KLA Corp

KLA Corp reported Q3 results last week, with our system detecting two new red flags on the accounting side: “Contract Costs” and “DSI”

The extract from our report below shows a sharp move up in the level of contract costs reported on the balance sheet. As noted by our system, reporting of contract costs is very rare in this sector (Semiconductors and semi equipment), with only 2% of companies reporting any contract costs.

Looking into the balance sheet disclosure itself, we see that the company describes this item as “Deferred costs of revenue” and we can see how the figure has grown over the last 9 months, from $133m to $243m. As at December 31, 2023 this item was $166m so it has grown by 46% in just 6 months.

Historically this item was relatively small, but given its current size and growth we are surprised that the company does not provide any disclosure of what this item is. Contract costs are typically costs incurred in advance of the contract starting, such as sales commissions or set-up costs. Because a certain degree of judgement is involved it is an area often associated with aggressive capitalization.

Based on Q3 non-GAAP gross margin of 59.8% ($1,411m), the increase in capitalized contract costs of $76m is highly material, representing over 300 basis points on the gross margin for the quarter.

The other item we flagged was inventory, which has been steadily increasing over the past 2 years (see extract from our report below).

Inventory is the largest item on the asset side of the balance sheet, amounting to over $3.0bn. This represents an increase of 5% over the past 9 months, during which time the cost of revenue has fallen by 10%. This now represents roughly 9 months of sales that are sitting on the balance sheet, despite a write-off of obsolete inventory in the quarter related to the Flat Panel Display business. As with contract costs, inventory is an area where there is some discretion over what costs get capitalized.

We note that the company also has significant commitments amounting to $2.1 billion to purchase “material, services, supplies and asset purchases”, which could make it difficult to unwind inventory in a slow demand environment (see extract from 10-Q below).