This Under-the-Radar Stock Is Key to the Semiconductor Industry

Semiconductors, memory, and integrated circuits aren't just the domain of techies anymore. These innovations are becoming ingrained into our daily lives. That trend is likely to continue in the years ahead, as artificial intelligence, autonomous vehicles, and the Internet of Things take off.

Instead of only betting on individual chipmakers, investors should also consider the companies that make the equipment these chipmakers need for their manufacturing processes. That's what makes KLA-Tencor (NASDAQ: KLAC) so interesting.

KLA-Tencor was formed in 1997 when KLA Instruments and Tencor Instruments merged, forming an industry powerhouse for semiconductor diagnostic equipment. KLA's products help memory, foundry, and logic manufacturers limit defects in their manufacturing processes -- extremely important, since producing faulty chips results in lost revenue and profits for KLA's customers.

Here are a few of the reasons why KLA-Tencor may be particularly compelling right now.

Competitive advantages

KLA-Tencor has a few key advantages within the semiconductor industry. KLA-Tencor has over 50% market share in the process diagnostic and control (PDC) market according to Morningstar, making it the biggest player by far. For some product lines, such as its Surfscan SP7 for bare wafer inspection, KLAC has as much as 90% market share, by some analyst estimates.

By virtue of its size, KLA-Tencor has also collected a vast database of past customer defects. KLAC uses this expertise not only to develop its next-generation products, but also to sell service contracts to its customers. Service revenue grew 13% last year and makes up just over 20% of its sales.

Finally, KLA-Tencor is well-positioned in its industry due to its narrow focus on diagnostics. Competitors such as Applied Materials and Hitachi have multiple business lines outside of diagnostics. Meanwhile, other competitors such as Nanometrics are much smaller.

Going smaller could make KLA-Tencor bigger

Beyond the mere growth of the semiconductor industry, diagnostics in particular has very favorable prospects. Leading-edge chips have to go through hundreds of manufacturing steps, all of which must occur flawlessly for the final product to meet quality standards. The move to smaller, more complex memory and semiconductor chips requires more process controls to make sure each manufacturing step occurs without hiccups. The increased importance of diagnostics should pave the way for KLA-Tencor to grow in the years ahead.

For instance, in the case of NAND flash memory, producers have begun increasing bit density by stacking memory cells on top of one another -- this is called 3D NAND. Since NAND flash bit demand is growing in the neighborhood of 40% per year, this is the most efficient way to cram more bits onto a single die.

Last year, companies began stacking memory cells into 32-layer NAND, the first generation of "vertical" NAND chips. This year, major memory producers are moving to 64-layer chips. Next year, the industry will be moving to 96 layers, with 128-layer NAND projected to be developed by the middle of 2019.

Stacking tiny flash cells precisely is very difficult, as the smallest imperfection in any step of the process can throw off the flatness and uniformity needed to achieve enterprise-ready 3D NAND.

All of these companies will need lots of diagnostic tools for every step of this stacking process, meaning KLA-Tencor should benefit from the transition to vertical 3D NAND architecture.

China

KLA-Tencor also should benefit from China's ambitions in the semiconductor industry. China imports the vast majority of its chips today, but has vowed to change that via its "China 2025" plan. China's goal is to be able to provide 70% of its domestic chip needs by that time.

While that time frame may be ambitious, one thing is certain: China will be throwing billions of dollars into the effort. China is projected to spend $11.8 billion on semiconductor equipment this year, up 43% from 2017, and that figure is set to grow in the years ahead. As the Chinese semiconductor industry looks to catch up in its manufacturing capabilities, it will need lots of process diagnostic tools.

In its most recent fiscal year, KLA-Tencor grew its China sales by 56% to $643 million, good for 16% of its total sales and much higher than the company's 16% overall growth rate.

The future at a discount?

Currently, KLA-Tencor trades for just 11.2 times forward earnings with a nice 2.9% dividend yield -- not what you'd expect from a company that just posted 16% revenue growth. That's because the market is fearing a semiconductor slowdown next year after a bumper 2018. Still, in light of the long-term tailwinds, now may be a good time to look at a company that's indispensable to today's leading chip manufacturers.

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Billy Duberstein has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.