Analog chip companies have largely been marking time this year, with individual stock performances bracketing the performance of the S&P 500. With expectations for a recovery in industrial, auto, and communications already factoring into the valuations, though, it's worth asking if expectations have gotten a little overheated. Between slower-than-expected industrial markets, high trailing inventory, and a relatively low payout ratio, Linear Technology (Nasdaq: LLTC) seems a little expensive at the current price.
A Weaker Near-Term Leverage Story?
One of the big drivers for analog chip stocks is the likelihood of significant leverage in the coming quarters. With companies like Analog (NYSE:ADI), Texas Instruments (NYSE:TXN), Maxim (Nasdaq:MXIM), and ON Semiconductor (Nasdaq:ONNN) operating well below capacity, the idea is that better utilization will spur significant increases in gross margins that will flow almost directly to the bottom line. 

SEE: 3 ETFs To Play The Semiconductor Rally

It's a fine idea, but I'm a little concerned about how that will work out for Linear in the near term. The company exited the last quarter with a record-high inventory level and nothing in the revenue growth guidance then or end-market developments since has suggested quick absorption of that inventory. Although obsolescence isn't a big threat, it will likely still weigh on results for a couple of quarters and introduce some volatility into the quarter-to-quarter results.
Longer term, this isn't a major concern of mine. Not only does Linear benefit from not requiring the latest in manufacturing technology (which is increasingly expensive), but management has long been ferocious about protecting margins – frequently turning away ostensibly good revenue growth opportunities to preserve the margins.
Autos Looking Okay, But Industrial Not So Much
My bigger concern today is the health of these end markets that Linear needs in order to realize that turnaround. Auto sales for the first half of the year have been pretty good, but there has been nothing from the guidance from major suppliers like Johnson Controls (NYSE:JCI), Honeywell (NYSE:HON), and so on to suggest that demand or build rates are significantly accelerating.
And it looks arguably worse on the industrial side. A large portion of chip demand in the industrial end market is tied to segments like factory automation, process control, and healthcare. None of these are looking particularly robust of late. Between earnings and sell-side conference presentations, companies like Emerson (NYSE:EMR), ABB (NYSE:ABB), and Honeywell seem to be getting more conservative, not less, with respect to 2013 and likewise with robot manufacturers like Fanuc.
Here again, my point is only about the discrepancies between near-term and long-term expectations. For the long term, I see no reason that chip content in vehicles won't increase, nor that factory automation won't continue to grow well – although the efforts of companies like ABB to increasingly develop their own chips could put a twist on things down the road.
The Bottom Line
Even though it's near a 52-week high, I'd still rather own ON Semiconductor than Analog or Linear. For Linear, I think the company will continue to generate strong cash flows and returns on capital, but I don't see enough long-term growth potential to justify a price target beyond the low-to-mid $30s. Couple that with what could be a risk of margin underperformance and wobbly near-term order trends in key end-markets, and I wouldn't feel good about starting new positions at today's price.
Disclosure - As of this writing, the author owns shares of ABB. 

Related Articles
  1. Investing

    The ABCs of Bond ETF Distributions

    How do bond exchange traded fund (ETF) distributions work? It’s a question I get a lot. First, let’s explain what we mean by distributions.
  2. Stock Analysis

    3 Stocks that Are Top Bets for Retirement

    These three stocks are resilient, fundamentally sound and also pay generous dividends.
  3. Investing News

    Are Stocks Cheap Now? Nope. And Here's Why

    Are stocks cheap right now? Be wary of those who are telling you what you want to hear. Here's why.
  4. Investing News

    4 Value Stocks Worth Your Immediate Attention

    Here are four stocks that offer good value and will likely outperform the majority of stocks throughout the broader market over the next several years.
  5. Investing News

    These 3 High-Quality Stocks Are Dividend Royalty

    Here are three resilient, dividend-paying companies that may mitigate some worry in an uncertain investing environment.
  6. Stock Analysis

    An Auto Stock Alternative to Ford and GM

    If you're not sure where Ford and General Motors are going, you might want to look at this auto investment option instead.
  7. Mutual Funds & ETFs

    The 4 Best Buy-and-Hold ETFs

    Explore detailed analyses of the top buy-and-hold exchange traded funds, and learn about their characteristics, statistics and suitability.
  8. Investing Basics

    Learn How to Trade Semiconductor Stocks in 4 Steps

    The enormously diverse semiconductor industry requires market players looking for exposure have specialized knowledge.
  9. Mutual Funds & ETFs

    What Exactly Are Arbitrage Mutual Funds?

    Learn about arbitrage funds and how this type of investment generates profits by taking advantage of price differentials between the cash and futures markets.
  10. Investing News

    Ferrari’s IPO: Ready to Roll or Poor Timing?

    Will Ferrari's shares move fast off the line only to sputter later?
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  5. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>

You May Also Like

Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!