DJ SMARTMONEY DAILY SCREEN: Can Analog Devices Get Respect?
By Ian Mount
Smartmoney.com
NEW YORK (Dow Jones)--Semiconductor makers certainly learned all about terms like "market correction" and "investor stampede" last year. When a combination of overcapacity, Asian downturn and investor fears united in the first half of 1998, chip stocks couldn't win for losing.
But 1999 has seen a resurgence in the sector, and today's screen, a search for rising but underappreciated stocks, turned up a disproportionate number of semiconductor makers. When we looked for companies that had beaten the S&P over both the near term and long term but were still trading below their peers (and had not received analyst upgrades in the last month), three of the 12 we turned up were in the semiconductor group.
And while the three chipmakers we came up with are up just over 60% since this time last year, just like the sector as a whole, they differ from their peers in one significant way: They had to climb out of a deeper hole. SmartMoney pick Analog Devices (ADI), Milipitas, Calif.-based Adaptec (ADPT) and little Unitrode (UTR) all had a horrendous 1998, even by industry standards. In each case, a problem above and beyond the general industry downturn - a ball dropped by management, a one-time writeoff, an important lost contract - made 1998 just a little worse for investors. So it should come as no surprise that they've been rewarded with lower multiples than their competitors.
The upside here comes from buying a s tock "warts and all" and hoping that the warts can be removed painlessly. It takes a lot of trust to buy these flawed gems (and it's your money, right?), but we think that the risk is worth the rewards.
Given our tortured history with Analog Devices, we thought it only fitting to focus on this stock. SmartMoney picked the Norwood, Mass., chipmaker as a bargain tech stock in Fall 1996, and it rose 130% in a year. We then named it a SmartMoney pick in 1998, only to be rewarded with a 20% loss. Will 1999 mark a return to greatness?
Today's earnings announcement, which ended a four-quarter streak of year-over-year revenue declines, was a good start. For the second quarter, the company exceeded expectations with revenues of $340 million, up 2.1% from the same quarter a year ago, and earnings of 25 cents per share (excluding a three-cent R&D writeoff). The company's gross margin - a standard chip industry yardstick - also grew to its highest point since the first quarter of last year. And Wednesday the stock was up too, 1 7/16, or 3.6%, to 41 3/16.
On first glance, it looks like the company has already finished its turnaround. And its valuation, though still below the industry average, is getting close. If that's all true, what's the upside for investors? "I personally think the wonderful thing about ADI is that the farther down you go, the bigger upside you have," says Erika Klauer of BT Alex. Brown. "Everyone is in a cyclical recovery, but Analog has a bigger upside."
What sent Analog into the toilet that Klauer speaks of was a significant decline in its chip sales to automatic testing-equipment maker Teradyne (TER), which, according to Klauer, had accounted for 10% of Analog's business and during last year's Asian financial crisis, "basically went to zero." The company had also made bad choices in the digital handset market, ending up with manufacturers such as Royal Philips Electronics (PHG), which lost out to Nokia (NOK) and Ericsson (ERICY).
But according to Joseph Osha, an analyst with Merrill Lynch, talks with Teradyne and Applied Micro Circuits (AMCC), another Teradyne supplier, suggest that Teradyne is burning through inventory and poised to place new orders. And in a conference call today, Analog CEO Jerald Fishman said the second quarter brought the "first signs" of an increase in orders from ATE customers and indicated that these orders accounted for about $10 million in revenues, up from $5 million the quarter before but still well off quarterly highs of more than $30 million.
SG Cowen Securities analyst Drew Peck dismisses the telephone problems, saying that Analog has other opportunities and telecom "may not be an industry they want to focus on" because industrywide standards mean that chipmakers have to compete on price, not product differentiation. This facile argument has a little "Well, I never liked you anyway" sound to it, but other industry watchers agree that Analog should prosper without being a major player in the telephone world, where Texas Instrument s (TXN), Lucent (LU) and Motorola (MOT) dominate.
About 70% of the company's revenue comes from analog chips, which translate real-world inputs into digital data (and vice versa), and the rest come from DSPs, or digital signal processors. But while analog chips provide a higher margin (about 60%), DSPs (which are used in, among other things, the wireless handsets), are expected to be the growth leader in the semiconductor industry over the next five years or more.
Analog has moved into the DSP world d ominated by Texas Instruments, and signed a product-development agreement earlier this year with Intel (INTC) that, though still speculative, has given heart to some company watchers. According to Tom R. Halfhill, an analyst with Silicon Valley technology research firm MicroDesign Resources, the relationship could help Analog leverage the bigger company's might to move into the PC market and also further into the embedded systems market (all those chips that run Furbys, CD players, etc.). In addition, a new h igh-end DSP chip Analog is developing, the Tiger Sharc, competes favorably with a similar chip from Texas Instruments.
"There are reasons to be optimistic about ADI," says Halfhill. "If they can deliver on the performance projections that they made, it would be a significant advance for them. "
And according to Klauer, Analog's "very, very lean" organization leads her to expect up to a 10% improvement in its gross margin, compared to an upside of 5% for companies like Texas Instruments.
But one asp ect about Analog that may scare investors - or may really hurt the stock - is the company's lack of a DSP fabrication plant. The company reduced its stake in the WaferTech chip fabrication plant after taking heavy losses in that venture, and now only owns 4%. While not having a DSP fabrication is a good move in bad times (because you don't have to keep it running to capacity), having one in flush years can mean that subcontractors, who are filled to capacity, will likely process their own work before Analog's. To avert this, Klauer expects the company to use its relationship with Intel.
Our main worry about Analog is its increasing valuation. While it once was trading at a great discount to its peers, it is moving into line. Even bullish analysts like Chris Chaney of A.G. Edwards, admit that the company's multiple is growing to the point that it may be a better investment for long-term investors than for those looking for short-term surges.
Still, the stock's multiples are lower than those of its closest competitors, Maxim Integrated Products (MXIM) and Linear Technology (LLTC), which trade at a 10% to 20% premium to Analog on projected earnings. And with the whole semiconductor market enjoying a resurgence, Analog should at least see incremental growth and an upward trend.
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