2023-12-27 01:01:14 ET
Summary
- I maintain my buy rating for ADI.
- ADI's recent results show potential for growth turnaround and further margin expansion.
- For valuation, I expect ADI's valuation to gradually trade down to its mid-cycle level.
Investment action
I recommended a buy rating for Analog Devices, Inc. (ADI) when I wrote about it the last time , as I believed ADI was the leader in the energy storage and automotive electrification sectors. The ongoing progress made back then in innovation and positioning itself to be aligned with environmentally friendly transportation should drive growth and margin expansion. Based on my current outlook and analysis of ADI, I recommend a buy rating. I believe FY24 might be the trough for this cycle, and ADI will start to see growth recovery soon. There are also possible indicators that led me to believe earnings could grow faster than the top line.
Review
Starting off the post with a review of the price movement. I wrote my initiation post in mid-October, when the stock was priced at ~$175. While the shares dropped to $154 a little after my post, it was followed by a strong rally to the $197 share price today. Hence, ADI has already reached my previous target price. Below, I review the recent results and my expectations for the future. For 4Q23 , ADI generated $2.717 billion in revenue, representing a 16.4% annual decline. While growth declined, it was better than expected, largely due to the strength in automotive and communications, partially offset by the weakness in industrial and consumer. The business also generated EBITDA of $1.56 billion and non-GAAP EPS of $2.01.
While the headline results are not very attractive and supportive to a buy rating, other operating metrics and qualitative indicators are certainly sending a much more positive message. To begin, although the book-to-bill ratio was still below 1x in 4Q23, bookings were up sequentially and cancellations were down significantly for the first time in over a year. Moreover, sell-through continues to outperform sell-in, suggesting that underlying demand has not deteriorated. All of these indicate to me that bookings have reached a stabilization phase, and is certainly an encouraging sign given that ADI is in the midst of the downturn. Secondly, I think the continual stability of pricing is limiting the revenue decline during this downturn. Thirdly, lead times have evidently normalized for more than 95% of ADI's SKUs. The counterargument to this lead time normalization is that it reduces the visibility into future revenue streams. However, I think that view is too myopic (focused on the near-term). A decrease in lead time is, in my opinion, a good thing because it discourages clients from placing unnecessary large orders (which often comes with incentives that hurt margins). In other words, more profitable growth.
ADI 4Q23 results also led me to believe that earnings could grow much faster than revenue, given the potential for margin expansion. At the gross margin level, I thought ADI performed very well given the huge drop in revenue and lower utilization rates. Looking at historical cycles, ADI gross margin typically drops by ~400 bps, which is how much it has dropped so far since the peak margin in 2Q22. I believe the trough to gross margin is near, especially when we consider that pricing has now stabilized and the growing adoption of hybrid manufacturing approaches. The latter improves the utilization rate, as ADI can now switch between external foundries and internal manufacturing depending on the industry situation. In other words, it helps to cushion any gross margin compression in a downturn due to low utilization rates.
Coupled with gross margins possibly turning around, ADI's ability to manage its operating expense profile bodes well for margin expansion. Over the past 10 years, ADI has reduced operating expenses as a percentage of sales by more than 1000bps. The recent spike over the past two quarters is largely due to the downcycle, mainly due to a lower revenue base. Suppose this reverts back to the 2Q23 level of 22.5% in the near term as the cycle turns; this implies a ~300bps margin expansion tailwind that should drive acceleration in earnings growth. On an absolute basis, 4Q23 operating expenses have declined from $752 million in 3Q23 to $692 million in 4Q23 and are expected to further decline by a low single-digit percentage in 1Q24. As such, I think there is a good chance for earnings to grow faster than the top line.
Valuation
Author's work
As I roll forward my model to focus on FY25, I think the upside is now much more attractive as the market is likely to start pricing in the recovery growth in FY25. Looking at ADI historical growth performance, after each downturn, it follows a small recovery followed by a huge growth in the high-teens percentage. For my model, FY24 should be the small recovery phase, and FY25 is the year where ADI will see stronger growth. For FY25, I am assuming 10% growth, half of the typical ~20% strong growth to be conservative. As for margins, I assume operating expense as a percentage of revenue to revert back to 2Q23 levels, driving 300bps expansion tailwind over the next 2 years. Valuation, on the other hand, should start to revert back towards the mid-cycle level as the cycle turns positive. ADI is currently trading at 24x forward EBIT (which historically trades between 13x and 20x), and I expect valuation to gradually trade down to 17x in FY24. I would not be surprised if ADI trades at a higher valuation in the near term as the market continues to price in elevated growth (recovery phase), but I think it is safer to assume a mid-cycle valuation to be conservative.
Risk and final thoughts
The risk is that the exact timing of recovery is difficult to predict. While there are many indicators that point to a potential trough in FY24, things could definitely get worse, and history might not be a good benchmark for this cycle. The current cycle is faced with rising rates, a tight labor market, and high inflation, all of which have not been present in the past two cycles. As such, I would recommend investors be more cautious when sizing positions.
I maintain my buy rating for ADI. Despite a slight revenue miss in 4Q23, qualitative indicators like improved booking trends, stabilized pricing, and normalized lead times suggest a potential turnaround. There is also potential for earnings growth to outpace revenue as gross margin stabilizies/improve coupled with operating expense reduction.
For further details see:
Analog Devices: FY 2024 Might Be The Trough Of This Downcycle