KLA-Tencor and the Fate of the Semiconductor Capital Equipment Sector

| About: KLA-Tencor Corporation (KLAC)

KLA-Tencor (NASDAQ:KLAC) is the world leader in yield management and process control solutions for semiconductor manufacturing and related industries. We have been discussing the changes and consolidation attempts in the EDA and ATE industries so far, both in the semiconductor infrastructure category. Another industry that suffers some of their conditions is the semiconductor manufacturing equipment sector.

Let’s look at KLA’s last earnings results. Quarterly revenues were $602.2 million, down 4% sequentially and 16% over the year, but still higher than the market’s expectation of $586.7 million.

EPS was down sequentially 11% to $0.67, beating the market’s expectation of $0.63. Over the year, EPS recorded a reduction of 24%.

By region, Asia contributed 72% of revenues compared with 61% a year ago. The U.S. contributed 22% and Europe the balance of 6% for the quarter. By segment, wafer inspection contributed 43%, reticle inspection 11%, metrology 22%, services 23%, and other markets brought in the balance 2%. Asia is where most manufacturing has shifted to, making it the industry’s most critical geography.

KLA-Tencor expects revenues of $560-$580 million in Q4, with EPS of $0.56-$0.60.

Management was concerned about the prevalent market conditions. In the earnings call, the company discussed the cautious investments being made by its customers. However, the company also said that the increased complexity from advanced technologies is creating new yield and defect challenges, driving the need for advanced inspection in measurement technology and accelerating adoption of process control and giving it confidence in its growth in the coming quarters.

This is true, except, the margin pressures faced by chip companies playing in the all-important consumer segment is also equally significant, making it harder for them to invest more in manufacturing. The chip industry is fast going to a fabless model, supported by the Foundries like TSMC, UMC, Chartered, SMIC, etc. The trend will likely further concentrate KLA’s customer base to a handful of companies, squeezing margins out even more drastically.

KLA continued to make advancements in its products, however. For instance, the company added features such as new optical modes that enable increased defect detection speed, demonstrate superior sensitivity and capture unique defect signatures and throughput. The company launched its latest mask inspection technology from Wafer Plane Inspection, or WPI, to cater to the 32-nanometer mask node. The WPI tool will be able to find all defects on a mask and show the defects that will print in an actual device wafer.

The company continued to be a leader in 45-nanometer technology, especially as the company saw increased customer investment in the defect inspection and memory spaces for its 45-nanometer development.

During the quarter the company announced the acquisition of the Belgian ICOS Vision Systems for $466 million. ICOS is the world’s leading supplier of equipment for visual inspection ICs. The company designs and manufactures inspection equipment for semiconductor packaging and interconnect applications.

With the acquisition, KLA will be able to enter the semiconductor packaging inspection, solar and LED lighting space and diversify from its current market space of semiconductor fab operations.

KLA has also been addressing cost control by shifting product development from the U.S. to its Singapore plant, which is currently operating at only 20% of capacity. With facilities now in Singapore, the U.S. and Israel, the company has an established global footprint that spans the product development phase as well.

Following the announcement of the results, the stock rose 4% to $44.60. However, it is currently trading at $38.75 levels.

KLA and its industry, like EDA and ATE, also needs to merge with certain adjacencies. I had said in an earlier piece that a Cadence (NASDAQ:CDNS)-KLA merger could be a step in the right direction, especially with increasing need to address defect and yield problems at the design level, dubbed the Design for Manufacturing [DFM] challenge. ATE would be another place that KLA could look for acquisitions in, to acquire a set of diversified customers.

I am envisioning a “Semiconductor Infrastructure” company / industry, which embraces manufacturing equipment, design tools, and test equipment.

1yr KLAC

Even with analysts confirming the weak market conditions for the semiconductor industry, KLA has a good opportunity to take advantage of this situation on account of its position in yield management products. The merger with ICOS will be beneficial, but the company needs to pick up more companies with bigger adjacencies. As I mentioned, an ARM-KLA Tencor merger will make the market space exciting.

Disclosure: None