These Semiconductor Equipment Companies Deserve Your Attention

Damian is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

In the highly cyclical semiconductor business, only a few companies possess the necessary strength to survive and succeed through the constant ups and downs. Although many analysts would support the idea of investing in sector behemoths like Applied Materials (NASDAQ: AMAT), in other words, playing safe, I would advocate on taking a closer look at some smaller, less-known companies like ASM International (NASDAQ: ASMI) and KLA-Tencor (NASDAQ: KLAC), which hold strong competitive advantages, mainly due to their cutting-edge and specific product offerings, and thus, stand as highly compelling investment opportunities.

The jewel of the Crown

ASM International is a leading provider of manufacturing process and technology solutions for semiconductor producers, carrying out front-and-back-end activities. After selling out a 12% stake of its back-end activities and distributing the gains among shareholders, while implementing a restructuring of its front-end segment, the company looks like a more appealing, even undervalued, investment.

Although it reported strong second-quarter results, a weak guidance for its third-quarter revenue led its stock price to plummet by over 15%, opening an attractive entry point for investors. Strong competition from Applied Materials is expected to continue, but considerable spending on R&D should provide the firm with a competitive advantage over the next few years. As a result, analysts anticipate that ASM will outperform the sector’s EPS performance in the long run, mainly on the back of its cutting-edge front-end tools business.

Moreover, the progressive migration of its front-end manufacturing activities to (the lower-cost market of) Singapore should help ASM improve its margins and returns. In addition, its back-end segment, with low-cost operations in Asia, looks like a hidden gem, for it remains consistently profitable, returning industry leading results.

Trading at a third of the industry average in relation to its sales and about half the mean in relation to its consensus earnings, this stock looks quite undervalued. Moreover, a 1.7% dividend yield makes the wait worthwhile. I´d say buy and hold, you will probably not regret it.

Goliath is not so agile

Applied Materials is a leading provider of manufacturing equipment, services, and software for the semiconductor industry, among others (including the solar photovoltaic and flat panel display industries). With almost ten times the market capitalization of ASM, the competition it poses is considerably strong. Its scale, broad product offering, and strong brand name provide it with a wide economic moat, allowing it to successfully compete in almost every segment of the industry. Moreover, hefty R&D investments keep the firm ahead of its competition, while continuous cost-control initiatives and increasing synergies make its prices more appealing.

However, I consider that Applied Materials is not an investment as attractive as ASM, even though analysts expect it to outperform the broader sector in terms of EPS growth in the long run.

For starters, the width of its product offering can be seen as a pro, but also as a con. Since many of its competitors specialize in particular products, Applied Materials runs disadvantaged in many of its end-markets, while smaller firms offer the best products in these particular niches. Furthermore, the cyclicality of the semiconductor business, a high fixed-cost structure, and the recent weakness in its solar equipment segment could strongly impact its future results. Finally, its valuation at 25 times consensus earnings and a PEG ratio of 2.8, both about double the industry averages, lead me to advocate on holding on this stock for now.

A closer inspection

KLA-Tencor is another interesting investment option in the semiconductor equipment business. With a market cap of almost $10 billion, it stands in between ASM and Applied Materials. However, holding a leading spot in the process diagnostic and control (PDC) market, the company offers margins and returns which are among the best in the industry.

KLA is the only pure-play provider of tools for the defect inspection and metrology markets, two segments from which the company derives most (79%) of its revenue -- another 18% comes from its services business. This dominant position in a market niche provides it with a wide moat and strong competitive advantage that should help it keep its peers at bay for a few more years, at least.

Going forward, several factors make KLA an alluring investment. Given the fact that at any given time, companies want to reduce their expenses, and KLA’s products lower its customers’ production costs, the firm is considerably less susceptible to the cyclicality of the industry than most of its competitors. Furthermore, as demand for consumer electronics continues to increase, the company’s solutions to ameliorate manufacturing efficiencies will accompany (Zacks). As this trend is expected to continue for a few years, the long-term prospects look particularly encouraging for the firm.

With a strong balance sheet that has almost $2 billion in net cash, the firm can comfortably enhance its shareholders’ value by yielding 2.72% of the current stock price in the form of dividends, while pursuing periodic stock repurchases. Trading at 15 times its earnings, about one-third of the industry average, this stock looks quite undervalued and should be added to your long-term portfolio.

Bottom line

Although Applied Materials is the semiconductor industry behemoth and offers attractive growth prospects and a juicy dividend yield, smaller companies, such as KLA and ASM, stand as more attractive investment opportunities. Strong competitive advantages make these companies great options for your long-term portfolio; and their generous dividend yields will certainly keep you happy in the meantime.

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Damian Illia has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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