Xilinx Is Still a Good Investment, But Investors Need to Be Patient

Earnings season can present good opportunities for investors to capitalize on. One such opportunity can be seen in diversified semiconductor company Xilinx (NASDAQ: XLNX  ) . Xilinx has declined around 5% since it posted its second-quarter results in mid-October.

Xilinx beat consensus estimates on both revenue and adjusted earnings in the second quarter. However, its revenue guidance of $587 million-$611 million for the third quarter fell behind the $607.8 million consensus estimate at the mid-point. This spooked investors and the share price has been in pullback mode ever since the results came out.

Xilinx offered weak guidance as it expects revenue from its industrial, aerospace, and defense business to decline sequentially. This segment grew briskly for four quarters and accounted for 38% of the company's revenue in the previous quarter. Hence, any weakness in this side of the business will no doubt have a significant impact on overall revenue.

Expected turnaround?
It is quite possible that this decline might be short-lived and the segment could grow again in the future. The industrial market has seen stable growth in 2013. The Manufacturers Alliance for Productivity and Innovation (MAPI) projects that manufacturing production will grow 2.2% in 2013. Subsequently, MAPI expects that manufacturing production will continue improving by a single percentage point in 2014 and 2015. 

However, it could be difficult predicting how the aerospace and defense business might perform. While aerospace might do better on the back of commercial demand, unmanned systems, etc., the same cannot be said about defense. According to AlixPartners, commercial aerospace would perform well as a result of higher deliveries. Moreover, aircraft deliveries are expected to grow at an annual rate of 2.3% over the next decade, and Xilinx might benefit from this secular growth. 

On the other hand, it is difficult to judge how defense might turn out to be, as the industry is highly dependent on government budgets. According to a McKinsey survey, defense industry executives are of the opinion that spending will decline. Hence, the future of the industrial, aerospace, and defense business is not exactly rosy, as growth in industrial and aerospace could be offset to a certain extent by declines in defense.

Growth can be expected in Xilinx's communications and data center business. Xilinx saw an improvement in revenue from this segment in the previous quarter on the back of LTE deployments in China. This could continue to benefit Xilinx over the next few quarters according to management. LTE deployment in China is being led by China Mobile (NYSE: CHL  ) , the world's biggest telecom company. The telco giant is expected to build 207,000 base stations in 31 provinces. 

More importantly, China Daily is of the opinion that China Mobile would be boosting its capital expenditure by around 50% in 2013 to $30.5 billion. China Mobile recently awarded initial contracts worth $3.2 billion as it sets out to build its 4G network, with Huawei and ZTE being the big winners. Now, both Huawei and ZTE are Xilinx's customers and this bodes well for the company.

Xilinx is also counting on its innovation to drive further growth. Sales of the company's new products increased 22% sequentially in the previous quarter, with the 28-nanometer chip family being a key driver. Xilinx's 28-nanometer chips have turned out to be quite successful and have helped it grow its gross margin by 400 basis points from the year-ago quarter.

Altera's threat
Xilinx is now focusing on its 20-nanometer chips. However, it would be facing tough competition in this area from Altera (UNKNOWN: ALTR.DL  ) . Altera is looking to go one up on Xilinx through its partnership with Intel to make chips on the 14-nanometer platform. Earlier this year, Altera chose Intel as its foundry partner. Altera is looking to capture close to 50% of the industry's revenue on the back of its 14-nanometer process over the next five years. 

But Altera is not stopping here, as it is developing the 20-nanometer platform. Altera's moves are probably hurting Xilinx now, as analysts believe that Ericsson could be moving away from Xilinx to Altera. But then, Xilinx managed to grow its communications business in the previous quarter despite this headwind. The company doesn't expect this probable customer switch to have an affect over its prospects in China. 

The bottom line
Xilinx's valuation and a decent dividend yield cannot be ignored either. The stock's trailing P/E of 23.6 is well-below the 30x industry average, and it has an annual dividend yield of 2.4%. Moreover, the communications business is still doing well while broadcast, consumer & automotive are also gaining traction. Hence, investors need to be patience with Xilinx and should refrain from hitting the sell button as the recent guidance miss might be a one-off.

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