ADI - Analog Devices Trying To Execute A Soft Landing In A Still-Evolving Chip Sector Correction

2023-11-17 13:04:12 ET

Summary

• The semiconductor down-cycle is underway, with lead times continuing to decline and demand softening in major end-markets like industrial and communications.
• Analog Devices has handled the downturn well, focusing on higher-margin opportunities and tight channel inventory management, but there is still a risk of a larger-than-expected cut to next quarter guidance.
• Chip demand should trough in 1H'24, and Analog is looking at years of above-average growth opportunities, driven by its leverage to high-value auto, aero/defense, industrial, and communication markets.
• Analog shares are worth owning below $200 and the upcoming earnings/guidance report could offer a chance to buy in on weakness.

The semiconductor down-cycle is well underway, with lead-times already down about a third from the record high seen mid-2022, but a lot of uncertainty remains as to just how the bottoming out process will go. The down-cycle has taken longer to materialize due in part to customers hanging on to more inventory to de-risk their supply chains and catch up on backlogs, but it’s certainly here now and demand has softened in many major end-markets.

Analog Devices ( ADI ) has worked to actively manage this downturn, undershipping relative to demand and focusing on higher-margin, higher-value opportunities to support margins. I believe this has helped the stock outperform many of its peers since my last update (though modestly underperforming the broader semiconductor sector), and I believe that can continue to be the case. I do see some risk of a larger-than-expected cut to next quarter guidance when the company reports on Nov. 21, but I’d regard a sell-off as a buying opportunity.

Demand Is Softening And Estimates Are Coming Down

Between recent evidence of ongoing demand weakness (ongoing declines in lead-times, distributor services pointing to weak demand, and so on) and semiconductor earnings reports that included weaker than expected guidance for the next quarter (including, but not limited to, Microchip ( MCHP ) and Texas Instruments ( TXN )), estimates for Analog’s fiscal first quarter of 2024 have been coming down ahead of the upcoming fiscal fourth quarter report – anticipating that the company will more or less match the “meet and lower” pattern that other analog chip companies have followed recently.

To that end, expectations for that fiscal first quarter are about 5% lower now at the revenue line relative to when I last wrote about the company and closer to 15% lower relative to mid-year expectations (before the company warned of two or three further quarters of inventory burn-off), and earnings expectations have come down even more in anticipation of weaker margins on lower capacity utilization and persistent cost inflation.

There’s not much dispersion in estimates for fiscal Q4’23, with the sell-side all within about 1% of each other at the revenue line and within 30-40bp at gross margin. There’s a nearly 10% spread between the high and low revenue estimates for Q1’24, though, and likewise a broader range of estimates for gross and operating margin.

With many sell-siders (and likely many investors) already anticipating a weaker guide, I think Analog’s upcoming earnings/guidance report is more meaningfully de-risked. Texas Instruments set the tone , and I expect a more measured guide along the lines of the softer landing anticipated in NXP Semiconductors ’ ( NXPI ) guidance where this company too has been undershipping relative to demand to maintain better channel inventory control as demand softens.

A Typical Cyclical Correction, With Growth On The Other Side

Despite more than a few sell-side analysts making predictable “it’s different this time” calls in 2022 alleging that the semiconductor industry had changed and the past cyclicality would be changed by the ongoing expansion of chip usage in new markets (like electric vehicles), nothing has actually changed that much.

The particular combination of surging demand from new markets (like EVs) and excessive capacity/inventory corrections during the pandemic did leave the industry flat-footed and lead-times ballooned to a new record as customers scrambled to secure enough semiconductors to deliver on their own backlogs. Since then, though, meaningful new capacity has come online and demand has softened, with broad weakness in China and weakness in particular end-markets like consumer devices, industrial, and wireless (particularly 5G equipment).

Assuming that the most recent guidance from Microchip, NXP, STMicro ( STM ), and Texas Instruments proves accurate, and likewise that Analog’s prior guide for two to three quarters of elevated inventory digestion holds up, this will end up being a pretty typical two-year correction cycle with revenues down about 20% to 25% from peak to trough. The markets may change, but this cyclicality really doesn’t.

Looking at particular markets, I do see some modest risk to Analog’s auto market outlook. While the company has minimal exposure to the UAW strike (the Big Three is <10% of auto sales), pushouts on EV launches are a threat to battery management-related sales. On the other hand, connectivity, audio/visual, and ADAS are pretty much powertrain-agnostic opportunities for Analog, so the risk from EV pushouts is relatively limited.

I’m comfortable with Analog’s aero/defense and healthcare exposure, as I expect both markets to remain healthy, and defense could offer some upside. Industrial is a known risk for the near term, as automation and instrumentation (including test equipment) demand bottoms out, and likewise with 5G-related wireless. Data center and wired communication should be healthier, particularly with Analog’s leverage to increased content in higher-speed connectivity (400G and beyond).

The Outlook

Analog’s fiscal second quarter of 2024 (the April 2024 calendar quarter) should be the low for the cycle, and I expect healthy growth thereafter albeit with some uncertainty on the timing – China has yet to inflect and there's still risk to assuming a recovery in short-cycle industrials in the second half of 2024, particularly given the uncertainties around the election cycle.

Once the cycle turns, though, Analog should be looking at strong revenue growth opportunities. Management’s 7% to 10% revenue CAGR guidance looks plausible, driven by content growth in autos (electrification, including battery management, connectivity, and audio processing), data center, industrial automation (including leverage to electrification, automation, and sensing), healthcare, defense, and 5G (including edge computing/industrial IoT-driven demand).

I also expect Analog to be a strong performer where margins and free cash flow are concerned. Analog is fairly aggressive with self-obsolescence and willingly walks away from business with sub-par returns (a change in strategy that has greatly aided O n Semi ( ON ) recently), and the company is less vulnerable to competition from Chinese chip companies on the low-to-mid-range end of the analog spectrum. Analog isn’t going to challenge Broadcom ’s ( AVGO ) 60%-plus operating margins, but it should comfortably outperform rivals like Microchip, NXP, and TI with margins in the mid-to-high 40%.

All told, I’m looking for longer-term revenue growth of around 6%, and I’d note that my FY 2024 revenue estimate is still lower than the sell-side average ($10.8B versus 11B), but no longer so low relative to the low end of Street expectations (the lowest published estimate I see for FY’24 is currently $9.2B). On the margin side, I do expect operating margin to dip into the low-40% next year, but recover into the high-40% in a couple of years.

At the free cash flow line, I do think Analog’s hybrid fab-light strategy does limit the risk of surplus/under-utilized capacity (particularly relative to Texas Instruments), but at the cost of less leverage to a stronger-than-expected recovery. Said differently, this is a lower-risk strategy, and if the next phase of the cycle is stronger than expected, TI will benefit more (relative to Analog), but Analog will generate stronger FCF margins. I’m looking for long-term adjusted FCF margins approaching 40%, driving FCF growth of around 9%.

The Bottom Line

I believe Analog is undervalued on discounted cash flow, particularly relative to its quality, and can offer a high single-digit long-term annualized total return from here. I also think the shares are undervalued below $200 on the basis of margin-driven EV/revenue and EV/EBITDA. I see some risk of a weaker-than-expected FY’24, but I think this is a name that would be well worth buying on weakness given management’s strong execution on margins and the multiple growth markets that the company will be addressing in the coming years.

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