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There's a saying that goes, "Once is happenstance, twice is coincidence, the third time is enemy action". With a small collection of chip company earnings in hand, it does look like the long-await recovering in semiconductors is at hand. As is so often the case, though, the markets have anticipated the reality and Xilinx (NASDAQ:XLNX) shares have been bid up to something less than a full bargain.

An Encouraging Third Quarter

Certainly a little context is important when looking at Xilinx's report. For starters, while it was an encouraging report, results were still at the lower end of original (before the late-quarter revision from management) guidance range. It's also important to remember that sales were down - down 8% sequentially and 10% from last year.

Like most companies with strong operating leverage, it cuts both ways. With lower revenue, gross margin contracted almost two points sequentially though close to flat on an annual comparison. Further down the line, operating income was down 11% sequentially and 25% annually on a GAAP basis; stripping out amortization and restructuring charges doesn't change much.

The Refresh That Ends The Pause

When Xilinix's peer Altera (NASDAQ:ALTR) warned the Street of lower earnings back in December, management said that they thought the market was bottoming. Texas Instruments (NASDAQ:TXN) echoed this sentiment, and both companies suggested that customer orders were below end-market ship rates and that inventories were getting very low.

It seems like that's holding true. Although sales to the communications and industrial markets were both down this quarter (9% and 7% respectively on a sequential basis), management pointed to improving orders in these markets. That basically corroborates similar reports and guidance from Linear Technology (NASDAQ:LLTC) and leading chip fab Taiwan Semiconductor (NYSE:TSM).

Here's the note of the caution - rebuilding inventories will only last so long. End-user demand needs to pick up for this to be a real recovery. To that end, guidance from companies like F5 (NASDAQ:FFIV) has been supportive, but what Xilinx really needs to see is a resumption of telco spending on base stations, backhaul, and networks. If companies like China Mobile (NYSE:CHL) and Verizon (NYSE:VZ) get back to spending on network upgrades, that will ignite the demand at OEMs like Cisco (NASDAQ:CSCO), Alcatel (NYSE:ALU), and Ericsson (NASDAQ:ERIC) that Xilinx really needs to see.

Still A Strong Long-Term Trend Story

Even if the 2012 recovery takes a little longer to play out, there are good fundamental reasons to own Xilinx for the long haul. Together with Altera, the companies largely dominate the programmable logic device market [Lattice (NASDAQ:LSCC) is a weak sister and Microsemi's (NASDAQ:MSCC) Actel is narrowly focused on flash-based products for the low-power and military markets]. As PLDs continue to displace ASICs over time, that leadership position should be worth more and more.

In the short run, Altera has the lead in the 40nm space (holding more than 60% share), but Xilinx looks like it's coming back strong in 28nm. Odds are the companies will continue to trade leadership back and forth through product generations with neither company holding a commanding edge.

The Bottom Line

In the short run, the biggest risk is that this recovery is just short-term inventory restocking that fades out in the wake of growth struggles in Europe and China. Longer term, it would stand to reason that Altera and Xilinx should see more competition either within PLDs or from a different approach altogether - it's just not too common for companies to produce these kinds of returns and cash flow for the long term.

For now, though, Xilinx shares have rebound enough that they aren't necessarily the best chip cycle recovery play. Broadcom (NASDAQ:BRCM), Atmel (NASDAQ:ATML), or Microsemi could all be more attractive in that regard. Thinking about the bigger picture and the longer term, though, it's hard to argue against these shares. The company already pays a good dividend and has a compelling leadership in a growth market with at least some barriers to entry. Trading maybe 25% below full-cycle fair value, Xilinx makes for a tempting addition to quality tech stock portfolio.

Source: The Chip Recovery Is Underway At Xilinx