By Thomas W. Smith, CFA
Strong Signals from ADI
The integrated circuit maker's latest earnings lack excitement, but healthy trends in its niche markets should ignite growth
On Nov. 19, Analog Devices (ADI ) reported results in line with consensus expectations for the October quarter. Revenue rose 8% year-to-year, and 2% quarter-to-quarter. The chipmaker said it expects revenue and earnings per share (EPS) for the January quarter to be flat, vs the October quarter. Like many other chip companies, ADI offered little specific guidance for two or more quarters ahead. Overall chip sales remain in the doldrums in the second half of 2002, and are on the way to better times in 2003. While ADI's report may sound rather ordinary, try reading between the lines.
We at Standard & Poor's interpret much of the general guidance from Analog Devices (ranked 5 STARS, buy) as bullish for the company, as well as for its competitors operating in the high-end analog, mixed-signal, and digital-signal processor (DSP) markets (mixed-signal chips have both analog and digital features).
First, management reminds us that the penetration of chips into electronic goods such as wireless handsets and base stations, medical equipment, DVD players, and digital video cameras is generally rising, and the present level of about 15% appears headed toward 20% over the next few years. Second, the percentage of semiconductors associated with signal processing is rising. As folks want more high-quality voice- and video-transmission equipment, and wireless everything, the need for digital-signal processors and the complementary analog chips that surround them will be in high demand.
LEADING MARKET SHARE. Given these two favorable trends, the company believes it can grow revenue at a 20%-to-25% pace for some years to come. This forecast is subject, of course, to the periodic downturns of the whole economy and the cyclical semiconductor industry.
Analog Devices has weathered the industry downturn better than many of its peers because of its focus on the high-growth DSP market. It's at the forefront of developing integrated circuits for a wide range of real-world signal-processing applications. Real-world signals such as sound waves, light, heat, pressure, and acceleration are streams of continuously varying information. Conversion of these analog or "linear" signals to and from the ones and zeroes of the digital world for processing, storage, and transmission requires a series of sensors, data converters, amplifiers, and other components.
Analog Devices holds a leading market share of nearly 40% in both data converters (30% of ADI's revenue) and high-end amplifiers (20% of revenue). ADI sources another 25% of revenue from other analog and mixed-signal semiconductors, and 20% from DSPs.
LEADING THE WAY. The rise of signal processing is evident in the latest semiannual forecast from the Semiconductor Industry Assn. As evident in the table below, DSPs are expected to outgrow the industry in worldwide sales through 2005. Growth for analog chips as a broad category is more in line with the industry, but we believe sales of high-end analog will likely exceed the industry.
A common refrain among industry observers was that the SIA forecast is too optimistic, and that industry growth in 2003 might more likely be in the 10% to 15% range rather than the SIA's 20% projection. Even if overall chip sales in 2003 should run slow, we think DSPs would still outrun most other chip types, and that DSP sales growth in 2004 would still likely be 20% or above judging from past industry-cycle patterns.
Worldwide Semiconductor Sales (in millions of dollars and percentage change)
2000 2001 2002e 2003e 2004e 2005e
Analog 30516.3 23180.2 23878.2 28334.9 34529.5 36332.3
38.2% -24% 3% 18.7% 21.9% 5.2%
DSP 6141.5 4256.1 4890.8 6511.5 8393.5 9409.3
40% -30.7% 14.9% 33.1% 28.9% 12.1%
Total Integrated Circuit 204393.6 138962.6 141402.4 169334.6 206033.8 205506.0
36.8% -32% 1.8% 19.8% 21.7% -0.3%
e= estimate. Source: World Semiconductor Forecast 2002-05 (Nov. 2002) published by SIA
BIGGER WAFERS, WIDER MARGINS. For ADI, a strong point in 2003 will be the completion of a factory transition to larger 6-inch and 8-inch wafers. The switch will allow the company to fit more chips on each wafer and thereby raise efficiency compared with production on the present 4-inch wafers. The transition should be largely in effect and begin to boost gross margins in the April quarter.
We expect ADI's gross margins to improve from about 53.5% in fiscal year 2002 (ended October), to 57% in fiscal year 2003 and 60% in fiscal year 2004. This margin improvement also comes in part from greater revenues being spread over a fixed-cost base. Most of the costs for the transition have been paid, implying low capital expenditures for the next couple of years.
OTHER PLAYERS. Based on the notion that there are likely to be two strong years for semiconductor sales ahead in this industry cycle, and that ADI is well-positioned in some key niches and should see some improvement in production efficiency, it's presently our favorite play in this part of the chip industry.
ADI carries a moderate amount of debt, but the valuation is typically lower than for the pure-play high-end analog chipmakers. Prior to its latest earnings release, ADI was S&P's Focus Stock of the Week (see BW Online, 11/11/02, "A Chipmaker in the Sweet Spot"). In that report, our valuation assessment is laid out in more detail.
Other companies toiling in similar fields include Texas Instruments (TXN , ranked 2 STARS, avoid), which makes DSPs, high- and low-end analog, and a variety of other chips. Maxim Integrated Products (MXIM , ranked 3 STARS, hold) and Linear Technology (LLTC , ranked 4 STARS, accumulate) develop high-end analog chips, and boast high gross margins and no debt.
Analyst Smith follows semiconductor stocks for Standard & Poor's
Edited by Karyn McCormack
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