KLA Corporation’s (Nasdaq: KLAC) second quarter fiscal 2026 revenue increased 7%, its non-GAAP operating margins expanded 50 basis points to 42.8%, and its non-GAAP EPS grew 8% year-over-year. KLA’s tax rate came in higher than expected. At the guided tax rate, non-GAAP EPS would have grown nearly 10%.
It generated a trailing twelve month return on equity (ROE) of 101%, which is down from its five-year average of about 110%. The lower, but still incredibly high ROE, is due to lower leverage (a lower debt-to-equity ratio). To better understand how KLA is able to generate such high ROE please read my DuPont analysis article here.
KLA’s quarterly free cash flow (FCF) increased 67% from the same period in the prior year, resulting in an FCF margin of 38% and FCF conversion on non-GAAP net income of 108%.
For calendar year 2025, KLA’s revenue grew 17%, non-GAAP EPS increased 29%, and FCF grew 30% to roughly $4.4 billion (up from about $3.3 billion in calendar 2024). In calendar 2025, it returned $3 billion to shareholders as a growing dividend and share buybacks. KLA returned about $2.9 billion to shareholders in calendar 2024.
KLA is a free cash flow machine. From calendar year 2020 through calendar year 2025, KLA’s revenue grew at a 16% compounded annual growth rate (CAGR), and during that six-year period FCF increased every single year and grew at a 20% CAGR. During that time, the FCF margin increased from 29% to 34.4% and averaged 31%. The business prints free cash.
KLA has a target to return 85% of FCF to investors through dividends and share repurchases over time. It has increased the dividend for 16 consecutive years at a 15% CAGR. In the last five years (since calendar year 2021) KLA has allocated almost $12 billion buying in about 15% of the shares outstanding at an average price of $441 (compared to today’s stock price of about $1,400). This included an accelerated share repurchase in 2022 when tech stocks were getting crushed. Anyone that says tech stocks can’t operate at the bleeding edges of innovation and grow at above-market rates for a long period of time, while also returning gobs of cash to shareholders hasn’t met KLA Corporation. In fact, businesses like KLA that generate far more cash flow than they can use internally is the definition of a truly great business, according to Warren Buffett.
KLA’s balance sheet has gotten even stronger in recent years with cash up and net debt down. Since the end of fiscal 2022, its cash position has grown from $2.7 billion to $5.2 billion and net debt (inclusive of capitalized leases) has decreased from over $4 billion to only $902 million (meaning KLA could pay off all of its net debt with only a few months worth of FCF). I wouldn’t be surprised if KLA is saving up for an acquisition.
Key takeaways from the earnings call…
(1) KLA’s growth in the quarter was slower than normal because of the higher-than-expected tax rate, but mainly because of supply shortages and constraints. It’s having difficulty getting some of the memory and optical components it needs to manufacture its machines and fill demand, and its foundry customers are “constrained by the ability to build new fabs and new shelves,” meaning there’s nowhere to house the machines. KLA management expects this to be transitory, resulting in slower growth in the first half of calendar 2026 and faster growth in the back half of the year as more industry capacity comes online. Importantly, KLA management stressed that the “industry outlook for 2026 has strengthened over the past few months” and that KLA is “experiencing strong customer momentum that has accelerated over the past 3 months.” KLA thinks this translates into a growth acceleration towards the end of 2026 and a “setup for ’27 [that] is pretty remarkable.”
(2) Calendar 2025 was the sixteenth consecutive year of growth in KLA’s higher-margin services revenue, and over those 16 years, its services revenue increased at a CAGR of a little more than 12%. But KLA’s higher-margin services business grew 15% in calendar 2025, which is above its long-term average of 12% and above its target of 12%-14% average annual growth. And importantly, on the call, KLA CFO Bren Higgins said “there are a lot of drivers that suggest we can operate at the higher end of the [12% to 14%] range versus the lower over time.”
Higgins said that KLA’s business model “designed to deliver 40% to 50% incremental operating margins” plus higher-margin services growing at the higher-end of its long-term target range plus a faster growing advanced packaging business (see below) that has the potential to generate margins above KLA’s current corporate-level margins should support a “63% plus [non-GAAP] type gross margin profile” over time. Keep in mind that KLA’s gross margins are over 1,000 basis points (or 10 percentage points) higher than its two primary domestic semiconductor capital equipment peers.
KLA’s higher-margin services currently account for 24% of total revenue. One common pattern in the portfolio I manage at Bastion Fiduciary are companies that have large, growing, and long-lived installed bases with a value-added services business attached (Trane, GE Vernova, and Vertiv are other holdings that benefit from a similar dynamic). The services business increases the value proposition for the customer, while at the same time increasing switching costs, providing an innovation feedback loop, and creating a long tail of high margin, recurring revenue for our holdings.
In KLA’s case, it has an installed tool (machine) base of over 50,000 and those tools have a life of about 20 years. Those tools live in semiconductor foundries (like those from Taiwan Semiconductor) and KLAC’s engineers work full-time in the foundry customer factories making sure the machines are running optimally so that foundry customers can meet their yield (throughput) goals. KLA engineers working full-time at a customer’s site can then send immediate, real-time feedback to KLA’s R&D team, which drives consistent technological innovation. About 75% of KLA’s services revenue takes the form of a three-year subscription contract, and these contracts have customer renewal rates of about 95%. KLA’s management has said that it generates services revenue equal to 100% of the average selling price (ASP) of the tool over the lifetime of that tool, implying that annual service contract revenue is equal to about 5% of the ASP of the tool. This is high-margin, recurring, and long-duration revenue growth, and a key part of the thesis, and remember that the number of tools in operation (the size of the installed base) should grow over time.
KLA is clearly an incredibly profitable business, which is supported by its industry-leading gross margins, incremental operating margins in the 40% to 50% range, and ROE of around 100%. 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.
At a high level, KLA’s growth is being driven by more chips and increased complexity of those chips.
The number of chips is growing because of the digitization and electrification of everything, with semiconductors in everything from cars to rockets to satellites to drones to medical devices to consumer electronic devices to household appliances, and oh yeah, AI data centers.
The number of chips is also being driven by new(ish) players in the chip industry, namely the hyperscalers designing their own advanced AI silicon. Because of all this chip demand, as well as the AI hurricane-force tailwind and onshoring (partly for geopolitical reasons), semiconductor foundries are being built outside of Taiwan and South Korea, and Intel is 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 like Texas Instruments and Micron) that purchase semiconductor capital equipment (or wafer fabrication equipment) machinery, software, and services from companies like KLA Corp.
Increased semiconductor complexity (i.e. moving to smaller nodes) generally means more process steps (the steps number in the hundreds) and more steps in the process means more process control technology (like KLA provides) is needed to check for defects at the various stages of the manufacturing process. Leading-edge logic chips are more complex to manufacture (because of larger die sizes, more layers, more steps, smaller and more packed circuitry/transistors, the new process architecture of gate-all-around, and 3D packaging), which requires more inspection for defaults/defects. Logic chips are stacked high with over 100 layers and each layer of the chip must be inspected for defaults. The design and manufacturing complexity is such that if one part of these chips fail, then the whole chip (or system-on-a-chip) fails, which drives demand (and pricing power) for process control (imaging and inspection) equipment.
Very briefly on 3D packaging… 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 has said that advanced packaging has emerged as a “new meaningful served market for KLA” beyond its traditional process control market opportunity.
Source: official materials
Disclosure: John Rotonti is an investor in and the portfolio manager of the Bastion Industrials and Infrastructure portfolio, which owns shares of KLA Corporation, Trane, Vertiv, and GE Vernova. John personally owns shares of Texas Instruments.
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.