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MagicDiligence researches and recommends the most attractive value stock investing opportunities from Joel Greenblatt's Magic Formula Investing and similar screens. We use fundamental (and some technical) analysis to find equities of great companies with growth potential, outstanding management,... More
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  • Can KLA-Tencor Improve Your Yield?

    KLA-Tencor (NASDAQ:KLAC) is one of the world's biggest semiconductor equipment firms. The company specializes in the process, diagnostic, and control (PDC) segment of the market. In a nutshell, PDC tools are used to find and correct defects in the manufacturing lines of semiconductor factories ("fabs"). Getting a high number of working chips per silicon wafer (yield) is one of the biggest keys to good profitability for semiconductor firms, making KLA's tools extremely important to its customers. The company sells to 3 primary customer categories: foundries (contract manufacturers like Taiwan Semiconductor (NYSE:TSM)), logic (integrated chip makers like Intel (NASDAQ:INTC)), and memory (commodity memory firms like Micron (NASDAQ:MU)).

    MagicDiligence likes KLA-Tencor's business and positioning very much. PDC is an attractive growth market. In the big picture, the semi market in general continues to enjoy robust growth. Driven by intense demand for electronics everywhere from cars to appliances to phones and tablets, the industry is expected to grow to nearly $400 billion in 2015, from about $320 billion last year, representing 8% compound annual growth. What's more, as semiconductor processes continue to shrink and gain complexity, the potential for defects rises sharply. Even when counting the 2008-09 recession, KLAC has grown operating earnings at a 13% compound annual clip since 2008, one of the best marks in the industry.

    Another great thing about the business is its strong competitive advantages. KLA-Tencor dominates the PDC market, holding aver 50% market share worldwide. Although there are larger firms competing in PDC, notably Applied Materials (NASDAQ:AMAT) and Hitachi (HIT), KLAC is the only pure play, has the most diverse product portfolio, highest dedicated PDC R&D budget, and boasts the most experienced and skilled service force in the niche. These advantages show up in the firm's operating margins, which have peaked as high as 36% and come in at about 20% mid-cycle. Compare that to AMAT's 15% figure.

    We're also looking at a financially strong outfit. Cash on the balance sheet dwarfs debt, $2.6 billion to $750 million. KLA has come in cash flow positive for every year in the past decade. Efficiency is excellent too, with a 5-year average ROIC of 21.6%. Finally, the dividend yields a solid 3.3%, is well-covered at only 27% of free cash flow, and has been raised for 3 consecutive years.

    The only thing we can really complain about here is the industry's heavily cyclical nature. We have to be careful with cyclicals in Magic Formula® Investing (NASDAQ:MFI), because they are usually screened *after* a peak in earnings. Clearly KLAC is entering a modest downturn. Orders in the last quarter fell to $506 million, from $827 million the quarter before, and next quarter are forecast to be in a wide range of $550-750 million. We really need around $800 million to support reasonable growth estimates. The biggest weight right now is the really weak PC market, which fell by a rather alarming 5% in the holiday quarter (following an 8% decline in Q3).

    Over the long term, though, semiconductors are still required for smartphones and tablets, too! OEMs and component makers will adjust their product plans, but KLA's tools will still be necessary - even more so as components continue to shrink. Modeling significant weakness for the 2013 fiscal year, followed by a partial rebound in 2014 and 7-8% growth from there, I think KLA-Tencor is worth about $53 a share. While that is about 13% upside from current prices, we like to see greater margins of safety here at MagicDiligence before considering a formal recommendation.

    Jan 16 6:27 AM | Link | Comment!
  • Magic Formula Investing Weekly Roundup 1/13/2013

    Magic Formula Investing (NASDAQ:MFI), as described by hedge fund manager Joel Greenblatt inThe Little Book that Beats the Market, consists of ranking stocks by earnings yield (cheap) and return on capital (quality), adding the rankings together, and buying from the resulting lists. Below are stocks that have moved into, and dropped out of, 3 of the MFI screens used by MagicDiligence:

    Entering the 50 over 50 million screen:

    CACI International Inc. (NYSE:CACI)
    HollyFrontier Corp (NYSE:HFC)

    Dropping out of the 50 over 50 million screen:

    Collectors Universe Inc (NASDAQ:CLCT)
    Pitney Bowes Inc. (NYSE:PBI)

    Entering the 50 over 1 billion screen:

    Ubiquiti Networks Inc (NASDAQ:UBNT)

    Dropping out of the 50 over 1 billion screen:

    Marvell Technology Group Ltd (NASDAQ:MRVL)

    Entering the 30 over 3 billion screen:

    Gannett Co Inc. (NYSE:GCI)
    The McGraw-Hill Companies Inc. (MHP)

    Dropping out of the 30 over 3 billion screen:

    Joy Global Inc (NYSE:JOY)
    Marvell Technology Group Ltd (MRVL)

    Jan 13 9:49 AM | Link | 1 Comment
  • Are Hard Disk Drive Makers Really That Cheap?

    The two major hard disk drive (HDD) makers,Seagate (NASDAQ:STX) and Western Digital (NASDAQ:WDC), have been perennial Magic Formula® Investing (NASDAQ:MFI) stocks for years. Good ones, too. Both are up over 55% over the past 5 years, handily outperforming the S&P 500. The past 12 months have been particularly fruitful, with Seagate more than doubling and Western up 40%, easily exceeding the market's 11% return.

    Yet, by most valuation metrics, both stocks continue to look very cheap. At $44, Western Digital's P/E ratio is just 5.8, price to free cash flow is 4 times, price to sales is 0.8, and the MFI earnings yield is a very high 25%. The numbers are similar for Seagate at 4.4, 3.9, 0.86, and 24.7%, respectively. Both companies now pay dividends - Seagate paying a 4.5% yield at 12% of free cash flow, and Western a 2.3% yield at about a 9% payout ratio. To put this in perspective, the S&P 500 has an cumulative P/E ratio of about 14, roughly a 9% MFI earnings yield, and pays a 2% dividend.

    The drive makers are even cheap against the group of large-cap stocks in MFI. The average earnings yield of the "top 30 over 3 billion" MFI screen is 15.4%.

    Given this, WDC and STX on the surface look like intriguing MFI investments. But we need to do some "magic diligence" to be sure.

    The Market has Never Liked Us

    The first thing we need to tackle are the valuations. Comparing the P/E and earnings yield against the market isn't a great yardstick. For many years now, concerns over flash-based technology overtaking HDDs and industry volatility has kept valuations in the space low. Over the past 5 years, WDC has carried an average earnings yield multiple of 23.3% and a price-to-sales ratio of 0.76. Seagate's figures are 17% and 0.64, respectively. When you consider this, current valuations don't look nearly as enticing.

    Keep in mind too that profitability has always been a roller-coaster ride for HDD makers, given unpredictable supply and demand balance. Over the past 10 years, WDC's gross margin has fluctuated between 15% and 30%. STX has been between 14% and 31%! Look at those ranges and then look at the trailing 12 month figure for each stock: WDC at a 31% gross margin and STX at nearly 33%. Both companies are currently delivering decades-high levels of profitability.

    Put simply, the HDD makers are operating at historically unsustainable levels of profitability, but their stock valuations are only slightly below historical averages.

    The Changing HDD Landscape

    The next question to ask is: has something fundamental changed that would allow these high levels of profitability to continue indefinitely? If so, we can justify expecting a higher valuation for these stocks in the future.

    There have indeed been seismic shifts over the past 14 months. In December 2011, Seagate closed its purchase of Samsung's HDD business. Western Digital followed soon after, buying Hitachi Global Storage in March 2012. Together, these two moves consolidated what was a relatively fragmented market. Western and Seagate now operate an effective duopoly, controlling 87% of the global HDD market. Fewer competitors means more rational pricing and better balanced supply/demand, which should ensure better-than-historical profitability for both firms.

    How much better remains a question, though. Gross margins really took off for both firms in CYQ3 of 2011, when floods in Thailand literally sank a major production facility for WDC, crippling production capacity and causing unit prices to increase over 20%. While pricing hasheld up pretty well over a year later, I expect it to moderate going forward, which will mitigate some of the consolidation advantages.

    Growth Potential is Limited

    Few will argue that the prospects for HDD unit growth are mediocre at best. HDD units are expected to decrease 5% this year, the second straight year of decline, an industry first. PC shipments in 2012 were down over 6% in each of the last 2 quarters. Flash memory-based tablet sales are expected to easily outpace notebooks in 2013 - to say nothing of the plethora of flash-driven ultrabooks coming into the market.

    Long story short... the long-awaited replacement of HDDs with flash is finally happening, and rapidly. With consolidation behind them, it will be difficult for Western and Seagate to maintain unit volume, much less grow it substantially. For growth, it will have to be expanding margins and share buybacks. The latter is a Seagate specialty. They have averaged a 5% share count reduction over the past 5 years and are aiming to reduce share count from 400 million to 250 million over the next 2 (!) years. Western Digital has not bought back much stock, historically, but this has been changing recently.

    Putting It Together

    MagicDiligence believes higher gross margins are here to stay, but expects some pullback due to the flood issues subsiding. I've targeted a 29% figure for WDC and 30% for STX. That implies an average unit price of about $62-64 for both firms - above historical levels but below recent peaks.

    My unit growth expectations are quite modest. Near term (next 5 years), I've modeled it at 0%, and even that may be generous. Longer-term, I think it declines 5% annually before plateauing off. I know these companies have some SSD exposure and SSD/HDD hybrid drives, but I see these as just "treading water" products that are unlikely to be growth catalysts.

    Shareholder cash returns should be solid going forward. Seagate is liquidating a large portion of their float and Western's share buyback activity has picked up. Dividend raises from both firms are highly likely given low payouts of free cash flow.

    Western Digital clearly has the better balance sheet. Cash outpaces debt, $3.5 billion to $2.1 billion, with a 0.26 debt/equity ratio, vs. Seagate's $2.4B to $2.9B (0.82).

    Lastly, I've pegged a target pre-tax EBIT/EV earnings yield of 20% for STX and 21% for WDC, a bit better than their historical norms.

    This leaves my price target for WDC at $53 and STX at $34, a 20% and 1% upside, respectively. Neither margin of safety really piques my interest, although WDC looks like the better buy, mainly due to its stronger balance sheet.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Jan 11 6:29 AM | Link | Comment!
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