I've made no secret in the past of my respect for Linear Technology (Nasdaq:LLTC). This specialist in high-performance analog (HPA) chips is not only one of the largest analog chip companies; it boasts some of the strongest margins and long-term returns on capital in the industry.
Although I believe the company is in a good position to meet growing demand in the industrial and automotive categories, I'm less confident that its business philosophy makes it a great pick for a chip rebound.
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Does this Quarter Mark the Bottom?
Linear had a decent enough fiscal second quarter, with revenue up 3.7% from last year and down about 9% sequentially. Although that was a little short of analyst expectations, it was a modest miss at worst. Computing continues to be quite weak, and the recovery in communications has been sluggish at best. Industrial was weak late in 2012 (no surprise given the fiscal cliff drama), but autos looked a little stronger.
On the profit side, Linear lost a little leverage. Gross margin fell about half a point from last year and a similar amount on a sequential basis due in part to mix and pricing. Operating income was likewise sluggish - down slightly from last year and down 14% from the prior quarter. At 43.5%, Linear's operating margin was more than a point shy of analyst expectations.
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The Markets Aren't Exactly Roaring Back
Listening to management's comments on the call, it sounds like the first two months of this quarter were pretty weak from an orders perspective, with orders improving significantly at the close of calendar year 2012. Even so, management guided to sequential revenue growth of 1-4%, with the mid-point about a point below the prior analyst expectation of 3.5% growth.
Investors should not expect a red-hot recovery from Linear. Almost two-thirds of the company's business comes from industrial and automotive customers, and while those industries may end up with a better 2013 than feared just a month ago, investors have heard a lot of cautious guidance recently. In particular, companies such as Agilent (NYSE:A) and Siemens (NYSE:SI) have been a little cautious on test/measurement and factory automation - big end markets for Linear's industrial chip business.
It's also important to note that Linear's exposure to handsets and mobile devices is very low - just rounding errors compared to companies like Broadcom (Nasdaq:BRCM) and Avago (Nasdaq:AVGO). Consequently, ongoing strength in that market won't help Linear all that much.
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Good Business, but Maybe not the Right Time
There's a lot to like about Linear. The company's IP position is strong, and it has long been a leader in the HPA market. What's more, the acquisition of Dust Networks last year could be a big deal down the road if companies adopt wireless sensor networks in a big way.
On the other hand, Linear manages itself a little different from others. The company is fierce in protecting its margins, and it will turn away growth if it comes at too high a cost to its margin goals. Witness the fact that the company basically let itself get designed out of the Apple (Nasdaq:AAPL) iPad as opposed to taking a lower price. Consequently, I think Linear generally works better as a chip stock to own during tougher times in the chip sector, and not so much during rebounds or growth cycles.
The Bottom Line
Plenty of attractively-priced chip stocks are still out there, including Broadcom and Avago. For Linear, however, I see less near-term potential. On the basis of mid-single digit long-term revenue and free cash flow growth, I believe these shares should trade in the mid-$30 range, more or less in line with the current price. While this chip stock probably has limited downside, I don't think the upside is particularly compelling right now.
At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.
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