This article is part of our weeklong series on 11 incredible dividend stocks. Get the lowdown on this series.
Dividends and technology stocks are a bit like investing's Hatfields and McCoys. There's an age-old blood feud between the two that isn't likely to end anytime soon. Just look at the facts: As of summer 2011, the IT sector of the S&P 500 yielded just 1% flat, by far the lowest yield of any sector. By contrast, the telecom sector, which is increasingly intertwined with advanced technology itself, yields more than 5%.
However, just because the technology sector stinks when it comes to dividends, that doesn't mean you throw the baby out with the bathwater and steer clear of the sector. In fact, a well-managed technology company paying out a high-yield offers some of the best opportunities for both income through dividend payments and growth. With KLA-Tencor (Nasdaq: KLAC ) , you'll find just that.
KLA-Tencor competes in the advanced semiconductor equipment space. Semiconductors, or chips, are the building blocks of modern-day electronics. The advancements in the field are dizzying, and that leads to exacting demands on the equipment to produce these chips. For example, new equipment needs to precisely fit into a building because minor shifts in the buildings foundation can destabilize equipment whose precision is measured in nanometers, causing entire batches of chips to be defective.
To say the least, it's a very complex field that presents challenges. Companies in the space must constantly be investing in research and development to keep pace with the stunning innovations. Not only that, but KLA-Tencor competes with large competitors such as Applied Materials (Nasdaq: AMAT ) , a division of Hitachi (NYSE: HIT ) , and smaller Nanometrics (Nasdaq: NANO ) .
However, this complexity also creates opportunities. In KLA-Tencor's case, the company specializes in a unique portion of the market called "process control," which reduces defects and corrects problems in chip production. Because of their complexity, chips suffer from high defect rates. For example, while early prototypes might have only a 20% yield, or 20% of chips working, more mature chips might see yields greater than 90%. Given this high defect rate, it's easy to see why a company offering advanced solutions that can increase yield is a compelling solution. Their products decrease defects, thus increasing profits for semiconductor companies.
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Why it's incredible
Although key rivals such as Applied Materials are larger, KLA-Tencor holds a dominant market share in its space. That's an all-important point. KLA-Tencor has long-term relationships with its customers, so its process control procedures and engineering staff are firmly ingrained within existing processes. Process control is an important cost-control component for semiconductor companies, so switching away from KLA-Tencor presents a huge risk in this advanced field. More to the point, the company's vast expertise across the semiconductor world has allowed it to stay ahead of the competition's technological developments.
KLA-Tencor pays out only 23% of its net income in the form of dividends. Making semiconductor equipment is a highly cyclical business, so that payout ratio could increase in the future as customers pull back on production in any downturn. Still, that's an extremely comfortable ratio even if KLA's earnings take a dip in the quarters ahead. Looking at the company's balance sheet, it appears that the case for dividend strength becomes even stronger.
It's always a strong idea to keep a reserve amount of cash in the bank in a cyclical industry, but KLA-Tencor has much more than a rainy-day fund. The company has more than $1 billion in net cash. When you consider that KLA's earnings bottomed out at leading to negative earnings of only $118 million (before unusual items such as writedowns) during the depth of a financial crisis, which brought most of the semiconductor industry to its knees, a safety blanket of $1 billion should be more than sufficient to protect the company against any potholes ahead.
Semiconductors could cyclically pull back demand and slow KLA-Tencor's dividend growth, but the biggest threat is that competitors will make inroads in the process-control market.
The company's largest threat, Applied Materials, recently spent almost $5 billion acquiring Varian Semiconductor (Nasdaq: VSEA ) , a company that competes in a different section of the market from KLA-Tencor. Furthermore, Applied Materials continues pushing into the solar and LED space. KLA-Tencor competes in those spaces, but they’re considered growth areas for the company. Its bread and butter is still in chip-manufacturing expertise.
The solar and LED process-control markets offer higher revenue growth but also provide lower margins. That still could spell trouble for KLA-Tencor, because even though its dividends might look safe even while losing LED and solar business, resulting lower sales-growth rates could spook investors and drag down the company's share price.
With KLA-Tencor you get a technology company paying out an impressive 2.5% dividend that has managed to grow revenue by a compounded rate of 7.5% over the last five years and earnings per share by 19% over the same time frame. Those outsized growth rates aren't likely to continue for a company that's so dominant in its industry, but KLA has an extremely low payout ratio and still has plenty of growth ahead. With a dominant position in its industry, plenty of extra cash on the books, and room to keep increasing payouts to shareholders, look for this technology dividend dynamo to continue cranking up its yield in the years ahead.