As wireless companies seem committed to never-ending capital spending and network upgrades, it would make sense that key suppliers to this market would be strong secular growth stories. Add a product/technology transition story to the mix and you have a pretty interesting growth story. That's the very short version of the buy thesis on chip company Altera (Nasdaq:ALTR) and while it's a compelling story, it is not without some risks and bumps in the road.
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A Tough Third Quarter
Both Altera and rival Xilinx (Nasdaq:XLNX) told us all that this would be a bad quarter, but results at Altera were actually a little worse than expected. Revenue fell almost 1% from last year and almost 5% from the prior quarter, as telecom spending, which typically makes up close to half of Altera's revenue, dropped sharply and revenue fell almost 13% sequentially. The company's industrial business was not good either, down about 7%, and though the networking/computing segment was strong, up over 30%, it's relatively small.
Part of the bull thesis on Altera is the company's operating leverage, but that cuts the other way when revenue falls off. To that end, gross margin fell nearly three points from the second quarter, while operating income fell about 14%. (For more on operating leverage, see Operating Leverage Captures Relationships.)
Has Wireless Hit a Wall?
By no means has all the data come in yet, but there are at least anecdotal signs that there has been a pretty significant slowdown in wireless network spending. Powerwave (Nasdaq:PWAV) preannounced a dreadful quarter and blamed slowdowns in spending at key customers, like AT&T (NYSE:T) and T-Mobile. At the same time, a host of foreign operators have become a bit more cagey about their near-term spending plans, and resorted to sneak-speak language like "monitoring the situation."
There is frankly nothing that Altera can do about this. If Huawei and Alcatel-Lucent (NYSE:ALU) are not selling the gear that contains Altera chips, there is not much else to say about it. At the same time, investors shouldn't overlook the risk of substitution. There are rumblings out there about companies considering low-cost base stations; a move that would benefit companies like Lattice (Nasdaq:LSCC), Cavium (Nasdaq:CAVM) and Texas Instruments (NYSE:TXN), at the expense of Altera and Xilinx.
Share and Share Alike
One of the arguments in favor of Altera is that it is a share gainer. Field programmable gate arrays are displacing application specific integrated circuits in a host of applications and that displacement seems to be a one-way move. While Xilinx has been the traditional leader in this market, Altera has been gaining share, of late, and seems to have an early lead in the 28nm segment. It's still early days, though, so Altera shareholders can expect to hear all manner of rumors and speculations on whether Xilinx has stemmed that share loss.
Always Threats Around
Altera is a strong player in FPGAs and it is a little unusual that this growing market is largely controlled by just two companies. That raises the question of whether another company, like Texas Instruments or Broadcom (Nasdaq:BRCM), would look to get into this market. A smaller company would likely look at a target like Lattice, or small private companies, in the hopes of building it up, while a larger player may make a bold run at Altera or Xilinx. Look at it this way, with Altera's returns on capital and cash flow generation capabilities, it has to be inevitable that a larger company will look at this market and think, "we need to get some of that." (Returns on invested capital is a great way to measure the true value produced by a company. For more, see Find Quality Investments With ROIC.)
The Bottom Line
Maybe Xilinx is about to launch a counter-offensive that will grab share back from Altera, or maybe Altera's guidance is a sign that they are tied to the wrong customers. Or maybe wireless network spending is going to stall out for a while. Those would seem to be about the only explanations for Altera's valuation, even a dreary cash flow and revenue growth projection would show this stock undervalued by more than 20%. While investors are spoiled for choice among cheap, high-quality chip names, Altera is a name to consider, both for its present-day valuation and its long-term growth potential.
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