Analog Devices Marking Time Until The Rebound

By Stephen D. Simpson, CFA | November 28, 2012 AAA

Apart from a few signs of life in the telecom infrastructure space, there hasn't been much to cheer about for semiconductor stock investors lately. Consumer electronics are still pretty weak, auto build rates have slowed noticeably and industrial demand has swooned on macro/fiscal worries for 2013. All in all, Analog Devices (Nasdaq:ADI) did OK for its fiscal fourth quarter, but the reality is that these quarters are basically "filler" ahead of the next rebound.

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OK Numbers, but Some Softness in Gross Margins
Analog's fiscal fourth quarter certainly wasn't strong, but it wasn't really out of line with other large chip companies like Linear Technology (Nasdaq:LLTC) and Texas Instruments (Nasdaq:TXN). Unfortunately, there wasn't much in the company's guidance to suggest a rebound is coming soon.

Revenue fell 3% from last year and rose 2% from the fiscal third quarter. The large industrial segment (more than 40% of revenue) saw revenue come in 5% lower sequentially, and lower than management had expected. Likewise, revenue for the auto segment (down 4%) was disappointing. The consumer segment saw a big sequential improvement (up 28%), likely helped in part from Apple (Nasdaq:AAPL) business, but the year-on-year comp of 7% was the worst of the four segments. Communications was, oddly enough, the bright spot as revenue rose 3% sequentially on improving 3G and 4G deployment activity.

Margin performance was definitely mixed, though. Utilization slipped again (to about 67% from 70% last quarter), and gross margin slid almost two points on a sequential basis. Although the company recaptured some of this through leaner operating expenses, adjusted operating income still declined about 1% from the fiscal third quarter.

No Good News Soon
I can't imagine that anyone following the earnings cycle of Linear, TI and Microchip Technology (Nasdaq:MCHP) was expecting Analog to have great news in terms of guidance. That said, the range of a 6 to 12% sequential decline in revenue was a little worse than the norm. Likewise, the company's decision to actively manage its inventories and run its utilization rate into the mid-50% range is going to have gross margin consequences. For what it's worth, it's a decision that Microchip has also taken as a means of controlling chip inventory.

Analog would certainly benefit from a good, solid rebound in industrial end markets (as would Linear), but that may not be so quick to arrive. Worries about Europe, China and the U.S. fiscal cliff have companies pulling back, and a range of companies from Eaton (NYSE:ETN) to General Electric (NYSE:GE) to Illinois Tool Works (NYSE:ITW) have set the stage for at least a weak start to the next year.

Can Investors Wait for Things to Get Better?
Although this has been a pretty lousy year for most chip stocks, Analog has actually outperformed both the S&P 500 and most other chip stocks of significant size. It's not as though this outperformance isn't deserved - even in a tough year, Analog converted about a quarter of its revenue into free cash flow, and the company pays a good dividend.

That argues for patient investors hanging on for that eventual recovery. I still believe that Analog has significant margin improvement potential when demand recovers and pushes up fabrication utilization rates, and that will be good for profits and cash flow. The trouble is that the recovery might not materialize for at least a few more quarters, and I don't think Analog can continue to outperform the broader market if that recovery continues to slide back.

The Bottom Line
There are certainly some individual semi names here and there that could be more compelling today - I like Broadcom (Nasdaq:BRCM) and Qualcomm (Nasdaq:QCOM), and LSI (NYSE:LSI) looks pretty interesting (though risky too). Likewise, I can't say that Analog Devices is strikingly cheap at today's levels. But when it comes to quality and total return prospects, I still see nothing wrong with long-term shareholders sticking with this leading player in analog chips.

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

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