KLA-Tencor (Nasdaq:KLAC) has a lot of what investors ought to look for when shopping for stocks for their portfolio. The company is a leader in its space (with greater than 50% market share), posts excellent relative margins and continues to simultaneously re-invest in the business without being miserly towards shareholder capital.

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All of that said, KLA-Tencor is a semiconductor equipment company and more than a decade of positive cash flow doesn't erase the cyclicality of this sector or this business. While ever-smaller circuits increase the demand for more sophisticated equipment, predicting the peaks and valleys of the cycle is notoriously difficult and investors have started to get a little more cautious.

A Leader in a Must-Have Segment
KLA-Tencor has a leading market share in the process diagnostic & control (PDC) segment of the chip equipment sector, as well as a strong share in metrology. KLAC competes with well-known names like Applied Materials (Nasdaq:AMAT) and Hitachi (NYSE:HIT), and less well-known names like Rudolph Technologies (Nasdaq:RTEC) and Nanometrics (Nasdaq:NANO).

Compared to the large names, KLA-Tencor benefits from being so clearly focused on its core markets (inspection and metrology), while also being large enough to outspend small rivals by 10 times or more on research and development.

Just as important, KLAC's equipment is hardly a luxury of chip makers. Flawed wafers and chips can wreck a chip maker's efficiency, and KLA-Tencor's equipment helps these companies quickly spot and address problems in the manufacturing process. What's more, as chip fabrication migrates down to 20 nm, the number of PDC steps increases and KLAC has the opportunity to sell more and higher-priced equipment.

Orders Jumping, but the Street is Skeptical

In its last earnings report, KLA-Tencor reported that orders nearly doubled on a sequential basis to almost $1 billion. As major chip producers like Samsung and Taiwan Semiconductor (NYSE:TSM) look to fill out their capabilities and capacity in 28nm and below, orders are starting to pick up and that's helping companies like KLA-Tencor and Lam Research (Nasdaq:LRCX) with above-average exposure to these companies.

That said, sell side analysts and institutional investors appear to be getting more cautious about the cycle in general. While KLAC and ASML (Nasdaq:ASML) are close to its 52-week high, Applied Materials has been weaker, chips are trading at a premium to the equipment companies and analysts are talking about whether the cycle is already peaking.

The Bottom Line
To give some idea of the range of opinions out there, most analysts are looking for the current fiscal year's revenue (ending June) to be below last year's and then increasing in the next two years. A few analysts, though, are calling for ongoing declines in this year, the next and the year after, while others are looking for accelerating growth in two years' time. In other words, imagine almost any opinion on KLAC's revenue trajectory and there's probably at least one analyst projecting that.

While KLAC is near a 52-week high, it has not only not surpassed prior peak profitability (in free cash flow terms), but also trades below its historical full-cycle average valuation (approximately three times sales). Long-range free cash flow modeling on semiconductor equipment stocks is tricky because of the inherent cyclicality, but fair value nevertheless looks to be somewhere in the low $60s. What's more, assigning that long-run sales-based multiple suggests a fair value more along the lines of mid-$60's.

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At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.



Tickers in this Article: KLAC, AMAT, RTEC, TSM, LRCX

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