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.
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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.