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Should KLA-Tencor Investors Be Worried About This New Ban on Exports to China?

By Billy Duberstein – Nov 14, 2018 at 2:03PM

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The U.S. Commerce Department announced that it will prohibit equipment sales to an up-and-coming Chinese memory manufacturer.

The U.S. Commerce Department recently announced a ban on the sale of U.S. semiconductor equipment to China's state-owned Fujian Jinhua Integrated Circuit Co., a company at the heart of China's "China 2025" Plan to become a global technological powerhouse.

Fujian is alleged to have conspired to steal DRAM memory designs from U.S. memory manufacturer Micron Technology (NASDAQ: MU) and the Commerce Department wrote that "Jinhua poses a significant risk of becoming involved in activities that are contrary to the national security interests of the United States."

Last week, the U.S. Justice Department indicted both Fujian and United Microelectronics, a Taiwanese alleged co-conspirator -- as well as three individuals -- and filed suit to prevent the two companies from exporting any products that incorporate stolen designs.

That's likely to be good news for Micron, but it could potentially be problematic for the companies that supply the equipment necessary to produce memory chips. These equipment providers include KLA-Tencor (KLAC -3.53%), Applied Materials, and Lam Research.

KLA-Tencor reported first-quarter earnings on Oct. 29, and management touched on how the ban might affect -- or not -- its financials.

A worried woman looks at her laptop.

Image source: Getty Images.

Management sees limited effect

It's perhaps no surprise that KLA-Tencor's management didn't sound any alarm bells, given the newness of the announcement. Management pointed out that the ban was related to just one specific company, Fujian, and that the ban wouldn't necessarily apply to the entire country, or to non-memory sales.

"I think we feel OK. I mean, strategically, that this situation around export control tends to be confined to that one particular situation," CFO Bren Higgins said. "... we don't think it has much effect on how we're running the business or planning for it into next year." 

Last quarter, China made up 27% of KLA-Tencor's revenue, but that's distributed between native Chinese companies and multinational corporations with fabrication plants in China. KLA-Tencor also sells equipment to more than just memory manufacturers such as Fujian, also counting non-memory Chinese foundries as customers.

On the negative side, management did say that most of the 27% of Chinese revenue was made up of native Chinese companies. So if the equipment ban eventually expands to all China companies, it would affect most of that revenue.

But on the plus side, management said that most of its Chinese revenue was in foundry and logic, not memory. That's in contrast to KLA-Tencor's overall mix, which skews more toward memory, which accounted for 57% of shipments last quarter. China has long produced older-generation semiconductors, but its memory segment is relatively new.

Recent results were solid 

Fortunately for KLA-Tencor, the ban on selling to Jinhua comes at a time of solid financial performance. Last quarter, revenue grew 12% to $1.09 billion, beating expectations by $20 million, while earnings per share of $2.46 came in $0.35 ahead of expectations. The company guided in line with analyst expectations for the current quarter and said it expects the first half of 2019 to grow over the second half of 2018, which was down from the first half of 2018.

Other elements should encourage investors. KLA-Tencor has a great balance sheet, with over $2.8 billion in cash and only $2.2 billion in debt, giving it a net cash position of over $500 million.

I also think at least some of these China fears have been baked in to KLA-Tencor's price. Shares have fallen from over $120 per share to just above $90, and KLA's forward P/E ratio has compressed to only 10.2 times forward earnings, down from the mid-teens earlier this year.

Some risks remain

While I'm still bullish on KLA-Tencor's long-term prospects, investors need to keep track of some key risks. KLA-Tencor is still hoping to close its $3.4 billion acquisition of Israeli company Orbitech soon, which needs Chinese approval. While management expressed confidence in seeing the deal close, it remains to be seen if China will deny approval as retaliation against recent moves by the U.S. Commerce and Justice departments.

In addition, a prolonged U.S.-China trade war could potentially lead to an economic downturn. Since KLA is a somewhat cyclical stock, a downturn could cause its sales to decline after a multiyear boom. And if the U.S. decides to take the drastic measure of cutting off equipment sales to all of China, not just Fujian, it could have a significant impact.

Still, I think KLA's long-term positives and balance sheet outweigh the risks. For those with a higher risk appetite, KLA-Tencor still seems like a good value here, even after the U.S. equipment ban.

Billy Duberstein owns shares of Micron Technology and has the following options: short April 2019 $33 puts on Applied Materials, short December 2018 $87.50 puts on KLA-Tencor, short February 2019 $125 puts on Lam Research, short June 2019 $25 puts on Micron Technology, long January 2021 $65 calls on Micron Technology, short January 2020 $28 puts on Micron Technology, long June 2020 $70 calls on Micron Technology, long January 2020 $90 calls on Micron Technology, short June 2019 $40 puts on Micron Technology, long January 2020 $70 calls on Micron Technology, long June 2020 $70 calls on Micron Technology, short January 2019 $45 puts on Micron Technology, short January 2020 $40 puts on Micron Technology, long January 2020 $80 calls on Micron Technology, long January 2020 $75 calls on Micron Technology, short November 2018 $32 puts on Micron Technology, and short January 2020 $37 puts on Micron Technology. His clients may own shares of some of the companies mentioned. The Motley Fool recommends Lam Research. The Motley Fool has a disclosure policy.

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