Xilinx vs.

Altera: in the race for supremacy, Altera walks away with better valuation Few evenly-matched semiconductor companies battle for market share more fiercely than the programmable-logic device (PLD) market leaders, Xilinx, Inc. (NASDAQ:XLNX) and Altera Corporation (NASDAQ:ALTR). PLDs are semiconductor integrated circuits, or chips, that are manufactured as standard chips programmed to perform desired logic functions. Key benefits of PLDs over application-specific integrated circuits (ASICs) and application-specific standard products (ASSPs), their traditional rivals, are lower initial costs and faster time-to-market. Apart from cost, design capability is also important for PLDs, because most PLD companies secure contract wins at the design stage of the customers product cycle. Xilinx and Altera have highly similar revenue growth profiles and P/Es. However, Alteras share price increased 18% to $23.81, while Xilinxs share price rose 14% to $25.57 (reference period: 31 August 2006 to 31 August 2007). Alteras is currently trading at P/E of 25.3x while Xilinx is trading at 24.1x. Although both the stocks have appreciated well, based on our analysis of the two companies, we conclude that Altera has an edge over Xilinx due to its focus on cost management and verticals that require complex design capability, resulting in high-margin customer wins. Xilinx and Altera corner nearly 88% market share Cutting-edge technologies have allowed Xilinx and Altera to retain their leadership positions and duopoly over the years and keep second-tier FPGA rivals at bay. In the PLD business, Xilinx, with a customer base of 7,500 and ~50% market share, is the generally-accepted leader, followed by Altera, with roughly 33% share. Alteras customer base, however, is literally twice that of Xilinx at over 14,000. Both the companies have strikingly similar revenue trends. Xilinxs financial results are a mixed bag. Its earnings growth has averaged in mid-single digits for the past few quarters. Although the companys gross margin is impressive at 61%, this whittles down to a 21.9% operating margin. In contrast, Alteras earnings growth has averaged in high-double digits for the past quarters. The companys gross margin of 66.4% has led to an operating margin of 23.7%. Strong correlation in revenue trends A graphical comparison indicates that apart from the Dec-05 qtr, Altera and Xilinx are moving approximately in the same direction, suggesting that the underlying revenue performance has been marketdriven, with small vendors making meager share gains.
Exhibit 1: Revenuemoving in the same direction

Source: Gridstone Research.

The weakness in Alteras revenue in the Dec-05 qtr was due to several customer program transitions and inventory accumulation by customers. (Reference: Alteras Dec-05 qtr Earnings call transcript dated 25 January 2006.)

Xilinx and Altera have similar end-market classifications (Exhibit 2) and customer mix. Moreover, the communication vertical has been the largest revenue contributor for both the companies, followed by the industrial and consumer verticals; this suggests that barring exceptions, any movement in the customer verticals could affect both companies equally.
Exhibit 2: Revenue by Customer Vertical QE Sep- QE Dec05 05 Altera Total revenue Rev-Commn (%) RevIndustrial (%) RevConsumer (%) RevComputer & Storage (%) Xilinx Total revenue 398.9 Rev-Commn (%) 48.0% Rev-Data Processing (%) 13.0% RevIndustrial & Other (%) 24.0% RevConsumer & Automotive (%) 15.0% Source: Gridstone Research. 449.6 48.0% 11.0% 27.0% 472.3 48.0% 10.0% 27.0% 481.4 49.0% 10.0% 26.0% 467.2 45.0% 10.0% 29.0% 450.7 44.0% 9.0% 31.0% 443.5 44.0% 10.0% 30.0% 445.9 45.0% 8.0% 32.0% QE Mar06 QE Jun06 QE Sep06 QE Dec06 QE Mar07 QE Jun07

291.5 40.0% 33.0% 16.0% 11.0%

281.9 43.0% 33.0% 15.0% 9.0%

292.8 44.0% 33.0% 13.0% 10.0%

334.1 44.0% 34.0% 13.0% 9.0%

341.2 41.0% 33.0% 15.0% 11.0%

317.4 39.0% 35.0% 15.0% 11.0%

304.9 39.0% 37.0% 15.0% 9.0%

319.7 40.0% 35.0% 16.0% 9.0%

14.0%

15.0%

15.0%

16.0%

16.0%

16.0%

15.0%

For example, in the Jun-07 qtr (Exhibit 3), the increase in contribution from the communication vertical for both the companies was due to improvement in the wireless as well as the wireline markets. (Reference: Alteras and Xilinxs Jun-07 qtr Earnings call transcript.) Customer verticals determine profitability for these companies; the industrial vertical has the highest profitability, followed by the communication and consumer verticals. Given this, Alteras revenue mix appears more favorable, compared with Xilinx, since a greater percentage of Alteras revenue comes from the industrial vertical. Related management commentary: Alteras Sep-05 qtr Earnings call transcript dated 24 October 2005 Number two, just going back to an earlier comment. I think we also have said quite consistently that our margins really dont vary by product, but they do by market segment, and we have said historically that consumer is lower, industrial is higher and then the other two being communications and computer and storage are more in the middle. The marginally superior revenue mix of Altera provides it a better cushion on margins. Analyzing the cost management efforts of both the companies is a useful exercise.
Exhibit 3: Differentiating FactorMargin QE QE Sep-05 Dec-05 Altera Operating income Operating margin Xilinx QE Mar-06 QE Jun06 QE Sep-06 QE Dec-06 QE Mar-07 QE Jun07

87.2 29.90%

76.2 27.00%

56.6 19.30%

80.1 24.00%

86.3 25.30%

78 24.60%

70.2 23.00%

75.7 23.70%

Operating income 82.3 Operating margin 20.60% Source: Gridstone Research.

119.8 26.70%

119.4 25.30%

93.1 19.30%

93.2 19.90%

82.2 18.20%

79.4 17.90%

97.5 21.90%

As the exhibit above illustrates, Altera has consistently maintained better margins. In the recent past, Xilinx and Altera have articulated the importance of cost efficiency in their businesses and have implemented specific plans to achieve it. However, looking at the current data, Altera seems to be winning the battle in cost reduction and efficiency. A comparison on a few parameters would validate this. PP&E and depreciation The PP&E expenditure for Xilinx and Altera is low as both follow a fabless business model (neither has a wafer manufacturing facility). However, there is a subtle difference in the way they deploy the strategy.
Exhibit 4: Difference in Fabless model Particulars Xilinx Number of subcontractors Primarily 3United Microelectronics independent semiconductor Corporation (UMC), Toshiba Corporation foundries (Toshiba) and Seiko Epson Corporation (Seiko) Testing and Assembly Majority of testing is done by Xilinx, while assembly is done by Xilinx, Siliconware Precision Industries Ltd, and Amkor Technology. Source: Gridstone Research. Altera Primarily 1Taiwan Semiconductor Manufacturing Company (TSMC) Majority of testing and assembly work is done by TSMC

Xilinx has not outsourced its assembly and testing process completely whereas Altera has. Moreover, Altera has maintained its strategy of outsourcing work primarily to a single vendor, compared with Xilinxs strategy of having multiple vendors.
Exhibit 5: Impact of complete and partial outsourcing on capex and depreciation QE QE QE QE Jun- QE Sep-05 Dec-05 Mar-06 06 Sep-06 Altera PP&E, net Purch of PP&E Depreciation CapEx/depreci ation Xilinx PP&E, net Purch of PP&E 348.8 (15.7) 349.9 (13.8) 13.0 1.1 358.3 (22.0) 14.0 1.6 358.5 (13.0) 13.0 1.0 359.7 (14.0) 13.0 1.1 367.7 (20.6) 13.0 1.6 413.0 (63.2) 18.0 3.5 416.2 (15.6) 12.0 1.3 165.4 (7.4) 6.5 1.1 166.0 (7.7) 7.0 1.1 171.3 (8.1) 7.1 1.2 172.0 (8.1) 7.4 1.1 174.8 (9.6) 6.7 1.4 178.4 (10.7) 7.1 1.5 184.8 (13.9) 7.5 1.9 182.3 (5.0) 7.5 0.7 QE Dec-06 QE Mar-07 QE Jun07

Depreciation 13.0 Capex/depreci ation 1.2 Source: Gridstone Research.

The increase in capex of Altera for the past three to four quarters was also partially due to implementation of an ERP system; on the other hand, for Xilinx, the increase in capex was primarily due to expansion of current and new facilities. Outsourcing the work completely also means that Altera has lower capital expenditure and depreciation expenses, which has a positive impact on margins and cash flow. Inventories
Exhibit 6: Inventory data QE Sep-05 Altera Cost of (COR) revenue QE Dec- QE 05 Mar-06 QE Jun-06 QE Sep-06 QE 06 Dec-QE Mar-07 QE Jun-07

97.6 70.7 65

93.8 70.7 68

97.1 66.8 62

113.3 77.8 62

110.5 93.4 76

107.0 78.5 66

104.5 83.2 72

113.1 73.5 59

Inventories, net Inventories turnover days

Inventories COR Xilinx Cost of (COR)

as

72%

75%

69%

69%

85%

73%

80%

65%

revenue

154.0

166.5 211.9 115 127%

178.2 201.0 102 113%

192.1 194.6 91 101%

180.6 199.0 99 110%

178.0 185.2 94 104%

168.0 174.6 93 104%

168.5 145.6 78 86%

Inventories, net 199.7 Inventories turnover days 117 Inventories as % COR 130% Source: Gridstone Research.

As seen in the exhibit above, Xilinx and Altera manage inventory quite differently. After the slowdown in the tech sector in 2000-01, Altera has consciously been maintaining lower inventory levels to avoid write downs or excess supply. As a % of cost of revenue, Altera has consistently maintained its inventory at 6580%, compared with Xilinxs historical average of over 110%. However, in recent quarters, Xilinxs inventory turnover has decreased due to improved forecasting accuracy, fewer mixed issues, and decrease in distributor inventories. This inventory comparison also indicates that Alteras turns business, as a % of overall revenue, is more than that of Xilinx. Maintaining lower inventory levels can be a good strategy in the PLD market, since loss of sales here could be minimal, as they are not volatile, compared with ASIC and ASSP markets. Moreover, customer losses could be low since the PLD companies secure most customer wins at the design stage, making it difficult and costly for a customer to change the vendor. Summary Altera continues to be the favorite PLD maker on the Street because of its superior returns. This clearly reflects that that the stock markets prefer companies with higher efficiencies that offer better returns vis-vis those that have dominating market shares but are laggards in terms of stock performance. Thus, if Xilinx has to catch up with Altera on these counts, it needs to sharpen its focus on cost management and margins.