Tickers in this Article: ADI, LLTC, ONNN, TXN
Since Analog Devices (NYSE:ADI) reports off the normal calendar cycle, the company's earnings reports can serve as a sort of “mid-quarter” update on the analog sector. To that end, what Analog Devices had to say wasn't terribly encouraging. While there are seasonal recoveries underway in the industrial and auto sectors, signs of a big recovery are still lacking. With many players in the analog sector already having traded up on recovery expectations, value investors may find this stock a little lacking in appeal.

Results Broadly On Target
Analog Devices came in pretty much as expected this quarter. Revenue declined 2% from the year-ago level and rose 6% sequentially, and basically matched the average of sell-side estimates. The company's industrial and auto businesses led the way on the sequential comparisons, with these units up 11% and 14% respectively on largely seasonal recoveries. Consumer remained disappointingly weak (down 6% sequentially), while communications continues to gasp for air (down 2%).

As expected, ADI's margins continue to track to revenue trends. Gross margin declined more than a point versus last year, but improved more than a point sequentially, matching Street expectations. Operating income was basically unchanged (down 1% from last year and up 1% from the prior quarter), while operating margin was just slightly lower than expected.

SEE: A Look At Corporate Profit Margins

A Quick, Sharp Turnaround Isn't Shaping Up
Listening to the conference calls of companies in the industrial and communications markets this past quarter, it sounds less and less likely that we'll see a sharp second half recovery. Analog Device's guidance would certainly seem to support that a big improvement is not coming over the summer. While the Street had been looking for 4% sequential growth, the midpoint of management's guidance came in a little below 2% sequential growth.

Some of this may prove to be Analog Devices-specific. There are concerns, for instance, that the company lost the microphone business for the next Apple (Nasdaq:AAPL) iPhone. Even so, it doesn't sound like there's enough momentum in core markets like industrial, auto, or communications to get excited about peers like Linear Technology (Nasdaq:LLTC), Texas Instruments (NYSE:TXN), Microchip Technology (Nasdaq:MCHP), or ON Semiconductor (Nasdaq:ONNN) – or at least not on the basis of an underlying market demand recovery.

SEE: Can Earnings Guidance Accurately Predict The Future?

Little Is Likely To Change For ADI, Apart From Capital Allocation
In the wake of the unfortunate passing of CEO Jerry Fishman, I don't believe that much is going to change with the Analog Device story. This is still a powerful margin leverage story, where higher volumes should lead to higher utilization and meaningfully higher margins (which will produce higher earnings and cash flows).

Likewise, I believe Analog Devices will continue to run itself as it has always done. M&A is not likely to be much of the story, unless the company can finds an undervalued opportunity in the analog or DSP space where it can acquire a fabless company and bring that production in-house (to improve utilization and margins).

It does appear that the company is changing its capital allocation policies, though. Analog has long held on to large amounts of cash – much more than it needs for normal operations (particularly since it doesn't do many M&A transactions), and (perhaps more arguably) more than it needs to survive the cyclicality of the industry. Now the company is looking to change that, lifting its payout target to about 80% of free cash flow (FCF) in the coming years from a historical rate in the 60%'s and 70%'s.

SEE: Free Cash Flow: Free, But Not Always Easy

The Bottom Line
I do still believe that Analog Devices is something of a coiled spring when it comes to improving its utilization and margins. But I also don't think there's much of anything that the company can do to accelerate that process. As a result, I'm drawn more to company-specific stories like ON Semiconductor, Avago (Nasdaq:AVGO), and perhaps Atmel (Nasdaq:ATML) where operating improvements, product cycles, and so on can have a bigger impact.

I'm also of the mind that Analog isn't a particular value here. As I see the company likely to produce mid single-digit FCF growth across the full cycle, $45 seems like a pretty fair price for the stocks. While I do think these shares could offer a trading opportunity if and when the company's core markets improve, less short term-oriented investors may find less appeal here.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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