Analog Devices - Sustainable Topline Revenue Growth Is Required To Create Appeal

| About: Analog Devices (ADI)


Analog Devices reported solid second quarter earnings and issued a comforting outlook.

Strong balance sheet, stable revenues and high margins offer safety.

To create appeal for shareholders, topline revenue growth will have to become consistent through the cycle.

Analog Devices (NYSE:ADI) released a solid set of second quarter results this week which were accompanied by a strong outlook for the current third quarter.

After years of revenue stagnation, Analog appears to finally have found growth again. That being said, I am still not convinced about the growth prospects given the bad revenue track record over the past few years. Stable margins and a very strong balance sheet support the current share price, but growth is needed to create appeal.

Second Quarter Highlights

Analog Devices reported second quarter revenues of $695 million which was up 5% compared to last year and up 11% compared to the seasonally softer first quarter.

The company reported net earnings of $187.4 million, up 14.0% compared to last year. Earnings per share rose by seven cents to $0.59 per share.

Looking Into The Numbers

Year-on-year revenue growth was solid given that revenues rose by just a percent on an annual basis in the first quarter. Growth was driven by the communication business which reported 25% growth with revenues coming in at $154.8 million.

The automotive and industrial businesses saw a solid performance as well, posting 10 and 5% revenue growth, respectively. Weakness was seen at the consumer side of the business which posted a 23% drop in revenues to $77.7 million.

Gross margins were very strong at 66.1%, up 210 basis points compared to last year and up a 100 basis points on a sequential basis.

Sales growth allowed Analog Devices to display solid operating leverage with operating expenses falling by 70 basis points to 34.3% of sales. Expenses fell by 220 basis points compared to the seasonally weaker first quarter.

The combination of increased gross margins and cost containment in operating expenses resulted in a big boost to operating earnings. Margins were up by 270 basis points on an annual basis to 31.7% of sales.

While effective tax rates inched up to 13.8% of operating earnings, tax rates remained very low especially compared to statutory tax rates.

Third Quarter Outlook

For the current third quarter, Analog anticipates 1-5% revenue growth on a sequential basis which would result in revenues of $702-$730 million. At the midpoint of the guidance, revenues are anticipated to grow some 6% per annum.

Gross margins are anticipated to increase by another 50 basis points while operating expenses are expected to stay flat or increase by a maximum of 3%. This should result in GAAP earnings of $0.60 to $0.64 per share.

Valuing Analog Devices

Analog Devices ended its second quarter with $4.81 billion in cash, equivalents and short-term investments. The company holds $872 million in debt, resulting in a solid net cash position of $3.94 billion.

Trading at $52 per share, Analog Devices is valued at $16.5 billion which implies that operating assets are valued at roughly $12.5 billion.

At the current pace annual revenues could come in around $2.75 billion as earnings could come in around $725-$750 million. This values operating assets at around 4.5 times annual revenues and 17 times annual earnings.

The company pays a quarterly dividend of $0.37 per share, providing investors with a 2.8% dividend yield.

Long-Term Struggles To Disappear?

Between 2004 and 2013, Analog has struggled to grow reporting flat revenues of $2.6 billion which implies that revenues are falling adjusted for inflation. The company remains incredibly profitable, yet the lack of topline revenue growth is limiting appeal. Note that the company managed to grow margins in recent years while earnings per share saw an additional boost thanks to share repurchases.

Investors are relieved to see growth in annual revenues at mid single digits as both the second quarter results as well as the third quarter guidance came in ahead of consensus estimates.

While the recent growth appears to be very encouraging, growth is driven by the cyclical industrial and automotive markets which are doing quite well at the moment. This leaves me wondering what the real growth rates through-the-cycle will be in the future.

Takeaway For Investors

Analog is kind of a steady business reporting hugely attractive margins, operating with a rock-solid balance sheet while it returns decent sums of cash to its shareholders.

The large cash holdings, and relatively high stable operating margins allow for a great deal of safety, thereby warranting the current valuation at 16-17 times earnings excluding cash. The problem is that the company is ¨stuck¨ in today's valuation if it cannot grow revenues consistently throughout the economic cycle.

While the company remains optimistic about the remainder of the year, markets appear to have their doubt about the sustainable growth rate of revenues. This appears justified given the performance over the past decade.

I am a buyer on dips, but won't chase shares at current levels given the disappointed long-term revenue track record.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.