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Tailwind From China Propels Growth for This Chipmaker

Infrastructure buildouts mean higher demand for Altera's programmable logic devices.

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 Altera (ALTR) reported strong first-quarter results, thanks to higher demand for programmable logic devices from the 4G LTE wireless infrastructure buildout in China. We are maintaining our $41 fair value estimate and narrow Morningstar Economic Moat Rating.

For the quarter, revenue was $461 million, up 1% from the fourth quarter and an increase from sales of $411 million in the year-ago quarter. First-quarter sales exceeded the firm's January outlook of down 2%-6% sequentially, thanks to strong wireless telecom spending on 4G LTE infrastructure buildouts in China. The Chinese LTE buildouts helped increase PLD sales to the telecom and wireless segment by 14% quarter over quarter. Telecom and wireless is Altera's largest end market and accounted for 49% of total revenue in the quarter. As for the other end market segments, sales to industrial, military, and automotive customers grew 1%. However, revenue fell 20% and 3% quarter over quarter in the networking, computer, and storage segment and the other segment, respectively. Altera achieved a gross margin of 67.1%, down from 68.3% in the fourth quarter, because of product mix associated with higher telecom and wireless PLD sales. Operating income came in at $135 million versus $117 million last quarter.

For the second quarter, management looks for revenue to grow 2%-6% sequentially, as it expects further growth in the telecom and wireless segment as well as the computer and storage end market. However, it anticipates the industrial, military, and automotive segment to decline while the other segment remains flat. Altera gave a brighter forecast than rival Xilinx (XLNX), which expects revenue to be flat to up 4% sequentially next quarter. We continue to believe that healthy PLD demand from the Chinese 4G LTE buildouts will be a key driver for Altera for the foreseeable future. We believe the shares are attractive at the moment, trading at a discount to our fair value estimate.

PLDs Should Outgrow the Overall Chip Industry
Altera operates in the programmable logic device segment of the semiconductor industry. PLD chips are unique in that they can be programmed, so their circuitries can be customized by electronics manufacturers for specific applications. This is in contrast to the predominant high-volume application-specific integrated circuits, which have fixed functionality and cannot be reconfigured, typically found in the semiconductor industry. The PLD segment is dominated by two players, Altera and Xilinx, and made up less than 2% of the roughly $300 billion semiconductor market in 2013, according to Gartner.

The decision involved in choosing a PLD over an ASIC in an electronic design typically boils down to economics. Since they are programmable, PLDs are larger in size, making them more costly on a per-unit basis. ASICs are much cheaper to manufacture in mass volume but have significantly higher up-front startup costs. Therefore, PLDs are generally used in electronics applications that don't have the volume to absorb the up-front costs needed to create an ASIC, such as those in the industrial, automotive, military, and wireless and wireline communications infrastructure areas.

Altera has a very favorable business. We think both Altera and Xilinx have narrow moats, thanks to their market dominance (they hold 39% and 50% share, respectively, according to Gartner) and high switching costs associated with PLDs. Engineers tend to become trained and well versed in programming PLDs from a specific vendor and will often stay loyal to a company's products because of the familiarity they gain with the software and design tools of that particular platform.

Additionally, the initial up-front costs of developing cutting-edge ASICs have risen exponentially as semiconductor technologies advance. As a result, the volume necessary to make ASICs cost-effective has grown substantially, which in turn has expanded the market opportunities for PLDs. This trend has allowed the PLD segment to outgrow the overall chip industry and will provide significant tailwinds for Altera.

Switching Costs Are High, but Industry Is Cyclical
We believe Altera has a narrow moat. It and Xilinx have a near-duopoly in the PLD segment, as both benefit from high switching costs associated with programming PLDs. Engineers tend to become trained and familiar with software and design tools for programming PLDs from a specific vendor and often will stick with PLD products from one company. In addition, once an electronics maker has chosen a PLD for an application, it will tend to stick with the chip because it would have to redesign its products in order to switch logic devices. These dynamics keep lesser PLD competitors at bay and also make it difficult for customers to switch between Altera and Xilinx.

The PLD segment, along with the overall semiconductor industry, is fairly cyclical, and Altera's financial results will ebb and flow over time. In recent years, the firm has become more exposed to the communications equipment industry, which has resulted in some volatility in business levels, as capital spending on the wireless infrastructure buildouts tends to be lumpy. Altera must remain at the forefront of PLD innovation or risk falling behind technologically, which would probably result in market share losses to Xilinx.

Andy Ng does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.