Fool Buys KLAC
August 24, 1995

KLA Instruments Corporation
NASDAQ:KLAC
Type: Mid-Cap Growth (Investing For Growth)
HQ: 160 Rio Robles, P.O. Box 49055, San Jose, CA 95161-9055
Phone: 408-434-4200
Closing Prices, August 23rd, 1995: Bid $86 3/4 Ask: $87

Trailing 12-month revenues: $442 million
Trailing 12-month EPS: $3.06
Last quarter reported: June 1995 (FY: Jun)
Next quarter reported date: 1Q, about November 15, 1995
Consensus EPS estimates for quarter: $0.97e, vs. $0.54 in last year's 1Q
FOOL ratio: .55

Trade: Buying 65 shares, August 24th

I. OVERVIEW

KLA Instruments (NASDAQ:KLAC) is the world's leading manufacturer of yield monitoring and process control systems for the semiconductor industry. This equipment is used by semiconductor manufacturers along their production lines to monitor the quality, speed, and output of fabrication facilities. KLA Instruments has the dominant market share in this emerging market, and its multimillion-dollar products are used by every major worldwide semiconductor manufacturer.

The company just finished its fiscal year 1995 (ended 6/30), and reported outstanding growth. Revenues were up 82% to $442.4 million, with net income rising 94% to $58.6 million. Earnings per share were very strong, up from $1.37 in 1994 to $3.06 in 1995 (excluding a $25 million writeoff for acquired technology). The company then announced a 2-for-1 stock split (which will take place about a month after our purchase tomorrow), and that it had record bookings of another $500 million for its KLA 2100 series of wafer inspections systems. That is the company's biggest, but not only, business.

The stock has doubled in the past year, after having more than doubled the year before. And it also just showed up as a new Investing for Growth holding, the revolutionary investment approach developed by Robert Sheard (MF DowMan) right here in Fooldom (refer to the Investing for Growth folder in our Fool's School). With a low Fool Ratio, an outstanding two years behind it, the best quarter in its history announced a few weeks ago, a stock split coming, and a powerhouse balance sheet, we're excited about adding KLAC to The Fool Portfolio. We expect these shares to double in the next 12 months.

II. THE BUSINESS

We led off our overview by noting that the company was the world leader in "yield monitoring and process control systems". . . er. . . what? (That's the company's phrase.)

That's the sort of description that is enough to put even very patient readers off. What the HECK, one may be forgiven for asking, is "yield monitoring"? The question is unfortunately not very well answered in the company's jargon-filled 1994 annual report. BUT, good news, because those who bothered requesting the 10-K for 1994 get a much better explanation.

To wit, "yield" in the semiconductor business refers to the number of good die per semiconductor wafer, the key goal of semi manufacturing. Higher yields increase the revenue a manufacturer can obtain for each wafer processed. KLA's machines save its customers money, paying for themselves fairly quickly, by monitoring the semiconductor manufacturing process, detecting and analyzing problems as they occur along the fabrication line. KLA's inspection systems precisely capture trillions of features on wafers that are as small as 10 millionths of an inch on a side.

As we wrote above, the good news is that these things more than pay for themselves in not much time. That's why KLA's revenues have increased from $167 million to $442 million in just two years. Even better, though, is the trend that has been going on over that time, which is that semi manufacturers are buying MORE of these systems to add to each of their fabrication lines. When KLA first started in this business, it was building systems that were used OFF of the production line to do analysis and testing. Its customers might purchase one of these machines, and run it before starting production. But now KLA's systems are built for use during IN-LINE production, so that all the monitoring is happening while fabrication is happening. Further, its customers are buying up additional new copies of its systems, which now monitor increasing numbers of steps in the process. The top ten semiconductor plants that have adopted KLA's approach average seven KLA systems per fab. And as the company announced in its earnings report a few weeks ago, one U.S. customer recently ordered the eleventh unit for just a single one of its fabrication facilities.

The company has several different systems that anyone requesting the annual report can read about and look at. (They're fairly handsome little devils, in KLA's characteristic mustard color.) The company also diversified in the past 12 months into making software to run such monitoring systems, both its own and that of competitors. But KLA's competition is losing. . . for most of its businesses, KLA holds market shares exceeding 50%, and in some cases as high as 70%.

Business is beautifully spread out geographically, with roughly one-third of sales in the U.S., one-third in Japan, and the other third everywhere else (mainly, the Asia-Pacific region and Europe).

III. THE FINANCIALS

KLA has a very strong balance sheet, with cash and cash equivalents of $245 million (there are about $25 million shares out right now, making for $10 per share in cash). It is a cash generator, showing very positive cash-flow numbers. And its net profit margin, as Fools have no doubt noted, is well over the requisite 10% that we mention in our Motley Fool Investment Primer.

I'd like to share with you my favorite line of numbers in the company's annual report:

1.6% >> 3.6% >> 4.7% >> 6.3% >> 8.1% >> 11.0% >> 14.4% >> 14.8% >> 16.9%.

Those are the net profit margins for this company over the past nine years. Just LOOK at the consistency of the growth. It's extremely impressive. . . highly Foolish.

Fourth-quarter earnings were 94 cents per share, vs. 45 cents for the corresponding quarter the year before. Those came off of $136 million, vs. $72 million the previous year. The net profit margin for that quarter was 17.6%, showing even further ongoing improvement.

Estimates for the first quarter of fiscal '96 (ended 9/30) show $0.97 expected, vs. $0.54 last year. For the whole year, the latest earnings estimates (published a week ago) show earnings per share expectations of $5.00 (ended 6/30/96) and then $7.00 for the year after that. Everything looks extremely rosy in San Jose, California.

IV. STOCK PERFORMANCE

The stock, as noted earlier, doubled last year, doubled the year before that, and we expect it to double in the next 12 months as well. Also as noted earlier, KLAC will be splitting 2-for-1 on September 29th, so don't be surprised when you see this thing down in the $40's or $50's in a month. Novice investors sometimes overrate the effect of stock splits, thinking that because you now have twice as many shares, you have more money (or something like that). Not so. You'll simply have twice the number of shares at half the price. That said, stock splits do carry a bullish connotation, and that news can't hurt any.

V. THE FOOL RATIO AND THE FUTURE

We noted above that the company's earnings are currently $3.06. And in its buy report issued last week, SoundView Financial put earnings at $5.00 for next June and $7.00 for the June after that.

Time to do our Fool Ratio! (If you're not familiar with our valuation technique, just read "The Fool Ratio" article in our Fool's School area.)

First, the P/E ratio. That's easy. The price is $87 and the trailing twelve-months earnings per share is $3.06. . . so the P/E is 28.4. Now we just need to estimate the forward growth rate. Well, the total growth over two years from $3.06 to $7.00 is 129% (2.29). To annualize that, we take the square root of 2.29. . . you'll get 51.2%. The Fool Ratio (a.k.a. PEG) takes the price-to-earnings ratio as a ratio of the growth rate. Let's do it: divide 28.4 by 51.2. You'll get .55. . . a Fool Ratio that is very much in our buy range (.50 or less optimally, but up to .65 generally)..

As you can see, we're buying two semiconductor companies this week. It's The Fool Portfolio's first foray into the industry, and it comes after a tremendous amount of past success for companies like Intel, Micron Technology, and many others. Both of our new buys have doubled in the past year. Do we feel late to the party? Nope. Attractive valuations remain for both these stocks, and their businesses are continuing to explode. We are living in the midst of an incredibly dynamic technology revolution, and semiconductor companies are a primary beneficiary.

Further, in the case of KLA Instruments, the company has a niche: the monitoring of the manufacturing process. This is an extremely profitable business, with much less competition than semiconductor manufacturing. The company is well-managed by CEO Kenneth Levy (also the co-founder, 20 years ago), it has a global business, new products, and technology answers that pay for themselves. To be frank, the only real problem we see here is Mr. Levy's posture in the photographs of him in the '94 annual report (page 2). . . he sits with his legs spread too far out!

Anyway, we think we're going to make some money here.