You Should Prefer TI and Xilinx Over this Semiconductor Stock

David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Given how much innovation we have seen out of the tech sector, many investors are naturally eying semiconductors. But they should be mindful of some of the challenges / roadblocks ahead. In particular, I am concerned about supply-chain disruptions and poor free cash flow generation. With that said, I also see consolidation as the major producers aim to transition product portfolios to better service the custom chips that customers are demanding. Below, I review three companies with differing risk/reward.

Altera (NASDAQ: ALTR): The Good & The Bad

Altera is a semiconductor producer that specializes in the designs of PLDs and IP cores. It is quite expensive at a respective 17.4x and 16.6x past and forward earnings. But the company is on a strong growth curve and is expected to boost EPS by 13.7% annually over the next 5 years. Altera has seen free cash flow increase dramatically since around 3Q 2009; but, after 1Q 2011, it has dropped to $618 million from $1 billion, giving it a dividend yield of 6.2%. So investors are naturally wondering if the stock could under-perform on such a low yield.

During the third quarter, Altera grew revenue 6% sequentially--at the high-end of guidance. Management also shipped all 3 of the 28-nanometer production qualified devices, which was a milestone. Yet during the fourth quarter, several dangers lurk. A 6% to 10% sequential decline in the top-line has been guided, with the loss of two major customers accounting for half of it. Loss of 2 designs to ASICs for Altera's largest customer is disconcerting. Management claims that opportunities for 28-nanometer are substantial, and they are, but high-end performance leadership does not always translate to high margins. According to the company, programmable products can drive large ROI through, since management can release just one major design to cover a large amount of customers. But wafer costs are now increasing amidst supply chain issues.

Meanwhile, Altera's communications customers are generally reducing inventories. This is due to a slowing business trend, which have caused telecom firms to hold back s/upply. The lean communications business environment depends on the macro economy, which remains uncertain. In particular, the company is gaining market share in the economically-vulnerable European region. I recommend avoiding the stock on that note

Why You Should Back TI (NASDAQ: TXN) & Xilinx (NASDAQ: XLNX)

TI is one of the more diversified semiconductor producers, with production in analog, embedded, processing, and wireless markets. But the company is also quite expensive at a respective 18.9x and 15.8x past and forward earnings. And the recent decision to lay off 5% of its workforce suggests weakening fundamentals. However, management has framed this as a way of turning over a new leaf. They claim that the focus on long life cycle embedded applications that will be coupled favorably by the $450 million a year in cost savings. In my view, the decision to exit the mobile app processing market--a high-growth area--suggests competitive weakness. This was supposed to be a big market, but the company has fallen behind by failing to service the custom chip demands of large customers, like Samsung and Apple.

How will the new focus for OMAP processors and wireless chips fare? I am actually optimistic about this. Momentum has already been seen in new embedded applications, and these trends are accelerating.

A better investment to make could come through hunting for takeover targets. Xilinx is valued at $8.7 billion and generates fairly good free cash flow relative to the industry. FCF has climbed from around $208 million in 2005 to around $700 million, or an 8% yield, today. The balance sheet is meanwhile clean, as evidenced by the quick ratio of 6x and low debt-to-equity ratio. The company's strategy also looks strong. For example, the decision to use TSMC to produce next-generation Virtex-8 FPGAs will pay off when mass production starts early 2014--the 20nm chips it runs on consumes half the power of 20nm parts. Performance has also been stronger-than-forecasted in all of the last 5 quarters with an average beat of 11.3%. I recommend making an investment in this company alongside one in TI.

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