Inside the Apple/PA Semi Deal: Micro and Macro Perspectives

Last week, Apple (AAPL) made a tiny debit from their enormous cash reserves to buy small semi conductor design firm PA Semi. At approximately $278m, the deal barely shifts the multi billion dollar cash account on the balance sheet; still it has left many analysts, watchers and writers asking questions.

The first and most obvious is “why?” Why did a company that favors buying companies in the early stages of development buy a company with an established customer list? And why, given Apple's focus and success with consumer-focused products, would it choose to invest in the challenging and cyclical semiconductor industry?

Another more macro set of questions queries whether the deal represents a possible shift in Apple’s acquisition policies. Was this the start of a more acquisition friendly Apple; one interested in taking advantage of weaknesses in the current financial markets to fortify underlying tech assets?

Apple remains characteristically tight lipped on both the micro and macro points. Spokesman Steve Dowling said only, “Apple buys smaller technology companies from time to time, and we generally do not comment on our purposes and plans.” In last week’s earnings conference call, CFO Peter Oppenheimer shared a similar perspective.

Without direct insight, we’re all left to speculate and make educated guesses. This two part article will look at the micro issues - the PA Semi buy and its logic - and the larger issue of Apple’s general M&A perspective.

PA Semi – so what’s the deal?

Some are speculating this wasn’t a purchase driven by existing technology but instead aimed at acquiring intellectual capital. The theory surmises that Apple’s interested in acquiring IP and engineers to help them create their own customized lower-cost, lower-power consuming chip set for use in the iPhone or future devices.

Another angle of analysis theorizes Apple wants to take the chips PA Semi has already designed and make them exclusive components to Apple products. Taking the chips off the market and controlling supply, they say, will give Apple a significant competitive advantage. It will make it harder for other firms to catch up, or duplicate Apple’s products.

However it’s sliced, the purchase seems to come down to one of these categories: Buying product (as speculated by Forbes) or buying IP (Macworld) to build something new.

–•• WHO IS PA SEMI, WHAT’S SO SPECIAL ABOUT THEM? ••–
Palo Alto Semiconductor (PA Semi, for short) is a specialist “fabless” microprocessor company. They aren’t in the business of manufacturing chips, they design them. Before the acquisition put them on the global map, few outside the semiconductor industry, or involved in engineering devices, likely knew them. Semiconductor design firms aren’t usually household names.

The company was founded in 2003 by Dan Dobberpuhl, a former standout chip designer for Digital Equipment Corporation in the 90s. Today, the company has a staff of about 150 and is well funded by Bessemer Ventures, Highland Capital Partners and Venrock.

PA Semi’s core technology is a series of high performance low-power chips named PWRficient processors. As the name suggests, efficiency in electrical power consumption and resource allocation were principle parts of the design. The company’s corporate white-papers suggest the chip family uses as little as 1/5th the power of comparable Intel (INTC) Xeon or AMD (AMD) Opteron X86 chips.

More than 50 patents were filed to support PA Semi’s specialized designs. The foundation on which their chips are built, however, is licensed. PWRficient chips are built around the “Power Architecture” chip platform. This is the same architecture that powered pre-Intel Macs (Power PC chips). It’s also the backbone of Cell Processors (the powerful chips custom created by Sony (SNE), Toshiba (TOSBF.PK) and IBM (IBM) to power the PS3 gaming platform).

–•• WHAT DOES IT MEAN TO APPLE ••–
Apple exited the Power PC chip market in favor of Intel chips in 2006. Intel’s processors were lower cost (as a result of manufacturing scale). The Intel chips have also had significant impact on Mac Sales. This last quarter, for example, Apple’s 36% record setting profit increase was powered in no small part by the sale of 2.29 million computers, a 51% year over year improvement.

The question raised is – why does Apple want a company focused on a chip design that Apple already abandoned? Especially given the decision to switch to “Intel Inside” has brought incredibly positive financial results.

The possible answers break into three categories: Door Number 1. Apple has specific product plans for the technology (e.g., they are buying tech); Door Number 2. Apple is buying intellectual property in the form of smart engineers; or the neutral Door Number 3: Apple sees opportunity in getting both.

DOOR NUMBER 1: THE CASE FOR BUYING TECHNOLOGY

Speculation here has hinged on how PA Semi’s chips could be used to power Apple’s existing products. To be sure, there’s no question chips that consume less power which allow portable devices greater battery life. Another upside of drawing less power is these chips will produce less heat. A third angle is sizing. “System on a Chip” designs, especially those producing less heat, can be clustered together into a smaller space, thereby giving more design leeway for the final packaging of a product (itself, one of Apple’s signature elements).

New Macs in an ultra-portable format are one theory that’s been put out there. The universal binary architecture that Apple currently uses could, presumably, be built around a PowerPC again. Such a prospect doesn’t make much sense, however. The switch to Intel is a significant factor in consumer shifts from PCs to Macs. Additionally, Intel has shown a willingness to work with Apple to meet design constraints. For the MacBook Air, as a case in point, Intel made efforts to adapt chip sizes to fit the computers' ultra thin form factor. For Apple to abandon a positive partnership seems beyond remote given the circumstances.

Another big speculation is the iPhone. Low power “system on a chip” configurations could mean longer battery lives or smaller phones; wins in both categories. Such a configuration could even theoretically power the kind of dual screen clamshell designs that have been patented and speculated on. Adding to this buzz, an in house chip design could add a larger barrier to block copycat competitors from trying to either match or reverse engineer Apple’s hardware innovations and designs.

Tempting and even compelling as the iPhone applications are today, all of Apple’s iPhones and iPods are powered by ARM based processor technology. The marketplace for these components is broad. There is already a host of system on a chip and low-power chip vendors in (or entering) the market. As much as exclusivity could be an advantage, and makes good copy, it seems likely to be too expensive to warrant a shift. A partial re-design? Or part of a basket of components? That would make more immediate sense.

[Note: All of the product assumptions built around existing chips assume the Power Architecture licenses underlying the PA Semi chips can be transferred to Apple. There’s some speculation that might not be possible. For the sake of argument, and reviewing product applications, this presumes Apple can (and will) sort out any such IP issues.]

If not Macs or iPhones, then What?
The Mac and iPhone represent the biggest growth opportunities in the current product line, and therefore get the most attention but Apple’s got more in its hip pocket. Could one of those products – Apple TV/Time Capsule/AirPort be the bigger beneficiary of this purchase?

It seems partly a question of whether this deal applies to existing products, derivative products or something new entirely.

PWRficient chips, it turns out, have advantages that go beyond just power savings. One of the upsides is security. The designs have integrated acceleration for encryption and decryption processing. This could be advantageous for storing and securing data without taxing a device’s software. For one application, imagine a smooth running password vault on your iPhone, more efficient device-based eCommerce. Network storage on a home network could potentially benefit as well.

Another advantage of the chipset in PA Semi’s arsenal is the way the architecture can handle modular storage architecture. This with security applications make for potential NAS products. In fact, NEC (NIPNY.PK) and Mercury (MRCY) are already PA Semi customers. Of course, Apple isn’t really in the enterprise storage market. Besides the fact that the Xserve servers Apple makes are a niche product, they are on the Intel platform just like the Macs. It would be a surprise for that to change.

Given Apple’s strengths in consumer focused products, it’s hard to imagine they’re aiming to get deeper into the enterprise server market. It’s possible, just doesn’t seem the best way to build on the momentum they have. A more likely theory is that PA Semi technology could get mashed up into a new product that offers a broader array of home networking functionality. Maybe it takes the form of a newer, bigger sibling, to the Time Capsule products revealed earlier this year.

Another natural extension might be a next generation Apple TV. Currently the system runs an Intel 1.0 GHz "Crofton" Processor. In its current configuration, which lacks a cooling fan, the device is quiet but known to run at high temperatures (about 110degrees when in use according to tests reported at Digital Trends). Apple has said this is normal and no cause for concern. Still, a lower power chip architecture could conceivably address the issue in future models and a PWRficient chip set could do just that and improve storage architecture for the device too. Another bonus, the chip can be attached to a larger than normal number of Input/Output (I/O) devices. That could potentially expand home media opportunities.

Another class of product theories could look toward embedded applications or in a farfetched but interesting idea, lead to some form of Apple gaming platform. It would be “out of left field” but it's not without at least one interesting element. Turns out – Power Architecture based chips, those of the same fundamental foundation as PWRficient chips, power all of today’s home gaming consoles:

•The Xenon chip in the Xbox 360 is a 3 core Power PC chip
•The Broadway chip in the Wii is a slower Power PC derived chip reported to run at about 729Mhz.
•The Cell Processor in the Sony PS3 was a custom developed evolution of the PowerPC built by Sony, Toshiba and IBM.

An Apple game platform is far from likely, but it makes for amusing speculation.

DOOR NUMBER 2. THE CASE FOR BUYING ENGINEERS
The second theory of the deal is an engineering purchase, an IP buy. It’s equally plausible. Maybe even more so if Power Architecture licenses prove non transferable.

PA Semi features a headcount of approximately 150 talented engineers. The group includes specialists skilled in processor design, software engineering, ASIC and system architectures. Many of these engineers, including some of the firm’s top tier executives, have tremendous experience.

As it stands, Apple engineers already are often tasked to create custom motherboards and system architectures in order to allow products to fit Apple’s external (or usability) design criteria.

There’s no question, adding a large group of talented staff to the pool of resources already in Cupertino would be valuable. An in-house semiconductor design team could both help Apple work with existing suppliers to customize chips for exclusive use, or potentially, build chips from the ground up.

THE RESULT?
Engineer talent? Product Enhancements? New Chips or Re-engineering old? Where is Apple headed?

The safe answer is to say it’s a little of both, or a lot of both. The safe, diplomatic prediction is “flexibility.” But as an experienced former Silicon Valley CEO was quick to point out, “such perfect synergies never happen.” To his eye, this will be an either/or proposition with only a trickle of overlap.

A new Apple TV? A new storage product? Designers to build for the future? Reality is, where Apple is headed with PA Semi is a mystery (probably just as Apple wants it). Whenever or whatever though, one thing is actually somewhat certain – the deal will figure prominently into Apple’s plans. Steve Jobs not only had a direct hand in negotiating the deal, according to reports, many of the final meetings actually took place in his own home. The purchase of PA Semi wasn’t an arm’s length transaction. This was the first step in a friendship.

Looking at Apple’s purchase of Palo Alto Semiconductor opened the door to two core questions. One, the micro look, questioned what Apple’s specific interests in the company were. Why did they make the purchase? The second question is a recurring issue and more macro in focus: does this small scale purchase give any indication of a change in Apple’s M&A strategy?

When it comes to the official company line, Apple spokespeople say, “Apple buys smaller technology companies from time to time, and we generally do not comment on our purposes and plans.” Like most companies, they give little guidance about how the company may plan to use (or not use) any cash reserves.

The thing about Apple is: they have a massive cash war chest. In December, for example, Fortune reported that Apple’s cash stock, then at about $15.4billion, exceeded the reserves of HP (HPQ) and IBM. In fact, only Cisco (CSCO) and Microsoft (MSFT) had horded more. Now, as of the most current earnings period, cash has ballooned to $19.4b.

As a matter of practice, Apple doesn’t pay dividends. And similarly, so far, they haven’t hinted at any major (large scale) plan for a stock buyback either (between 1999 and December 2007, only in the ballpark of $215 million went to buybacks). The question that gets asked is what will Apple do with all its cash?

On the one hand, keeping it around provides tremendous flexibility but, at some point, investors and analysts start questioning whether some of it should be allocated toward longer term investment, and whether it’s being wasted without alternate deployment. How much cash is too much?

Historically, Apple’s practices have emphasized buying early stage companies that bring product and talent that Apple can nurture and mold internally to the end product of their choosing. PA Semi was a little more mature but, to a large extent, it still fits with that perspective.

Whether the buy proves for engineering, or driven by the existing chip products, nothing directly indicates a change in practice. On the other hand, could Apple accelerate the pace of small transactions, or even consider something larger, given all that cash? Of course.

Adding to the possibility of more are questions surrounding a recent hiring decision. Earlier this month, Apple hired former HP attorney Charles Carnas to head up the corporate sector of its internal legal team. Carnas had been Deputy General Counsel at HP. In that role, he became known partly as a merger and acquisition specialist. He oversaw HP’s $4.5 billion dollar purchase of Mercury Interactive in 2006. He also handled corporate securities issues in the $25billion purchase of Compaq in 2001.

Carnas’ addition to Apple’s legal team is by no means a flashcard to future M&A plans. There is surely enough securities and general corporate legal work to warrant a highly experienced division head; which he clearly is. Further, if M&A was on the agenda, capable outside counsel could surely shoulder the burdens. On the flip side – he’s considered a legal heavy hitter, a guy who knows his way around asset purchases and acquisitions.

Looking to the crystal ball, it’s most likely the hiring of Carnas is just a sign of Apple’s maturation. The role had been empty since 2000. The addition was only a matter of time. Back to M&A efforts though? I wouldn’t be surprised to see more deals, probably small, over the coming year. One or two here, a few there.

Apple’s innovation may be largely organic, but that doesn’t mean they can’t or won’t buy some fertilizer every now and again.

Comments

[hardmanb:]

Interesting article, with well reasoned and researched speculation.

2008 Apr 29 05:03 AM

[wallawallab...:]

Very cogent and nuanced treatment of complex subject matter. Best written Alpha article in many moons. As an investor, I never have any concerns or second thoughts regarding Apple's/Jobs' judgement, insight, and direction for the future. At the risk of sounding hyperbolic, I'd say there is no stronger, better positioned, or adaptable tech company on the planet. And it is only beginning.

2008 Apr 29 06:44 AM

[raceluver:]

Good speculative article. Speculation is growing around a "gaming platform". Apple's introduction of a gaming platform similar to Nintendo would do wonders for the company and its lineup of products. I would bet on this aspect of the purchase.

2008 Apr 29 08:05 AM

[pinz:]

I'm not an engineer - but I suspect there is a totally different reason than yet outlined. These chips are supposed to have unique security features which is why they are tied to the defense department. What if Apple was to come out with a line of premium priced super secure computers for defense and corporate use? A New niche? ERIC

2008 Apr 29 09:21 AM

[toknowyou:]

I really enjoyed this article. I don't feel like a gaming system is in the works being that they have never really focused on it in the past, but the thought of it is very interesting and I would bet it would become the next trend much like every other product they put out. However if they decide to go the game system route, I would like to see some sort of partnership with Nintendo. They both seem like they are heading the same direction as far as innovation goes. Just think of the possibilities.

2008 Apr 29 10:16 AM

[martyg:]

ibm has announced some unbelievable new products that are on the shelf. 500,000 songs on an ipod. huge increases in reducing power and increasing battery life. i don't think aapl would close any door and integrating those products back into aapl should not be thought of as impossible. aapl seems to always think ahead. way ahead.

2008 Apr 29 10:35 AM

[Aerial:]

How about a PA semi co-processor to differentiate the Macintosh from the PC makers using the same Intel platform?

This would justify the higher costs (and margins) of buying Apple products, while providing accelerated functions for many common processes.

Also what about a PA semi powered Newtonesque hand held computer? Surely that is the next little "Big Thing" that will come out of Apple.

I've read somewhere that PA semi has some 10 year contracts to produce chips for DOD applications, if true, how many chips won't meet DOD standards and will have to be scrapped unless they can be used for less rigorous applications?

Aerial

2008 Apr 29 10:37 AM

[XLT75:]

The defense angle is actually interesting... building a mac platform that is 'security hardened' harkens back to the day that that AirForce used Color NeXTstations as their semi-secure communications platform that stood apart from the DISA communications platform. Making a Mac that was MILSPEC would provide a source of long term [contracts are usually 10 years+] revenue stream (plus being a high-margin nature).

2008 Apr 29 10:49 AM

[LongAPPL:]

Very good article.

I tend to think the obvious is true in this case. The iPhone is clearly a new "platform" - not just a device. No one really cares if their mobile device runs intel chips or not - the ability to run windows and attract switchers is not a factor. The overwhelming limiting factor in mobile computing is and will always be power consumption. Another limiting factor to the corporate acceptance of the iPhone is security.
It seems to me that these chips address both and allow expansion of the hardware beyond the current envelope to encompass GPS, Remote shutdown, G3 power, and even gaming. Add to this a way to make copycats fall short and it is obvious - this is all about the iPhone.

It is what it is!

2008 Apr 29 10:53 AM

[LongAPPL:]

typo - G3 should be 3G...

2008 Apr 29 10:56 AM

[taro76w:]

One possible option not mentioned here: Didn't Google design their own servers to keep up with the demands of their network? I could easily imagine Jobs not thinking any smaller than Google and the superb design team of PA could most likely help him design a back bone easily meeting or beating the Google foundation. Maybe we'll see him playing in the elite league of Microsoft and Google in a not too distant future.

2008 Apr 29 10:56 AM

[jmmx:]

Very good article. Thanks.

It seems to me that the most likely use is to revamp the iPhone/Touch architecture.

In discussing the migration to different chip sets, a few of things might be pointed out.

First, Apple receives very little credit for accomplishing 2 of the most extraordinary feats of engineering in computer history: the migration from the Motorola 68x chips to the PowerPC, and the from that to the Intel chipset. These moves, enormous engineering feats, occurred virtually flawlessly. How many times have you encountered a bug in a program that causes it to not behave properly? That code the size and complexity of an OS is ported to a completely different chipset, required to work with old code, and is done with so few problems is absolutely astounding.

The second point is that the move to the Intel chips was facilitated (I am sure to an incredible degree) by the DESIGN OF OSX.

The whole base architecture of the OS is BSD Unix. Once that got ported, the rest of the OS came along - not for free, but a heck of a lot more easily.

Which brings us to the current issue. My guess is that there already exists some flavor of Unix for the PA-Semi chipset, possible even BSD Unix. Therefore, the port could be performed with RELATIVE ease. (Please - do not interpret this as anything but profound respect for the Apple software engineers!)

IMHO

2008 Apr 29 11:01 AM

[User 184972:]

This is pure speculation on my part but I think their expertise in security could be the key to this transaction. The iPhone /Touch product line is just getting going. It's future will no doubt be in retail commerce. You can use them to buy songs at Starbucks now. Shortly, it will be to buy lattes. After that, it will be to buy anything - and not just at Starbucks. All through iTunes. For all this to work, security will have to be unbreakable. I don't think any other company sees this coming And no one else will be able to put together the infrastructure that Apple already has in place. I love how Apple quietly, behind the scenes, is putting together a juggernaut.

2008 Apr 29 11:14 AM

[Eric Stark:]

Gaming platform? Not gonna happen. There are already three heavyweights slugging it out. (This is not like MP3 players, where it was a good idea but where there were no established players.)

Military division? Come on. Servers or taking on Google? I mean, really.

How about the obvious? PA Semi has smart engineers who know how to integrate power efficiency and security into already existing designs and patent them so followers have a harder time following. That works on the iPhone "platform", the iPod "platform", the iMac "platform", and perhaps the (so far not very successful) Apple TV "platform."

Smart enough engineers to have designed a set which the military - of all institutions - to have adopted (and adapted) in record time, and well regarded enough to have fab plants produce them in quantity on almost no notice. That's something!

Apple cannot stand still with the iPhone (or iPod, for that matter), and this acquisition will rocket fuel the next iteration. (OK, not the next, that's already in the pipeline, no doubt, but the next next.)

2008 Apr 29 04:17 PM

[DavidK:]

Just a thought now that we are seeing a few companies other than Apple trying to use Leopard. They could develop a chip to be included with Apple computers that will compliment Intel chips and using it to run part of the OS in such a way that it would make it virtually impossible to load the OS and get the same optimization as an Apple Computer. Like the old Alti Vec support.

2008 Apr 29 07:56 PM