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The Bullish Case For Altera Corporation With Phil Taller Of Bluewater Investment Mgmt.

Currently at 2,135.55, the NASDAQ Composite is down 133.6 or 5.89% year to date. A similar result is true for the S&P 500 Index (-6.66%) and the Dow Jones Industrial Average (-5.41%). If investor sentiment and current media headlines are indicative of anything, it’s that investors remain fearful and as a consequence we’ve been told that massive amounts of capital remain on the sidelines. It is at a point such as this, when one of Warren Buffett’s famous sayings come to mind, “Be Fearful When Others Are Greedy and Greedy When Others Are Fearful.” While it is extremely hard to time the market, what we do know is that equities are a lot cheaper today (approximately 5% in aggregate) than they were at the beginning of the year. To get his take on investing and US equities, we had to the opportunity to engage Phil Taller, Principal & Portfolio Manager at Bluewater Investment Management. Read on to find out more about one of Mr. Taller’s larger holdings. To give you a hint, its a semiconductor company that has gross margins of about 65% and is one half of a duopoly in its vertical.

Biography: Phil Taller is a Principal and Portfolio Manager at Bluewater Investment Management and has more than 14 years experience as an investment analyst and portfolio manager.

Phil Taller, Principal & Portfolio Manager at Bluewater Investment Management

He began his investment career at Bunting Warburg in 1991 as a research associate. In 1994, he joined Jones Heward Investment Management as an equity analyst providing recommendations on Canadian equities to a group of portfolio managers. In 1995, Phil joined Trimark as a portfolio manager on the Canadian equities team. Appointed a vice-president in 1998, Phil co-managed $10 billion in North American equities. In December of 1998, Phil joined Bluewater.

Phil’s undergraduate degree is a Bachelor of Mathematics with a specialization in Computer Science. He worked as a software developer for four years before returning to school to pursue an MBA. He earned an MBA from York University in 1991 and a Chartered Financial Analyst designation in 1994.

Q: Mr. Taller, why don’t you tell us a little bit about your firm, Bluewater Investment Management – its investing philosophy, specialties/edge and the funds that it manages?

A: Bluewater is a firm that focuses on investing in growing businesses, mainly through North American equities. We believe strongly in owning a relatively small number of businesses and knowing them well. When we look at a business, we look for growth opportunities that are driven mostly by a company’s own efforts, not just the economic cycle. Usually, a company with good growth potential has created new products or services that its customers value highly. Our businesses often have competitive advantages that they have built and strengthened over many years.

Bluewater manages assets for private clients and for mutual funds through its relationship with Mackenzie Financial Corporation. The mutual funds include the Mackenzie Universal Canadian Growth Fund, the Mackenzie Universal Canadian Balanced Fund and the Mackenzie Universal American Growth Class. I spend most of my time on our US equities.

Q: Given your style and penchant for bottom up analysis, what are some of the processes/methods that you follow when carrying out due diligence on companies? In addition, when assigning fair value or net asset value to a company, what valuations metrics/models do you work into your calculation (for eg. do you incorporate a DCF analysis, or do your work out the break up value of a company etc.)?

A: When we have decided that a company has good apparent growth characteristics, we begin to study it more intensely. Our due diligence includes meeting with management, as well as speaking with outside observers such as competitors, customers, suppliers and ex-employees. An assessment of the management team is an important part of our process. We read extensively about the company and its industry. Our main tool for valuation is a discounted cash flow (DCF) analysis, which requires building a model of the company’s historical financial statements leading to a projection of future cash flows. A key feature of our DCF models is that we attempt to be conservative in our projections. Our hope is that we will always be raising our numbers as the actual figures come out. We always assume that companies “fade” over time to a growth rate equal to the economy, even though we believe they are capable of better.

Q: How do you incorporate the impact of macro issues into your valuation process?

A: Although we spend relatively less time on macro issues, there are concrete ways to capture macro problems in our valuation process. A great example is the downturn of 2008. Beginning in 2006, we began to model in a drop in the economy for 2007, simply because we felt it was prudent after a long expansion. Although there was no recession in 2007, we shifted the weak numbers in our models into 2008. This caution served us well, as we were able to sell off equities where pricing seemed excessive, and our portfolios weathered the storm relatively well.

Today, several elements of our models reflect potential challenges, such as higher tax rates, higher discount rates and modest future growth.

Q: Now on to the interesting stuff, Mr. Taller, given your focus on US mid-caps, why don’t you let us in on 1 or 2 of your top stock picks? If you can start off by telling us a little bit about what the company does, then highlight the outlook for the sector/vertical the company operates in and it’s relative competitive position within that sector/vertical, it’s valuation and how that compares with its peers, any catalysts or propellants of the stock price in the future and lastly, some of the risks associated with the companies.

A: One of the bigger weighted holdings in our US portfolios is Altera [ALTR:NASDAQ]. Altera is a semiconductor company in San Jose, California that specializes in what is referred to as programmable logic.  The company’s main product is called an FPGA, or field programmable gate array.  Essentially, an FPGA can be programmed after it is made.  The same FPGA design can be used in many different applications.  This flexibility compares with the more widely used ASICs, or application specific integrated circuits, that are programmed before manufacture and cannot be changed.  An ASIC is typically used for one product only, and cannot be used in other designs.

Historically, FPGAs were much larger and more costly to use than ASICs, so they were typically used for prototyping new products or for products with small volumes.  As the electrical circuit line widths (the “geometry”) in semiconductors have gotten smaller over time, the complexity of chip design has increased astronomically.  A few years ago, at the 90 nanometer geometry node, the cost to design a new chip was about $20 million.  At today’s 40 nanometer node, the cost has risen to $60 million.  Fewer designs are using ASICs because a higher and higher sales volume is required to offset the cost.  A company like Altera can design one FPGA and amortize the cost over many customer designs.  At the most current geometries, FPGAs have become much more competitive on size as well.

We have owned Altera for several years. Our thesis has been that FPGAs would start to take significant market share from ASICs in the core of many systems and leave behind the prototyping niche. This movement has started to happen, but the FPGA market still remains much smaller than the ASIC market.

A nice feature for investors is that there are really two dominant FPGA companies, Altera and Xilinx, who make up about 85% of the market between them.  This duopoly is competitive, but highly profitable.  Altera’s gross margins are about 65% and its operating margins have begun to move in to the 30’s.  We chose Altera as our preferred investment in the FPGA space because we like the management team and what they have achieved technically with both the FPGA chips themselves and the design software that is used alongside the chips.  Altera’s market share is smaller than that of Xilinx, but we believe they are well positioned to gain share in the future.

We believe the current price (24.81/sh as of the close, Jun 30/10) still offers a discount to our DCF fair value.

The main risk for Altera that could delay its progress is simply the macroeconomic environment.  The company’s products go into many electronic systems, such as wireless base stations, whose sales are driven by capital spending.  An economic slowdown could lead to lower capital spending overall, which would impact Altera’s sales.  As with any company in the technology area, there is also the risk of design or production problems that could hurt the company’s competitive position.

Thank you Mr. Taller!

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