Analog Devices Inc..Q4 2019, Letter to the Shareholders

Analog Devices Inc..Q4 2019, Letter to the Shareholders

Dear Fellow Shareholders

We are living in a time of astonishing innovation in the Third Wave of Information and Communications Technology (ICT), as we refer to it at ADI. This wave is characterized by ubiquitous sensing, hyper-scale and edge computing, and pervasive connectivity. These technology modalities enable the generation of vast amounts of data that allow us to glean actionable intelligence about the world. As one of the very broadest high-performance analog solutions providers, we play a critical role at the nuanced intersection of the physical and digital domains, by providing the building blocks to sense, measure, interpret, connect, and power the edge. Essentially, ADI is where the data is born.

This era of extraordinary technological change will continue to improve quality of life globally through continuous advancements in areas such as seamless and efficient automation, more sophisticated communications networks, universal and affordable healthcare, environmental integrity, and much more.

Through our research and development (R&D) investments and strategic acquisitions, ADI is better equipped than ever to solve our customers’ toughest engineering challenges from sensor to cloud, from DC to 100 gigahertz, and from nanowatts to kilowatts. And as analog engineering challenges become more complex, our customers are telling us that they want us to provide more complete solutions. This provides ADI with new, attractive opportunities to deliver profitable growth in the years ahead.

Solid Financial Results for Fiscal 2019

In fiscal 2019, we delivered revenue of approximately $6 billion amidst challenging macroeconomic conditions and trade uncertainty. Our business-to-business (B2B) markets, comprised of industrial, automotive, and communications, achieved modest year-over-year growth and outperformed the semiconductor industry again. We delivered industry-leading adjusted gross margins of approximately 70%, adjusted operating margins of more than 40%, and adjusted diluted earnings per share of $5.15.1 Notably, we generated strong cash flow as evidenced by our 33% free cash flow margin, which places us in the top 10% of the S&P 500.

The strength of our innovations and customer engagements, the diversity of our franchise, and our operational discipline have enabled us to consistently deliver strong returns. Over the last five years, ADI has generated a total shareholder return of 148%, or more than double the S&P 500 return.

Our Fiscal 2020 Priorities

As we enter fiscal 2020, I would like to describe the three primary priorities on which we are focused to continue driving ADI’s long-term success.

1. Deepening Customer-Centricity

ADI possesses among the broadest product portfolios, applications expertise, and manufacturing capabilities in high-performance power management and precision and high-speed signal processing technologies, which helps our customers bridge the intersection between the physical and digital worlds.

Throughout the year, we saw robust customer engagement driven by a couple of factors. First, our customers are facing a scarcity of available analog engineering talent and they are increasingly turning to us for that expertise. Second, our customers are encountering more complex challenges in the Third Wave of ICT with digital systems increasingly relying on real-world data to create actionable intelligence.

As a result, we see our customers partnering with us more deeply to gain the full benefit of our technology capabilities and product innovations with relationships starting earlier and lasting longer. As a testament to that, our opportunity pipeline value achieved record levels in fiscal 2019.

2. Efficient Use of Capital

At ADI, we have an intense focus on creating and delivering best-in-class value for our customers and doing so is our first call on capital.

Our success is underpinned by our philosophy that superior innovation drives superior results and we understand that R&D enables our virtuous cycle of innovation-driven success. This is why we invested more than $1 billion in R&D during fiscal 2019. We choose our investment areas judiciously—focusing on what we believe are the most attractive opportunities across our business, particularly in our B2B markets.

Also, given the growing demand for analog technology and the evolving needs of our customers, we have acquired two companies to increase the scale and the scope of our offerings over the past five years.

With the acquisition of Hittite in 2014, ADI became the market leader in high-performance RF and our portfolio now spans the entire frequency spectrum from DC to 100 gigahertz. Since this acquisition, ADI has more than doubled the revenue from this portfolio, and in fiscal 2019, our RF revenue increased more than 30% year-over-year led by growth in industrial and wireless communications.

The acquisition of Linear Technology (LTC) in 2017 added highperformance power management and additional precision signal processing to our portfolio, expanding our offerings to deliver more complete solutions. Our new power management design wins across 5G infrastructure, data center, and automotive are moving to production this year, and we expect a more meaningful revenue ramp in fiscal 2021. This puts us on a path to double LTC’s historical revenue growth rate in the years ahead.

Through our development of cutting-edge innovations and our ability to solve the most difficult problems across a broad array of applications, we generate significant cash flow and are deeply committed to delivering strong shareholder returns. In fiscal 2019, we generated nearly $2 billion of free cash flow and delivered on our target of returning 100% of our free cash flow after debt repayments in the form of dividends and buybacks.

3. Capitalizing on Secular Trends

As the data age rapidly evolves and the demand for edge computing rises, analog technology becomes even more relevant. Currently, a modest 10% of data is generated outside the cloud, and by 2025, this amount is expected to grow to 75%.4 We believe this trend uniquely positions ADI to capitalize in two ways. First, we will be a critical partner in the collection, curation, and communication of our customers’ edge data. Second, with more than 85% of our annual revenue coming from B2B markets, we are well-aligned with the markets driving this increase in data—let me provide you a few examples.

In Wireless Communications, we are pushing the limits of 5G innovation with our market-leading microwave and integrated transceiver portfolio, adding algorithms and optimized power solutions to differentiate our portfolio. These enhancements enable customers to dramatically increase data density, while reducing their radio footprint and power. Importantly, 5G is more than just radio innovation—it requires a complete re-architecting of the core and wireline network to meet the 5G vision of gigabit speeds, low latency, and high reliability. This network expansion is expected to require a significant upgrade to the backhaul system, unlocking another new revenue opportunity.

In Automotive, the center of value creation is pivoting from the internal combustion engine to the electric powertrain and passenger comfort and safety. Again, ADI plays an important role in enabling these advancements. In electric vehicles, our battery management solutions provide customers up to 20% more miles per charge vs. our competition and we are revolutionizing how monitoring and controlling batteries will be solved—and doing so wirelessly. In Level 3+ autonomous vehicles, our high-speed signal processing technology is necessary to deliver the ever-increasing levels of resolution and range required in active safety systems.

In Industrial, the rise of Industry 4.0 and digital factories is increasing the need for more sophisticated sensing, measuring, and actuating solutions. This creates additional demand for our precision signal chain and power management franchises and expands our addressable market for our suite of connectivity and sensor solutions.

Finally, in Healthcare, demographic and economic pressures, coupled with the availability of new sensing and diagnostic capabilities, are opening up a myriad of new opportunities for ADI. This includes mission-critical X-ray systems, where we are pushing performance to new levels with our photonic conversion solutions by reducing dosage intensity, while increasing image fidelity. And, wearable devices with our clinical-grade vital signs monitoring solutions are poised to enable hospital-grade patient monitoring at the home.

 Our Sustainable Future

ADI has long been focused on responsible sustainability efforts, but I believe the time has arrived where we not only prioritize sustainability, but also environmental regeneration. To this end, ADI employees will increasingly bring their ingenuity and energy to trailblazing new solutions that restore and replenish natural resources and ecosystems, reduce our carbon footprint and the environmental impact of our operations, as well as partner with our customers and suppliers to reduce the impact on our planet.

To provide just one example, our innovative battery management solutions are at the heart of building more efficient electric vehicles, which helps to curtail tens of millions of tons of CO2 entering the atmosphere. Putting this into perspective, every million ton reduction of CO2 emissions is equivalent to the annual CO2 absorption by over one million acres of mature forest. As we look ahead, we believe we have a bigger role to play in engineering a sustainable future. We will be providing more on our strategy and commitments, which are aligned with the United Nations’ Sustainable Development Goals, in our Sustainability Report this year.

Looking Ahead

Over our company’s 55-year history, ADI has navigated several important transitions because of our ability to successfully sense and adapt to technological, demographic, and economic changes. Our leading technology portfolio and customer relationships, business diversity, and focus on continuous improvement has created a strong business model with both a broad array of optionality and opportunity as well as long-term resilience.

 As the world becomes more digital, more autonomous, and more intelligent, I am confident in our ability to deliver stronger performance. This is due to the many thousands of talented people across our company who are passionate about creating industry-leading innovation and dedicated to the success of our customers each and every day.

I have been with ADI for more than 30 years, and I can say unequivocally that I have never been more excited about the prospects and opportunities that lie ahead.

Sincerely,

Vincent Roche

President and Chief Executive Officer

Analog Devices, Inc.

Stock Idea…Analog Devices Inc…ADI on the NYSE

Stock Idea…Analog Devices Inc…ADI on the NYSE

Analog Devices, Inc. (Analog Devices) designs, manufactures and markets a portfolio of solutions that leverage high-performance analog, mixed-signal and digital signal processing technology, including integrated circuits (ICs), algorithms, software and subsystems. Its products include Analog Products, Converters, Amplifiers/Radio Frequency, Other Analog, Power Management and Reference, and Digital Signal Processing Products. The Company is a supplier of data converter products. The Company is a supplier of high-performance amplifiers. Its analog product line also includes products of high performance radio frequency (RF) ICs. The Company's DSPs are used for high-speed numeric calculations. The Company offers its products for applications in various end markets, such as industrial, automotive, consumer and communications. The Company operates in the United States, Rest of North/South America, Europe, Japan and China.

Business Model Themes

Analog Devices is one of the world's largest analog chipmakers, with an especially strong position in analog signal processing chips. We think it is well-positioned to profit from more advanced and higher-priced semiconductor content in automobiles, 5G wireless networking equipment, and industrial applications like medical devices and factory automation equipment in the years ahead.

Analog chips are used to convert real-world signals, such as sound, temperature, and pressure, into digital signals that can be processed. We believe Analog Devices has a wide economic moat because of its proprietary analog designs and high customer switching costs; since analog chips are neither particularly expensive nor do they require cutting-edge manufacturing techniques, high-quality analog chipmakers tend to retain design wins as long as the end product is being built, all while maintaining healthy pricing and strong profitability over time.

Most of Analog Devices’ organic sales come from data converters and amplifiers used in various end markets, such as wireless base stations, and the company expanded into power management chips via its acquisition of Linear Tech. An especially promising end market for the firm continues to be the automotive sector. Not only are traditional cars adding electronic content in their vehicles such as sensors, active safety systems, and advanced infotainment systems, but also hybrid and electric autos are doubling and tripling the amount of chip content inside of each vehicle. 

We're also seeing a similar trend of increased chip content in industrial applications like robots, factory equipment, and medical devices. ADI has tens of thousands of customers in these end markets. Further, ADI's signal chain semiconductors will likely be prominently used in 5G wireless network equipment. Nonetheless, ADI still faces challenges in a fragmented analog market. The firm has many competitors with equally strong expertise in analog chip designs, and the semiconductor industry is highly cyclical. Regardless of new product releases, Analog Devices' sales probably will continue to ebb and flow with the rest of the sector.

Sustainable Competitive Advantage (Moat)

We believe that ADI has a sustainable competitive advantage, thanks to intangible assets around proprietary analog chip design and manufacturing expertise, as well as switching costs that make it difficult to swap out analog chips for competing offerings once they are designed into a given electronic device. We are confident the firm is more likely than not to generate excess returns on capital over the next 20 years.

We believe that leading analog chipmakers benefit from favorable characteristics that lend themselves to economic moats. Moats for chipmakers with analog expertise tend to come from intangible assets associated with the strength of proprietary chip designs, as well as switching costs that make it difficult to swap out analog chips for competing offerings once they are designed into a given electronic device.

We believe analog engineering talent is difficult to come by, as greater emphasis is placed on digital chip improvements, and it often takes years to train up-and-coming analog engineers in the intricacies of chip designs. Thus, it is extremely difficult for startups to replicate the many years of analog expertise held by incumbents. Leading analog chipmakers also face stringent quality requirements in some end markets, such as the automotive industry, for example, where defects can only be tolerated as low as one part per million.

Although the analog chip market is quite fragmented, it would be difficult for any startup to achieve this level of quality while still being to satisfy high-volume production. Furthermore, analog chips tend to make up only a small portion of a product's bill of materials, so purchasing decisions tend to be based on performance rather than price, helping ADI and its peers retain pricing power. Automotive, industrial, and communications infrastructure customers, in particular, are unlikely to choose an inferior analog chip in order to save pennies on the cost of a piece of equipment worth tens of thousands of dollars.

Similarly, engineers are loath to swap out an analog from an existing design (again, only to save a few pennies on cost) because of the onerous redesign and retesting costs associated with the switch. One can imagine the frustration and possible reputational damage to a product if a perfectly functioning electric toothbrush or thermostat were to fail because of an unforeseen change in how the analog chip interacts with the rest of the circuit board. Again, such damages would be amplified in far more expensive equipment like cars, planes, or satellites. 

ADI and its chipmaking peers tend to profit from these high switching costs by having lower ongoing R&D and capital expenditure investments than digital chipmakers, which helps to contribute to healthy returns on capital for shareholders. In particular, buyers of analog semis typically don't demand smaller chips packed with more transistors, but rather, reliable products that deliver the desired accuracy and precision in power management or signal processing. Shrinking the chip might not necessarily enhance accuracy (and might even serve to reduce it), so analog chips tend to be made with lagging edge manufacturing techniques.

ADI and some of its peers take this benefit one step further by concentrating on end markets where product lives are measured in decades, as opposed to the increasingly short life cycles associated with consumer devices like PCs or handsets. ADI likely earns less than 10% of revenue from personal electronics devices like smartphones, tablets, and PCs. All else equal, we are less confident in outsize economic profits from chipmakers that serve the handset and PC industries, given the shorter product life cycles, intense competition, and customer concentration as a handful of tech titans exert tremendous buying power.

The analog chip space is highly fragmented, but ADI is the only firm with a substantial market share lead in any subsegment of the business. The firm has nearly 50% share of the data converter analog chip market, and these chips are widely used in communications infrastructure equipment, in particular, as they convert analog voice signals to digital signals for processing, and vice versa. We believe that ADI will retain its relatively dominant position in converters over time.

Management

We view Analog Devices as a well-run organization and an Exemplary steward of shareholder capital. Vincent Roche, a longtime ADI veteran, became president in 2012 and took over the CEO role in May 2013. Ray Stata, one of ADI's cofounders, is chairman of the board. Analog Devices has done a good job of distributing cash to shareholders, raising its dividend to $0.62 per quarter and targeting a 15% annual dividend increase. ADI announced that it plans to distribute 100% of its free cash flow to shareholders through dividends and opportunistic stock buybacks.

We approve of ADI’s acquisition strategy. First, the firm made a smart move to acquire Hittite Microwave, as the firm paid what we consider a reasonable 30% premium for a highly profitable radio frequency chipmaker. We believe ADI will benefit from selling Hittite products into 5G wireless equipment in the years ahead. We also think ADI made another shrewd deal to acquire Linear Tech, the highest-margin analog chipmaker. ADI has taken on a relatively high degree of leverage to buy Linear, but strategically, the deal makes quite a bit of sense and we anticipate that ADI will generate healthy free cash flow in order to pay down the debt over time.

(The above information was edited from a Morningstar Equity Analyst Report)