Altera (Semiconductors) CJ Baker. Katie Trevino. Ivan Salazar. Brian Davis. Katrina Fitzgerald

Transcription

1 Altera (Semiconductors) CJ Baker Katie Trevino Ivan Salazar Brian Davis Katrina Fitzgerald Page 1

2 Table of Contents Executive Summary 6 Business and Industry Analysis Company Overview 11 Industry Overview 13 The Five-Forces Model 15 Rivalry Among Existing Firms 17 Industry Growth Rate 17 Concentration and Balance of Competitors 19 Differentiation 20 Switching Costs 20 Economies of Scale 21 Learning Economies 21 Fixed-Variable Costs 22 Excess Capacity 23 Exit Barriers 24 Threat of New Entrants 25 Economies of Scale 25 First Mover Advantage 26 Channels of Distribution and Relationships 27 Legal Barriers 28 Threat of Substitute Products 29 Bargaining Power of Customers 30 Price Sensitivity 30 Switching Costs and Differentiation 30 Importance of Product Costs and Quality 31 Number of Buyers and Volume per Buyer 31 Relative Bargaining Power 32 Page 2

3 Bargaining Power of Suppliers 33 Price Sensitivity 34 Switching Costs and Differentiation 34 Importance of Product Costs and Quality 34 Relative bargaining Power of Suppliers 35 Number of Suppliers per Volume Supplier 35 Value Creation Analysis 36 Cost Leadership 36 Simpler Product Designs 37 Cost Control 38 Lower Input Costs 38 Economies of Scale 39 Differentiation 39 Research and Development 40 Brand Image 40 Product Appearance 41 Quality 42 Delivery 42 Competitive Advantage of Firm 43 Lower Input Costs 43 Research and Development 44 Delivery 45 Accounting Analysis 46 Key Accounting Policies 46 Foreign Currency Risk 47 Research and Development 48 Operating vs. Capital Leases 51 Benefits and Pension Plans 52 Accounting Flexibility 52 Foreign Currency Risk 54 Page 3

4 Research and Development 54 Operating vs. Capital Leases 56 Benefits and Pension Plans 58 Actual Accounting Strategy 59 Foreign Currency Risk 60 Research and Development 61 Operating vs. Capital Leases 62 Benefits and Pension Plans 63 Quality of Disclosure/Red Flags Qualitative Analysis 64 Quantitative Analysis 66 Sales and Expense Diagnostics 67 Undoing Accounting Distortions 73 Financial Analysis, Forecasting, and Cost of Capital Estimation 75 Liquidity Analysis 75 Current Ratio 75 Quick Ratio 76 Working Capital Turnover 77 Accounts Receivable Turnover 78 Days Sales Outstanding 79 Inventory Turnover 80 Days Supply of Inventory 81 Cash to Cash Cycle 82 Conclusions 83 Profitability Ratio Analysis 84 Gross Profit Margin 84 Operating Profit Margin 85 Net Profit Margin 86 Asset Turnover 87 Return on Assets 88 Page 4

5 Return on Equity 89 Internal Growth Rate 90 Sustainable Growth Rate 91 Capital Structure Analysis 92 Debt to Equity Ratio 93 Times Interest Earned 94 Debt Service Margin 95 Z-Score 96 Estimating Cost of Capital 97 Cost of Equity 98 Alternative Cost of Equity 101 Cost of Debt 102 Weighted Average Cost of Capital 103 Forecast Financials 104 Income Statement 104 Balance Sheet 111 Cash Flows 118 Valuation Analysis 123 Methods of Comparables 124 Trailing P/E 124 Forward P/E 125 Price to Free Cash Flows 126 Price to Book 127 P.E.G. 127 P/EBITDA 128 EV/EBITDA 129 Intrinsic Valuations 130 Discounted Dividend Model 130 Discounted Free Cash Flows 131 Residual Income 133 Page 5

6 Abnormal Earnings Growth 135 Long Run Residual Income 136 Analyst Recommendation 138 Appendices 140 Liquidity Ratios 140 Profitability Ratios 141 Capital Structure 143 Sales Manipulations Diagnostics 143 Expense Manipulation Diagnostics 144 WA cost of equity (regressions) 145 Methods of Comparables 153 Intrinsic Models 156 Resources 160 Page 6

7 Investment Recommendation: Executive Summary Fairly Valued HOLD (11/10/2008) ALT-NYSE ( ) $ Week Range: $13.10-$24.19 Revenue: $1.38Billion Market Capitalization: $4.35Billion Shares Outstanding: Million Initial Book Value Per Share: Return on Equity: 18.0% Return on Assets: 13.1% Cost of Capital Estimated R-squared Beta Ke 10-Year Year Year Month Back Door Ke: 6.9% Published Beta: 1.19 Cost of Debt: 3.48% WACC (BT): 8.42% Altman Z-score Initial: Current Market Share Price( ): $15.19 Financial Based Valuations Initial Trailing P/E: $14.16 Forward P/E: $15.20 Price to Book: $4.38 P.E.G. Ratio: $15.71 Price to EBITDA: $10.22 Enterprise Value/EBITDA: $5.61 Price to Free Cash Flows: $11.95 Intrinsic Valuations Initial Revised Discounted Dividends:.7312 Free Cash Flows: Residual Income: Long Run Residual Income: Abnormal Earnings Growth: Page 7

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9 Industry Analysis Altera Corporation is a semiconductor company specializing in the production Programmable Logic Devices (PLDs). They were founded in 1983 when the technology was invented and compete in the PLD market. Their programmable chips allow customers to program specific functions such as processing, memory, and logic functions, to place in the end users final products. They currently are a leading innovator in this industry with their constant introduction of new product designs. Altera s direct competitor is Xilinx and, both of the companies compete with two other smaller firms, Lattice and Actel. These firms compete on product differentiation, innovation, and cost-control. The major factor that each firm competes on is product differentiation. Differentiation is a key for this industry because it is highly competitive and, the market is expending at a quick pace. It is crucial for each firm to gain as much market share as possible. In the PLD industry, firms face a moderate-low threat of new entrants. This industry invests millions of dollars each year on research and development which makes it hard for new entrants to enter. Firms spend time and money to specialize their products so, customers tend to remain with the same company and do not switch. This makes the bargaining power for customers very high. Firms in this industry rely heavily on suppliers to produce inputs for their products so the bargaining power for suppliers is high. The main key success factors for the PLD industry are differentiation and cost control. To maintain high differentiation firms must invest money in research and development. Firms have to keep their input costs from suppliers low in order to be successful. Maintaining tight cost-control and differentiation are the keys to operating in this industry. Page 9

10 Accounting Analysis The accounting analysis helps determine the firms key accounting policies and whether they are disclosing them properly. The extent to which a firm discloses its financial statements is key to determine whether or not a firm is properly valued. Complete disclosure gives investors and the public an accurate view of where the company stands at that point in time. In the financial statements, firms tend to disclose only what is required by the SEC so; they might appear more attractive which can lead to distortions. The key accounting policies for Altera are currency risk, research and development, operating leases, and pension plans. Overall, Altera discloses the minimum requirement for the SEC. Across the PLD industry; all four firms disclose a relatively low amount regarding their financials. Even though Altera discloses the minimum requirements, they are considered to be a high disclosure firm compared with their competitors. Foreign currency risk is handled straight forwardly and well as pension plans. Operating leases cause some concerns but, since they amount for such a small amount, they raise no red flag. Altera s main accounting policy, research and development, is very poorly disclosed. This policy had to be restated as an asset and not as an expense. Altera relies heavily on research and development in order to remain a player in this market. Therefore, research and development is an asset and should not be expensed. Financial Analysis, Forecasting, Cost of Capital In order to value a firm properly, an analysts has to conduct three categories of ratios: liquidity, profitability, and capital structure. Liquidity refers to how fast a company is turning their assets into cash. We use the following ratios: current ratio, quick asset ratio, A/R turnover, A/R days, inventory turnover, inventory days, and cash- Page 10

11 to-cash-cycle. The profitability ratios refer to how fast a firm is turning profits. The following ratios are used: gross profit margin, operating profit margin, net profit margin, asset turnover, ROA, ROE, IGR, and SGR. The capital structure ratios inidicate how well management is running their firm and, the following ratios are uses: debt to equity, times interest earned, and debt service margin. These ratios help understand the company thoroughly. The next step in valuing a company is to forecast financial statements for the next 10 years. By conducting these ratios and forecasts, we are able to see the current condition of the firm as well as the future condition. The ratio calculation showed us that all four firms differ greatly. Some firms had excellent ratios in one category and lacked in another and vice versa. Most of the major discrepancy came between the two larger firms, Altera and Xilinx, and the two smaller companies, Lattice and Actel. Since they differ greatly in size, their ratios were not similar. Our forecasted financial statements gave us data for out intrinsic valuations. Many lines in the financial statements are more important to forecast than others. Altera s important items were, net income, CFFO, CFFI, book value of equity, and retained earnings all of which would be used in the intrinsic valuations. The discount rates used in forecasting where calculated by determining the cost of capital, cost of debt, and the weighted average cost of capital. To find the cost of equity, we performed regression analysis. Once that was completed, we inserted that into CAPM to arrive at a cost of equity of 15.35%. Next, we found our cost of debt by taking the weighted average of all our interest rates on our current debt. We arrived at a cost of debt of 3.48%. We then found our weighted average cost of capital (WACC) to 14.85%. The most important factor to determine during this analysis is the sales growth rate because it is the foundation to our prospective analysis % -15% -8% 0% 11.5% 11.5% 11.5% 11.5% 11.5% 11.5% Page 11

12 Valuation Analysis Valuation analysis is the most important step when valuing a firm. By conducting the method of comparables and intrinsic valuations, we are able to accurately value Altera. Valuations help determine whether a firm is undervalued, fairly valued, or overvalued. This analysis provides investors with the proper information about a firm. In the method of comparables analyst use seven ratios to determine the firm value. The seven ratios we calculated are: p/e (trailing), p/e (forward), p/b, P.E.G., p/ebitda, P/FCF, and enterprise value/ebitda. We determined these calculations did not give us a proper value of our firm because of their differing outcomes and the in admissibility of certain ratios. Intrinsic valuations portray the firm at a much more accurate value. The models used are: discounted dividends, free cash flow, residual income, long-run residual income, and abnormal earning growth. When applying these models we determined a much more consistent valuation. We determined that Altera is fairly valued at the current stock price. The most relevant model to Altera s valuation were the Residual Income and Long Run Residual Income models and they produced projected values very near the observed stock price when using our estimates of cost of equity, growth rates, and return on equity. Business and Industry Analysis Company Overview Altera Corporation was founded in 1983 when the technology of programmable logic solutions was invented. Altera Corp. created a chip that was cost-efficient and Page 12

13 would allow customers to program particular functions for their systems. With this invention, customers were now able to program their products to their liking at a reasonable price. Currently, Altera Corp. is a leading innovator in programmable logic solutions. Altera Corp. strives to bring quality-driven products to their customers, so they can efficiently bring their products to the market faster. Altera Corp. operates in 19 different countries and is headquartered in San Jose, California. Altera Corp. offers many products to four different market segments, which are communications, computer and storage, consumer, and industrial. They operate and compete in the programmable logic device industry. Their main products are programmable logic devices such as, field programmable gate arrays (FPGAs), complex programmable logic devices (CPLDs), and Hardcopy ASICS. They also offer design software and services, which are essential to purchase with the PLDs and Intellectual Property. Altera Corp. is constantly trying to innovate and bring more efficient devices that require less power consumption to their customers. Since FPGAs and CPLDs differ greatly in use, they are not viewed as competing products but instead divided into two sub-segments. Altera Corp. is a leading seller of FPGAs, the fastest growing subsegment, whose sales total 71 percent of all PLDs sales. Altera Corp. holds 33 percent of FPGAs market share and continues to increase it. Increasing their share is essential to growth for the company. Altera Corp. s main competitor is Xilinx Inc. They both combine to hold over 80 percent of the PLDs market share. Smaller companies such as Actel Corporation and Lattice Semiconductor Corporation make up the rest. Currently Altera Corp. has a market capitalization of 6.18 billion. Even though they experienced a negative growth rate for the year because of less demand from the communication and industrial market segments, they were able to acquire more market share and continued their strong profitability (Altera 10K). YEAR Total 1,578,768 1,769,930 1,843,207 2,233,260 1,769,918 Assets* Net Sales* 827,207 1,016,364 1,123,739 1,285,535 1,263,548 Page 13

14 Growth 16.23% 22.87% 10.57% 14.40% -1.71% *In Thousands Industry Overview Altera Corp. is in an innovative and competitive industry. Companies provide programmable logic devices to customers who program functions for their use. Altera Corp. and their main competitor, Xilinx Incorporated, dominate the PLDs industry. They account for over 80 percent of the market share. Smaller companies, Lattice Semiconductor Corporation and Actel Corporation, make up the rest of the market share. Once a customer decides on a particular device from a firm, they stick with that firm for at least two years. Each company s device operates differently and requires heavy instruction. It is not easy for customers to switch back and forth. They would have to start from step one and re-do their project completely (Altera 10K). There are three main product sub-segments that make up the semiconductor industry: ASICs, application-specific standard products or ASSPs, and PLDs. ASICs are built for one customer while ASSPs are built for one application. They both can only be programmed once. PLDs, however, can be programmed by many customers and be used for many different functions. PLDs have a more complex programmability, so their per-unit cost is much higher than ASICs. ASICs have a higher up-front cost and manufacturing time is much more extensive. More customers are leaning towards purchasing PLDs because prices are continuing to go down for programmable logic, electronic systems have a smaller product life cycle, and the high risk of failure for ASICs (Altera 10K). While Altera Corp. and Xilinx Inc. do compete in the ASICs and ASSPs part of the semiconductor industry, their main focus is PLDs. Their goal is to eliminate the need and use of ASICs and ASSPs and only focus on PLDs sales. Page 14

15 Customers vary between the four market segments, communications, computer and storage, consumer, and industrial. Those segments can be broken down further into sub-segments. Market Segment Communications Computer and Storage Consumer Industrial Market Sub-Segment Networking Wireline Wireless Computer Office Automation Storage Broadcast Entertainment Automotive Instrumentation Military Security/Energy Management Most of the customers for the semiconductor industry are distributors and individual sales representatives who then get our product to its end user. Programmable logic products can be used in many different applications for example routers, mainframes, broadcasting equipment, or navigation systems (Altera 10-K). To stay competitive in this industry, firms have to invest greatly in their Research and Development team. Firms are constantly trying to improve their products and keep the customers they have as well as gain new ones. With a great R&D team companies have the ability to differentiate their products and improve the quality and efficiency of them as well. Xilinx Inc. is the industry leader in R&D. They do not outsource silicon wafers but instead have formed partnerships with chip manufacturers. This enables them to focus and spend more on research and development. Both Altera Corp. and Xilinx focus on producing PLDs to the four different market segments, with communications being the largest. They also focus heavily on selling Page 15

16 FPGAs. PLDs are a more advanced technology that can be sold to thousands of customers. Firms can spread costs over more customers compared to ASICs who have high costs to spread over fewer customers (Altera 10K). Xilinx Inc. continues to grow steadily over the years, while Altera Corp. did face a set back with a negative growth rate for the past year. A negative growth rate or a declining growth rate can be attributed to new product introduction that did not generate enough revenue. Growth rates for the past five years for each company are as follows: YEAR Xilinx Net 1,842,700 1,726,300 1,573,200 1,397,800 1,155,977 Sales* Growth 13.82% 20.92% 12.55% 9.73% 6.74% YEAR Altera Net 827,207 1,016,364 1,123,739 1,285,535 1,263,548 Sales* Growth 16.23% 22.87% 10.57% 14.40% -1.71% Sustaining and gaining market share in this industry requires quality, innovative, and efficient products. It is highly competitive and requires firms to constantly improve their products to be able to compete. Altera Corp. will remain competitive by continuing to produce innovative products that appeal to customers and that are also reasonably priced. The analysis will further explain this industry and firms that compete within it. The Five-Forces Model The Five-Forces model is a tool for analyzing an industry s structure and overall profit potential. This model is categorized into two sub-segments: degree of actual and potential competition and bargaining power in output and input markets. Furthermore, the main five forces are then divided into sections which better assist with identifying the degree of competition and attractiveness of the industry. The first segment is divided into rivalry among existing firms, threats of new entrants, and threat of Page 16

17 substitute products. The second segment which determines the actual profit of an industry is derived through the bargaining power with its customers and suppliers. Successfully evaluating the industry as a whole is critical to a successful business valuation. For a company to be a worthwhile investment, it needs to not only be a well run organization providing better quality goods and services than its peers, but it must also be in an industry that is likely to see long term growth. The five-forces model can give us a good picture of the degree of competition that is likely to exist among firms in the industry. Altera is part of the semiconductor industry called programmable logic devices (PLDs). These are chips that perform functions necessary for the operation of industry technology, high-end consumer products, communication equipment etc and can purchased off the rack and programmed by the manufacturing facility using them. These chips can perform three different types of functions, processing, memory, and logic. Processors are used for control, central computing tasks, and signal processing, (Altera 10-K). Chips for memory store instructions and data while, logic chips manage the interchange and manipulation of digital signals within in a system, (Altera 10-K). Firms in this industry are able to compete on non-price dimensions through the development and implementation of state-of-the-art technology. PLDs are becoming more popular all the time and growing industries rarely see aggressive price wars. The cost of entry into the semiconductor industry is extremely high which keeps the threat of new entrants low. The only element of the industry that warrants even a moderate fear of new entrants is the possibility of reverse engineering. Buyers have very little power over this industry which makes the bargaining power of customers low and allows the firm to be at an advantage. The bargaining power of suppliers in this industry is moderate-low. The following table summarizes our analysis of the five factors and the degree of competition produced by each segment: Competitive Forces Level of Competition 1. Rivalry among Existing Firms Moderate Page 17

18 2. Threat of New Entrants Low 3. Threat of Substitute Products Moderate 4. Bargaining Power Of Customers Low 5. Bargaining Power of Suppliers. Moderate Rivalry Among Existing Firms Recognizing the rivalry that exist within existing firms of an industry helps influence a firm s ability to differentiate themselves from their competitors. In the semiconductor industry for programmable logic products it is essential for firms to be able to stand out in the industry in order to maintain their currently market share and find ways to gain new market share. The level of competition in an industry will determine how a firm will develop their price strategy. Growing technology industries fare better by focusing on different aspects of their product such as innovation and differentiation whereas price wars are more common in mature industries. In the PLD industry it is important for firms to be willing to invest money and time into their research and development department if they want to maintain steady growth. Rivalry among existing firms is divided into different elements such as industry growth, concentration, differentiation, switching cost, learning economies, fixed-variable cost, excess capacity, and exit barriers. The following firms in the semiconductor industry for programmable logic products are each other s main competitors: Altera Corp., Xilinx Inc., Actel Corp., and Lattice Corp. Industry Growth Rate Understanding the industry growth rate provides existing firms and new firms entering the market with a good perspective of the intensity of competition among all the firms. In a rapidly growing industry there is no need for firms to take market share Page 18

19 from one another because they should be concentrating in expanding their product to attract new customers entering the market. Contrarily, an industry with a slow growth rate will see firms to use pricing to take shares from competitors. The PLD industry has seen significant year over year growth as illustrated by this table: *Calculated using Net Sales The graph above demonstrates the industry growth rate of the digital logic device market for the last five years. In this industry the growth has been fairly steady. However, last year s growth dropped drastically compare to the other years. It is the firm s responsibility to offer their customers better more advanced products, especially during this tight economic period. The industry growth in this market is composed of three main segments: communications, industrial, and consumer and database storage. Firms will have to compete within these segments, primarily with the communication and industrial markets since they make up more than 70% of the industry sales. In order for the industry growth rate to be steady again the firms will have to continue to innovate and differentiate their main products which are field-programmable gate arrays (FPGA) and complex programmable logic devices (CPLD). The PLD industry is a subset of the larger data logic market and it must be noted that better PLD products are causing them to rapidly replace the other types of Page 19

20 products suited for similar application. Industry experts tend to agree that off the rack PLDs will continue to replace their dedicated application counterparts that take much longer to develop and are only economical on a very large scale (Altera 10-K). Concentration and Balance of Competitors The degree of concentration refers to the number of firms in an industry. The size of the firms also determines the price in the market. The larger the firm is the greater chance a firm has with formulating competitive strategies with regards to price control and other competitive moves. However, industries with lower concentration are forced to compete on a cost leadership strategy. The larger companies in the semiconductor industry for digital logic devices are able to work in partnership to insure prices will remain consistent. They also set and enforce the rules of competition among the other small firms. Some small firms have been pushed out of the market under the industries tightening conditions. Meanwhile, the larger companies have been gaining market share without slashing prices. The concentration effect is evident in the PLD industry. Page 20

21 Differentiation The uniqueness of a firm is defined primarily by its ability to distinguish itself from its competitors. If a firm is able to successfully differentiate its product, it will give that specific firm a competitive advantage over the other firms in the industry. Firms who compete in the semiconductor industry with programmable logic devices tend to focus in technical innovations since they each offer similar products. The major competitors in this industry seek competitive advantage through rapid technological changes that occur very commonly. If any of the firms fail to develop and manufacture new and more advanced products it would adversely affect the success of their company very quickly. Furthermore, since the firms produce similar products they tend to specialize toward certain applications. The more efficient and reliable a firm can make their devices perform, the more market acceptance they will receive with the products. Firms achieve this goal by making a significant future investment in research and development. The firms under this industry invest millions of dollars to be able to innovate and differentiate their product, which meet the changing needs of customers. Switching Costs One main concern many firms in an industry encounter is whether they can change the direction of the firm by doing something else with their products. This is referred to as switching costs. If a firm wants to compete in a completely different industry they must take in took consideration the cost associated with switching from one industry to another. If the switching cost is too high then the firm will have to determine whether the switch will hurt the firm s financial status. Furthermore, if the switching cost is low then a firm will be able to be price competitive and easily from one product to another. In the semiconductor industry with the specialization on programmable logic devices the switching cost is high so firms have a difficult task Page 21

22 attempting to find alternative usages for existing products. Many of these firms have already invested millions of dollars in land, machinery, employees, and research and development which makes the decision to switch to a new product harder. Once a firm in the semiconductor industry has been established it is to their benefit to continue with the original game plan and find new ways to improve the current product. Due to the high switching cost in the semiconductor industry, many firms encounter a moderate form of competition. Economies of Scale The economies of scale exist arise when one large firm can perform a particular function more efficiently than two smaller firms: it involves mainly the size of operations. As a particular industry continues to grow, firms will have to gain experience in order to be more efficient with their products. In the semiconductor industry there are a couple firms, Altera and Xilinx, who dominate in their specialty. These firms have constantly invested in their research and development in order to continue to deliver the most innovative products in the market. The distributors of this industry expect the firms to have the best product for the customers. Overall, it takes a large amount of time and capital to be successful in the semiconductor industry. Altera and Xilinx have a much more stable total asset growth capacity than the other two firms in the industry. Year Altera 9.97% 13.60% 3.50% 17.47% % Xilinx 3.56% 17.55% 3.34% 4.23% 0.18% Lattice % -5.02% % 1.38% % Actel 7.98% -0.46% 7.09% 1.11% 6.97% Learning Economies The longevity of a firm who is able to compete in an industry for a number of years gives them an advantage in the learning economies of scale. The longer a firm remains in a specific field the more knowledgeable it will be compared to a firm who is just entering. Also, an industry must be able to evaluate and analyze the learning curve Page 22

23 of entry into the industry. In the semiconductor industry the labor market has to be willing to be on a continuous learning task because of the advancements that accrue with time throughout the firm s life cycle. If a firm is able to determine its learning curve then it will provide them with the opportunity to identify and forecast supply cost, transformation cost, and finished product cost (Pearson and Wisner). The semiconductor industry has large learning economies, which in most cases signify long term market gain and increased revenue for the oldest firms. This is due primarily to the high expense of research and development. The graph below shows the amount of money each firm spent on research and development the past 5 years. Research and Development Expense Fixed-Variable Costs The firms in an industry must manage their fixed to variable cost ratio suitably in order to determine the price of the product and the quantity of goods sold. In the semiconductor industry for digital logic devices, fixed costs stay relatively low. This is mainly due to the fact that the majority of production is outsourced to overseas silicon manufacturing companies. The firms in this industry invest quite a bit in research and development in order to compete and stay competitive but the breakdown of per unit Page 23

24 cost rests mostly in the manufacturing. Altera doesn t handle this portion of production directly so while its fixed-variable cost ratio remains very low, we must consider the amount of that cost being absorbed by manufacturing contracts. Excess Capacity A firm who has excess capacity often means that the demand for the firm s product is below what it could potentially supply to the consumer. This is good for the consumer because firms are forced to cut prices in order to sell the products and fill the capacity. Most of the firms in the semiconductor industry have avoided having excess capacity, particularly in the programmable logic device sector. The firms who fall under this category tend to base their inventory on estimates and assumptions according to the product lifecycle, market conditions, and technology changes. A great benefit for firms in this industry is that they outsource most of the products and most of their sales are on credit. Firms do stock a small amount of inventory in order to anticipate the customers demand. It is the responsibility of the management to properly balance the inventory and ensure the firm does not encounter a high excess capacity. The graph below demonstrates the firm s sales/ppe. Altera and Xilinx s ratios are much greater than the other to firms illustrating their ability to maintain a low excess capacity. Sales/PPE Page 24

25 Exit Barriers Barriers to exit prevent a particular firm from exiting an industry. A firm in the semiconductor industry has a high exit barrier due to the amount of capital a firm has invested. These firms do not focus on their employees when determining whether they are going to exit the industry. Moreover, there is small number of employees in each firm who do not belong to any union. In this particular industry all firms have invested a lot towards research and development simply to stay in pace with all the technology changes. The firms who decide to exit the industry will have a hard task liquidating all their specialize assets. Conclusion The PLD Industry has few enough competitors and is experiencing sufficient growth that price competition is unlikely. Innovation will continue to be the order of the day as long as new products are demanded and the market is not mature. Page 25

26 Threat of New Entrants The threat of new entrants is the possibility of new firms entering an industry. Whenever a new business is attempting to enter into a profitable industry it will bring challenges to existing firms by putting pressure on their goods and services. Furthermore, new entrants also put pressure on profits of existing firms which then leads to lowering prices. There are several factors that are considered when analyzing the threat of new entrants. These factors consist of economies of scale, first mover advantage, channels of distribution and relationships, and legal barriers. The threat of new competitors entering into the semiconductor industry is relatively low. A new company wanting to enter this industry would need to have a good amount of capital to be able to compete with the rest of the pack. However, new possibly entrants are finding it much easier than before to enter this industry because firms have been forming alliances to spread out the cost. Due to that fact, the threat of new entrants is moderate-low. Economies of Scale In most industries the economies of scale tends to benefit the large firms and creates a barrier for small emerging firms. The big players of the industry have a huge advantage compared to new firms wanting to enter because of the ability to keep up with the state-of-the-art operations of the industry. New entrants must also have the willingness to invest what current companies have done throughout the years in business. One of the greater investments in the semiconductor industry for digital logic devices is in research and development. The two main firms in this industry have invested over $265.6 million towards research and development. New firms will have to develop a better advance chip in order to establish themselves well in the industry. Moreover, customers in the semiconductor industry tend to be loyal to the product so new firms will also have to find ways to market their new and advance product. Overall, if any new entrants want to compete in this industry they must have a large amount of capital and be really creative in order to compete with the markets to gain any type of Page 26

27 market share. The graph below demonstrates the total assets of the four major firms in the semiconductor industry for digital logic devices. New entrants will have to compete with these experiences firms in order to accumulate the needed assets. Year Altera 1,523,760 1,763,666 1,827,896 2,214,792 1,769,918 Xilinx 2,421,676 2,937,473 3,039,196 3,173,537 3,179,355 Lattice 851, , , , ,285 Actel 316, , , , ,922 First Mover Advantage The first movers of the semiconductor industry for digital logic devices have had a great advantage compare to their current competitors. These firms have been able to established themselves with suppliers and set the standards high for the rest of the pack to follow. Most of the firms in this industry have intellectual property rights. Altera alone has 1810 patents both United States and Foreign. They also have over 870 patents pending. Altera and its competitor Xilinx have entered into technology licensing agreements that allow the companies to use the other s intellectual property. However, they also understand that because of the constantly changing technology their future success is not dependable on their patents and trademarks but on their innovative skills and technological expertise. Another benefit of being the first mover in this industry is the ability to control the price. Since the switching cost is pretty high, many new entrants have to be able to market the new programmable logic device. Customers in this marker tend to stick with the existing product because the firms have made their product dependable which has lead for customers to gain trust on the devices. The research and development the firms invest has been a major determinant of why they have remained on top of the market and customers stay loyal to the product. The graph below demonstrates research and development to sales ratio for Altera and Xilinx. The two firms have kept a stable ratio and continue to generate enough sales to the research and development Page 27

28 they expense. The other two smaller firms, Lattice and Actel, are not relevant because of their much lower revenue relative to the larger firms. Research and Development/Sales Channels of Distribution and Relationships Firms in any industry must build strong relationships with their distributors, support offices, manufactures, suppliers, and many others. New comers into the industry must develop the same important relationships as the existing firms to be able to have an advantage of survival. In this industry the access to distribution channels is essential because of the dependence on the distributors. Altera and its competitors rely on distributors to generate a significant portion of their sales and fulfill the customers orders (Altera 10-K). Altera s main distributor is Arrow Electronics, who has accounted for 40% of their total accounts receivable. Xilinx uses two main distributors, Avnet Inc. and Memec, who have accounted for 86% and 78% of total accounts receivable (Xilinx Page 28

29 10-K). The firms in the industry do not directly manufacture their silicon wafers. These firms must establish a great relationship with the subcontractors since the silicon wafer is the major device for the finish product. Without this part firms could see themselves in a shortage which leads to an increase in cost. Hopeful entrants into this industry might find it nearly impossible to get started because they will run into challenges trying to establish a strong relationship with the overseas manufactures. These kinds of relationships are vital to the success of a new entrant s product. Legal Barriers Industries that require a high amount of technology research make it really difficult for any new entrants to compete. Legal barriers such as: patents, trademarks, contracts, licenses, copyrights, trade secret laws, and government regulation are a main reason why new entrants find it difficult to be part of a section of an existing market. Once a patent has been acquired from an existing firm for a product it can last for several years. In the semiconductor industry a firm must put trademarks in order to distinguish their product, technologies, and services from the competitors within the industry. Also, many firms within the industry might enter into license agreements with one another. Whenever firms form alliances within the industry it only makes it harder for new possible entrants to produce certain products and limits their opportunity for entry. Another issue a new entrant might encounter is lawsuits. They must be able to handle several lawsuits and have sufficient capital to cover yet another cost. Conclusion: Threat of New Entrants The semiconductor industry for digital logic device market faces a moderate-low threat of entrance. It is pretty difficult for a new firm to enter into this specific market and successful. There several factor that affect the ability of any new entrants such as: economies of scale, first mover advantage, channels of distribution and relationships, and legal barriers. In this industry the successful firms have invested millions of dollars in research and development in order to stay on the cutting edge of all the new Page 29

30 technology. Customers tend to be loyal to their product which allows for existing firms to have a first mover advantage. Furthermore, the distributors and suppliers in this industry work one-on-one with the firms creating a long-term relationship and it gives these firms the best prices in the market. If legal barriers did not exist, then the threat of entrants would increase. Legal barriers protect the existing firm from the possibility of new entrants to steal their ideas on the products. New entrants must be aware of these factors when considering if they want to enter an industry. In the digital logic device market a firm must have a large amount of capital to survive. Threat of Substitute Products Another form of competition, in any industry, is the threat of substitute products. It does not require even being the same form as an existing product to serve as a substitute. The threat of substitute products is characterized by the relative prices and how well other company s products work in the industry. The threat of substitute products in the Programmable Logic Device industry is extremely high based on these characteristics. Companies in this industry spend millions and even billions of dollars every year on research and development as seen illustrated in the chart below. The reason why companies spend this kind of money is because the PLD industry is intensely competitive and each successive product generation is characterized by rapid technological change, and price decline. Usually products of this industry will always cost less, maintain greater functionality, and allow for lower power consumption for whatever electronic device they are serving. Even after a company spends all that money developing a new product, copy cat suppliers perform reverse engineering to develop their own product at a cheaper price. Patents can only do so much in the digital market, which is why reverse engineering is ultimately the main threat of substitutes (Altera 10-K). Page 30

31 Year Altera 178, , , , ,581 Xilinx 222, , , , ,101 Lattice 87,092 90,957 97,231 81,968 82,977 Actel 40,798 41,720 45,701 48,242 56,926 Bargaining Power of Customers The semiconductor industry is extremely competitive, and when one breaks it down to the PLD (Programmable Logic Device) sub-industry, it s no different. Opposed to the Semiconductor industry as a whole, the PLD market is highly compromised of two companies that make up a majority of the market share. Does this mean that customers of PLD s have bargaining power in this industry? The answer to this question cannot be a simple yes or no. When analyzing the bargaining power of customers, one must look at two aspects: price sensitivity and relative bargaining power. Price Sensitivity Price sensitivity refers to the amount that a customer would care to bargain for prices and the disposition of a customer to purchase a product based on price exclusively. Two major factors that determine how price sensitive a customer might be include: how differentiated the products are and, how high the switching costs are in the market. Switching Costs and Differentiation The main customers in the PLD market are big distribution companies and independent sales representatives. For Altera, their main distributor is Arrow Electronics and, for Xilinx their main distributors are Avnet Inc. and Memec. These distribution Page 31

32 companies are usually franchised by large component manufacturers to sell an extended assortment of products to customers in the communication field, computer and storage sector, consumer, and industrial markets. These distribution companies and independent sales representatives are held responsible for creating demand and aligning customers in these markets to the right PLD vendor. Because each PLD vendor s integrated circuits are proprietary to any customer s electronic system and complex in nature, this can be a very tedious task. This is commonly referred to as the design-win phase because once a customer is aligned with the correct vendor; it could take from 6 months to over 3 years for volume production. This translates into the products of this industry as being extremely differentiated and the switching costs as extremely high. The cost of switching PLD vendors is usually so high, because after the customer selects its vendor it generally takes several years from that point before the customer has completed its entire system design, built prototypes, sampled the market place for customer acceptance, made any modifications, and established volume manufacturing capacity. (Altera 10-K) Importance of product costs and quality Another factor of how price sensitive a customer will be, depends on how important the product is to the customers own product quality. Fortunately for the PLD market, its customers need PLD s to manage the interchange and manipulation of digital signals within their electronic devices. Without PLD s, these products could not carry out the tasks they were created to perform. (Altera 10-K) Number of buyers and Volume per buyer Altera has few buyers because the distribution channels are already set in place and most of them maintain the first mover advantage. Altera s main distributor is Arrow Electronics Inc, which on a worldwide basis accounted for approximately 45% of total sales, while the next biggest distributor only accounted for approximately 13% of total sales. This gives Arrow Electronics Inc. a higher bargaining power relative to all other Page 32

33 distributors that Altera supplies. This means that a couple of distributors are way more price sensitive than others, but comparatively speaking, all of Altera s customers are price sensitive due to the number of buyers in the market compared to most other industries. (Altera 10-K) Relative Bargaining Power Relative bargaining power refers to the power that customers have in actualizing a certain price and the cost to each company of not doing business with the other. In this PLD industry, companies rely heavily on distributors to produce a substantial portion of their sales and to fulfill almost all of their customer s orders (usually over 90%). These distributors are not easily added or replaced because, as with most vendors in the market, there are intricate distribution infrastructures that are already set in place. These distributors carry out two major operations for companies in PLD industry. The first operation usually entails logistic functions such as order entry, credit, forecasting, inventory management, and the shipment of products to the end customers. These logistic functions are elaborate processes that are also very time consuming. The second operation includes putting the essential capability in place to produce demand for PLD devices at an engineering level. This usually encompasses the training of an extensive sales team along with the hiring of specialized applications engineers skilled in promoting and servicing products at the engineering level. Thus, the cost to companies, in the PLD industry, of switching distributors is very high. These distributors already have relationships with a majority of the end customers and any failure of a distributor to perform as anticipated would financially lower all future sales. These distributors also have the economies of scale to maintain large inventories with people who specialize in inventory management (Altera 10-K) Conclusion In the short run, the customers in the PLD industry cannot be very price sensitive because the products of this industry are complex in nature and can be Page 33

34 extremely differentiated. Customers also have a hard time being price sensitive because the cost of switching to a different vendor can be exponentially high. It could take years before a vendor can mass produce a product for an end user and if this process were broken, it would cause a heavy financial burden for both companies. Although, in a semiconductor industry characterized by smaller, faster, and cheaper, the customers can be price sensitive in the long run. In this industry, the failure of a company to continually produce cheaper products will ultimately lead to their demise. This is exemplified by the high relative bargaining power that customers of this industry maintain. Continual innovation and technological advances are what ultimately fuels this type of industry. Price Sensitivity Short Run= Low Long Run= High Relative Bargaining Power of Customers High Bargaining Power of Suppliers In the past, companies in the PLD market took on the role of the entire production process that included design and manufacturing. Now these companies are appointing most of these production processes to other companies in the industry. Most PLD vendors outsource mainly from specialized foundries and other independent suppliers for assembly and testing purposes. Companies are now becoming leaner and more efficient. Chip production now resembles a gourmet restaurant kitchen, where chefs line up to add just the right spice to the mix. Although the growth potential is high for companies in the PLD industry because of the reduced overhead that comes along with the production process, they lose some control or power over the business as a whole. ( Page 34

35 Price Sensitivity The price sensitivity of suppliers, in the PLD market, is dependent on the number of other suppliers in the industry, how differentiated the product is, and how much it would cost a company to switch to a new supplier. Switching costs and Differentiation If there were many suppliers in the market, and the product they were supplying was undifferentiated, then a supplier couldn t be in a strong position to bargain on its selling price. However, suppliers in the PLD market have been moving in the opposite direction. The main components found in all devices in the PLD industry are Die. Die are cut from silicon wafers, which are produced by independent foundries. The production of die from silicon wafers is extremely expensive, which has caused, over the last decade, many foundry companies to be pushed out of the market. The foundry industry is now dominated by only a few large companies that control a majority of the market. Die is a much differentiated product as well. There are no substitutes in the present market today for silicon wafers. These few suppliers have large economies of scale for mass production and they also contain timely access to advanced process technology that companies in the PLD industry just don t have any more. (Altera 10-K) Importance of product for costs and quality Another factor of how price sensitive a supplier will be, depends on how important the product is to the customers own product quality. This is a very important factor for the suppliers of the PLD industry. All of the companies in the PLD industry depend entirely on independent subcontractors to supply them with die and completed silicon wafers. If there is a failure of any of these subcontractors to deliver silicon wafers or to satisfy company s demands, it would materially disrupt their businesses. Page 35

36 Relative Bargaining Power of Suppliers The products that the suppliers of the PLD industry sell are differentiated and there are only a limited number of large foundries in the economy. Furthermore, most of these distribution channels are already set in place based on continuing relationships between the suppliers and buyers of this industry. Most of the companies in the PLD industry rely entirely on the input of finished silicon wafers in order for their business to operate. Any disruption between a supplier, of silicon wafers, and a company in the PLD industry would be materially devastating. The PLD vendor would need to find another foundry that had the capacity to produce their most advanced products and would not be able to fulfill previous customer orders in a timely and cost effective manner. There is no threat from silicon suppliers of forward integrating because the designing of PLD devices is far too specialized. Due to the competitive nature of the PLD industry, if a foundry lost a customer, it would not be too long before they could replace the missing business. Number of Suppliers and Volume per Supplier There are very few silicon wafer suppliers in the market today because of how differentiated the product is and because they maintain a first mover advantage with distribution lines all set in place. All the companies in the PLD industry get their wafers from either one or two major suppliers. Altera is no different from the norm of the industry because they receive nearly all their silicon wafers from by TSMC located primarily in Taiwan. This means that the volume per supplier is extremely large for every order. This translates into the suppliers of the industry having a very strong bargaining position over their customers. Conclusion In conclusion, the reason why the bargaining power of suppliers is so important is because it represents how high costs will be, which in turn effects how high the gross margin will be. Because there are only a handful of foundries and their products are Page 36

37 differentiated, they are highly price sensitive. As the suppliers of cutting-edge equipment and production skills, merchant foundries enjoy considerable industry bargaining power. ( Price Sensitivity High Relative Bargaining Power of Suppliers High Analysis of Key Success Factors for Value Creation in the Industry In any business valuation it is helpful to identity the key success factors for the industry in question. They are good at helping us determine the overall profit potential of the industry and in order for us to evaluate our firm, we must determine what activities the firm must be engages in and what qualities it must possess for it to be profitable. This process also helps firms determine what technique they will use to guarantee their own success in the marketplace. The two most common types of gaining market share and increasing profitability are cost leadership and product differentiation. Ideally a company would be capable of producing the best most differentiated products and maintain cost leadership but that is rarely possible, if ever. In the PLD industry, differentiation is the best and most typical strategy but, it is important to maintain a combination of the two. Cost Leadership This strategy is best used when firms in the industry are selling and producing similar products, which means that the firms are competing on price. When the firms all have similar products, the best way to out shine their competitors is to sell their products at a better price than the other firms. In order for firms to compete on price Page 37

38 they have to lower their cost of production by using a simpler product design, cost control, lower input cost, economies of scale, and/or more efficient production. Cost is always a factor but highly differentiated products rely less on cost than homogenous products. PLDs serve similar functions to several other products in the market but differences in their design allow them to be used more effectively and at a cheaper price. Simpler Product Designs The PLD industry operates within the larger market for Digital Logic Devices. PLDs are one type of advanced semiconductor that can perform the functions of a Digital Logic Device. Other products within this market include ASSP and ASIC chips. A PLD is generally considered to be more expensive and less customized product than either the ASSP or ASIC solutions. However, both ASICS and ASSP products take an extremely long time to design and fit to an application. A company wishing to use ASSPs or ASICs in their product must wait up to two years for the chips to be designed for their needs, manufactured in bulk, and shipped to the new production facility. PLDs on the other hand, can be purchased off the rack and programmed during production. If sufficient lead time is available and the customer requires a very large quantity, the per unit cost of a ASICs solution will typically be lower than a PLD solution. However, if lead time is rushed or the quantity is limited, the simplicity of the PLD design allows for a cheaper product. The PLD market has had a compounded average of 9% over the past five years (Altera 10-K). The PLD industry has been expanding because simpler and better performing designs have begun to compete more directly with the ASICs and ASSPs without imposing the necessary lead times or minimum bulk. Here is a chart form Altera s K illustrating the qualities of the different products: Page 38

39 ASIC ASSP PLD Customizable Yes; by manufacturer No Yes; by enduser Erasability/Reprogrammability No No Yes Relative Time to Market Slow Immediate Fast Relative Per Unit Cost Low Moderate Moderate to High Relative Customer Development Cost High Low Moderate to High Cost Control Using strategy of cost leadership, firms have to find different ways to reduce the cost by limit unnecessary spending. In the PLD industry, it is very costly to produce PLD. So for firms to reduce the price of PLDs they purchase silicon wafers from their suppliers. This helps the firms to be able to compete on price. Also the money not spent on producing their wafers can be used to increase their advantage in the quality and development of better PLDs. Lower Input Costs There are a finite number of suppliers capable of manufacturing PLD inputs on the scale necessary for a major PLD producer. Keeping these costs low is mainly a function of contact negotiation. Asian companies such as Taiwan Semiconductor Manufacturing Company, who is Altera s main supplier, produce the majority of wafers used by PLD makers. It is important for a PLD company to be able to name a price they are willing to pay and to forge and maintain god relationships with the companies that supply their inputs. PLD companies are aware of the power that suppliers have over them and must constantly be working to make those relationships run more smoothly. Altera identified its exposure to fluctuations in the price and availability of Page 39

40 inputs in their corporate reporting. This is an area where experience in the industry is crucial. Startup companies are at a definite disadvantage based on both their ability to negotiate low prices and their ability to take the first inputs available in the event of a shortage (Altera 10-K). Economies of Scale and Efficient Production Large companies have a definite upper hand when it comes to production. The ability of a large PLD maker to negotiate with suppliers gives them an advantage over smaller companies that are not making purchases on nearly the same scale. This gives PLD companies an incentive to gain market share even if it means greatly discounting their prices. The PLD industry is highly concentrated with two major players, Altera and Xilinx, comprising 33% and 51% of the market respectively over the past year. The other smaller companies, Lattice and Actel, only make up 16% of the market share together. With overall demand falling last year, the large companies are likely to gain market share while the less powerful small companies may be crowded out by their inability to exert any bargaining power over their suppliers. Differentiation Focusing on differentiation requires the firms in the industry to know what customers are looking for in the products they require. This means it is important for a firm to accurately assess the quality of their new products before attempting to market them. The firm must also be able to set itself apart from the rest of the firms. By specializing on specific applications Altera and Xilinx have unspoken agreements within the market. Altera concentrates mainly on selling CPLDs to the communications and industrial segments. They also have focused on designing their products with much less power consumption (Altera 10-K). Xilinx produces and sells more FPGAs and, they sell more heavily in the consumer and automotive and industrial segments. The newest innovations they have been working towards are producing products with 65 nanometer Page 40

41 technology (Xilinx 10-K). They each develop products with distinct and different customers in mind. This prevents the market form becoming glut with overly similar products. Research and Development Maintaining a high product quality within any technology industry relies on excellent research and development. In the PLD industry, companies must continually debut new products and product upgrades to win their share of new bids in the market. Research and development can include efforts to streamline their production process and offer products at lower cost but, the main goal of research and development in the PLD and customizable logic industries is to create faster and higher performing products. These products are usually used in fairly high-end equipment where performance rather than cost is the determining factor. The current state of the industry shows the main players choosing to focus their research and development efforts on specific fields such as reducing power consumption and producing 65 nanometer technologies. They can develop distinctly better products rather than simply offering a similar version of every product their competitors offer. Altera and Xilinx over the past 5 years both have spent between $100,000-$400,000 on research and development. The smaller companies barely spend half of that with their totals ranging from $40,000-$ Altera outsources the majority of its production so that it can focus on its core ability in research and development. Brand Image There are relatively few players in the PLD industry. Altera and their main competitor Xilinx comprise over 80% of the market share with the rest being comprised of small mostly private companies. Brand image is not as large of a concern as it would be in consumer products driven market with many alternatives. Seekers of digital logic solutions are fairly limited in their choices and while reputation for delivering a reliable working solution is important to industry success, a widely recognized brand image is Page 41

42 not. The firms spend a low amount on marketing and advertising expenses and depend on their distributors and sales representatives to gain new customers. Altera s and Xilinx s selling, general, and administrative expenses have only fluctuated about $100,000 over the past 5 years concluding that they don t spend a great amount trying to increase their advertising and marketing efforts. It is unlikely that we will see any major expansion of advertising efforts by any major players in the industry. Product Appearance Customer s reaction to the aesthetic of our product is minimal. All of our products are housed within larger electronic equipment. Therefore, our products are typically only seen by a few factory workers before being placed inside a computer, television, or cable box. It would be unwise for a producer of PLDs to spend any significant amount of time or money changing or improving the look of their product. As indicated by the chat below, Altera and Xilinx s selling, general, and administrative expense has not fluctuated over time. These are extremely function oriented pieces of equipment. Appearance plays little or no role. Selling, General, and Administrative Expenses Page 42

43 Quality Because the operating languages and technologies embedded in PLDs are completely proprietary, customers have very little ability to switch producers if they are unsatisfied with the product they receive. Therefore, they really do their homework and ask around before committing to a company. Quality is of the upmost importance to PLD firms because word of failed products is likely to get around to potential customers and limit your ability to gain market share. High quality products rely both on excellent programming and reliable physical inputs. Customers also receive software relating to their product that creates the functionality desired by the customer, (Altera 10-K). The software quality is essential for maintaining quality products and customers retention. A reduction in the quality of the silicon wafers used to make PLDs would have an immediate adverse effect on the quality of the finished products. Delivery Timely delivery to manufacturing facilities all over the world is necessary in the PLD industry. Most PLDs are inputs in large scale manufactured products that rely on Just-In-Time techniques. A reputation for meeting the delivery requirements of customers is necessary for long-term success. Conclusion Product differentiation is the most important competitive advantage in the PLD industry. Products must be more specific and higher performing to win customers. The market is expanding rather rapidly so, it is not yet necessary to engage in aggressive pricing. New customers fill the companies need for growth and proprietary compatibility will tend to keep customers where they are so winning over customers initially is crucial. In this industry, that must be accomplished through product performance and specificity not lower price. With that in mind, we must ignore price completely. If one firm were to lose the ability to acquire inputs at competitive prices, it would quickly lose Page 43

44 market share and profitability. It is imperative, then, that companies in the PLD industry maintain good relationships with their suppliers. Firm Competitive Advantage Analysis A comparison of the previously identified key success factors in the PLD industry to the business priorities of Altera Corporation reveals many similarities. Altera uses a differentiation strategy and combines elements of leadership strategies to insure continuity in the marketplace. The following is an analysis of Altera s success at achieving those key success factors. Lower Input Costs Altera is acutely aware of the power that suppliers have over their business. This is a selection from the current 10-K report under a section outlining business risks: We depend entirely on independent subcontractors to supply us with finished silicon wafers. The failure to these subcontractors to satisfy our demand could materially disrupt our business. Nearly all of our silicon wafers are produced by Taiwan Semiconductor Manufacturing Company (TSMC) in its manufacturing facilities located primarily in Taiwan. The remaining portion of our silicon wafers are produced by Sharp Corporation in Japan. Silicon wafer production facilities have at any given time fixed capacity, the allocation of which is determined solely by our vendors and over which we have no direct control. We have no formalized long-term supply or allocation commitments from our foundry suppliers. Our operations would be disrupted if TSMC terminates its relationship with us and we are unable to arrange a satisfactory alternative to fulfill customer orders on a timely basis and in a cost-effective manner. To ensure the continued supply of wafers, we may establish other sources of wafer supply for our products as these arrangements become economically advantageous or technically necessary. However, there are only a few foundries Page 44

45 Obviously, the availability of wafers is a major concern for Altera. They go on to say that fluctuations in the price of these wafers could seriously affect their margins. They also admit that they have no direct control over their supplies. It is our opinion that Altera must insure that these inputs are available in ready supply at a reasonable price. This is a great source of risk for Altera. The long relationship that Altera has with their current suppliers indicates that major disruptions are unlikely, but they must be kept always under scrutiny. The technology in this industry changes very quickly. If Altera were to experience a devastating period of lack of inputs, the resulting drop in cash flow could cripple their research and development efforts. That would pace them behind the curve for new product development and, it would take years for the company to recover, if they were able to do so. Research and Development Research and development is the most important element of differentiation strategy in a technology industry. Altera has chosen to seek portions of the market not served well by other players in the industry, such as the CPLD share and the communications and industrial market segment. By subdividing the market in this way and catering to particular market segments, they can provide excellent solutions at lower research and development costs than if they were attempting to lead in all areas of the industry. Some traits that Altera is currently looking to enhance are speed, density, power consumption, and functionality, (Altera 10-K). They are also looking to operate mainly in the low-cost and high-volume application. The company has so far done a good job of developing new products. They have developed seven new families of products over the past three years. However, as they look to the future it is important to keep true to a differentiation strategy and not overlap too many qualities of existing ASICs and ASSP technology which are low-cost and high-volume. One way Altera could differentiate more is gaining more share of FPGAs market. They represent 33% of the market share to date with Xilinx being the highest seller. If they can gain more of this share, they will better differentiate their products. Page 45

46 Delivery Delivery is another element of differentiation that Altera must be careful about. Their inability to directly control the scheduling of their manufacturing process limits their ability to deliver products in a timely fashion. In industries like the PLD industry where there are many levels of products being shipped from one factory to another and combined to build end products, the ability to deliver products in a timely manner can be as important as the quality of your products. Again, our team would urge all involved with this company to closely monitor the activities of TSMC and Sharp Wafers in order to spot potentially hazardous interruption. Conclusion Altera does a good job of developing new products through research and development but, they have exposed themselves to great risk by outsourcing all their fabrication to other companies. These companies now hold Altera over their proverbial barrel as even one devastating period of fabrication failures could cripple the company for years. As long as Altera can maintain its vendor relations its research and development efforts should keep it at a stable and profitable level. However, an interruption of the fabricators would be as devastating as GM s sudden ability to manufacture auto classics. Page 46

47 Accounting Analysis Any financial evaluation would be incomplete without thorough accounting analysis. Not all companies are completely forthright in their accounting policies and even GAAP compliant companies accounting numbers are sometimes misleading. It is completely possible for financial statements to offer an inaccurate view of the companies actual value and profitability as a company. With that in mind, there are six steps to the accounting analysis used for this valuation. First, we will look at the accounting policies that are significant and related to the firm s key success factors. Second, flexibility must be assessed. It s important to understand how much wiggle room the companies have when financially describing these important business elements. Next, specifically identify how the company used the leeway given within the accounting standards and find out what undue benefits may have been gained from that accounting choice. Sometimes red flags or serious signs that a company may not be performing at the level it should be will appear when analyzing why manager s made specific decisions. Lastly, we will adjust the books to better answer the questions that are important for financial valuation. This step works to prevent mistakes in valuation that might arise from faulty or deceptive decisions made by managers struggling with the agency problem. Key Accounting Policies The most important accounting policies a company has are those that relate most closely to its key success factors. When a company executes its key success factors well, it is likely to very profitable and gain value but inaccurate accounting representation of these business activities can lead to an inaccurate valuation. Also, if managers are willing to distort the accounting numbers they are most likely to do so on important policies that will greatly improve the picture of their company s financial outlook. Earlier, Altera s key success factors were found to be product differentiation, quality, and timely worldwide distribution. These business elements require a deeper look into accounting practices as they relate to research and development, employee Page 47

48 pensions and benefits, foreign currency risk, and the use of operating versus capital leases. Even subtle distortions in these areas could greatly mislead an analyst. Good accounting analysis will reveal whether or not the company is doing a good job of achieving their key success factors. Foreign Currency Risk Currency Exchange rates are a significant business factor for any company that operates overseas. They can be very dangerous to profit margins and cannot be controlled by individual companies. So, companies have to do their best to insure that they are protected against adverse currency exchange rate shifts. There are several methods for doing this including contract manipulation, international derivative markets, and careful projections of what currencies will be shifting. Also, in today s volatile market, it is important that a company be diversified among many countries so that no one shift in exchange rate can drastically affect the company s bottom line. Altera does the majority of their business, both sales and production, overseas. Almost 80 percent of buyers are international. Asia Pacific is 34 percent, Europe is 24 percent, and Japan is 20 percent. The US only makes up 22 percent of buyers. Page 48