Building a Kulicke and Soffa Pyramid

| About: Kulicke and (KLIC)
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I have followed the chip equip maker Kulicke and Soffa (NASDAQ:KLIC) for 13 years - through thick and thin, through several up/down semiconductor cycles, and I think KLIC is the premier "way shower" for the chip industry as it emerges from a decline.

The theory is simple: KLIC makes the equipment (bonders) that chip makers must utilize if they wish to assemble chips for sale. That's why their part of the semiconductor market is called "back end assembly". Think of the holidays, the gift wrapping section and the Post Office. No one wraps a gift if they are not intent on sending it, correct?

Whereas it takes about a year to ramp front-end chip making equipment, the back-end can ramp in a matter of days (if not hours). During early 2007 the chipmakers spent significant capex on front end chip equipment - in anticipation of using that equipment later during the next up cycle. A year has gone by and now that equipment is ready to go. So it's a waiting game. If demand picks up, new bonders are going to be purchased posthaste, especially (I think) the new line of bonders written about in a March 19, 2008 Chipstock article "Sock it to em - KLIC introduces a New Bonder Line". An increase in demand will ignite the process.

Usually the chip stocks begin their advance about 6 months before order visibility has improved. The first three weeks of the advance is rapid; after that it's anyone's guess how the cycle will go, but the main idea is that a turn for the better has been put in place. I think this is where we are now.

Chip stocks are not linear investments, they rise and fall in a unique supply/demand cycle. As stated on the homepage of my website, "Liquidity in semiconductor stocks (demand) is primarily driven by investors' perception of the timing and maturity of the underlying semiconductor cycle. Being on the right side of those perceptions - and at the right time - is the key to trading the stocks successfully."

So what to do? First of all, learn a little about the cycle and base investment decisions on probabilities. Look at the trading history of the company (See: A Silicon Canary Begins to Chirp, October 27, 2007). This article was written 7 years ago, but it could have been written this week since the basic investment ideas about the semiconductor cycle are contained in it. For that matter, Broadcom (BRCM), Vishay (NYSE:VSH) and FormFactor (NASDAQ:FORM) could also be traded using the same information, but I like KLIC the best. It is a "pure play" on the overall nature of the cycle because the single reason chipmakers buy bonders is they have a demand to meet. It's as simple as that.

Secondly, I have developed a pyramid structure for purchasing KLIC (see below). It requires a margin account because I like the buying power to grow as the stock advances. There also must be a "reserve" withheld in the account to allow for pullbacks in the stock - and to avoid margin calls - so I will not be taken out of the position on a pullback.

At the beginning of an upswing, when KLIC is in the $4s and $5s, margin buying power is limited, but once the stock crosses above $6 it strengthens. I begin with 70% of buying power to purchase the stock, leaving the remaining 30% of buying power to cushion pullbacks in price.

For every 10 cents the stock rises, I buy a set amount of shares. Any unforeseen changes in market conditions, however, could severely skew the results of this "best case" scenario, so an investor must be careful to take only the risk he/she is comfortable with. My recipe may not be yours.

It is also possible to pre-set the buys above the going price (for example: 5.70, 5.80, 5.90 etc) with conditional trading (available online at most brokerages). I occasionally add a couple of buys below the price in case of a pullback (5.60, 5.50, 5.40). But the important thing to remember is keeping a monetary cushion in the margin account in case the stock pulls back 20% or so. An investor would not want to invoke a margin call because of overzealous plunging. This strategy should not be used once the stock crosses into the high single digits ($9). At that point it would be a totally different ball game - with the concentration being on when to sell, not how much to buy. And never used in a downturn like we had in 2H'2007.

For those of us who have followed the company for years, we already have bought thousands of shares in the upper $4s and low $5s last month in anticipation of a move higher from here. However, there is risk involved. KLIC is a high-beta stock (it fluctuates much more than the market) and there is the possibility that our assumed rise in the semiconductor cycle remains premature.

But as stated in the articles (above) $4.50 has been the bottom during the last 10 years (except for 2002), and I believe the company - coming out of this downturn - will be in strong financial shape. Thus far there have been no surprises in the conference calls; and the company is determined to de-lever the balance sheet with cash payments to decrease debt in the quarters ahead. Oppenheimer upgraded KLIC today to outperform, so there must be others thinking as we do. I think the only difference this time will be a paradigm shift in the way the market views this remarkable company.

Lastly, my approach is an intermediate "buy and hold" strategy. It's not for a week or two, and it's not for forever either. I think this cycle could take KLIC investors into cycle highs during 1Q' 2009. The timing of the sell will be the hard part. KLIC's new line of die-bonders might even impel the stock up to the $14 level. We'll cross that fortuitous bridge if we ever get there. (If that happens, it will be a good problem to have.) As in all things financial - caveat emptor. KLIC's volatility has driven many an investor away - just when the fruit seemed ready to fall from the tree, and conversely, just when the blue light special shined for buyers.

An objective look at the semiconductor cycle might convince the logical mind that "chip volatility" has been dujour for 25 years. One is tempted to think he can buy KLIC at a low price, hang on, and eventually "all will be well". But the emotional cost is something else entirely. True to form, as soon as you're in, you're suddenly down 15-20% the following week and thinking, "Uh oh. What have I done now?". Suddenly you're not so sure. Anxiety sets in. Nobody ever loves this stock when it's down. I've seen this script play out on the KLIC message boards for 13 years.

But maybe that's why the risk/reward for KLIC is so skewed to the extreme. During a previous cycle it suddenly lost 90% of its value in the summer of 02, but then rallied 800% the next year. Thus far in 2008 we were (-65%) from the July'07 highs before an intermediate change in the tide a few days ago. The selling in the summer of 2002 seemed interminable (sound familiar?). If conditions were that bad in Q3'2002, how could KLIC rally so fiercely just 6 months later? A changed perception of fundamentals did it. That was the biggest swing ever, from a $1.50 to $17.25 in a year. The median drop for the last 2 decades has been close to (-65%), which is near the price of $4.60 in March, 2008.


I listened to a radio show on NPR one Saturday afternoon called "This America", by Ira Glass. The particular episode was about a car dealership in the South that hosts an annual contest which gives away a brand new truck. Here's the catch - the winner has to be the one who holds onto the side of that truck the longest. The last person standing gets it. It sounds simple but winning this truck is no piece of cake. Over the next torturous 2 days the contestants drop off one by one until one cantankerous guy (who's won the truck before) reminds the two people remaining nearby, "You might as well give up. I always win. I have a special ability to withstand pain." And sure enough, after a couple of hours, one of them swallows his bait and gives up.

That leaves one contestant to go, a kid, who really wants the truck, and who begins to resent the other guy - which is what our winner wants. He whispers quietly to Ira, "The anger will inspire him to give up sooner. And he'll feel justified too".

And as I recall, our shrewd calculating fellow did indeed win the truck for his second time. And as soon as he won, he made a point of consoling the losers tenderly, saying his comments weren't personal, just practical, which increased his aura of invincibility in case they ever considered competing against him again.

I don't know why this thought popped into my mind today, but it seems that holding KLIC is a lot like holding on to the side of that truck. It's more about one's psychology than the stock itself. The Wall Street sages say that a bull market is like climbing a wall of worry, and never was that more true than with KLIC.

Disclosure: I have a long position in KLIC.