KLA-Tencor's Numbers Tell The Story

| About: KLA-Tencor Corporation (KLAC)


Let's examine KLA-Tencor's investment case.

The firm registers one of the higher marks on the Valuentum Buying Index, given current market valuations.

KLA-Tencor has an excellent combination of strong free cash flow generation and low financial leverage.

As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In KLA-Tencor's (NASDAQ:KLAC) case, we think the firm is worth $69 per share, about in line with where it is trading. But let's see if this current valuation makes sense.

For those that don't know us, we're the firm that lets the numbers tell the story. We love straight talk, and we put more weight in numbers than anything else. We think numbers tell the whole story -- analysts can have different motives, management can commit fraud, authors can be biased, the board can be incompetent, but the numbers -- well, they don't mislead.

As such, we think a comprehensive analysis of a firm's discounted cash-flow valuation is the best way to identify the most attractive stocks. We think there may be some investors that may not know what a fully-populated discounted cash-flow model is, but here's a brief snapshot of the income statement that we develop for all the companies in our coverage universe. We have corresponding fully-populated balance sheets and cash-flow statements, too. We make the model for your use here.

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Our methodology culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best. If a company is undervalued both on a DCF and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. KLA-Tencor posts a VBI score of 7 on our scale, reflecting our 'fairly valued' DCF assessment of the firm, its attractive relative valuation versus peers, and very bullish technicals. A score of 7 is actually a decent measure in this market environment. On a relative valuation basis, we compare KLA-Tencor to peers Applied Materials (NASDAQ:AMAT), Cree (NASDAQ:CREE), and Lam Research (NASDAQ:LRCX).

In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score (from ideas included in the Best Ideas portfolio). The table below reveals how companies with the respective scores when added to the portfolio performed subsequently (until the measurement date or until the security was removed). The sorting mechanism inherent to the Valuentum Buying Index is rather remarkable, and we think it is a helpful tool for any investor.

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Our Report on KLA-Tencor

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Investment Considerations

Investment Highlights

  • KLA-Tencor earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. Return on invested capital (excluding goodwill) has averaged 70.7% during the past three years.
  • KLA-Tencor is among the largest semiconductor equipment companies in the world. The firm supplies process control and yield management solutions to a variety of industries: LED, data storage and photovoltaic.
  • KLA-Tencor has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 20.4% in coming years. Total debt-to-EBITDA was 0.9 last year, while debt-to-book capitalization stood at 17.7%.
  • Purchasing decisions of KLA-Tencor's customers make the timing, length, and severity of up-and-down cycles difficult to predict. The worldwide market for process control and yield management systems remains highly competitive.

Business Quality

Economic Profit Analysis

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. KLA-Tencor's 3-year historical return on invested capital (without goodwill) is 70.7%, which is above the estimate of its cost of capital of 11.3%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. KLA-Tencor's free cash flow margin has averaged about 27.2% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At KLA-Tencor, cash flow from operations increased about 11% from levels registered two years ago, while capital expenditures expanded about 46% over the same time period.

Valuation Analysis

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Our discounted cash flow model indicates that KLA-Tencor's shares are worth between $52.00 - $86.00 each. The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $69 per share represents a price-toearnings (P/E) ratio of about 21.5 times last year's earnings and an implied EV/EBITDA multiple of about 11.6 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 7.4% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 16%. Our model reflects a 5-year projected average operating margin of 31.5%, which is above KLATencor's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.8% for the next 15 years and 3% in perpetuity. For KLA-Tencor, we use a 11.3% weighted average cost of capital to discount future free cash flows.

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Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $69 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for KLA-Tencor. We think the firm is attractive below $52 per share (the green line), but quite expensive above $86 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

We estimate KLA-Tencor's fair value at this point in time to be about $69 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of KLA-Tencor's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $89 per share in Year 3 represents our existing fair value per share of $69 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

Pro Forma Financial Statements

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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.