Analog Devices Already Pricing In A Recovery

| About: Analog Devices (ADI)
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As a general rule, semiconductors are great second-chance stocks as the ups and downs of this surprising cyclical industry take the stocks on roller-coaster rides. Unfortunately for investors just coming back around to check on Analog Devices (NASDAQ:ADI), the market has already more than counted on a solid recovery at this leading analog chip company. Improving sell-side estimates and better-than-expected operating leverage could lead to more upside in this recovery cycle, but this isn't a fundamentally cheap stock anymore.

Tough Numbers, But Who Cares?

With semiconductor investors firmly focused on the 2013 recovery story, Analog Device's fiscal first quarter results are going to be an afterthought to many investors. Even so, I think there is plenty for more quantitatively-oriented investors to chew on.

Revenue fell 4% from the year-ago level and more than 10% from the prior quarter, with every category showing sequential sales declines. The declines in consumer (-22%) and communications (-12%) were the worst, with industrial down 8% and auto down about 3%.

With lower chip sales volumes came lower utilization and lower expense leverage. Gross margin declined a half-point from last year and more than a point from the prior quarter as utilization came in around the mid-50%s (second-lowest to Texas Instruments (NYSE:TXN)). That deleverage continued through the operating items, as operating income fell 10% from last year and 22% from the prior quarter.

Green Shoots?

Sell-side analysts and semiconductor investors spent most of 2012 waiting on a recovery that never materialized. Hopefully the encouraging information from Analog Devices isn't another false dawn.

Management guided revenue growth slightly below prior sell-side estimates, but 4% to 8% sequential growth is a welcome improvement, particularly as it seems that industrial and communications demand is recovering.

A recovery in industrial demand would certainly be good news for Analog, as well as TI, Linear (NASDAQ:LLTC), and Avago (NASDAQ:AVGO). I'd be careful, though, about confusing inventory rebuilds from very low levels with a full-on recovery. In recent quarters a lot of industrial customers slashed orders and went to very short lead times.

The reason I'm skeptical is as follows. About 75% of "industrial" chip demand (for the industry, not ADI specifically) comes from factory automation, building control, energy, and healthcare. Healthcare is still quite weak, as companies like Medtronic (NYSE:MDT) continue to report pretty soft CRM revenue. Automation has been looking better at ABB (NYSE:ABB), Rockwell (NYSE:ROK), and Emerson (NYSE:EMR), but most of these players are cautious about calling a recovery and are looking for better results in the second half of the year. Likewise with building controls - companies like Honeywell (NYSE:HON) and Johnson Controls (NYSE:JCI) still seem more than a little jittery.

I'm incrementally more confident in the communications recovery, particularly as companies like AT&T (NYSE:T) and China Mobile (NYSE:CHL) roll out next-gen infrastructure. Here too, though, investors have been burned before and the large telecom equipment suppliers are still expecting rather than seeing significant order improvements.

Leverage It To The Hilt

Analog Devices is a sizable player in the analog space, with strong share in amplifiers and converters. Analog is also an above-average operator, as seen by this relatively mild recent peak-to-trough cycle. Better still, with the company producing nearly 63% gross margin with mid-50%'s utilization, I'm very optimistic about what the company can achieve when utilization rates move up into the 80%'s or higher. At the best of times, I think this company could generate gross margin above 70% and might get operating income before 40% - making Analog one of the most leverage-rich names in analog and chips in general.

The Bottom Line

Unfortunately, Analog is still in a cyclical business and that creates problems for investors who prefer long-run discounted cash flow methodologies. Analog is more likely than not going to see upward revenue revisions in the coming quarters (if the recovery is real) and will likely surprise many analysts with its margin leverage. Generally speaking, stocks do well when sector recoveries combine with upward revisions. That said, even a long-term forecast of 5% free cash flow growth doesn't point to much value beyond the $45 level.

So investors have a dilemma here. While Analog Devices is likely fairly valued for the long term, these stocks routinely overshoot in the recoveries and undershoot in the declines. Those who can be comfortable with investing more on momentum and investor psychology than underlying long-term value could still do well here, but as the value increases so too will the volatility and investors shouldn't ignore the downside if this recovery proves stunted or premature.

Disclosure: I am long ABB. 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.