KLA-Tencor
Plus, AT&Tea anyone?
by Jeff Fischer
([email protected])
ALEXANDRIA, VA (July 27, 1998) -- A volatile day left the Fool Port confounded, surrendering 0.23% as a result. Amazon.com was seen shrugging midday, frustrated, and finally saying (in a Brooklyn accent), "Aww right, which way do I go here, huh?" The stock ended the day higher, prompting it to ask, "You wanna piece of me? You think you can take me? Ha."
Our Foolish Four stocks shined as all of them rose. AT&T (NYSE: T) announced a strategic partnership with British Telecom that you can read about in today's Lunchtime News, and -- to get the view of the situation from across the big blue pond -- read about the news on our sister Fool U.K. site.
Also rising was 3Dfx (Nasdaq: TDFX). The stock trades at 12 times its trailing twelve months of earnings, at 8 times earnings estimates for this year, and at 6.7 times 1999 estimates of $2.21 per share. Starbucks (Nasdaq: SBUX) and Innovex (Nasdaq: INVX) continued to decline, not to mention 3Com. Innovex is fighting a war of technology and Starbucks said last week that it will make the lower-end of earnings estimates in 1999 -- growing 35%. Though Starbucks is off to a less than stellar beginning for the Fool Port, the business is healthy as ever. From 1,700 stores today, the company will likely have over 3,000 locations within five years.
Despite the interesting stories behind each of these stocks, it's time to cover a different company today -- one that we don't mention often.
STOCK REVIEW
In our methodical review of each Fool stock, it's time to consider the forgotten, the enigmatic, the mistake (?) for the Fool Port -- KLA-Tencor.
KLA-Tencor (Nasdaq: KLA) Stock Price: $27 Market Cap: $2.35 billion Trailing Sales: $1.18 billion Price/Sales: 1.99 Last Qtr Sales: $274 million Book value: $13.50 per share Price/book value: 2.0 Recent Gross Margin: 53% Recent Operating Margin: 13% 5-year est. growth rate: 23% P/E on far estimate: 20.3 Earnings Estimates: $1.72 in FY98 $1.33 in FY99What caused the Fool to buy it? On August 24, 1995, Tom and David announced the Fool Flash Buy Report on KLA Instruments, the company that later became KLA-Tencor. On that same day, they also announced the purchase of Applied Materials (Nasdaq: AMAT), another semiconductor equipment manufacturing leader. The Fools were essentially buying numbers one and two in the industry.
At the time, semiconductor stocks had been on fire for the past year, and many investment advisors and analysts hypothesized that the industry would no longer be cyclical thanks to the increased and sure to continue demand in the PC market. Never mind that claiming semiconductor equipment will no longer be cyclical is akin to saying that the giant factories and machinery used to make automobiles represent a great and steady investment as well.
But in 1995 the industry looked so good that Micron Technology (NYSE: MU), a seller of commodity DRAM chips, was consistently the most active and highest-flying equity on the New York Stock Exchange -- with some analysts' earnings estimates topping $15 per share for 1998. In reality, the company will actually lose over $1 per share this year. (Yes, analysts can be that wrong.) Earnings estimates for KLA and Applied Materials were equally ambitious, and when the Fool ran the PEG on the stocks it derived equally attractive valuation prospects. Beyond that, sales, earnings growth, and margin improvement at both companies had bordered on astounding over the past seven years and showed no signs of slowing. Expecting continued great things from these two companies, the Fool bought a modest amount of both.
What has happened since? Boom went bust. Soon after the purchase, semiconductor shares began to slide. The industry hit a downturn that continues today, with earnings estimates falling quicker than a Florida flash flood. The Fool Port chugged ahead relatively unharmed, though, because strong performances in Iomega and America Online overshadowed the lagging semiconductor shares.
As a result, before long these stocks rarely received mention in Fool columns because 1) other stocks were more interesting and were outperforming the market, and 2) semiconductor equipment is not incredibly exciting to a typical Fool -- even if they understand the biz incredibly well. KLA-Tencor continues to be mentioned less frequently than our Foolish Four stocks. If the business surged and the stock with it, probably the column would address it more frequently. Unfortunately, that's not the case, and the KLA story has been slightly boring compared to an America Online or Amazon.
The semiconductor slide and outlook was so bad by 1996 that the Fool sold Applied Materials that year. The Fool also questioned itself, "Why did we buy both?" It was hardly diversification, though it did provide security should one of the leaders surpass another, although the companies did focus on different needs. The Fool continued to hold KLA, though, because it still wanted exposure to this admittedly dynamic and growing industry. Even today KLA possesses a 23% expected annual growth rate (the stock now trades at 22 times its '99 earnings estimate).
Despite the Fool's steep loss on the shares in a strong market since 1995, the stock has outperformed the S&P 500 over the past five years, at least until just a few days ago, when it appears on the chart to have merged with the S&P performance-wise -- tied. The ten-year chart is more telling. KLA has underperformed the S&P 500 over the past ten years rather consistently but for the '94 to '96 pop, and then again during a quick blast in 1997. (If the industry is appearing to turn, stocks can run quickly and hard.)
During the past three years over which the Fool has owned the shares and lost over 45% in them, KLA's business has remained profitable and has even grown sales and earnings, albeit inconsistently. The biggest company news came about a year ago when KLA Instruments merged with Tencor, making it an undisputed leader in its niche providing complete solutions to clients. The merger has gone well. Earnings estimates have come down in the industry, though, and KLA-Tencor is expected to earn $1.33 per share in 1999 following $1.72 this year. That's a guess, but it doesn't make for an attractive stock valuation in the meantime. With a book value of $13.50 per share, KLA is trading at 2 times book. Of course, companies like this can justifiably trade much lower if economics demand it.
What lessons have been learned? Tom and David are the first to admit that many lessons have been learned, and meanwhile their investment philosophies have slowly evolved over the past three years as do everyones'. Tom's Cash-King Port buys only brand name consumer leaders, so neither of these stocks would qualify. And the Fool Port knew that it was taking a "KLA-like" risk in buying Innovex, and even 3Dfx, and now these three stocks together will make us seriously think three times over before buying a company in any industry that is perceived as cyclical.
Meanwhile, as investors, we've never understood KLA and Applied as fully as we should. We admit that without shame, but instead with Foolish and progressive humility. Even analysts don't understand this business very well, obviously. Part of the reason this industry is typically granted a low valuation is not only that it's cyclical, but that the cycles are hard to predict and just as difficult to understand.
Tom and David have also stated since the purchase that you can't value these companies on PEGs or even on YPEGs, as was done three years ago. Those techniques don't work for cyclical companies, and either way they're only one measure of a stock's potential (and not a very qualitative one at that, by itself) and not to be taken on faith alone. Another lesson that was reiterated rather than learned was that patience can indeed pay off. In the fall of 1997, our KLA investment was a mere fraction shy of beating the S&P 500 for us since our purchase. Then we unlearned this -- or, the gain was merely taken away as the stock crashed back to lows.
Perhaps our patience will still eventually be rewarded, but when we're finally rewarded by KLA, we'll probably be in a mental position of wanting to finally sell the shares. The weakness of investing in cyclical stocks at the wrong time is that you often have the desire to sell when you're finally about to profit substantially -- when the investment has finally come back for you. You have the urge to sell on any good news because you already have years worth of waiting behind you. We aim not to fall victim to this urge if we do wait for this stock and industry to turn. In fact, part of the reason that we didn't bail on KLA last fall was because we didn't want to sell prematurely on an industry upturn. That upturn proved to be false. But will it next time?
(Whew! Is all of this worth it? Probably not. I'd rather have owned a more predictable growth story for the past three years and going forward, of course, but KLA is now at least an interesting and beaten down diversification in an otherwise strong market.)
What could cause the Fool to sell it? The company has lowered expenses in line with revenues and remained profitable. We'll sell the stock if we need money for another purchase (though at this value, a KLA sale doesn't raise much cash anyway) or if the business begins to weaken fundamentally (beyond the weakened industry).
The port does still believe that this is a good (but inferior) industry in which to invest over the long term. The computer and chip equipment industry promises to boom and lag and bust and boom probably a few times over the coming decade -- with the end result perhaps being, in KLA's case, a stock that can keep pace with the S&P as it has over the past five years. But the possibility of KLA crushing the S&P seems more likely if the market lags or falls for years (KLA is already beaten up now), while the likelihood of us finding something that we like better improves the more time that we have to look.
In the meantime, here's hoping that KLA's industry can recover before long, and KLA's stock with it. With Asia in the conundrum that it's in, though, this doesn't seem incredibly likely. In conclusion, KLA has been another lesson in the need to have a reasonably diversified portfolio in order to more consistently beat the market and build wealth. The Fool Port, based on the Foolish Four, has weathered several lagging stocks almost -- you could say by the overall numbers -- "without incident."
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Day Month Year History Annualized FOOL -0.23% 7.53% 53.45% 414.99% 51.03% S&P: +0.57% 1.18% 18.22% 150.28% 25.96% NASDAQ: +0.11% 2.03% 23.11% 168.44% 28.20% Rec'd # Security In At Now Change 8/5/94 710 AmOnline 3.64 117.38 3127.75% 9/9/97 580 Amazon.com 19.11 125.50 556.70% 5/17/95 1960 Iomega Cor 1.28 5.50 329.55% 10/1/96 84 LucentTech 23.81 94.38 296.40% 8/12/96 130 AT&T 39.58 60.00 51.60% 4/30/97 -1170*Trump* 8.47 6.94 18.08% 2/20/98 200 Exxon 64.09 71.44 11.46% 2/20/98 215 DuPont 59.83 61.94 3.52% 2/20/98 270 Int'l Pape 47.69 43.94 -7.87% 7/2/98 235 Starbucks 55.91 46.19 -17.39% 8/24/95 130 KLA-Tencor 44.71 27.19 -39.19% 1/8/98 425 3Dfx 25.67 15.00 -41.56% 8/13/96 250 3Com Corp. 46.86 25.94 -44.65% 6/26/97 325 Innovex 27.71 13.50 -51.28% Rec'd # Security In At Value Change 8/5/94 710 AmOnline 2581.87 83336.25 $80754.38 9/9/97 580 Amazon.com 11084.24 72790.00 $61705.76 5/17/95 1960 Iomega Cor 2509.60 10780.00 $8270.40 10/1/96 84 LucentTech 1999.88 7927.50 $5927.62 8/12/96 130 AT&T 5145.11 7800.00 $2654.89 4/30/97 -1170*Trump* -9908.50 -8116.88 $1791.63 2/20/98 200 Exxon 12818.00 14287.50 $1469.50 2/20/98 215 DuPont 12864.25 13316.56 $452.31 2/20/98 270 Int'l Pape 12876.75 11863.13 -$1013.63 8/24/95 130 KLA-Tencor 5812.49 3534.38 -$2278.12 7/2/98 235 Starbucks 13138.63 10854.06 -$2284.56 1/8/98 425 3Dfx 10908.63 6375.00 -$4533.63 6/26/97 325 Innovex 9005.62 4387.50 -$4618.12 8/13/96 250 3Com Corp. 11715.99 6484.38 -$5231.62 CASH $11876.47 TOTAL $257495.84
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