Back in June, we highlighted the semiconductor equipment sector as a “pick and shovel” play to benefit from trends such as artificial intelligence, autonomous driving, and the Internet of Things. The market undervalues values these companies and prices them as if their profits are going to significantly decline. The market is missing the structural shifts that will drive profit growth via increased demand and less cyclicality going forward.
We recommended four stocks to investors in that initial report. Today we are digging deeper into one of those stocks: KLA Tencor (KLAC: $90/share), the most profitable company in the industry and this week’s Long Idea.
Long-Term Profit Growth Is Impressive
KLAC operates in the semiconductor process control segment, which is a subset of the semiconductor equipment sector. The company controls 52% of the market or nearly five times its closest competitor.
It’s almost impossible to make a case against KLAC based on its current profitability. We analyzed the company’s 10-K for fiscal year 2017 (which ran through June 30) on Monday, and the results were impressive. The company has a 54% return on invested capital (ROIC), which puts in the top 2% of all the companies we cover, and it grew revenue by 17% in 2017.
Investors are clearly discounting KLAC’s impressive 2017 due to the cyclical nature of the semiconductor equipment industry. Figure 1 shows that this fear has some merit but is likely exaggerated. KLAC’s after-tax profits (NOPAT) and margins have been cyclical, but have consistently trended upwards over the past 20 years.
Figure 1: KLAC’s NOPAT and Margin Growth Since 1998
Source: New Constructs, LLC, and company filings
Since 2007, a major cyclical peak, KLAC’s NOPAT has increased by 7% compounded annually while its NOPAT margin has expanded from 25% in 2007 to 37% over the last twelve months. Over the last five years, KLAC has generated a cumulative $3.7 billion (26% of market cap) in free cash flow. Going forward, analysts expect the semiconductor process control market to grow by 11% compounded annually until 2020. No matter where we are in the cycle, the long-term growth trend for KLAC looks strong.
Smoother Cycles Minimize Volatility
In addition to the long-term growth trend, there have been structural shifts in the semiconductor industry over the past few years that should make cycles less volatile going forward. We covered these changes in our original report, but we’ll recap them briefly here:
- Customer Consolidation: There have been a wave of acquisitions in the semiconductor industry over the past few years. This consolidation should reduce competition and the risk of oversupply that leads to falling prices, just as it did in the airline industry.
- China Demand: The Chinese government has come to view the country’s semiconductor manufacturing capability as a strategic imperative in the past few years, which means it could continue to support investment in new manufacturing even if prices decline.
- Increasing Complexity: As chipmakers work to make smaller and smaller chips, they have to use increasingly complex structures. This complexity should increase demand for process control equipment.
- The Internet of Things: The growth of connected devices is already increasing the demand for processing power. The automotive semiconductor market grew by 8% in 2016 and is expected to grow 11% in 2017.
This last point is especially crucial for KLAC and other process control management companies. As computers take on more complicated and crucial tasks, the tolerance for error goes to near zero. If a chip in your cellphone malfunctions, that’s an inconvenience. If a chip in your car malfunctions, it could cause a fatal accident. That means automotive semiconductors require more sophisticated and rigorous testing, increasing demand for KLAC.
High Profitability Provides a Competitive Advantage
As discussed above, KLAC has a dominant market share in the process control industry, and there’s nothing to suggest it will lose that position going forward. On top of its market share advantage, KLAC dominates its competitors, which include Nova Measuring Instruments (NVMI), Applied Materials (AMAT), and ASML Holdings (ASML), in terms of ROIC and NOPAT margin, per Figure 2.
Figure 2: KLAC’s Profitability Leads The Pack
Sources: New Constructs, LLC and company filings
Importantly, KLAC’s impressive margins don’t come at the expense of investing in its future. The company spends ~15% of revenue on research and development, which is right around the industry average.
KLAC’s superior ROIC and margins should give the company the ability to withstand pricing pressure if competitors try to cut into its market share. Meanwhile, the company’s strong free cash flow and $2.9 billion in excess cash give it the resources to invest in new production and strategic acquisitions to maintain its industry position.
Bear Case Assumes Major Technological Change
Aside from the cyclical nature of the industry discussed above, it’s hard to find a strong bear case for KLAC. Most major threats to the business would require an unforeseen technological development, such as chipmakers running up against a wall in their efforts to make smaller and more complex chips, or some drastic change to the semiconductor manufacturing process.
Aside from these unforeseeable developments, KLAC acknowledges one of the biggest risks in the “Risk Factors” section of its 2017 10-K. Among the listed risks is, “The possible introduction of integrated products by our larger competitors that offer inspection and metrology functionality in addition to managing other semiconductor manufacturing processes.”
In short, if one of the companies that provides equipment used in the manufacture and assembly of semiconductors could integrate those products with some of the testing and measuring products that compete with KLAC, that bundle could draw customers away.
Lam Research (LRCX) tried to acquire KLAC last year in a combination that could have led to such integrated products, but the deal was blocked due to antitrust concerns. Given the antitrust ruling, a firm would have to invest significantly to develop the measuring products in house. At the moment, this risk remains hypothetical, but investors should continue to watch developments in this area.
Buy The Dip in KLAC
KLAC had been on a year-long tear until it peaked at ~$110/share on June 8. Since then, the stock has pulled back by ~16%, creating a buying opportunity. Investors have a chance to snap up this great company at a bargain price. In fact, the stock is cheap by almost any metric. Its price to economic book value (PEBV) of 0.8 implies that the market expects a permanent 20% decline in NOPAT. The company also looks cheap on conventional valuation metrics, as it has a P/E of just 16x.
As we wrote in our original report, KLAC is valued similarly to its peers in the semiconductor equipment sector based on its ROIC. However, the stock is significantly undervalued compared to the S&P 500, and Figure 3 shows that it trades at a discount to the tech sector as well. ROIC explains 46% of the difference in valuations for companies in the tech sector, and KLAC’s enterprise value divided by invested capital (a cleaner version of price to book) is roughly half of what it should be based on the regression