May 01, 1996
Type: Large-Cap Growth
HQ: 3050 Bowers Ave., Santa Clara, CA 95054
Closing Prices, May 1, 1996: Bid $39 3/8, Ask $39 1/2
Trailing 12-month revenues: $3.6 billion
Trailing 12-month EPS: $2.56
Last quarter reported: February '96 (FY: Dec)
Next quarter reported date: 2Q, Week of May 16, 1996
Consensus EPS estimates for quarter: $0.99e vs. $0.54
FOOL ratio: .43
Year-ahead PEG: .36
Trade: Selling 100 shares, May 2, 1996
A PORTFOLIO DECISION. Having watched KLA Instruments (NASDAQ: KLAC) and Applied Materials move in virtual lockstep ever since we purchased both on the same day (August 24, 1995; check out the accompanying graph in the online sell report), we've now realized that we essentially bought the same stock twice. We consider this a portfolio MISTAKE. (Yeah, yeah, never mind the mistake regarding having bought EITHER in the first place!) So in an effort to diversify our core group of holdings to take better advantage of the hundreds of other investment opportunities (in different industries) today, we have decided to ditch one of our semiconductor equipment companies and take our losses.
BOUT OF THE HEAVYWEIGHTS: WHO'LL HIT THE CANVAS FIRST? Once we reached our portfolio management decision to sell one of these two sets of shares, the question was which.
In the corner to our right, weighing in at a P/E of 14, is KLA Instruments, the world's leading manufacturer of monitoring equipment for automated semiconductor "fabs" (factories). KLA's machines automate the semiconductor industry's chip production lines, adding efficiency that improves the output (known as the "yield," analogous to crops).
And, in the corner to our left, weighing in at a P/E of 13, is Applied Materials, the world's largest manufacturer of front-end process equipment, the stuff that builds the chips in the first place.
The first thing we note is that there has been a recent weakness in orders among the semiconductor manufacturers. . . a result indicated ahead of time by a whole bunch of these semiconductor stocks getting cut in half at the end of last year. The word from automation companies like KLAC, on the other hand, has consistently been that they are doing fine "maintaining internal book-to-bill ratios above 1.0." What that means in Foolspeak is that they are continuing to get more than $1 of new orders for every new $1 of sales. . . a good thing. Round One goes to KLA Instruments.
As the two titans strut out to the center of the ring for Round Two, we note as well that the monitoring systems ordered for new fabs can easily be put into existing foundries to enhance the yield. In facilitating automation in this way, monitoring systems increase gross profit margins, and pay for themselves in short order. During a period of uncertainty for the semiconductor manufacturing industry, orders for automation equipment should still continue to grow at record pace as manufacturers attempt to squeeze operating efficiencies out of their existing factories. Round Two, thanks to a flurry of counterpunching, goes to KLA Instruments.
As Applied Materials emerges from its corner a bit wobbly-kneed to start Round Three, we hear its trainer (CEO Jim Morgan) barking something. It turns out what he's saying---and he's gone on record with this a number of times now---is that he doesn't see a production move from today's 150 millimeter wafer to the larger next-generation 200-300 millimeter level anytime soon. (Larger wafers will reduce costs because manufacturers can fit more chips on 'em, meaning fewer wafers for the same number of chips). Fair enough, but the Japanese (NEC's subsidiary Anelva) and the Koreans (Samsung) aren't agreeing, as both are apparently pushing forward with aggressive plans to develop equipment that can do up to 300 millimeters that is still backward-compatible with smaller wafers. If they succeed, many of the large semiconductor manufacturers could conceivably start to adopt products like this. Lam Research (NASDAQ: LRCX) and Novellus Systems (NASDAQ: NVLS) view Applied's decision to eschew 300 millimeters (for now) as a business opportunity, so our guy AMAT could be vulnerable to this issue in a year or two. Round Three (oomph): KLA Instruments.
KLA leads off Round Four inflicting some bad body blows, in the form of its Board of Directors having announced last week (as documented in our Fool Portfolio reports) that it would buy back 1%-2% of its outstanding stock over the next 18 months. Now THERE is a use of the cash war chest that we approve of! These decisions usually indicate a management that believes its shares are cheap. . . we like their go get 'em attitude.
Wait! Hold on there, Nelly! AMAT just fell to the canvas. . . and a count of eight, nine, ten. . . he's done! KO in four. Stick a fork in that fella.
TAKING LOSSES. You gotta love it. We know, we know, you shouldn't really ever love a loss, especially one in excess of 30% (in half a year!). That said, in our experience, the best things to sell are the ones that are down for you. The best things to try never to sell are your great winners. The reason they're winners in the first place is because they're great companies, proven out over time; unless something changes dramatically for a winner, we'd advise holding. . . holding to the grave, if possible.
Selling losers is another matter. "Why was the stock a loser?" a Fool must ask herself. Well, it can be lots of reasons. . . too many to list here. The prominent reason that we lost money in this particular case is probably that we bought a great company at the WORST point. Semiconductor equipment is a cyclical growth industry. . . that is, it rises strongly over time, but in a much less linear manner than traditional growth companies. At the time we bought, we didn't really understand this. . . or anticipate that Wall Street would so severely devalue these shares based on near-term prospects. We were shocked to see great companies like KLA and Applied get slain in such short order.
Looking forward, which is all that really matters to us (the past being irrelevant to our investment FUTURE), we expect that over the next three to five years Applied Materials will continue to outperform the broader market (as it has over the previous five). But in the intermediate term (one to three years), we think there's at least a decent chance we can find a better investment. We will hold KLAC for now, demonstrating our belief in this business. But with so many horses out there in the field, we don't want to ride two down-and-outers.
We'll sell our holding of Applied Materials tomorrow. We probably won't sell at market open, because we've seen market makers mysteriously change the price on us in the past, when we've announced a trading decision. But by the end of the day, we'll have liquidated, raising about $4000 cash.