1 Prudent Play on the Chipmaker Market

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

We are living in an era of "hyperinvention." We all want our PCs (and tablets) to operate faster and perform a greater number of tasks simultaneously. There's no doubt in my mind that demand for faster microprocessors will increase exponentially over time. There's one service company whose sole role in life is to make sure that production lines are flawless, and that microprocessors are manufactured at top speed and precision. That's where KLA-Tencor (NASDAQ: KLAC) comes in. 

It's already happening

You need to look no further than at global makers of microprocessors ("chips") to realize that the hyper invention phase has already begun. All of the leading chipmakers are constantly improving the speed and quality of their chips at a furious pace, and setting very specific goals as to what quality of chips they would be producing three and five years down the road. 

Take Intel (NASDAQ: INTC) for example. For 2013, the giant chip maker plans to ship first tablet and smartphone chips made with 22-nanometer chips, and increase capital spending on production of 14nm chips. For 2015, the company already expects to reach peak production of its 14nm chips, and ramp up manufacturing of 10nm chips. And this just goes on and on. 

And Intel's biggest rival, Taiwan Semiconductor (NYSE: TSM), has no intention of being left behind. In 2013, Apple initiated trial production of TSM's A6X processor. In 2014, the company plans that its 20nm chip production will exceed the 2012 production level of 28nm chips. And for 2015, TSM plans that its 20nm production will exceed the 2013 production level of 28nm chips. 

And in order to make this predictions - a viable reality, Intel and TSM must make sure that their production lines are flawless. KLA handily solves this probem for them.  

The solution

KLA's primary job is helping its customers improve production yields by reducing the number of chips with manufacturing defects. You can't build new semiconductor fabs or make big technological changes without including this technology. KLA is an integral part of those cutting-edge fabs. Companies can't exist without KLA.

In addition to catching defects, KLA also helps its customers identify underlying flaws in their manufacturing processes, which are some of the most complex manufacturing processes on Earth. There can't be many products more complex to build than a computer chip with 2 billion tiny transistors, each 22 billionths of an inch apart, so tiny that a speck of dust could ruin them.

KLA's business is fixing and preventing the semiconductor manufacturing mistakes that dominant chipmakers simply can't afford. And KLA is a great opportunity for the following reasons.

Great financials

KLA's profit margins are impressive. Gross profit margins have averaged more than 54% since 2002. Net profit margins were negative in the deep recession of 2009. But in nine of the last 10 years, margins have come in at stout, double-digit figures, generally between 14% and 25%.

In addition, the company is gushing cash flow. From mid-2002 through the end of 2012, KLA generated about $4.1 billion of total free cash flow on roughly $24.9 billion in sales. That's an overall free-cash-flow margin of just over 16%. If you can generate $0.16 of free cash flow on every $1 in sales, you've got a wonderful business on your hands.

And on top of all that, KLA has a very safe and conservative balance sheet. The company has more than $2.5 billion in cash and marketable securities, nearly four times more than its debt, which checks in at less than $750 million. In fact, approximately a quarter of each share is pure cash.


KLA's management thinks like owners, and act like owners. Even during the extremely difficult business environment of 2009, KLA did not cut its dividend. Even more impressive is that KLA bought back $102 million of stock that year. The dividend is up 167% since then, and share repurchases have consistently exceeded $100 million per year. The stock currently yields 2.7%. Recently, KLA announced a dividend hike of 12.5%. That's what shareholder- friendly companies do.

Valuation front

With the S&P 500 trading at more than 17 times earnings -- above its historical average of around 15.5 times earnings -- anything under 15 times earnings is acceptable. KLA trades for 14 times earnings and roughly 3 times sales. TSM and Intel trade at 14 and 12 times earnings and 4.5 and 2.2 times sales, respectively.

I believe that all three companies are trading at a comfortable pricing territory. But KLA, more than the former two, has a great advantage of being the ultimate "picks and shovels" company. KLA doesn't care which chipmaker wins the race, as long as it's servicing its production lines. Hence, it has a reduced degree of business risk.  

Looking ahead

The world is becoming faster and faster with each minute. The ultimate engines behind this progress are microprocessors, and the company to serve these chipmakers is KLA. With its fortress like balance sheet, cash flow generation, and shareholder friendliness - KLA is well-positioned to take the world one step closer to better, and much faster, chips.  

Shmulik Karpf has no position in any stocks mentioned. The Motley Fool recommends Intel. The Motley Fool owns shares of Intel. 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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