Shares of field-programmable gate array (FPGA) manufacturer Xilinx (NASDAQ:XLNX) dropped 10.7% on Wednesday following the company's fiscal 2020 third-quarter report. They dropped slightly more on Thursday. Investors had expected it to be a tough period for the chipmaker, and revenue and earnings did decline, as management had laid out a few months prior.  

However, the company had a few unexpected surprises in store for shareholders and employees: a 7% reduction in its workforce through layoffs and a slowdown in hiring, and a cost reduction plan to make business more efficient. It isn't the end of the world, as Xilinx's FPGAs still have a future in the development of data centers, 5G mobile networks, and automotive technology, but cost-cutting at this level tends to throw shade on a stock's growth prospects. Don't panic just yet, though.  

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Image source: Getty Images.

Business is officially in pullback mode

The trade war between the U.S. and China had started to take a toll on Xilinx, but up until the three months ended Dec. 28, 2019, the chipmaker was still notching year-over-year growth. In the most recent quarter, though, sales fell 10% from the year prior to $723 million, and adjusted earnings per share fell 26%.  

There was some good news, though. Even with sales of FPGAs in reverse, gross profit margin on products sold improved to 66.8%, compared with 64.8% in the prior quarter. Still, operating expenses grew again, as they have been all year, which meant a steep drop for the bottom line -- thus all but eliminating a strong performance through the first half of the fiscal year.  

Metric

9 Months Ended Dec. 28, 2019

9 Months Ended Dec. 29, 2018

Change

Revenue

$2.41 billion

$2.23 billion

8%

Gross profit margin

65.9%

69.2%

(3.3 pp)

Operating expenses

$973 million

$838 million

16%

Adjusted earnings per share

$2.58

$2.55

1%

Pp = percentage point. Data source: Xilinx.  

CEO Victor Peng said the expectation is that Q3 will be a trough and that business will rebound from here, but it will be a gradual rebound rather than a fast turnaround. Fourth-quarter 2020 revenue is expected to be $750 million to $780 million, up 6% sequentially but down 8% from a year ago at the midpoint of guidance. Gross margin should also improve again, forecast to be 67.5% to 69.5%, and operating expenses should be $351 million to $355 million -- which includes a $17 million to $20 million benefit from cost cuts but a $25 million to $30 million charge related to severance pay.

Aligning costs with reality

Things don't look great at the moment for Xilinx, but it's important to remember that the chipmaking business is a cyclical one -- even for hardware that is benefiting from strong secular tailwinds. Before investors get too distressed over the quarterly update, there are a few factors to bear in mind.

First, Xilinx's data center business is still healthy. Second-quarter sales from the segment were an all-time record, and while Q3 and Q4 are both going to come in lower, cloud computing is still pushing demand higher and is expected to do so for years to come. Automotive is another segment that should provide long-term growth as FPGAs find their way into the advanced driver assist packages available in most new cars. However, data centers and autos alone only accounted for 28% of sales in Q3.  

That leaves the wireless and mobile segment as the primary source of pain. At about a third of overall revenue, the division's year-over-year tumbles made a big impact on Xilinx's results the past couple of quarters. Even with trade tension between the U.S. and China easing recently, Huawei remains out of the picture. Peng said, however, that even if the White House lifts its ban on doing business with the Chinese tech giant, he doesn't see revenue coming back to the pre-ban level. 5G mobile deployment has also taken a breather as telecoms gear up for the next big push, which has meant delays in purchases from Xilinx for the time being.  

As a result, Peng and his team are declining to provide any specific guidance on fiscal 2021. Paired with the cost-cutting announcement, that cloudy view is what has the stock in retreat once again (the stock price is off nearly 40% from all-time highs reached in spring 2019). Xilinx will likely return to growth in fiscal 2021 -- as data centers and autos are expected to grow and the company starts to lap the Huawei sales ban -- so the aggressive cost-cutting is likely more a realignment of the business with reality rather than a reason to panic. Nevertheless, the Q4 report in another few months will be an especially important one to watch, indicating just how long the current slump will last and how strong of a rebound can be expected. Stay tuned.