Semiconductors: Why Xilinx And Altera Will Struggle

by: Takeover Analyst

Over the last six months, semiconductor firms Altera (NASDAQ:ALTR) and Xilinx (NASDAQ:XLNX) gained 11% and 26.4%, respectively. The Dow Jones returned 16.4% over the same time period. Based on my review of the fundamentals and multiples analysis, I recommend holding out for now on these two firms, and instead focus on investing in smaller-scale players.

From a multiples perspective, Altera is the cheaper of the two. It trades at a respective 16.5x and 17.4x past and forward earnings, while Xilinx trades at a respective 17.8x and 18.8x past and forward earnings. To put this in greater context, consider that Xilinx is currently valued at 97% of its historical 5-year average PE multiple versus 87% for Altera.

On the other hand, Xilinx does offer a stronger dividend yield at 2%. In the light of these weak multiples, I recommend considering TranSwitch (TXCC), which, in my view, is trading at a significant discount to intrinsic value largely due to the dearth of information on the firm right now. The fundamentals, however, have proven strong, as evidenced by the 22.5% gain over just the last three months.

At its third-quarter earnings call, Xilinx's management pointed towards better-than-expected performance:

"Gross margin was 65.8%, up from 63.9% in the prior quarter and better than anticipated, driven primarily by favorable customer mix and continued overall cost reduction. Operating expenses were $199 million, flat with the prior quarter and a little less than guided, primarily due to lower variable expenses associated with lower revenue and increased attention to fiscal discipline. Operating margin was 26.8% for the quarter.

New product sales decreased 13% sequentially and increased 5% on a year-over-year basis. Virtex-6, Spartan-6 and our 28-nanometer product families all posted solid sales growth during the quarter. The new product category, however, was impacted by declines from our Virtex-5 customers in the wireless segment. Mainstream products declined 1% sequentially, and base products were flat".

While secular trends in the transition over to FPGAs and PLDs is positive for Xilinx, the company has lost share in 48nm. Even in 28nm, which the company is aggressively pushing forward, the gains have been elusive. Management still expects to realize a 70% share in the PLD market in 28 nm. And on the operational side, management guided for upwards of 66% in gross margins - slightly better than expectations - while budgeting for an attractive amount of R&D to sustain free cash flow. Even still, Altera has achieved greater efficiency and is catching up in terms of share.

Consensus estimates for Xilinx's EPS forecast that it will decline by 22.6% to $1.82 in 2012, and then grow by 23.1% and 19.6% in the following two years. Assuming a multiple of 18.5x and a conservative 2013 EPS of 1.93, the rough intrinsic value of the stock is $35.81, implying 4.1% downside.

At its most recent earnings call, Altera provided a conservative outlook. Management guided for between a 5% to 9% sequential decline in revenue. Inventory reductions in wireless will further hinder top-line momentum. The main catalyst that the firm has in its fold to weather a challenging economy is its "structured ASICs" solutions, which provide the best of both worlds in PLDs and ASICs.

Consensus estimates for Atlera's EPS forecast that it will decline by 20.1% to $1.91 in 2012, and then grow by 2.6% and 20.4% in the following two years. Assuming a multiple of 18.5x and a conservative 2013 EPS of $2.21, the rough intrinsic value of the stock is $40.89, implying 5.2% upside.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: We seek IR business from all of the firms in our coverage, but research covered in this note is independent and prospectively commissioned. The distributor of this research report is not a licensed investment adviser or broker dealer. Investors are cautioned to perform their own due diligence. Always discuss investments with a licensed professional before making any financial decision. Statements made within this report may include “forward-looking statements” as stipulated under Section 27A of the Securities Act of 1933, Section 21E of the Securities Act of 1934, and the Private Securities Litigation Reform Act of 1995. Since these statements are uncertain, actual results may be materially different from those expected.