Kulicke & Soffa (KLIC) Analysis

Kulicke & Soffa (KLIC) is a manufacturer of semiconductor manufacturing hardware. The stock currently trades at $7.46 on EPS of $1.92. The strangely low multiple and otherwise intriguing stats convinced me to take a deeper look. Unfortunately, although it has some promise and seems to have come long way, KLIC seems more like a speculative play than a value play.

Financial Integrity
For a company with such an up-and-down history (check the ten-year earnings for details) in such a cyclical industry, the first questions is: how stable is it? Surprisingly, the answer is “very.”

The Altman Z-score comes out at 3.92, which is rock solid. The company has been engaged in long-term de-leveraging over the past decade, with Debt/Equity and LT Debt/Assets at their lowest levels of the decade (.31 and .17 respectively). The company has paid down 60% of the outstanding debt from its $251M high point in 2007. The company also has sufficient cash on hand to cover all the debt that comes due within the coming year – there’s almost twice as much cash on hand ($181M) as there is total LT debt ($98M).

Stability has also been enhanced by substantial improvements in gross margins over the past few years. Since 2008 gross margin has hovered around 40%, as opposed to the 25-30% range occupied in previous years. Much of this seems to have been accomplished by a cost-saving migration overseas to new production facilities in Singapore and Malaysia.

To emphasize the impact of these savings, compare the revenues and earnings of two years: 2009 and 2003. In 2009 KLIC had sales of $225M and operating income was -$74M; in 2003 sales were $494M and the operating income was -$47M. Gross margins were 40% and 25% respectively. Operating expenses were $162M in 2009 and $171M in 2003. Since they were relatively stable, a comparison of the effect of gross margins is pretty straightforward (and even more relevant). At the old margins, 2009 operating income would have been -$105M and the loss would have increased by over 40%. Obviously this doesn’t remove the violent cycles of the semiconductor equipment and manufacturing industries, but it does help mitigate their effects.

There is a significant off balance sheet obligation, but it appears to pose no major threat to stability. The company is committed to purchase $100M worth of raw inventory materials from its suppliers. Some of the orders can be freely canceled and others have a cancellation fee. Since KLIC has an existing order backlog of $250M and since even in 2009 they achieved revenues of $225M, there is probably en

Assets
The company’s assets are a pretty dull story. P/B is 1.6, below the industry average. Values look solid – plenty of cash, receivables aren’t out of line.

Enterprise value: 545M market cap + 98M LT debt – 181M cash = $446M

Earnings
The company’s currently having a great year. Actually, that’s a bit of an understatement – it’s an absolutely fantastic year, with net income ($142M) almost three times higher than the next best year over the last decade ($56 in 2004). With that in mind, it’s pretty easy to see why KLIC trades for less than 4x earnings: investors don’t believe these numbers will continue.

To get a better sense of what to expect in the future, the past year needs to be put in the context of normalized earnings. I’ll estimate normalized earnings by using a modified ROE method. The company’s leverage has varied wildly over the past decade (especially after the dot-com bubble burst and nuked the company’s equity), so averaging the ROA over the past 5-10 years and multiplying by the current financial leverage might be more appropriate than a simple average of ROE. The choice of time frame makes a lot of difference. Using the full decade gives a negative value due to the truly enormous losses suffered in 2002.

5-year ROA: 8.57%
10-year ROA: -3.4%

The five year value probably makes more sense considering the de-leveraging and cost-reduction that the company has undertaken since the early 2000s. Financial leverage is currently 1.8x, so that puts average ROE at 15.43%.

Avg. ROE x Book Value/Share = Normalized EPS
.1543 x 4.38 = $.68/share

With 74M shares, that’s $50.3M and that makes for a normalized P/E of 10.5 (9x enterprise value), which is more pessimistic than what appears to be the consensus forward P/E: 6x. The normalized EPS above also doesn’t account for any taxes but that shouldn’t be a factor for quite a while. KLIC has tens of millions in NOL carryforwards in every jurisdiction it operates in. It also has substantial tax holidays in several of its operating areas: 50% in China to 2012, 100% in Malaysia to 2014. The company’s Singapore holiday expired in February 2010, but they’re negotiating to extend it (luckily they’ve got enough credits to offset at least a year’s earnings anyway).

Quality
Does the firm’s quality make up for the uncertainties about its earning power? Yes and no. It gets solid returns on its invested capital, but its market position is a little shaky.

Greenblatt-style ROIC gives a pretty nice result for KLIC. Assuming $56M in cash is “necessary” to be conservative, it comes out like so:

EBIT = $148M
Invested Capital = Net Working Cap + Net Fixed Assets = (473-125-125) + 30 = $253M
ROIC = EBIT/Invested Capital = 148/253 = 58%
With normalized earnings (it’s not like they’re paying much T anyways) : 50.3/253 = 20%

Market-wise, there are two points of concern. The first is that, according to the 10-K, much of their recent sales have been driven by customers switching to new copper-based production using KLIC’s newer equipment. Judging by the enormous run-up in sales this year and the relatively high concentration of the company’s business among its largest customers, that makes me think that its customers might have already accomplished a lot of the upgrades they needed. The top two customers alone accounted for 33% of sales last year, so that’s a significant concern.

The other concern is the potential for new competition. KLIC mentions that alternative packaging technologies have been developed that don’t require wire bonding (one of KLIC’s major focuses). This threat is couched in the usual “maybe, who knows?” tone of all 10-K risk reports but it’s still unsettling when combined with the fact that orders from large customers will probably be dropping off – it’s more potential downside than I’d like.

Ultimately, there are too many uncertainties to make this a solid value play. The concentration of customers might make it possible to gauge future demand (and I noticed that David Tepper just bought a pile of Semiconductors HOLDRS), but I’d hesitate to dive in without stronger evidence or an immediate catalyst. Long holding periods aren’t exactly appealing with such a cyclical company – even if the company deserved a higher multiple (not convinced it really does…) there’s still the risk that a downturn in the sector would arrive before investors recognized its possible value.

Latest 10-K: http://www.secinfo.com/d12TC3.r2zzw.htm#1stPage

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