip integration has led to a new, meaningful served market for KLA. What was once a rounding error in WFE calculations is now, according to KLA internal estimates, an approximately $11 billion market growing faster than the core WFE market.”
“As we approach the close of calendar year 2025, we continue to expect mid-to-high-single digit growth in WFE, modestly improved from our previous outlook discussed last quarter. Growth in 2025 is being driven principally by increasing investment in both leading-edge Foundry/Logic and Memory to support growing AI and premium mobile demand, partially offset by lower demand from domestic China. Given KLA’s strong business momentum, expanding market share opportunities, and higher process control intensity at the leading-edge across all segments, we remain on track to outperform the WFE market in 2025. The advanced packaging market is also expected to grow more than 20% compared to last year. Finally, customer discussions have become more constructive on expectations for calendar year 2026 to be a growth year for the industry, with a broader spending profile than 2025 for both WFE and Advanced Packaging.”
“We expect to meaningfully outperform the mid-to-high single-digit WFE growth rate in 2025 driven by rising process control intensity inclusive of the significant growth of the advanced packaging market.”
“The long-term secular trends driving semiconductor industry demand and investments in WFE and advanced packaging are compelling and represent a relative performance opportunity for KLA over the next several years. KLA’s business has gone from being primarily indexed to leading-edge R&D investment and Foundry/Logic customers, to now addressing all growth markets in WFE, including memory, advanced packaging, and both leading-edge and legacy-node logic.”
“This performance demonstrates how KLA’s process control leadership has expanded beyond leading-edge R&D investment to address all growth markets in WFE, including high-bandwidth memory and advanced packaging. Accelerating investment in scaling AI infrastructure is fueling technology development investment across the leading edge, driving more designs, increased complexity, shorter product cycles and higher-value wafers. Alongside this growth, the industry is also seeing rising demand for advanced packaging.”
“We’re seeing rapid growth in demand for KLA’s advanced packaging portfolio, which has emerged as a meaningful market for the company as heterogeneous device integration has become more complex. KLA’s advanced packaging systems revenue continues to gain momentum through a combination of intensity gains and market share improvements across our portfolio. For calendar year 2025, we expect advanced packaging related revenue to exceed $925 million, up approximately 70% year-over-year. KLA’s service business also continues to deliver strong growth. Services grew to $745 million in the September quarter, up 6% sequentially and 16% year-over-year. Consistency and resiliency are hallmarks of the KLA’s service business.”
“The market and technology road map for leading-edge WFE supporting high-performance compute is driving relative inflections for process control. This opportunity, coupled with the evolving complexity of advanced packaging, supports an even broader market opportunity for KLA.”
“While it is still too early to provide precise calendar 2026 revenue guidance, our view today is that first half revenue levels will be roughly flat to modestly up compared to the second half of calendar 2025, with accelerating growth in the second half of the calendar year. This outlook is inclusive of the revenue impact related to additional market access loss related to certain customers in China resulting from extended export controls from the U.S. government. We estimate the revenue impact on the December quarter and calendar 2026 to be approximately $300 million to $350 million for KLA. For calendar 2026, this impact is spread roughly evenly across the first and second half of the calendar year.”
“Our business model is designed to deliver 40% to 50% incremental non-GAAP operating margin leverage on revenue growth over the long run.”
“If there are more players doing more leading edge in more locations, that’s going to be accretive to overall intensity… But when you think about leading edge, leading edge was tremendously efficient, right, with most of the investment being really driven by one [Taiwan Semiconductor] of our customers. I think as you start to see a broadening out there, it creates more opportunities for leading-edge engagement, process control intensity as a lot of the strategic investment happens to support what is an accelerating growth opportunity for our customers. So I think we’re encouraged by that profile as we move forward.”
“In terms of how we were thinking about running the company and over the long run, certainly our 40% to 50% long-standing incremental operating margin target does drive how we size the company. Gross margin obviously is a factor in that. And so we have to think about where gross margins are trending as we consider that. We outperformed that target pretty significantly as revenue has grown in the mid-teens. I’d call it above trend line growth in 2025. So as we move forward, I think the easiest way to think about that is if you’re more or less a trend line, we’re more or less in the middle of the target range. And if [revenue] growth levels are above that high single-digit trend line, we should outperform it. If growth level is below, we’ll probably underperform the target a bit. But that’s how we’re going to size the company over time, and our performance over longer periods of time is obviously very consistent with that.”
“And now if you take our views on 2025 at $11 billion or so [the size of the global advanced packaging market], we’re approaching 6%. So we’ve seen an escalation here in terms of intensity as the requirements have changed fundamentally related to the high-performance computing on the logic side and the memory side. So we think that, that continues over time. I don’t think you’re going to see that kind of — that slope of growth. But we do expect that as density shrinks and processes become more complex, that it does play to the need for more advanced systems. And of course, we have our front-end portfolio that we can use to address this interesting market. So I think it’s a new SAM for KLA. We have a lot of great drivers within WFE that we think are driving process control and KLA share of the market, and we’re augmenting that growth with this growth that we expect to see in advanced packaging that likely over time grows modestly faster than WFE. So it’s a really encouraging opportunity. And I think as we start to move up the value chain in terms of new capability required, then I think it creates an opportunity for us to drive something in the neighborhood or better than general corporate averages on margins.”
“But as I look at KLA’s share of the advanced packaging market, we’re about 6%. And if you look at KLA’s share of the PC market, it’s closer to 8%.”
“Just think about the cost of yield failure in packaging and how much it’s worth to ensure that that’s not happening. So that’s what we’ve really seen in terms of that. They’re not — it’s obviously not our most advanced tools, but it is. They are systems that we use in the front end and that would have been considered the most advanced tools if you go back a few years. So absolutely, they’re the ones that pulled us in. I mean we did not come to them. It was almost the other way. They said, we want you to provide this capability. So when we think about the road map for packaging, and remember, what we’re talking about advanced packaging, we’re, in many ways, early innings because there’s still other technology inflections that are going to go into HBM over the next several years as the rest of the market catches up with these advanced packages. So we’re really talking about a pretty small percentage of available packages being inspected at this high level. Now over time, people will learn more about it, and they won’t inspect at the frequency. So that’s why we see the growth will continue, but it won’t continue at the rate we’ve had for the last couple of years, but it should outpace overall WFE growth.”
“But when you get into what’s going on with — especially around the high-bandwidth memory and the challenges that people have relative to the new design rules, we’re actually seeing, in some cases, higher sensitivity requirements, in some cases, for DRAM on some layers than we’re even seeing in logic. So we’ve had a bit of a reversal of some — in some areas, and we’ve seen big adoption of early on as people are debugging these processes and then realizing they don’t have a lot of process margin. So that’s the other thing there — and when they start EUV, then they’re using our systems for print check. So you see a lot of applications happening, and that’s really what’s been driving this increase [in their DRAM business]. We thought it would happen. Years ago, we were hoping it would happen sooner, but it’s definitely we’re seeing leadership in some areas in terms of the need for process control as they retool these DRAM facilities to deal with some of the new market requirements.”
“The other thing you have to keep in mind is that the reliability requirements in a stack of DRAM chips in an HBM device, the device is only as good as the weakest DRAM.”
“Gross margins for KLA are generally impacted, I’d say, almost exclusively impacted by what we sell, not so much who we sell to and where we sell it [for example to China]. So it really is a factor of how it’s impacting certain product types. But we have a pretty extensive portfolio of products, the broadest in our segment of the industry. And depending on what you’re buying, it can carry different margin profiles. Certain parts of the market, like [advanced] packaging tend to carry a more dilutive [margin] stream. As I mentioned earlier, I think, over time, that goes from being a headwind to a tailwind. Service tends to grow and has a dilutive gross margin, but we believe an accretive operating margin. So you do have some of the moving parts.”
“I think the semiconductor industry has been prudent in terms of adding capacity. And right now, when we talk to — when we try to reconcile the external discussions about CapEx [for AI data centers] and what that translate into in terms of wafers, not enough wafers will be available to achieve those objectives in the time frame. And our view is that it’s not necessarily a bad thing. It means it’s not going to — it’s unlikely to overheat if those forecasts remain intact because there’s more gating factors than there are people making announcements. It’s easier to make an announcement about investment in the data center than it is to build a new fab. So I think it’s going to take some time for the industry to absorb and support the capacity demands implied by all the public announcements.”
“I would say that you definitely feel there’s more urgency on the DRAM front in terms of timing. We’ll have to see how that plays out in terms of slots as we move into next year. Given our lead times, what we can accommodate, obviously, we try to work closely with our customers on that front. But there’s certainly — I think from a pricing point of view, I think the dynamics that are driving HBM pricing overall, there’s definitely a sense of urgency from our customer base.”
“And now I think the realization by a lot of our customers is they might — there might be more opportunity in memory than they thought, and those are accelerated from what they even told us a few months ago. So I think that that’s part of what you’re seeing. I think everybody is a bit amazed by the number of applications that are being realized using AI. Even inside of KLA, we keep coming up with new ways to leverage the technology. And I don’t think we’re the only ones doing that. So I think the memory guys are right now feeling, wow, there’s more opportunity if they could add capacity. And those are kind of the conversations because they realize that it takes longer, as I said, to ramp the supply chain than it does to make these announcements about CapEx.”
“We’ve seen service actually pick up a little bit here. It’s been a little stronger than we expected. Obviously, we’ve had some FX benefits, but we’ve also had some strengthening as utilization rates have gone up, we’ve seen some strengthening in some of our billable business. So I think our service growth will be in our target range of 12% to 14% this year. And I would expect right now, as I look at next year, that we’ll be in the same range as well. So I think we feel pretty good about where that is, both based on the growth expected in the installed base, the lifetime increase in the tools, the incremental value that’s coming from the complexity in the systems and how that’s affecting the pricing as it relates to contracts, the opportunities in the acquired businesses that we’ve acquired over the last few years to drive their service business and new requirements that we’re seeing, this is a factor in ’25 as well. But as you think about packaging, a different service model for packaging, but also for DRAM, where the utilization rates to some of the earlier questions have been higher and higher expectations of performance of our system. So I think there’s some new opportunities for growth there that, frankly, if you go back a couple of years, I don’t think we fully anticipated, both on the [advanced] packaging front but also on the high bandwidth memory front supporting HPC.”
Disclosure: John Rotonti is an investor in and the portfolio manager of the Bastion Industrial and Infrastructure Portfolio, which owns shares of KLA Corporation. John personally owns shares of Taiwan Semiconductor.
Disclaimer: This article is intended for informational purposes only and does not constitute tax, financial, or legal advice. Investing carries risks, including potential loss of principal. Consult a qualified professional for personalized recommendations and to ensure compliance with applicable tax laws and regulations.