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KLA-Tencor Corporation (KLAC): One Prudent Play on the Chipmaker Market

KLA-Tencor Corporation (NASDAQ:KLAC)We are living in an era of “hyperinvention.” We all want our PCs (and tablets) to operate faster and perform a greater number of tasks simultaneously. There’s no doubt in my mind that demand for faster microprocssors will increase exponentially over time. There’s one service company whose sole role in life is to make sure that production lines are flawless, and that microprocessors are manufactured at top speed and precision. That’s where KLA-Tencor Corporation (NASDAQ:KLAC) comes in.

It’s already happening

You need to look no further than at global makers of microprocessors (“chips”) to realize that the hyper invention phase has already begun. All of the leading chipmakers are constantly improving the speed and quality of their chips at a furious pace, and setting very specific goals as to what quality of chips they would be producing three and five years down the road.

Take Intel Corporation (NASDAQ:INTC) for example. For 2013, the giant chip maker plans to ship first tablet and smartphone chips made with 22-nanometer chips, and increase capital spending on production of 14nm chips. For 2015, the company already expects to reach peak production of its 14nm chips, and ramp up manufacturing of 10nm chips. And this just goes on and on.

And Intel Corporation (NASDAQ:INTC)’s biggest rival, Taiwan Semiconductor Mfg. Co. Ltd. (NYSE:TSM), has no intention of being left behind. In 2013, Apple initiated trial production of TSM’s A6X processor. In 2014, the company plans that its 20nm chip production will exceed the 2012 production level of 28nm chips. And for 2015, TSM plans that its 20nm production will exceed the 2013 production level of 28nm chips.

And in order to make this predictions – a viable reality, Intel Corporation (NASDAQ:INTC) and TSM must make sure that their production lines are flawless. KLA-Tencor Corporation (NASDAQ:KLAC) handily solves this probem for them.

The solution

KLA’s primary job is helping its customers improve production yields by reducing the number of chips with manufacturing defects. You can’t build new semiconductor fabs or make big technological changes without including this technology. KLA-Tencor Corporation (NASDAQ:KLAC) is an integral part of those cutting-edge fabs. Companies can’t exist without KLA.

In addition to catching defects, KLA also helps its customers identify underlying flaws in their manufacturing processes, which are some of the most complex manufacturing processes on Earth. There can’t be many products more complex to build than a computer chip with 2 billion tiny transistors, each 22 billionths of an inch apart, so tiny that a speck of dust could ruin them.

KLA-Tencor Corporation (NASDAQ:KLAC)’s business is fixing and preventing the semiconductor manufacturing mistakes that dominant chipmakers simply can’t afford. And KLA is a great opportunity for the following reasons.

KLA’s profit margins are impressive. Gross profit margins have averaged more than 54% since 2002. Net profit margins were negative in the deep recession of 2009. But in nine of the last 10 years, margins have come in at stout, double-digit figures, generally between 14% and 25%.

In addition, the company is gushing cash flow. From mid-2002 through the end of 2012, KLA-Tencor Corporation (NASDAQ:KLAC)generated about $4.1 billion of total free cash flow on roughly $24.9 billion in sales. That’s an overall free-cash-flow margin of just over 16%. If you can generate $0.16 of free cash flow on every $1 in sales, you’ve got a wonderful business on your hands.

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