It's getting a little more difficult to find fresh things to say about Analog Devices (Nasdaq:ADI). Just as it was a quarter ago and a year ago, this company remains one of the best analog chip companies (one of the best semiconductor companies overall, actually), and it remains stuck in a macro environment that just isn't moving forward fast enough. Significant margin potential remains dormant within this company, though I fear Wall Street's love for the company has eroded the discount.

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A Somewhat Somber Third Quarter
Analog Devices didn't post a bad fiscal third quarter, but it wasn't great either. Instead, it looks like more of the same "muddle through" that has become all too familiar lately. Revenue fell 10% from last year, but it did rise 1% sequentially - good enough for the company to come in at the bottom of its guidance range, but no better. Not too surprisingly, there wasn't a lot of revenue growth variability by product line. Analog and amplifier products did best with 2% sequential growth, while power management was the laggard at negative 1%.

Margins continue to be a feature part of the "hurry up and wait" thesis; they're not bad, but this quarter is far from what the company can do in better times. Gross margin continued to improve sequentially (up 40 basis points), while eroding from the year-ago period (down about a point and a half). Likewise, operating income improved slightly on a sequential basis, while falling by more than 20% from last year on an adjusted basis.

SEE: Analyzing Operating Margins

A Familiar Story at the Macro Level
There weren't too many surprises in the company's guidance. While it did point to a revenue midpoint below prior expectations, it was a modest revision. Arguably the bigger news is that the company continues to see below-normal seasonal patterns. On a more positive note, guidance does point to a book-to-bill above 1.0.

Looking at Analog's end markets, industrial was flat this quarter, and the company seems to be doing reasonably well relative to other industrial-exposed chip names like Atmel (Nasdaq:ATML), Linear Technology (Nasdaq:LLTC) and ON Semiconductor (Nasdaq:ONNN). If there was encouraging news, it was that management said initial orders from large industrial customers declined but have stabilized.

Other markets are still looking wobbly. Autos remain weak on pressure in Europe - not great news for Maxim (Nasdaq:MXIM) or ONNN, while communications is still unpredictable. Analog Devices saw good sequential growth this quarter (up 9%), but guidance suggests that there's still no sustained improvement in the market - something investors in companies like Alcatel Lucent (NYSE:ALU) and Ciena (Nasdaq:CIEN) ought to consider.

SEE: Vital Link: Manufacturing And Economic Recovery

On a more positive note, it looks like consumer revenue will pick up strongly. Connecting the dots, there's pretty strong evidence that Analog Devices won a socket in the new Apple (Nasdaq:AAPL) iPhone (most likely the MEMS microphone). Keep in mind, though, that winning Apple business is like being invited to Fight Club - you can't talk about it, so it's just speculation at this point.

The Bottom Line
With utilization down around 70%, Analog Devices is not showing its full potential in terms of margin. Of course, there's no telling when the macro picture will improve such that the orders roll in and allow management to really show what the company can do. Consequently, this remains a story with significant untapped potential, but not much clarity as to when the tapping will occur.

The downside to the stock today seems to be more about its popularity than its risk; most analysts are already on to the margin improvement story, and investors have long appreciated that Analog Devices has a relatively reliable safe harbor in an unreliable industry. Consequently, the valuation isn't all that compelling to me.

SEE: Equity Valuation In Good Times And Bad

If Analog Devices sees mid-single digit revenue growth for the bulk of the next five years and that expected margin leverage, fair value would seem to be around the mid-$40s. While that's a lower revenue estimate than those carried by the sell-side, going with their numbers (mid-to-high single digit revenue growth) only adds about $2 to the fair value number and moves it to the other side of the mid-$40s. Either way, while that may be good enough to play a momentum thesis built around improving industry fundamentals, it's not a lot of core undervaluation for value-inclined investors.

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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