There was ample investor enthusiasm for semiconductor stocks to start the year, but that love has cooled a bit lately. While Analog Devices' (NYSE:ADI) slightly cautious guidance on the next quarter may spook some investors, there's a more important story to keep in mind. Analog Devices has shown remarkable margin preservation through this latest downturn, and the company may be in place to deliver some truly incredible gross margins once orders and utilizations have come back up to speed.

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A Somewhat Wobbly Quarter
Analog Devices delivered results around the low end of its prior guidance range. Revenue dropped 10% on a sequential basis and a similar amount on a year-over-year basis. Consumer spending was especially weak (down 21%) and wireless was quite soft as well (down 13%). While industrial was still negative (down 3%), auto was positive (up 6%).

Despite a modest sales shortfall, margins stayed pretty solid. Analog Devices had a utilization rate of about 67% for the quarter, but gross margins fell just 110 basis points (BPS) sequentially (and three points year on year). Operating income fell 22% sequentially, but the company maintained an operating margin above 28% for the quarter.

Guidance May Feed the Bears
Wall Street is in the business of picking nits and some may harp on the fact that management's guidance for the next quarter was slightly soft. Whereas the sell-side had been looking for 3 to 4% sequential growth, management guided towards 1 to 4% growth.

With that lower end of the range in play, some investors may fret that Analog is lagging its peers. Linear Technology (Nasdaq:LLTC) offered stronger sequential guidance, and both Texas Instruments (Nasdaq:TXN) and Microchip Technology (Nasdaq:MCHP) have been talking about improving momentum in bookings.

Personally, I don't think there's much to worry about here. There may still be some inventory burn going on with industrial customers, and it's reasonable to think that first quarter demand may be a little sluggish on the basis of the slowing European economy. But I see nothing wrong with Analog Devices' management taking a slightly conservative view, particularly given what sounded like an overall optimistic assessment of the market over the next 12-18 months.

Looking for Leverage
Analog Devices and Linear are somewhat famous within the chip sector for maintaining very strong margins in a fiercely competitive industry. What may not be so well-appreciated is that Analog Devices continues to get more and more efficient with time. In fact, I think there's a good chance that as utilization picks back up into the high 70%'s, the company will see gross margins approaching 70%. If it can do that, there's upside to current sell-side analyst estimates.

The Bottom Line
For the present time, Texas Instruments seems to be a somewhat more dynamic option, as the company can benefit not only from the improving market conditions, but expanded market share and margin possibilities. Other investors may want to take a pass on analog altogether in favor of growth stories like Broadcom (Nasdaq:BRCM).

For Analog Devices, the stock is not strikingly cheap today but there is that possibility of substantially better margins when the good times return and positive analyst revisions. I'd definitely keep holding Analog Devices if I already owned it, and though it's not an especially cheap stock today it would still be worth a look to play the ongoing semiconductor recovery story.

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

Tickers in this Article: ADI, LLTC, TXN, MCHP

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