INVESTMENT THESIS
BUY-rated Analog Devices Inc. (NYSE: ADI).
In July, Analog Devices announced that it would acquire Maxim Integrated Products in an all-stock transaction that values the combined enterprise at about $68 billion. Maxim’s portfolio of linear and mixed-signal integrated circuits complements ADI’s analog and embedded applications. Maxim’s strength in the automotive and data center markets will further expand Analog Devices’ existing breadth in diverse industrial, communications, and consumer electronics end markets.
With the Maxim deal finalization as much as a year away, ADI continues to experience recovery in key end markets including automotive (up 40% sequentially) and diversified industrial. We look for ongoing strength in communications infrastructure as the 5G network rollout continues. Guidance for fiscal 1Q21 implies double-digit growth in revenues and adjusted EPS as the fiscal year gets off to a strong start.
RECENT DEVELOPMENTS
ADI shares advanced 31% in 2016, below the 70% peer-group gain.
For fiscal 4Q20 (ended 10/31/20), ADI posted GAAP revenue of $1.53 billion.
Analog Devices showed evidence of broad sequential recovery across its end markets, distribution and OEM customers, and regional markets in fiscal 4Q20. The quarter wrapped up an October 2020 fiscal year that was challenging for Analog Devices. During fiscal 2018 and 2019, the company’s communications infrastructure end market experienced softening demand related to the digestion phase in the data center buildout and the pause before the 5G phone base-station cycle.
The pre-5G pause also impacted mobile device demand and hit the company’s personal electronics end-market. Diversified industrial end markets were disrupted by tariffs and trade wars; and the pandemic caused a stoppage in demand from automakers, who shut down in late winter through spring and into early summer.
Most of ADI’s end markets showed good sequential momentum in fiscal 4Q20. The exception was communications infrastructure, which had an exceptionally strong fiscal 3Q20 in which revenue grew 30% sequentially.
The pivot to healthcare products helped offset weakness in areas such as aerospace-defense and semiconductor capital equipment. Automation, including test & measurement, was positive as well.
Communications infrastructure (20% of revenue) continued its strong performance in 4Q20 with 20% annual growth. After a huge fiscal 3Q20, communications revenue declined 14% sequentially. The volatility in revenue partly reflects the lumpy nature of 5G investments. Wireless strength was complemented by demand strength in wireline, as carrier and data center operators worked to keep up with surging traffic across core and edge networks. ADI continues to see 5G as a multiyear tailwind.
Automotive (15% of revenue) experienced a 41% sequential recovery in 4Q20, after being down about 30% annually in both 2Q20 and 3Q20. Automotive grew 1% year-over-year, for its first annual growth in eight quarters. Even predating the pandemic, automotive unit demand showed signs of being sated. Now, millennials’ flight to the suburbs, combined with the multimonth pause in OEM production, has cleared out dealers’ lots. We therefore expect this formerly fast-growing business to resume its strong trends from the middle of the decade, even if full demand recovery may still be few quarters away. We expect automotive unit growth to be supplemented by continued higher semiconductor content per vehicle.
The holiday device-building period was pushed back by the pandemic; sequential recovery in fiscal 4Q20, though significant, likely did not make up for lost demand over late winter through early summer. ADI has lost significant business with Apple, which has embraced facial recognition and no longer needs ADI’s taptic engine for its now-defunct home button. ADI is successfully diversifying the consumer business away from its former overreliance on Apple.
Maxim serves industrial, communications, automotive and consumer markets, similar to those served by ADI.
Within these broad niches, the two companies serve different niches. In communications, where ADI focuses on sales to wired and wireline telecom networks, Maxim has a stronger position in the data center, one of the fastest-growing markets in technology. Maxim’s automotive business is seen as complementary to that of ADI.
Once the companies combine, the breakdown of ADI revenue will be approximately 44% industrial (versus 50%-55% at present), 18% automotive (versus 13%-16% at present), 21% communications (versus 18%-20%), and 17% consumer (versus 13%-15%). The combined company will operate key technology platforms in analog & mixed signal (converters, amplifiers, interfaces, etc.); power management (voltage regulators, PMIC, supervisory, etc.); radio frequency (RF, microwave, and mmWave); and digitals & sensors (DSP, MEMS, optical, and MCU).
In wireline communications, ADI optical controls complement Maxim’s optical data-path connectivity. In the data center, ADI’s data center micro-modules can combine with Maxim’s processor and accelerator power solutions. In automotive connectivity, ADI has auto infotainment platforms that will be enhanced by Maxim’s video and high-speed data serial links. And in digital health, Maxim has optical, electro-chemical and bio-potential sensing solutions that will fit into ADI’s full-system solutions.
From a financial perspective, the deal will boost ADI’s annual revenue from the $6 billion range to about $8.2 billion (based on 2019 pro forma data). Adding Maxim could lower the gross margin to 69% from 70%, and reduce the non-GAAP operating margin to the high 30% range (a projected 38%) from ADI’s current low 40% range.
Those are day-one ratios, however. ADI has demonstrated that it can quickly integrate new assets, drive synergistic growth, and pull acquired businesses up to its own level of profitability. Significant deals in recent years include Linear Technologies in 2017, for $15 billion, and Hittite Microwave in 2014, for $2 billion. The three-year gap between Hittite and Linear, and then between Linear and MXIM, gave ADI time to restore balance sheet cash and reduce debt. Heading into the all-stock MXIM deal.
EARNINGS & GROWTH ANALYSIS
Revenue was above the high end of management’s $1.37-$1.51 billion guidance range and the $1.44 billion consensus forecast.
Non-GAAP earnings of $1.44 per diluted share were up 21% year-over-year and $0.08 sequentially. Adjusted EPS came in above the top of management’s guidance range of $1.22-$1.42 and also exceeded the revised consensus forecast of $1.32.
Non-GAAP earnings of $4.91 per diluted share were down 5% from $5.15 in FY19. F or fiscal 1Q21, ADI guided for revenue of $1.50 billion, +/- $70 million, or $1.43-$1.57 billion. At the guidance midpoint, sales would be up 15% annually and down 2% sequentially. ADI has been conservative in its guidance given uncertainties created by the pandemic. ADI also used non-GAAP EPS of $1.20-$1.40, hich at the midpoint implies 25%-plus annual EPS growth.
Our well-above-consensus forecast implies an overdue EPS recovery after two down years. We are implementing an FY22 non-GAAP EPS forecast of $6.57. We are not yet incorporating the Maxim acquisition into our earnings model and/or earnings estimates for FY22.
FINANCIAL STRENGTH & DIVIDEND
Given its strong cash-flow generation, the company hit its target of two-times operating leverage (based on 12-month EBITDA to net debt) three quarters ahead of internal expectations. We will revisit our financial strength rating as the Maxim deal moves forward.
ADI issued $2 billion in debt in 1Q17 in anticipation of the Linear deal, then added an additional $8 billion in financing directly related to the deal. Significant amounts of that debt have already been paid down.
The company had been paying down debt at a rate of about $1 billion per year; for fiscal 2020, ADI met its goal of paying down $300-$500 million. Net debt was $4.00 billion at the end of fiscal 2020.
Cash flow from operations was $2.25 billin in FY19, $2.44 billion in FY18, $1.11 billion in FY17, and $1.28 billion in FY16. The company continues to target an overall return to shareholders of 80%-100% of free cash flow (after debt service).
The board also authorized an additional $2 billion in share repurchases. Since beginning its repurchase program in fiscal 2004, ADI has bought back over $6 billion of its stock.
Prior quarterly dividend hikes include a 12.5% increase in February 2019, to $0.54 per common share; by $0.03, to $0.48, in February 2018; by $0.03, to $0.45, in February 2017; and by $0.02, to $0.42, in February 2016. The company paid annual dividends of $0.64 per share through the middle of the last decade.
Based on the company’s strong cash generation, we estimate that cash flow from operations will cover dividend obligations by 2.5-3.0-times, and that free cash flow will cover dividends by 2.0-2.5-times in FY20-FY21.
MANAGEMENT & RISKS
Vincent Roche has served as CEO since March 2013. CFO Prashanth Mahendra-Rajah replaced Dave Zinsner, now CFO of Micron. Robbie McAdam heads the Strategic Market Segments organization. Dick Meaney heads the Core Products & Technologies Group.
Any major acquisition carries risks, including overpaying, cultural compatibility, market downturns for a leveraged company, customer and market overlap, and other factors. We believe ADI has lowered its risk of acquiring Maxim by conducting the transaction as an all-stock deal.
The Linear acquisition presented risks based on price and product overlap. The two companies’ product lines have proven to be complementary rather than overlapping. The acquisition of Hittite was immediately accretive to earnings. The integration skills developed in absorbing Hittite helped to integrate the larger Linear, and will also serve with the Maxim integration.
Business with Huawei specifically and tariff headwinds in general are difficult to factor into ADI’s outlook, because these issues are completely beyond the company’s control. We note that Huawei, at most representing a low single-digit percentage of sales, does not represent nearly the customer concentration risk that ADI encountered with Apple, which represented low-teen percentages of revenue in fiscal 2016 and 2017.
COMPANY DESCRIPTION
Analog Devices is a semiconductor manufacturer specializing in high-performance analog and digital signal processor (DSP) semiconductors. In March 2017, ADI completed the acquisition of Linear Technologies.
VALUATION
On November 24, BUY-rated ADI closed at $136.89, down $0.18.
Source: Argus
