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
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)
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