Tiny Chips; Big Profits

 | Oct 15, 2013 | 10:30 AM EDT
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I have been optimistic on the semiconductor equipment space. In the last few months, investors have begun jumping on the next wave of semi capital spending.

What drives this spending is increasing complexity and the shift to smaller chip dimensions. As devices get smaller, the demands on semiconductor makers gets even greater. Stringent power requirements and ever-increasing demands for speed and larger memories are causing the industry to invest heavily in the next wave of equipment to manufacture such complex devices. In fact, the front end of the semi-equipment industry is expected to grow between 8% and 12% over the next three years.

Ever increasing complexity is forcing the industry to upgrade its existing fabrication plants and to build new, more modern facilities. For example, when the typical semiconductor dimension was 90 nanometers (nm), semiconductor makers were principally concerned about signal integrity. But now, with die shrinks down to 20 nm, semiconductor makers have a whole bunch of new headaches that need to be solved. That's where the front-end equipment makers like KLA-Tencor (KLAC) come in.

You can see the shift when you look at projections KLA-Tencor management made at the industry trade show Semicon West back in May. Gartner Research expects the process control market, which KLAC dominates, to reach $6.3 billion by 2017 -- up from $3.5 billion in 2010. The lithography business is expected to grow from $6.8 billion in 2010 to more than $12 billion in the next four years.

The total wafer front-end business is expected to be a $39 billion opportunity. Of that $39 billion market, KLAC products address an ever-increasing portion of the market as semiconductor dies shrink. For example, the company's tools address between 13% and 16% of the market, depending on the size of the device your making.

I think investors are beginning to wake up to the opportunity in this new world of tiny transistors. To understand what is going on, take a look at the new 128-gigabit multi-layered 3D-NAND flash memories. In the old days, a memory chip would have just one layer of transistors laid down directly on a substrate. But this new 3D flash memory has as many as 32 layers built on a 20 nm process. The total die is just 146 square millimeters, which is 25% smaller than what the current technology offers. All those 32 layers, moreover, are vertically interconnected. It's a microscopic 32-story building smaller than the size of your fingernail. As a kicker, Samsung claims its new V-NAND technology uses 45% less power.

Back in the bad old days of 2008, 80 gigs of flash memory would cost $600. Today, with this new technology, you will have one terabyte of storage for the same amount.

In order to make these types of semiconductors, chipmakers need to stock up on equipment made by KLA-Tencor.

KLAC is scheduled to report first-quarter fiscal 2014 earnings on Oct. 24, and analysts are expecting the company to earn $0.66 on $657 million in revenue. But the first quarter is the low point of the year. Second-quarter revenue is expected to jump to $760 million, and third-quarter revenues to $803 million. By year-end, the Street is looking for the company to grow 7.7% to $3 billion in revenue. Because of stock buybacks, higher gross margins and earnings leverage, the company is expected to grow earnings per share 19% next year.  Investors are buying the stock with the expectation that KLAC will be able to drive its sales higher over at least the next six quarters.

Some investors are even betting that KLAC will be able to acquire its main competitor ASML Holdings (ASML). That's a long shot -- but I think that, as semiconductors get smaller, KLA-Tencor's stock will get bigger.

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