Few fields move as rapidly as technology. Businesses creating outsized profits and returns for shareholders quickly get bull's-eyes on their backs and are targeted by other companies looking to disrupt their products by selling cheaper alternatives that still prove "good enough." Even if a company continues to dominate its particular field, other changes in technology can shift spending away from its products. Think about how Microsoft still dominates PCs, but it's pressured by sales shifting to mobile devices like smartphones and tablets.

With that in mind, today we're looking at how Altera (Nasdaq: ALTR) innovates. Technology companies can innovate either through acquisitions or spending more on research and development. We'll compare Altera's spending in these areas to that of its closest peers and assess whether the company is investing enough in its future.

Research and development
Over the past five years, Altera has spent an average of 18% of revenues on R&D. The table below summarizes how Altera's R&D expenditure relative to revenues compares to some of the company's closest peers:

Company

2006

2007

2008

2009

2010

LTM

Altera 19.1% 20.6% 18.8% 21.4% 13.5% 13.2%
Xilinx (Nasdaq: XLNX) 18.9% 21.1% 19.4% 19.5% 20.2% 16.6%
Lattice Semiconductor (Nasdaq: LSCC) 33.4% 36.3% 30.9% 28.9% 20.3% 21.2%

Source: Capital IQ, a division of Standard & Poor's. LTM = last 12 months. Dates above are calendar years, while yearly total is for company fiscal years closing in that period.

Altera, which operates in a virtual duopoly with Xilinx, has managed to sharply cut R&D spending as a percent of sales over the past five years. Some of the credit for these expense cuts can likely go to the lack of far-reaching competition in the programmable logic device market. Between the two of them, Xilinx and Altera control close to 90% of the market, while third-place Lattice Semiconductor toils away in its -- quite profitable at the current time -- niche of the industry. Interestingly, Altera spends 30% less on R&D compared to Xilinx, despite only having 12% fewer sales.

Can those industry dynamics last? There are some signs that new competition could soon be emerging. Namely, start-up Tabula recently raised $108 million to help it continue development on a 3-D programmable logic architecture. Far away in the microprocessor field, Intel (Nasdaq: INTC) recently turned heads by announcing its own 3-D chip architecture that it claims will offer vast power efficiency and performance advantages. Whether Tabula's architecture will have a similar effect in the programmable logic field remains to be seen.

Acquisitions
In technology, some of the best companies have turned growth through acquisitions into an art. IBM has adeptly spun off capital-heavy businesses like hard drives and PCs while it focused on acquiring additional services and software expertise that have transformed its business model.

However, on the opposite end of the spectrum, Hewlett-Packard is often criticized for underinvesting in research and development to the point that it has to overpay on acquisitions to catch up with competitors.

Investors should remember most of all that companies are valued by the cash flow they can bring in for their shareholders over time. If companies need to continue making purchases in perpetuity to keep growing, that amounts to a reduction in cash flows, and investors should treat acquisition spending as a continuing outflow against cash flow. With that in mind, let's take a look at Altera's free cash flow over the last five years against cash spent on acquisitions.

Editorial

Source: Capital IQ, a division of Standard & Poor's. LTM = last 12 months. Dates above are calendar years, while yearly total is for company fiscal years closing in that period.

Aside from a purchase of tiny Avalon Microelectronics late last year, Altera hasn't made any acquisitions since 2003. That combined with the fact it runs an asset-light model with almost no capital expenditures means the company's operating cash flow is effectively the same as its free cash flow -- a rarity in the acquisition-crazed tech world.

Final thoughts
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Eric Bleeker owns shares of no companies listed above. The Motley Fool owns shares of International Business Machines and Microsoft. The Fool owns shares of and has bought calls on Intel. Motley Fool newsletter services have recommended buying shares of Microsoft and Intel. Motley Fool newsletter services have recommended creating a diagonal call position in Microsoft and Intel. Motley Fool newsletter services have recommended shorting Xilinx. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.