KLA-Tencor Bad Earnings: A Good Reason for Having GAAP

KLA-Tencor (KLAC) was expected to lose about -$.06. It lost -$.12 non-GAAP (a slight miss). However, it lost -$2.57 using GAAP (a huge miss). This occurred even though KLAC’s $396.6M in revenues slightly beat analysts’ estimates of $394.1. The GAAP results (-$2.57/share) for the second quarter of fiscal 2009 include a $435 million charge for the aggregate impairment of goodwill and purchased intangible assets. New bookings for the quarter were estimated by KLAC in Jan. 2009 at $235M - $245M (I haven’t seen the conference call data yet). These are not enough to replace this quarter’s (Q2 2009) revenue of $396.6M. The near term future looks dim. The Q2 2009 revenue, $396.6M, is far down from the Q2 2008 revenue of $636M. The new bookings as a gauge of revenue replacement are even farther down (midpoint number = $240M).

This “write-off” tends to clear the way for KLAC to record positive results in the FY2010. Perhaps this is why the stock did not even move downward after hours. Still someone has lost. The book value of the company is now less. Stockholders’ equity has taken a hit. Really the stock should go down as a result. However, analysts tend to ignore one time charges to a large extent. Analysts probably will not downgrade the company too much for this huge miss. Yet it is a huge miss!

They should downgrade the company. Sure they have now increased the likelihood of better future earnings. However, more importantly they have shown bad management skills. This loss did not come out of thin air. I haven’t traced back through KLAC’s books, but it seems most likely that these intangible assets were bought by KLAC within the last few years. In other words they bought technology (patents and human capital), and goodwill associated with that technology, that would significantly lose its value in a few years.

Is this different from a bank buying risky mortgages (or risky companies)? To my mind it is not. Rather it is exactly the same kind of mistake. Does it indicate bad management (at least in this case)? I think it does. Does this indicate the company is likely to do well in the future? It doesn’t instill me with confidence. On this basis alone, I think this stock is in for a fall in stock price. It now clearly has negative earnings for FY 2009. FY 2010 doesn’t look much better. Semiconductor manufacturers are forecast to do poorly throughout 2009. Semiconductor equipment manufacturers will do poorly too. Virtually all the major semiconductor makers have announced bad results lately. The list includes: INTC, BRCM, QCOM, TXN, etc. Below are a few facts from recent news.

1. Orders for "durable goods" fell 2.6% last month to about $176 billion, following a 3.7% drop in November and an 8.5% slump in October.
2. NEC Electronics Corp. (NELTY.PK) reported a net loss of 19.9 billion yen for the December quarter. The chipmaker estimated losses for the fiscal year ending March 31 will total 65 billion yen, revised wider from the loss of 8 billion yen forecast in its last quarterly outlook. NEC Electronics Corp. said it would cut production at its plants, including in California, slash jobs and lower its capital spending.
3. Toshiba (TOSBY.PK) said it expects a net loss of 121.1 billion yen ($1.35 billion) in the third quarter ended Dec. 31, a reversal from net income of 80.5 billion yen generated in the same period last year. Toshiba Corp. said it would lower costs by $3.3 billion by cutting 4,500 contract jobs and halving capital expenditures.
4. TXN is cutting factory output to work off inventories, the company said this week. It plans to cut 3,400 jobs, more than half through layoffs. TXN is cutting its 2009 capital spending to $300 million from $763 million a year earlier, while also cutting its research-and-development spending.

There are many more negative stories in the semiconductor space. If companies are cutting back (and cutting Capex), they will not be buying new semiconductor manufacturing equipment. It could be quite some time before KLAC turns a profit again. I see this as another possible short play in a down market. The industry is down, and the management is responsible for serious recent mistakes. I don’t see the difference between buying risky loans and buying risky companies. KLAC belongs in the same category as the banks that took on too much risk.

As for the outlook for the economy, most of the news has been negative lately. The Fed’s outlook was worse in January than it was in December. The Davos conference issued very negative statements. The IMF has continually revised its world economic performance forecast downward in recent months. I believe IMF’s latest world GDP forecast is for 0.5% growth for all of 2009. The forecasts for the US and Western Europe are substantially worse. Considering the IMF GDP estimate was 3% world economic growth just 3 months ago, a significant downtrend still seems to be in place. In this kind of environment semiconductor equipment makers will be hurt severely. If they are showing questionable management on top of the negative environment, investors should be even more wary of them.

Disclosure: Short KLAC.

Comments

[najdorf:]

You have a point about likely poor revenues (and hence cash-flow) in the near future for most semi stocks. And the GAAP earnings serve a purpose and certainly should be examined - but they're not as big as you make them out to be.

Quarterly accounting earnings are just not all that accurate or important for companies that depend mostly on intangibles and technology. What matters is cash flow and the ability to provide returns to shareholders. Tech companies constantly have to make guesses about the future value of technologies, intangibles, and research, and these guesses are inaccurate ALL THE TIME. Even a non-tech company has to guess unguessable things like the level of future catastrophe losses, the percentage of mortgages that won't be repaid, forex rates, and commodity prices. All kind of companies are taking writedowns on this stuff, and some of them indicate real problems while others are irrelevant. Asset prices and sales of specialized products can shift very fast due to issues outside of a company's control.

However, no company was ever brought down by accounting writedowns alone - companies fail because they can't service/roll their debt or they can't produce adequate cash-flow out of their assets to justify their cost structure and shareholder investment. KLAC has no debt coming due until 2018 and can afford to pay their interest, so what you should be looking at is whether they'll be able to cut costs and whether they can rebuild sales. It's not as easy as just reading the GAAP earnings number.

Here's another way to look at GAAP earnings - KLAC shareholders are down $20/share over the last year (based on share prices). It's hardly shocking that in that economic climate, the company has to record GAAP losses - but they are simply recognizing what the share price already told them. Any other semi company is in the same position (who's up over the last year?), whether their accountants tell them they have to take a writedown or not. The earnings power of all companies in the field are at least temporarily impaired, whether they did acquisitions recently or not. This is why share prices are down across the board. You have no evidence that KLAC management is better or worse than every other semi company management that has seen their business degenerate over the last year.

This is all easy to see. What's hard to see is this: what happens next? I don't mean next quarter - most of the value of a stock is based on things that happen 5 and 10 years from now. The fact is that no one knows in a field like semis unless they have some insight into the technology and actual information about management and R&D, rather than guesses based on a GAAP number.

Jan 31 05:26 PM

[Tom Armistead:]

Revenue at Chip Equipment makers can suffer extreme swings. Typically writeoffs of intangibles are noncash.

To evaluate these situations, determine whether management is managing cash flow in such as way that there will be no short-falls, also aligning expenses with revenues. Verify that they are keeping R&D up to the proper size in order to compete on the next generation of equipment. Another consideration is whether they will be able to ramp up production when the business finally turns.

This type of information is subjective but reading earnings calls transcripts and analyst presentations will sometimes develop a feel for it.

Jan 31 06:39 PM

[know nothing:]

Bad management skills is the under statement of the decade! Lawers, guns, and gold...? Let's skip lawers. Family, Guns and Gold!

Feb 01 09:07 AM

[David White:]

Virtually all the chip makers have announced huge cut backs recently. Some are idling factories. The $SOX has been going down. In addition to the companies I mentioned, other notables with recent bad news were Sony, Hitachi, and Fujitsu. I am sure I have left many out. The real point is that none of them are doing well, even those that have managed to be profitable lately. This translates into a hugely negative environment for semi equipment makers. They cannot make money when no one is buying.

I have actually worked in the semi equipment market in the past. I am estimating that KLAC will lose $.5B to $2B over the next year (Jan-Dec 2009). The only quarter they have a prayer of making money in will be the Oct-Dec quarter. I really doubt they will manage that. Every time I look the economic data seem to get worse. The expectations for the S&P500 for Q4 2008 are now that its earnings will be 35% lower than in Q4 2007. The IMF recently lowered its estimate for world economic growth to 0.5% this year. Just 3 months ago that estimate was for 3% world economic growth. The trend is still clearly downward. Perhaps this will change.

Meanwhile you have to evaluate based on what you see. On Friday Merrill upgraded KLAC to a buy. I got the impression the analyst liked the fact that they might do better in future quarters for having written off this book value. The analyst seemed to think that KLAC had better margins than some other companies, so all they had to do was rein in costs. I take exception to this view. First they don't have any really great ways to rein costs. The problem is that one of their major costs is the highly educated people they employ. They could give them all big pay cuts. However, they would not likely keep them for very long that way. My view is rather that KLAC has been a less agressive company. They have not been pursuing market share as agressively as other companies. That is the primary reason for their better margins (they do have some good technology). However, if no one is buying, they are likley to lose even more market share during this downtrend. Then when the recession ends, they will have a harder time getting it back.

AMAT is a direct competitor to KLAC. It is generally thought to be more of a market leader. Yet it was initiated with a sell rating by Auriga USA on Thursday. Since I (and a lot of other people) view AMAT as a good company, I interpret this negative view of AMAT as a very negative view of this industry's prospects over the next year or more. These same prospects would apply equally to KLAC. Further the economists are not predicting a quick rebound from this recession. They are predicting a very slow one. This means that KLAC will not suddenly become hugely profitable after a year's time. Instead it will take another year or two (after the huge down year we are about to have this year) to get back to some semblance of normality. When you look at KLAC in this light, it looks vey bad. The company recently recorded a loss of more than 1/7 of its book value in one quarter. It guided lower than analysts had estimated for the following quarter. It is guiding to lose money this year. The losses are likely to be greater than the current guidance. KLAC seems likely to lose $.5B to $2B over the next year. This will be a substantial part of its book value. There is now doubt about a second half of 2009 recovery, although most people still think the worst will be in the first half. The semiconductor manufacturers have to be buying for KLAC to make money. The prospects are extemely dim in this area. KLAC has a CAPS rating of 3 stars. This latest earnings release is likely a harbinger of things. If brokerages can initiate AMAT as a SELL, KLAC definitely belongs in that category. It seems likely to move downward from its current CAPS rating. The ratings by Merrill seems likely to be a pump and dump scheme to me. If you believe Merrill, you deserve what you get. They haven't been particularly honest with investors lately, and I am not impressed that they lost $15+B last quarter. I think you have to stay away from KLAC until it shows some signs of a recovery in its business. The losses could get very deep indeed, especially if the somiconductor business gets much worse. It is very possible that KLAC could lose $2B in the next year. I am not saying they will, but you don't want to be in the stock while it is going down. In the current semiconductor environment, it can hardly do anything else. Plus there will be no big jump upward in a year's time. This economic downturn will not reverse itself quickly. It will reverse itself in a long slow process. There will be plenty of time to get into KLAC if the market environment and the company performance indicates that you should. Until KLAC shows some signs of a reversal, you should stay out (or sell short, especially if you think Merrill may be up to no good with a pump and dump scheme). Right now KLAC is still guiding lower. That is the reality. That is the trend. Don't fight the trend. It doesn't pay. If there is a spectacular upside to KLAC in the near future, no one has mentioned it. This includes the Merrill analyst who upgraded it. Keep in mind that this recession may still be worsening. When there are companies like AMZN that are beating their estimates (and are strongly profitable), there is no reason to risk your money in KLAC.

Feb 01 10:40 AM

[numinary:]

I'm speculating here, but didn't Intel announce that they were shifting the overwhelming bulk of their CapEx to the 32nm process node? Whatever equipment maker is in the lead with the 32nm equipment will take a higher share at Intel & be in the best position to recover as the economy rebounds. I imagine that the either KLA or AMAT has the best 32nm equipment, but I really don't know -- I'm an InP semi guy rather than a CMOS drone.

Feb 01 12:06 PM

[David White:]

numinary: there is usually some quantum shift going on in the industry at whatever time you are talking about. Likely both AMAT and KLAC are supplying Intel. I am sure KLAC will derive some income from that.

I did not say Capex was completely stopping. Off hand I am not sure what Intel's numbers are. However, the cut in Capex for TXN is likely farily indicative of the industry (it's less than 50% of 2008's). A lot of manufacturer's are talking about idling factories in 2009. Therefore not many companies will be spending lots of money on Capex. Again I did not say there will be no orders, but 50% or less of 2008's orders will be a huge hit for the semi equipment manufacturers. The 50% is just a ballpark figure, but it is likely a reasonable one.

AMAT pre-announced today that they would be announcing a loss of -$.09 to -$.11 for their Q1 2009 (ending Jan. 31). Their previous range had been flat to +$.04. -$.02 of the loss is going to be write downs for "doubtful accounts receivable related to certain customers' detriorating financial condition in the challenging economic and industry environment". In other words, no only can they not sell enough product, but the sales they do make may not all pay up!!!! Ouch!!! Things will get worse before they get better.

I should clarify that I have a reasonably good opinion about both of these companies. However, they are currently between a rock and a hard place. I see no reason to ride these companies down, as it seems this is their likely direction. When the semiconductor business starts to recover, I might then consider buying one or both of these stocks.

Feb 02 04:51 PM

[David White:]

KLA-Tencor has gone up strongly in this recent tech rally. However, it is not out of the woods yet. A lot of the rally may have been simple emotion. The Semiconductor Association has downgraded its 2009 global chip sales forecast to -21% from -5.6% yoy (June 8, 2009). In April, sales fell 21% yoy. The data portends protracted weakness in Asian exports. It also indicates a lot of the chip and semi equipment manufacturing companies will likely have a hard time throughout 2009. It could be time to think about shorting these stocks.

Jun 08 05:57 PM