From: Phil Cantine, Zach Hensley, and Billy Nand

MEMORANDUM

To: Real Client Managed Portfolio

From: Phil Cantine, Zach Hensley, and Billy Nand

RE: Xilinx

Date: April 27, 2004

PORTFOLIO POSTION

RCMP currently holds 200 shares of Xilinx, Inc (XLNX). As of Tuesday April 27, 2004, this position was valued at $7,206. The stock currently trades near $36 and has declined 20% from its purchase price of $45 on December 13, 2000. The results of an in-depth analysis of the company’s financial condition as well as the economic forces that affect its industry are detailed below. These results cast doubt on the company’s ability to sustain the level of growth necessary to support its current stock price.

COMPANY BACKGROUND

Xilinx, Inc. operates within the semiconductor industry. Its core business is the design and marketing of a proprietary family of programmable logic devices (PLD’s). The company is also engaged in the design and development of a number of support products including software design tools for customers using PLD’s, pre-set functions for PLD’s, and extensive customer training and technical support services.

The subset of the semiconductor industry in which Xilinx, Inc. competes is the market for logic devices. These integrated circuits basically handle the ‘grunt work’ in electronic devices, allowing central processors to focus on more complex functions. Logic devices are divided into three categories: custom gate arrays, standard cells, and programmable logic. All three categories have the potential to compete with each other because they perform similar functions. The degree of competition is dependent on price, performance, power consumption, adaptability, ease of use, time-to-market, and development costs.

The primary advantages of PLD’s are adaptability, time-to-market, and development costs. Customers use software to design and test the chips. The finished design is then sent to Xilinx for finalization, after which, associated manufacturers fabricate the product. The final product can also be re-programmed as the need arises. In comparison, the manufacture of pre-programmed logic devices requires costly and time-consuming prototype design and modification prior to final production, after which their function cannot be altered. PLD’s have lower development costs and shorter design times, although they do have higher per-unit costs owing to their increased complexity.

COMPETITION

Xilinx, Inc. commands a 50% share of the $2.3 billion PLD market. Its two largest rivals are Altera, Inc. and Lattice Corp. whose market shares are 31% and 10%, respectively. (source: Purchasing.com) Owing to the similarity of their product lines, all three companies are highly competitive.

ECONOMY AND INDUSTRY

The semiconductor industry appears to be recovering from their sharpest decline in industry history. After plummeting in 2001, the chip industry stayed very low for 2002 and most of 2003. The hardest hit companies in 2001 were makers of chips used for communications equipment. At the time 70% of programmable logic devices (PLDs) were used for communications equipment. That number dropped significantly to 50% by 2002. Industry analysts predict that the slow growth in revenue that began in the fourth quarter of 2003 will continue in 2004.

Programmable logic devices (PLDs) had an annual growth rate of 28% between 1995 and 2000. But the industry fell in 2001 and experienced a 65% decrease in revenues. The programmable logic device market is expected to steadily grow the next four years at an annual growth rate of 6%, rising from about $1.9 billion in 2002 to $2.5 billion in 2007. Programmable logic devices are expected to grow in demand while the average price is expected to only slightly increase from $9.41 to $9.46. Advancement of processing will increase the capacity of each programmable device. One of Xilinx’s new chips will use a new technology that will decrease costs by more than 50%. Xilinx expects to implement this new technology into 45% of its chips by the end of the year.

PROJECTIONS

Revenues

Xilinx's net revenues have declined sharply, with its 2003 revenues 30% less than its peak sales in 2001. However, its 2004 numbers have rebounded, with sales up 21%, and operating income up 110%,for the fiscal year. We continued to forecast this out for 2005, with sales growth 17% in 2005 and decreasing by 1% per year until 2011, as the logic chip industry begins to mature.

Costs and expenses

Xilinx has three areas of products - base products, mainstream products, and advanced products. The difference between the three sets of products is performance and the underlying manufacturing process technology, with the advanced products requiring newer technology and better materials. Xilinx has shifted from selling a split between mainstream and base products to selling primarily advanced products. As this has happened, its cost of revenues has slowly increased, from 37.7% in 1997. While we expect the company to continue the shift to producing advanced products, we expect its cost of revenues to decrease as it realizes economies of scope and scale. Cost of revenues has run at 38% of revenues for 2004. We forecast this to be 37% in 2005, and slowly decrease to 35% of revenues by 2011.

Just as the shift toward producing more advanced products will affect cost of revenues as a percentage of revenues, it will also affect research and development costs as a percentage of sales. Research and development costs have steadily risen as well, from 12.5% of sales in 1997 to a peak of 20.2% in 2002. We project research and development costs to run at 17% of sales in 2005 and onward.

As the company grows, we forecast Selling, General, and Administrative expenses to decrease as a percentage of sales. We forecast Xilinx's SG&A expenses to decrease from 19% of sales in 2005 to 17% of sales by 2009.

Buildings and machinery

Xilinx, along with many other chip manufacturers, had large projected growth figures during 2000 and 2001. Because of this, the company invested heavily in buildings and machinery that never was used. Each of these numbers increased sharply between 2000 and 2002, with the value of Xilinx's buildings on its balance sheet increasing threefold. The company has stated in its annual reports that it owns two buildings in San Jose that it expects to sell soon. Because of the unnecessary investment, and becausethe company has admitted it is looking to divest some of its fixed assets, we forecast Xilinx's investments in buildings and machinery to decrease as a percentage of sales and in dollar terms. Buildings will decrease from 14% of sales to 10% of sales by 2009, and machinery will decrease from 14% of sales to 10% of sales by 2007. Both of these ending projections factor in Xilinx’s sale of one building in 2004, and the projected sale of another building in 2005.

Options compensation

Xilinx has used stock options as a form of employee compensation, just like many other chip manufacturers. In the past, Xilinx was not required to record the options compensation as an expense on its income statement, but was required to list total options compensation in the footnotes of its annual reports. Xilinx chose to record the options compensation on its income statement below its net income figure, producing a pro forma net income, which included the options expense. In its reports to the public however, Xilinx would report its profits without including the options compensation. Some years the options compensation would have made a small impact on Xilinx's profits, and in other years, such as 2003, it would have reduced the company's net income to virtually nothing.

Recent shifts lead us to believe that companies will soon be required to record options compensation as an expense on its financial statements. Xilinx uses the options expense to retain high-quality talent it cannot adequately compensate with salary alone. Because of these two factors, we forecast Xilinx to continue to use options as a form of employee compensation, but to decrease its use. Options compensation has averaged about 10% of sales for the past four years, we forecast 2005's value stay with the historical average. We forecast Xilinx to slowly decrease its use of options compensation expense to 5%. The compensation was forecasted to be a part of operating costs, instead of being listed below the net income figure on the income statement.

Value

The assumptions listed above provide a baseline projection to value Xilinx. Given these numbers, Xilinx will have net margins of 7.6% in 2005, with the figure increasing to 13.8% by 2011 (without the options expensing, net margin would have been 18% in 2005, close to Xilinx's margins during 1997-1999). Return on equity ranges from 6.0% to 13.8% for the same range of years. With a long-term growth rate of 3.7%, and a WACC of 12.62% (provided by Bloomberg), we arrive at a share price of $8.21. This impliesXilinx’s shares are selling at a sharp premium at $36.03, its selling price on April 27, 2004.

We then created a (very) optimistic projection. Sales growth was forecasted to be 20% per year between 2005 and 2011, and costs were decreased so that net margins ranged from 22-26% per year with the options compensation included (a number Xilinx has never achieved). With the same long-term growth rate and WACC values, Xilinx's shares were valued at $22.10 per share. Even with these essentially unrealistic projections, Xilinx is currently selling at a sharp premium.

RECOMMENDATION

Given the state of the economy,the industry, and the company, we believe that Xilinx's shares are currently selling not on value, but on growth potential. When we factor in the growth into our model, we cannot arrive at a share price that justifies holding it in the portfolio. Therefore, our recommendationis to sell all 200 shares of Xilinx at market price.