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Altera (NASDAQ:ALTR) and Xilinx (NASDAQ:XLNX) are locked in a heated rivalry for dominance of the field programmable gate array (FPGA) market. Based on ongoing discounted cash flow analyses of both companies, I believe that Xilinx is breaking out as the victor of this rivalry.

Why Am I Writing This Article

I am a practicing engineer, but not the type that would know anything about semiconductors or embedded systems. A reader of my DCF Hub blog (who IS very familiar with FPGA) noticed that both Xilinx and Altera fell within my universe of stock valuations and expressed interest in hearing a more in-depth analysis. I am happy to oblige.

Tom Armistead wrote an interesting article on the rivalry between the two companies last month with a differing opinion.

Field Programmable Gate Arrays

FPGAs are powerful integrated circuits utilized in a variety of embedded systems. FPGAs have been around since the 1980s but until recently usage has been limited to niche markets, primarily defense spending. However, FPGAs have been increasing in processing power and speed and decreasing in price, and they are starting to take significant market share away from microprocessors and application-specific integrated circuits (ASICS). As the market leaders within the FPGA niche, Altera and Xilinx both stand to benefit from this transition.

Valuations and Valuation Histories

I have been calculating valuations for Xilinx and Altera (along with many other companies) weekly over the past year using a discounted cash flow analysis based on analyst consensus growth rates.

This is my most recent calculation for Altera:

Recent Price: $33.69

Earnings Projection
Forward P/E RatioOne Year Projected Growth RateFive Year Projected Growth Rate

Year 1 EPS

Year 2 EPSYear 3 EPSYear 4 EPSYear 5, Perpetual EPS
19.4220.07%6.23%1.441.731.841.952.08

From this earnings projection, a market discount rate of 7.4%, and Altera beta of 1, I have calculated the net present value.

Feb. 7 NPV: $25.56

Valuation Percentage: 132%

The chart below shows how this valuation has changed over the last year. The blue line represents the calculated net present value and the orange line represents the weekly price.

NPV Change Since Feb. 22, 2013: -9.9%

(click to enlarge)

Here are the same calculations for Xilinx.

XLNX:

Recent Price: $46.10

Earnings Projection
Forward P/E RatioOne Year Projected Growth RateFive Year Projected Growth Rate

Year 1 EPS

Year 2 EPSYear 3 EPSYear 4 EPSYear 5, Perpetual EPS
19.039.20%10.50%2.222.422.682.963.27

Based on this earnings projection, the market discount rate of 7.3%, and Xilinx beta of 0.97, I have calculated the net present value.

Feb. 7 NPV: $40.02

Valuation Percentage: 115%

NPV Change Since Feb. 22, 2013: +38.4%

(click to enlarge)

Neither company is particularly overvalued or undervalued at present, but Xilinx's valuation has increased substantially over the last year and Altera's has not. In my experience, it is often better to invest in a company with an upward trending fair value than one that is currently undervalued.

Xilinx May Be an Emerging Gorilla, But Altera Has A Shot With Intel

There is a persistent belief that new technology markets are a "winner take all" environment. This is because of the need to standardize. Once a chip (or any component, or platform) has been established as a standard, it is very difficult for BSP engineers, and they are unlikely to even consider using a competing product. If Xilinx becomes the clear market leader in a trendy emerging technology, for example the "internet of things," the market will reward it disproportionately.

This principle, and the investing dynamics, was popularized by Geoffrey A. Moore in his classic "The Gorilla Game". Gorilla game investing is a discipline in-and-of itself, but one of the key things to look for is early design wins in high profile projects that may set a standard for future developers.

So let's look at some of the more discrete verticals within the internet of things to see what FPGA solutions the tastemakers have embraced.

Wearable Computers: Invensense (NYSE:INVN) MEMS gyroscopes power many next generation wearable products, including Google glasses, and exercise equipment like the Fitbit. According to this job posting, Invensense uses the Xilinx ISE. Additionally, Xilinx CFO Jon Olson sits on the Invensense board of directors.

Rasberry Pi and Beaglebone Black: These cheap development computers are influential because they are aimed at the early educational and hobbyist market. They are what the next 12-year old prodigy is likely to be using. The startup Valent F(x) launched a successful Kickstarter campaign to create the Logi FPGA board for these computers. The Logi uses a Xilinx Spartan 6 FPGA.

Circuits For 3-D Printed Objects: I did a quick search for designs on Autocad 123D Circuits. I found two using Xilinx products and none for Altera.

So, overall, it appears that Xilinx is emerging over Altera as the standard FPGA supplier for next generation projects. But Altera does have some recent wins.

Altera recently signed a fabrication deal with Intel (INTC) to produce next generation ARM chips. Intel is still the most powerful chipmaker on the planet, and I am excited about Intel's Edison project. Although Altera may not be involved with the Edison, and this deal does not necessarily indicate a deeper relationship.

Altera also announced a strategic partnership with Intel subsidiary Wind River last week to deliver tools for Altera's ARM system on a chip platform.

There May Be No Winners Here, Or Anywhere Else, For Several Years

Markets have been weak throughout 2014, and in my opinion the broad market is still expensive. The market has fallen a bit and the discount rate has risen a bit since I complained about it in my last article, but I think we have further to go. I'm looking for the market discount rate to rise at least above 8% before I start looking for new bullish positions, and that is a minimum. 10-12% is more realistic for a true market bottom.

Additionally, technology markets are highly cyclical, and I think the current excitement over web 2.0, tablets, and smartphones needs to die off before the market can start getting excited about wearables, the internet of things, and FPGA.

All else being equal, a rise in the market discount rate to 10% would cause the NPV of Xilinx to fall to $28.92, an ~28% drop. The same macro correction would cause the NPV of Altera to fall to $18.50, also an ~28% drop. Note that I am calculating these drops based on the current NPV, and not the current price, as I believe both of these stocks could maintain a slight premium in a market crash.

Looking ahead to 2015 and beyond, Xilinx looks like it could be a big winner in the next technology cycle. Altera looks like a fair value, but there doesn't appear to be as much upside potential as there is for Xilinx.

Avoid A Pairs Trade

One thing I wouldn't do is attempt a long-short pairs trade with Xilinx and Altera. Market leadership can change, and a pairs trade would magnify the loss if Altera surprises. It is usually better to be long both or short both competitors.

Source: Xilinx Appears To Be Pulling Ahead Of Altera