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Can KLA-Tencor Improve Your Yield?

 January 16, 2013 08:12 PM

KLA-Tencor (KLAC) is one of the world's biggest semiconductor equipment firms. The company specializes in the process, diagnostic, and control (PDC) segment of the market. In a nutshell, PDC tools are used to find and correct defects in the manufacturing lines of semiconductor factories ("fabs"). Getting a high number of working chips per silicon wafer (yield) is one of the biggest keys to good profitability for semiconductor firms, making KLA's tools extremely important to its customers. The company sells to 3 primary customer categories: foundries (contract manufacturers like Taiwan Semiconductor (TSM)), logic (integrated chip makers like Intel (INTC)), and memory (commodity memory firms like Micron (MU)).

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MagicDiligence likes KLA-Tencor's business and positioning very much. PDC is an attractive growth market. In the big picture, the semi market in general continues to enjoy robust growth. Driven by intense demand for electronics everywhere from cars to appliances to phones and tablets, the industry is expected to grow to nearly $400 billion in 2015, from about $320 billion last year, representing 8% compound annual growth. What's more, as semiconductor processes continue to shrink and gain complexity, the potential for defects rises sharply. Even when counting the 2008-09 recession, KLAC has grown operating earnings at a 13% compound annual clip since 2008, one of the best marks in the industry.

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Another great thing about the business is its strong competitive advantages. KLA-Tencor dominates the PDC market, holding aver 50% market share worldwide. Although there are larger firms competing in PDC, notably Applied Materials (AMAT) and Hitachi (HIT), KLAC is the only pure play, has the most diverse product portfolio, highest dedicated PDC R&D budget, and boasts the most experienced and skilled service force in the niche. These advantages show up in the firm's operating margins, which have peaked as high as 36% and come in at about 20% mid-cycle. Compare that to AMAT's 15% figure.

We're also looking at a financially strong outfit. Cash on the balance sheet dwarfs debt, $2.6 billion to $750 million. KLA has come in cash flow positive for every year in the past decade. Efficiency is excellent too, with a 5-year average ROIC of 21.6%. Finally, the dividend yields a solid 3.3%, is well-covered at only 27% of free cash flow, and has been raised for 3 consecutive years.

The only thing we can really complain about here is the industry's heavily cyclical nature. We have to be careful with cyclicals in Magic Formula® Investing (MFI), because they are usually screened *after* a peak in earnings. Clearly KLAC is entering a modest downturn. Orders in the last quarter fell to $506 million, from $827 million the quarter before, and next quarter are forecast to be in a wide range of $550-750 million. We really need around $800 million to support reasonable growth estimates. The biggest weight right now is the really weak PC market, which fell by a rather alarming 5% in the holiday quarter (following an 8% decline in Q3).

Over the long term, though, semiconductors are still required for smartphones and tablets, too! OEMs and component makers will adjust their product plans, but KLA's tools will still be necessary - even more so as components continue to shrink. Modeling significant weakness for the 2013 fiscal year, followed by a partial rebound in 2014 and 7-8% growth from there, I think KLA-Tencor is worth about $53 a share. While that is about 13% upside from current prices, we like to see greater margins of safety here at MagicDiligence before considering a formal recommendation.



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