2023-05-02 10:22:36 ET
Summary
- Analog Devices has been growing fast, acquiring Maxim and experiencing an expansion in the analog semiconductor industry.
- In the long term, growth and margins should deteriorate because of the entry of new Chinese companies in the analog space.
- ADI looks expensive compared to its peers, and I expect low returns in the future.
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Analog Devices, Inc. (ADI) has been performing very well compared to the Invesco QQQ Trust ETF (QQQ) in the past year, beating it by around 23% points. Great shareholder compensation from buybacks and dividends combined with strong organic growth have been pushing ADI's price up. Analog semiconductor growth will return to the mean and ADI's long term prospects look worse as Chinese companies increase design and production capacity, making ADI's valuation expensive.
Company profile
ADI designs, produces and sells analog semiconductors used as data conversion products converting continuous values to digital inputs, in power systems, as amplifiers and sensors. It has more than 75,000 SKUs with long product life cycles, sometimes more than 10 or even 20 years.
By selling a lot of diversified chips and having exposure to secular trends like the electrification of the vehicle, industry robotics, smart grids and further digitalization of healthcare equipment, it has some downside protection in an event of a downturn in the economy and/or in the semiconductor industry.
Analog chips usually have the highest gross margins due to lower capital investments, compared with digital chips, to produce them. Long product life cycles and a dense portfolio of SKUs improve the margins by allowing continuous improvement in the SKUs manufacturing process and higher selling prices.
The company has been expanding mostly by acquisitions. It acquired Linear Technology Corporation in 2017 and Maxim in 2021.
Growth
Revenue per quarter in millions (StockRow)
From late 2017 to mid 2021, there was no growth in revenue with a slight contraction from late 2017 to 2019, followed by an expansion from 2019 to 2021. Late 2021 occurred the Maxim merger that boosted the revenue and from yearly 2022 to the last quarter of 2023 there was some organic growth.
Similar to Texas Instruments (TXN) , which is the analog market leader, growth has been slow and consistent across the quarters with some cycles of expansion and contraction. Last two years, ADI and TXN were in a cycle of expansion probably because, firstly, the semiconductor shortage affected analog chips and increased its prices; and secondly, because of the continuous electrification of vehicles, tripling its sales from 3 million vehicles in 2020 to 10 million in 2022, reaching a market share of 13% of the total vehicle sales.
In my opinion, the organic growth will be in the low single digits because the automotive industry, which is accelerating, is the second-biggest end market accounting for 21% of the revenue, while the biggest end market is industrial accounting for 51% of the revenue and industrial growth is slower. On one hand, most of the industrial innovation is mature with automation already being implemented for the past 20 years. On the other hand, generally industry is less competitive than the automotive industry having less reasons to invest in innovation. Still, industrial growth in the case of ADI will come from the continuous robotization of factories, improvement of healthcare equipment, renewable energies, but won't outpace the expansion occurring in the auto industry.
Analog chip value in Electric Vehicles (BCG)
Compared to internal combustion engines, battery electric vehicles will have 2.5 times more analog semiconductor content. This means that by 2035 if we consider there is only production of electric vehicles, the content of analog chips in the automotive industry will more than double. This is a fantastic opportunity for market leaders in the analog segment to grow, but it is also a great opportunity for countries like China, which has the largest automotive market, to build analog semiconductor companies stealing market share from ADI and TXN. In addition, there will be fierce competition from microcontroller and analog producers like Microchip ( MCHP).
Competition
Chip Market share by region (BCG 2022)
According to BCG , companies located in Mainland China will capture a lot of semiconductor market share in the next years. This trend will be seen in the analog chip industry where new and established Chinese semiconductor companies will build new factories and design centers to add much-needed capacity for growing industries like auto and smartphones.
Analog products have long life cycles, some being used for more than 20 to 30 years. The knowledge to design and fabricate these components has existed in the market for a long time, which makes them easier to copy than the most advanced chips. Analog semiconductors require less capital expenditures to design and fabricate. That's why they have the highest gross margins. Chinese OEMs are the second-biggest consumers of semiconductors, only surpassed by American OEMs but might become the largest consumer of semiconductors in the future.
New Chinese entrants in the analog industry have the ability to design analog chips, the capital to invest in new advanced and/or analog chip factories and the proximity to a huge smartphone, PC and auto industry that enables them to build relations and sell their products. Although they won’t be able to have a portfolio and a sales team capable of selling and supporting more than 75,000 SKUs, they still could steal some much-desired market share by the big American companies like ADI and TXN.
Chinese semiconductor companies will be a threat to a focused analog chip company like ADI, but there will also be the threat of established diversified firms like MCHP. MCHP sells microcontrollers and analog chips with most of their analog chips interacting with their microcontrollers, allowing MCHP to bundle analog with digital. By designing and selling the chips together, MCHP creates a technological advantage over ADI and increases the sales of both components. In fact, their analog sales increased organically 22% from 1,500 million in 2020 to 1,900 million in 2022 showing the ability to steal market share from ADI.
Valuation
I'm going to value ADI on a forward EV/EBITDA multiple, because it gives me a more detailed view about the company size as it incorporates net debt in the enterprise value. I prefer EBITDA to earnings or FCF because EBITDA gives a closer estimate of FCF than earnings and it is more easily disaggregated than FCF.
Analog semiconductor market should expand at a CAGR of 7% until 2028. Taking into account the end market distribution and the strong competition, I see ADI growing top line at 3% in the next three to five years. From a macro perspective, the USA consumption is still strong and the labor market keeps raising salaries at a fast rate, therefore, I expect macro to slightly reduce growth and margins. Excluding macro, EBITDA margins are going to get squeezed by the increasing competition in the industry.
YCharts
Historically, gross, R&D and SG&A expenses have been higher than currently. That means that there is a lot of room for expense expansion in an increasingly competitive environment.
Chinese companies might increase design and production capacity to the point where it exists the possibility of dumping prices like they did with steel . Analog prices will go down reducing the top line growth and decreasing the EBITDA margin.
Old analog chips will have to be replaced quicker and improved further to diminish the competitors ability to copy the analog chips and their ability to improve the chips. Customer support has to be enhanced to increase switching costs. These factors will move the R&D and SG&A margins closer to the mean decreasing the company EBITDA margin.
Adding to the 3% revenue growth rate, I consider that the EBITDA margins will decrease in the next years by a few percentage points staying inside the historical range. Although I'm predicting the deterioration of the company's fundamentals, I'm assuming the forward EV/EBITDA will stay the same to make things simple. Instead of modelling the decrease in share count caused by the buybacks, I'm deducing the FCF after the dividend is absorbed as cash affecting the net debt. Since the market cap equals enterprise value minus net debt as we reduce the net debt, the market cap increases.
The model output is 12% total return in three years, which is a good value in a slightly bad scenario, but it is likely not good for investors trying to outperform the S&P 500 or the Nasdaq 100.
Finally, I would like to look at their forward EV/EBITDA compared to other peers because there might be a chance of multiple compression when investors realize there is more competition in the industry causing growth and margins to deteriorate.
Author's Calculation
Looking at the chart, we can see that ADI is the second-most valued company, coming close of its rival TXN. There is room for multiple compression both in TXN and ADI, potentially reducing the targeted return of 12% over three years to a smaller number.
Risks
I see three main risks to my bearish thesis. First, the Chinese market is mainly focused in the faster growing nodes in order to design and fabricate advanced chips for gaming, PCs and servers. Analog chips will be for the most part ignored with the majority of the investment being deployed in advanced chip manufacturing and designing. The probability of this risk to materialize is low because there are sanctions regarding Chinese companies obtaining the most advanced chip manufacturing equipment, which won't allow them to enter advanced nodes and leave them opportunities to invest in legacy chips.
Second, ADI's exposure to the Chinese market is significantly lower than to the USA market, which will reduce the competition affecting the company. ADI sells 33% of its revenue to USA and 21% of its revenue to China. Compared with TXN that sells 55% of its revenue to China and 10% to USA, we can say it has less vulnerability to Chinese competition. This is also a negative for ADI because it will miss out on the potential growth of the Chinese market.
Finally, in my opinion, the risk with the highest impact in my thesis is that to become a useful analog chip producer, a company has to have a dense portfolio of SKUs. The portfolio influences smaller distributors to marketeer and sell your products and helps to win direct customers by improving convenience and technical expertise around multiple products.
Conclusion
ADI is very liked by Wall Street having 58% of the votes on buy and the remaining on overweight and hold. On the short term, ADI looks good since the increase in competition should take some years to materialize although it might happen sooner than expected. Even in my bearish thesis, I see the company returning around 10-12% in the next three years which is a positive sign for the company. By generating very strong free cash flow and having a lot of SKUs, it offers some downside protection in an event of a recession or in an increasing competition environment. For me, the expected return is too low and I rate the stock a hold.
For further details see:
Analog Devices: Faced With Slow Growth And Strong Competition