# The Story Behind KLA-Tencor's Decreasing Return On Equity

## Summary

The decrease in ROE is primarily due to a decrease in profit margins.

The equity multiplier and total asset turnover have remained constant between the past couple of quarters.

KLAC's return on equity could increase a bit more if they can somehow find a way to increase the asset turnover.

Most investors take a look at return on equity as a measure of how well a company is doing with respect to net income as a ratio to shareholders equity on the balance sheet. Companies such as IBM (NYSE:IBM), Boeing (NYSE:BA), or Altria (NYSE:MO) even have huge returns on equity. Typically a high return on equity value is pretty nice to have, but not all returns on equity are equal.

Although it is a straight ratio as suggested, it is a bit more complex than that. Not many investors know this, but return on equity can actually be decomposed into three parts, made popular by DuPont (DD) back in the 1920s. The decomposition of return on equity tells us three things:

1. Operating efficiency, which is measured by profit margin
2. Asset use efficiency, which is measured by total asset turnover
3. Financial leverage, which is measured by the equity multiplier

Prepare yourself for some algebra; I promise it will be pretty easy. We already know that profit margins are dictated by the equation of profit/sales. Total asset turnover is dictated by the equation of sales/assets and the equity multiplier is dictated by the equation of assets/equity. So when we multiply them all together we get the following proof:

 Profit * Sales * Assets = Profit = ROE Sales Assets Equity Equity

I for one am looking at return on equity in a much different manner now after learning this method. The part of the proof above that got me to investigate ROE more intently is the equity multiplier portion. Depending on how a company chooses to finance its assets (by debt or by equity), the equity multiplier can be really huge, causing the overall return on equity to be high. Personally I don't like a whole lot of debt on the balance sheet. But for capital structuring reasons debt can be used as a tax shield as taxes are calculated after interest payments.

I've chosen to evaluate KLA-Tencor Corporation (NASDAQ:KLAC) today because since I began writing about the company about a year ago, the return on equity has been a bumpy ride. For the past year that I've been looking at the stock it has had the return on equity profile depicted in the table below.

 Article Date ROE (%) 09Aug13 15.9 11Nov13 15.1 14Feb14 15.8 13May14 16.6 17Aug14 16.2 01Dec14 15.1

Operating Efficiency

As mentioned earlier, operating efficiency is the profit divided by the sales. This in essence tells us how efficiently the company is operating from an operations, financial, and tax perspective. From the table below we see that the profit margin decreased by 6.21% for KLAC from the fiscal fourth quarter to the first quarter. We see that net income has decreased and sales decreased over the period but at a smaller clip. Nonetheless, profit margins decreased which means the decrease in ROE can be attributed greatly to this. In KLAC's case approximately \$0.18 are generated in net income for every dollar in sales.

 1FQ15 4FQ14 Change Average Net Income (TTM) \$136 \$146 -6.69% Average Sales \$729 \$732 -0.51% Profit Margin 18.67% 19.90% -6.21%

Total Asset Turnover

From the equation I showed above, the total asset turnover ratio is defined by sales divided by assets. Total asset turnover gives us the big picture of how well the company is transforming all of its assets into sales. From the table below we see that the total asset turnover actually remained stagnant from the fourth quarter to the first quarter. Total revenues decreased while average assets increased at a low clip. This portion of the equation tells us that the ROE isn't related to the asset turnover in this particular instance.

 1FQ15 4FQ14 Change Revenues \$2,914 \$2,929 -0.51% Average Assets \$5,442 \$5,438 0.08% Total Asset Turnover 0.54 0.54 -0.59%

Equity Multiplier

The equity multiplier is the part of the ROE equation that I don't like. It's with this portion of the equation that a company can choose to get risky or play it safe. It completely depends on how the company manages its debt, equity, and on how well the cash flows are coming in to pay those debts. From the previous portions of the equation we pretty much determined that the ROE has decreased thanks to the profit margin decrease. An equity multiplier number of 1.86 is pretty good for my taste.

But it isn't until we break it out like I did in the table below that we can see if it is a good thing or a bad thing. As we can see assets have increased and equity has increased at a higher clip, causing the equity multiplier to decrease by 0.66%.

 1Q15 4Q14 Change Average Assets \$5,442 \$5,438 0.08% Average Equity \$3,597 \$3,588 0.27% Equity Multiplier 1.51 1.52 -0.66%

If we dig a little further we see that the equity value increased primarily because of an increase in common stock over the past year.

 Equity Make-up 1FQ15 4FQ14 3FQ14 2FQ13 Common stock \$1,236 \$0 \$1,206 \$1,194 Additional paid-in capital \$1,220 Retained earnings \$2,330 \$2,479 \$2,465 \$2,387 Accumulated other comprehensive income -\$36 -\$30 -\$31 -\$30 Total stockholders' equity \$3,530 \$3,669 \$3,640 \$3,550

In Other News

The chip industry has been on fire recently on the back of some good news. The good news entails Microchip recently announcing increased fourth quarter guidance while Cypress is going to merge with Spansion. Just these two bits of good news have lifted all boats with the rising tide. I anticipate KLAC to continue moving upward with the rest of the industry, but the gains for 2014 have been pretty phenomenal as it has gained 42.84% on the year.

Conclusion

The chip stocks are definitely a buy right now because it seems like the up-cycle is just about to kick in. But from what I pointed out in this article, not all returns on equity are created equal and in this case KLAC's return on equity is decreasing. It is primarily decreasing because of lower profit margins. When you multiply all the numbers together you get an ROE of 15.09% which is a 7.38% decrease from the prior quarter. This ROE makes KLAC the 7th highest in the Semiconductor Equipment & Materials industry (out of 44 companies). I'd like to see KLAC increase its profit margins a bit more right now which will eventually increase the ROE.