Xilinx: Modest Upside From Current Levels

| About: Xilinx, Inc. (XLNX)

Summary

Major tailwinds include - growth outlooks for the PLD & FPGA markets. New product concentration, continued pricing power, distribution concentration.

Commitment to shareholders, geographic diversification.

Debt load, FX unlikely to be a concern.

Near-term weakness is to be expected, continued industry dominance.

DCF indicates upside from current levels.

Xilinx (NASDAQ:XLNX) manufactures PLDs (programmable logic devices) for the semiconductor industry. Major tailwinds include the high growth outlooks for the PLD & FPGA markets, relative to the broader industry. New product concentration is vital, due to the fact that older products tend to be commoditized very quickly by competitors, resulting in price erosion. The company continues to increase its pricing power, which should allow margin expansion in the near-term. Although the company has a distribution concentration, it is not an issue. The company's commitment to shareholders continues, while not neglecting important aspects of the business such as R&D and capital expenditures. Revenues, profits and cash flow are expected to be stable going forward, given the company's geographic diversification. Although the company has a high debt load, not only are most of its contractual obligations 3-5 years from maturing, the company holds a sizeable cash position. FX is unlikely to be a concern due to the company's sales model. Near-term weakness is to be expected, due to seasonality within certain end-markets. The company's continued industry dominance remains its largest competitive advantage, which should bode well for the future.

Major tailwinds

According to research, the global PLD market is forecast to grow at a CAGR of 14.8% over the 2013-2018 period. This growth is driven by the device's superior functionality, compared to traditional alternatives. PLDs are reprogrammable, making them not only reusable, but also cost-efficient. The global FPGA market is forecast to grow at a CAGR of 8.1% throughout the remainder of the decade. This growth is driven by the need to solve problems associated with the handling of big data. In the information age where data is ubiquitous, FPGAs are perhaps the best solution to this problem, thus, expect the demand for FPGAs to be secular. Xilinx serves both markets through its numerous product offerings as shown below.


Source: SEC Filings

As the company sells extremely relevant products to the aforementioned PLD and FPGA markets, Xilinx is well-positioned to capitalize on the growth of these industries in the near-term.

New product concentration

Source: SEC Filings

As seen above, the company's revenues are heavily weighted towards its new products. Over the 2012-2014 period, new products comprised of 11%, 22% and 37% of the company's top-line in each of the respective years. This aspect of the business is significant due to the nature of the industry. Within the semiconductor industry, newer products tend to be able to command high ASPs, as they are typically more cost-efficient. As these products start to age (when even newer products are brought to the market), the once-new products will experience price erosion. Competitors eventually catch up, and the supply of the once-new products exceeds the demand by a large margin (as a portion of the demand has been shifted to even newer products), resulting in drastic price erosion. With this understanding, intuitive readers would be able to discern that a healthy concentration towards new products are a sign that Xilinx's innovations are keeping up with its rivals, and that the company is at little risk of experiencing large drops in its revenue base due to price erosion.

Continued pricing power

Source: SEC Filings

As seen above, Xilinx has managed to grow its gross margins over the 2012-2014 period. Gross margins grew from 64.9% in 2012 to 68.8% in 2014. As a company's gross margins increase, one can interpret this as the company being able to continually increase its pricing power, hence resulting in higher ASPs. Part of this increase in pricing power can certainly be explained by Xilinx's new product concentration. Another reason why the company has been able to steadily grow its margins is due to its dominance within the market. It's largest competitor within FPGA is Altera (NASDAQ:ALTR), who achieved slightly lower revenues compared to Xilinx in 2014. By holding a substantial share of the market, Xilinx continues to be the major supplier of PLDs and FPGAs, which puts the company in a better negotiating position compared to its smaller rivals. With the company continuing to lead the way in industry innovation, along with the fact that Xilinx is a market leader, I expect further profit margin expansion in the near-term.

Distribution concentration

Xilinx sells its products primarily to OEMs and EMSs. One of its largest distributors is Avnet, a company that I initiated coverage on recently. Avnet accounted for 55% and 64% of Xilinx's total accounts receivable in the years 2014 and 2013 respectively. Though the risk of having one single distributor account for such a large portion of receivables is undeniable, this risk is mitigated by the fact that Xilinx is still one of the largest, if not the largest player within the industries it serves. Also, recent data suggests that the company is slowly decreasing its sales concentration to Avnet, evident from the fact that Avnet accounted for a lower portion of total receivables in 2014 (55%) than 2013 (64%). Considering the secular trend of big data, FPGAs are here to stay. Hence Avnet has little reason to drop Xilinx as a supplier. Thus, any fears of revenue volatility are unfounded.

Commitment to shareholders

The company continues to be extremely dedicated to its shareholders, with most of its operating cash flow in recent years being diverted to rewarding shareholders through dividends and share buybacks. Recently, the company declared a quarterly dividend of 2 cents per share, further demonstrating its devotion to keeping shareholders happy. However, the risk associated with rewarding shareholders becomes apparent when the company focuses more on the shareholders than the business itself. Lawrence Fink, CEO of Blackrock, recently commented that the mania associated with appeasing shareholders comes with the risk of neglecting operations, which may affect long-term business viability.

Source: SEC Filings

Fortunately, this is not the case for Xilinx. The company remains focused on its business first and foremost, evident from the increasing R&D expenditure as a percentage of sales over the 2012-2014 period. Ergo, the company seems to be able to properly balance its obligations towards the business and shareholders. Some companies, pressured by Wall Street or activists, become short-sighted in their goals and do not devote enough to R&D (for a company like Xilinx) or capital expenditures. As the effect on the business is not readily apparent, many glance over this aspect of a business. However, reduced reinvestment will eventually rear its ugly head, as companies either lose their competitive advantages or become obsolete over the long-term. It is for this reason (Xilinx's focus on R&D) that I am of the opinion that the company is a long-term play.

Geographic diversification

Source: SEC Filings

Xilinx's revenues are geographically diverse. As seen above, the company has consistently derived about a third of its revenues (20%-30%) from the largest PLDs markets (North America, APAC, and Europe). Having such diverse exposure in a geographic context cushions the company from region-specific recessions or downturns. Said another way, if Europe continues its trend of anemic growth, the effect on the company's overall revenues is dampened significantly. Furthermore, a diverse geographic footprint also ensures that the company's revenues, profits, and cash flow are more stable compared to its less geographically-diverse rivals.

Debt load

Source: SEC Filings

As seen above, the company's total contractual obligations are exactly $2b, a figure that is far greater than its EBITDA or operating cash flow. However, the company's liquidity position remains intact, thanks to its modest cash balance, and large hoard of marketable securities. Given the current low-rate environment, coupled with the company's strong liquidity and growing cash flow, the company could glean further tax savings from issuing additional debt. Most of its contractual obligations are far from maturity (more than 3 years). Hence in the near-term, the company could afford to make a sizeable acquisition of one of its smaller rivals, and still be able to pay or rollover its debt when they come due. Although the Fed has hinted at a possible late-2015 rate hike, borrowing costs should not become a material problem, given the fact that the company's interest burden currently amounted to an insignificant percentage of revenues (approx. 1% of sales). Thus, Xilinx remains in an enviable position cash-wise, with options to augment top-line growth through inorganic initiatives, or lower its cost of capital through further debt issuance.

FX unlikely to be a concern

In recent months, many major U.S. corporations have been citing FX pressures related to the recent strengthening of the U.S. dollar vis-à-vis other major currencies. This appreciation can be attributed to the diverging monetary policy stance taken by the Fed, compared to its central banking peers. Although the recent FOMC meeting has stemmed the appreciation of the greenback somewhat, the fact remains that the dollar currency index is still at elevated levels compared to a year ago. It goes without saying that such a development within the FX market has led to currency issues, with many major corporations blaming feeble growth on the dollar appreciation. Xilinx is somewhat immune to the strengthening of the dollar, as the company transacts with its distributors and resellers using the USD. Some may cite demand pressures arising from a stronger dollar, however if one considers the strong demand for Xilinx's products, it is clear that FX issues will merely pose a small problem for the company.

Near-term weakness to be expected

In the company's Q3 earnings call, CFO Jon Olson cited weakness within the wireless and broadcast end-markets. He further elaborates that the company expects wired and wireless communications to remain flat sequentially while the A&D end-market should experience headwinds. However, the key thing to note is that most of this weakness is temporary and can be explained by seasonality issues such as program-related timing within the A&D end-markets and FDD-LTE deployments. Long-term demand remains strong, and hence Xilinx should perform well over a 3-5 year period.

Continued industry dominance

Xilinx continues to lead the industry in terms of innovation. One example to illustrate this dominance is the company's 20nm offerings. The company recently began shipping the industry's largest FPGA which delivers four times the capacity of any competing device. This only goes to show how far ahead of the pack Xilinx is. The company estimates that it is one-year ahead in terms of innovation relative to its competitors. In earlier paragraphs, I mentioned that the company remains focused on the long-term viability of its business, evident from its increasing R&D expenditure. This should allow the company to remain the industry leader in innovation in the near-term, which should translate to further increases in pricing power, and ultimately, meaningful expansion in profit margins.

Valuation

As seen in the above DCF model, company revenues are expected to grow at growth rates of 3% to 9% throughout the 5-year projection period. This growth is supported by the bright prospects of the PLD and FPGA markets which Xilinx operates in, along with the company's continued industry dominance and new product concentration. Overall top-line growth for FY15 is projected to be a mere 3%, due to the seasonality and low-growth issues cited by management. Beyond FY15, the company is expected to recover to its usual levels of revenue growth in the high single-digits, before tapering off slightly at the end of the projection period.

EBITDA margins are expected to gradually expand to 38% throughout the projection period. This expansion in margins is supported by the fact that the company's continued industry dominance and new product concentration allows it to derive a substantial amount of pricing power, evident from its continued improvement in gross margins. Xilinx's dedication to the long-term, which can be seen from its increasing R&D expenditure, should allow the company to continue staying ahead of the pack in terms of innovation, allowing for sustained margin expansion.

The company currently trades at 10.9x LTM EBITDA. Using this figure, along with a 9% discount rate (due to the company geographic diversification, healthy balance sheet, and strong secular demand for its products), the model produces a fair value of $57.50 for Xilinx, indicating that the company is undervalued by approximately 30% at current price levels. This number might be too low, considering that Xilinx's main competitor, Altera, currently trades at higher EBITDA multiples, pre-Intel announced-then-cancelled-buyout. Considering that Intel cancelled negotiations to buy Altera, Xilinx remains an attractive candidate for a takeover, which could lead to further upside. My outlook on Xilinx is therefore bullish - investors are advised to initiate a long position on the stock.

Disclosure: The author is long SPY.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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