Stocks can be funny sometimes – while Analog Devices (NASDAQ:ADI) is considered one of the best-run chip companies out there, and while it has great leverage to a lot of multiyear secular growth drivers, these shares tend to get left behind when the market turns bullish on the larger semiconductor space.
Since my last update these shares have modestly outperformed the broader semiconductor space, including more direct comps like Microchip (MCHP), NXP Semiconductors (NXPI), and Texas Instruments (TXN), but individual names that I’ve liked better than Analog (including Broadcom (AVGO) and Renesas (OTCPK:RNECY) have done better still.
While management’s announcement that they’re now under-shipping to demand should be a positive, I do still some risk that these shares lag the sector for a little while longer. In my last update I said that investors should look for chances to buy ADI shares in the $140’s and those who did in September/October of 2022 are still showing decent gains. I do believe the shares are still at least 10% undervalued and priced for solid long-term annualized returns, but I would look to get even more aggressive if this recent trend of lagging performance (20% underperformance vs. the SOX over the last six months) widens further.
The Reset Begins…
Analysts and investors in cyclical industries have a tendency to forget during the good times that these industries are still cyclical, and semiconductors are no exception. Lead-times blew out on severe post-pandemic supply constraints and it’s true that long-term demand for chips looks better than ever, but that fundamental cyclicality is still present, and Analog’s fiscal third quarter showed the first sequential revenue decline since early in 2020.
Revenue declined about 1% year over year and closer to 6% quarter over quarter, missing by about 1%. All but one segment was down sequentially, with Industrial revenue down almost 7% (missing by about 2%), Auto down 5% (a small miss), and Communications down 16% (a greater than 6% miss). Consumer was the lone exception, up 14% and beating by more than 12%, with management now confident that the sector has bottomed.
Gross margin declined 190bp yoy and 150bp qoq to 72.2%, missing by about half a point. Operating income declined almost 6% yoy and 12% qoq, missing by 2.5%, with margin down 230bp yoy and 340bp qoq to 47.8%.
Management is currently expecting another two or three quarters of inventory burn among its customers, and that’s driving weaker guidance. Management guided to a 12% sequential revenue decline at the midpoint, or about 10% below Street expectations, and operating margin was likewise guided lower 44% at the midpoint, or 130bp below expectations).
I didn’t really hear anything that surprised me in guidance – management is seeing a deteriorating macro environment across all markets, geographies, and customers, and that’s not too surprising given recent global manufacturing PMI numbers, nor company performances/commentary from the second quarter reporting cycle. Lead-times continue to shrink, and in response management is now actively under-shipping to apparent demand across all of its geographies.
Again, all that has really surprised me here has been the timing. Business has held up a little longer than I’d expected, but the magnitude of the reset is in line with what I’d previously expected. I also think that Analog is in relatively good shape next to Texas Instruments, but perhaps not as good as Microchip and NXP in terms of near-term financial performance.
A Pause That Refreshes
While downturns can exceed expectations just like upturns, and there are some significant macro risks out there (China seems to be tottering and U.S. auto production could get hit by a strike), I’m really not that concerned about Analog from a core fundamental perspective.
Analog focuses on premium products and actively practices self-obsolescence when margins/returns are no longer adequate (part of the reason the company has minimal smartphone exposure and has seen its Consumer business shrink almost by half as a percentage of revenue over the last five years or so). The company has comparatively low capital intensity (even with recent plans to increase capex), and the company enjoys strong share in attractive markets like power management (around 20%, virtually tied with TI), signal conversion (around 55% share), and amps/comparators (around 30% share, with TI at 40%).
Moreover, I see numerous underlying growth drivers for the business in the coming decade.
The auto business should be able to grow 20% or more a year on the back of exceptional strength in areas like battery management (designed into 16 of the top 20 EV OEMs, with more content growth opportunities in wireless BMS) and communications (Gigabit Multimedia Serial Link, or GMSL). While there could be some near-term risk to EV ramps due to supply constraints (like battery materials), and Analog doesn’t have STMicro or Infineon’s (OTCQX:IFNNY) leverage to MCUs and SiC power, they have more than enough to participate in electrification.
Analog is likewise well-leveraged to electrification and automation in industrial and commercial building markets. About a quarter of the Industrial segment is in areas like automated and electronic test – all of which are driven by strong digitalization and electrification trends in a range of end-markets (electric vehicles, factory automation, sensors, et al). Another quarter or so is more directly tied to automation, including robotics, process control systems, and emerging digitalization opportunities like digital twinning (which requires more sensing and connectivity).
Beyond this are other opportunities like mmWave and Massive MIMO in communications, and the eventual expansion of 5G to support industrial IoT. Analog also has decent leverage to what should be a multiyear growth cycle in aerospace, and Analog’s aero/defense offerings are some of its highest-margin products.
I also see nothing wrong with the fundamental business model that Analog uses. The company’s hybrid manufacturing model gives flexibility while preserving margins, and management believes they can still hold 70%-plus gross margins (extremely good in this industry) on a 15% peak-to-trough revenue decline. The biggest risk here may be executing on further operating and free cash flow margin expansion; I see more opportunities for operating leverage on growing chip volume growth over the next decade, but trees don’t grow to the sky.
The Outlook
Of course, there are risks. China is a pretty obvious near-term risk, and it is possible that drivers like industrial automation/electrification will materialize slower than currently expected. So too with the growth of EV production and the expansion of industrial IoT. I do believe these are all “when, not if” opportunities, but time will tell.
I’m slightly below the Street average estimate for FY’23 revenue (up about 2.5% yoy) and further below for FY’24 (down 12%), but I still expect mid-single-digit growth from FY’22 to FY’27 and long-term growth in the neighborhood of 6%. Free cash flow could be a little “wobbly” in the near term due to working capital changes and capex investments into internal capacity, but I think long-term adjusted FCF margins (by my definition, not the company’s) can approach 40% over time (versus a trailing average close to 27%). That would drive 9% to 10% annualized FCF growth.
Between discounted cash flow and margin-driven EV/revenue, I believe Analog is undervalued below the $185-$195 range, and I think investors can reasonably expect a high single-digit annualized long-term total return.
The Bottom Line
Considering the quality of the company, I think Analog offers a pretty respectable return today, and I’d note that sentiment usually starts improving once companies announce they’re under-shipping to demand. Still, I don’t rule out the risk of greater negative revisions over the next couple of quarters, a steeper peak-to-trough correction, and more relative underperformance in the short term. If you don’t mind short-term risk in pursuit of good long-term holdings, this is a name to consider, but if the shares lag more meaningfully, I’d look to be aggressive.
Read the full article here
