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Stock Strategist

This Tech Titan Is Poised to Gain 20%-Plus

We like the long-term prospects of this wide-moat semiconductor firm.

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Following is a sampling of stocks that recently jumped to 5 stars. By way of background, we award a stock 5 stars when it trades at a suitably large discount--i.e., a margin of safety--to our fair value estimate. Thus, when a stock hits 5-star territory, we consider it an especially compelling value.

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KLA-Tencor Corporation
Moat: Wide | FV Uncertainty: Medium | Price/Fair Value Ratio*: 0.71 | Three-Year Expected Annual Return*: 23.7%

What It Does: KLA-Tencor (KLAC) designs and manufactures yield-management and process-monitoring systems for the semiconductor industry. The systems are used to analyze the manufacturing process at various steps in a product's development. The firm's laser-scanning products are used for wafer qualification, process monitoring, and equipment monitoring. KLA-Tencor also provides systems for optical metrology and e-beam metrology.

What Gives It an Edge: Morningstar analyst Andy Ng credits KLA-Tencor with a wide economic moat, owing to the firm's leading technology expertise in the process diagnostic and control (PDC) segment of the chip equipment industry. These PDC tools are critical to the profitability of chipmakers, as they are used to maximize manufacturing yields during the semiconductor fabrication process. In Ng's view, KLA's dominance in its market segment has made the firm the de facto standard of PDC to the semiconductor industry. Setting it apart from its competitors, KLA has accumulated vast technical knowledge in this arcane field from an installed base of over 20,000 tools and having engineers in every chip manufacturing facility in the world. Also, Ng points out that KLA's market leadership position in PDC allows the firm to maintain the largest R&D budget in the PDC space and gives it an opportunity to work closely with customers to identify future technology trends early on.

What the Risks Are: Although it has been profitable during past downturns, KLA still depends on the deeply cyclical semiconductor industry for demand. It also faces a number of competitors (including Applied Materials (AMAT)) that have been attempting for years to penetrate its stranglehold on the PDC market. Also, KLA must keep its technological edge to maintain its dominance in PDC.

What the Market Is Missing: Ng believes KLA and other chip equipment firms have seen their stock prices slump recently as chipmakers have cut back on capital spending, starting a cyclical downturn in the semiconductor equipment industry. Nonetheless, Ng believes KLA should be able to weather the downtown better than other semiconductor equipment firms, as the continued migration by chipmakers toward the next generation of semiconductor circuit sizes (45 nanometers) will require new PDC tool purchases. In particular, KLA estimates that its market opportunity at the next-generation 45-nanometer technology node will jump 30% from that of the 65-nanometer node. This constant demand for more and more advanced PDC tools helped KLA stay profitable even in its fiscal 2003, during the depths of the worst downturn in the industry's history. Ng also points to competitive fears in the market as a reason for KLA's weak stock price. Mainly, some are concerned that Applied Materials is trying to gain a foothold in reticle inspection, a key business for KLA. However, Ng contends that the Applied threat has been overblown. In Ng's view, KLA's leading technical expertise and knowledge base, as well as large R&D budget in PDC, are strong competitive advantages for the firm that should help KLA fend off Applied in the reticle inspection portion of the PDC space. In the past, numerous attempts have been made by competitors to break KLA's stronghold in reticle inspection, but each time to no avail.

* Price/fair value ratios and expected returns calculated using fair value estimates, closing prices, and cost of equity estimates as of Wednesday, Sept. 3, 2008.

Jeff Viksjo does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.