Linear Technology, Maxim Integrated: The Other Lucrative Niche in Semiconductors

Since I wrote the Altera (ALTR) vs. Xilinx (XLNX) article, I have had multiple requests asking me what the other niche in semiconductors is - that has generated gross margins in excess of 60%...... the answer - Analog/Mixed Signal chips. Devices that perform functions like analog to digital and digital to analog conversion, power supply regulation, DC to DC conversion, etc. There are four companies in this space, but I will focus on the two companies that are better managed, and have pristine financials.

They are Linear Technology Corp. (LLTC) and Maxim Integrated Products (MXIM.PK). Maxim is in the process of re-stating earnings - as it did some options-backdating-shenanigans, and hence, needs to go back all the way to 2005, and redo the numbers that it reported. In the most recent conference call, MXIM's CFO said that it would re-file all of the 10Q's and 10K's [going back to 2005] - by the end of 2008. Hence, there is more risk in buying MXIM's stock [and hence a greater capital appreciation potential too].

Getting to the reason for this article, LLTC has historically sported gross margins in excess of 70% and Maxim, in the high 60s. This is only part of the reason for their exemplary numbers.

LLTC's and MXIM's chips are small. They have a few hundreds of devices on average, and some have less than twenty. In a business where Intel (INTC) and nVidia (NVDA) cram 20 Million plus transistors into a CPU/GPU, this is refreshingly different. The average selling price per LLTC chip was $1.57 in Q3 2008 [ended March 31, 2008] vs $1.67 in Q3 2007 [ended April 1, 2007].

So, these are cheap, ubiquitous chips - found everywhere - primarily in consumer, industrial, automotive and military/space. Yet, the company had gross margins of 77.5% in Q3 2008 vs 77.8% in Q3 2007. Moreover, both companies have a culture wherein engineers constantly ask themselves if they can perform the same function - or perform the same function with more precision - with fewer devices.

Since these chips are small, one does not need a $2 Billion fab and $10 Million dollar mask sets to make the chips that they design. In fact the process that they use to make their chips date back a decade [0.25u for the curious types - when Intel is pushing 0.025u (u=1/1,000,000 of a meter)]. So, they can make their chips using depreciated equipment; test their chips using legacy testers - making LLTC a free-cash-flow machine [I sound like a cheap internet "home business" advert].

In the last reported quarter, Maxim had record revenues. It could not say much else. So, let us focus on LLTC's numbers. LLTC had revenues of $298M of which $231M was gross profits for the quarter ended March 31, 2008 [the last 10Q I could pull from the SEC]. Revenue increase was 17% yoy, and costs increased 18% yoy - meaning gross profits increased 16% yoy from $198M in 2007. Net income was $99M in 2008 vs. $98M in 2007.

While this looks bad, it really isn't - as LLTC issued some $1.7 Billion of Senior securities [I am not going to discuss the +'s and -'s of issuing debt, but LLTC did and at a very attractive coupon rate of 3% for $1Billion and 3.125% for $700M, and ALL of it was used to re-purchase its stock]. EPS increased from 32c/share to 44c/share fully diluted. The company paid a dividend of 21c/share in 2008 for the qtr. vs. 18c/share in 2007 for the corresponding quarter.

There were 26% fewer shares for Q3 2008 vs. Q3 2007. The company used the entire debt facility mentioned in the prior paragraph to purchase its shares. If you want to know the gory details, pull up this file from the SEC.

So, in conclusion:
1. LLTC and MXIM participate in the highest margin niche in the semiconductor sector.
2. LLTC sells for an attractive valuation, plus the company pays a dividend of 84c/share/year.
3. They make cheap chips that are used everywhere. But LLTC and MXIM produce them cheaper.
4. They use legacy technology and equipment to produce chips - keeping a lid on capital expenditures.
5. LLTC has been aggressively buying back its stock.
6. MXIM may look risky, and is risky, but will probably do well - as soon as the uncertainties around the stock evaporate by the end of the year.
7. I used the words pristine financials for MXIM too - as they have over a billion in cash and no debt, and a very high gross margin business that generated record sales.

Notes: I currently have no positions in either stock, but after writing this article, I might buy into either on Aug 13, 2008.

Comments

[GregT]

Yes, their profit margins are incredible. But take a look at growth before you buy. Their growth over the past several years has been terrible. Consider that they make chips for things like PDA, cell phone, notebook PCs, etc that have grown tremendously over the past 5 and 10 years. Then look at revenunue growth at LLTC and you'll see that it has not kept pace. Great balance sheet and incredible margins, but their stock has traded in the same general range for the last 5 to 8 years because they are not growing. Take away the share repurchases and their EPS growth has been absolutely terrible.

2008 Aug 13 08:37 AM

[icuser]

There must be more to it. If it was easy to make 70% gross margin on a 20 transistor chip, they would have more competitors.

I looked at this link

Top 10 Semiconductor Stocks?source=more_aut...

And they compare quite well. These are not great time for semi's but it is clear that the chip market is getting better. These companies do well because they sell chips based on innovation. While some markets may have taken off, if there is no need for innovation the chips used are commodity and have little profit.

Basically, I like a strategy of innovation rather than "how cheap can I sell it". It may have slower growth but it has few big declines and does not whipsaw the employee's or investors.

2008 Aug 13 09:16 PM

[Randy Fay]

Thank you for the cogent analysis. I had forgotton about MXIM and LLTC.

2008 Aug 14 04:45 PM

[Kirk Lindstrom]

Thanks for the excellent article. I've watched both for many years. What has scared me off is insider selling and the number of stock options they issue to insiders and employees.

I will buy shares when I see insiders buy, such as a recent purchase of LRCX. See "Lam Research: First Insider Purchase in Many Years"
at seekingalpha.com/artic...

I have a feed from a program that looks for major insider buys at the SEC. If I were to see insiders making a major buy of either MXIM or LLTC, I'd be quite tempted to buy due to the exceptional financial fundimentals you wrote of.

Many stocks in this space often look more like a popular and profitable nightclub that generates a ton of cash flow but the cash is all given out as "Tips to the bartenders and staff" in exchange for free drinks and free admission thus leaving little cash left for the actual owners of the nightclub.

5 years without a single insider buy of note:
www.secform4.com/insid...
www.secform4.com/insid...
does not speak highly in my book.

2008 Aug 16 11:42 AM