Image Source: Yuri Samoilov
By Valuentum Analysts
Firms in the integrated circuits industry make components that form the electronic building blocks used in electronic systems and equipment. The industry is notoriously cyclical and subject to significant economic upturns and downturns, as well as rapid technological changes. Firms must innovate to survive, and products stocked in inventory can sometimes become obsolete before they are even shipped. Severe pricing competition and lengthy manufacturing cycles only add uncertainty to the mix. We're not fans of the structure of the integrated circuits space, but that is not to say that we don't think there are attractive firms within the group.
There are multiple secular trends driving potential growth for the integrated circuits group, and rapidly growing addressable markets are resulting from rapid technological changes. The rising count of connected devices bodes well for the space, and areas such as automotive and industrial are offering significant potential runways for growth for chip makers as the Internet of Things becomes reality. Mobile communications continue to evolve in terms of sophistication, and remaining on the front lines of innovation has never been more necessary for participants in the integrated circuits space.
When it comes to dividend growth investing, we prefer companies with net cash positions on the balance sheet in addition to robust free cash flow generation. These two characteristics are the foundation of the Dividend Cushion ratio and are core to our forward-looking dividend growth analysis. We like the idea of a company that operates in such a dynamic environment characterized by rapid technological changes such as the integrated circuits industry holding a cushion in the form of a sizable net cash position on its balance sheet. With that in mind, let's take a look at three of the top integrated circuit companies on the market today.
Analog Devices (ADI) - Dividend Yield: ~2.0%
Image Source: Robin Zebrowski
Analog Devices produces high-performance analog, mixed-signal and digital signal processing integrated circuits used by over 60,000 customers. The company derives two thirds of sales from data converters and high-performance amplifiers. 90% of revenue comes from the business-to-business space, and it expects its business-to-business markets, including industrial, automotive, and communications, to grow at a double-digit rate in the near term and therefore account for a larger mix of its business. Its strong position in wireless should continue driving outperformance there.
The 2017 acquisition of Linear Tech has created a high-performance analog industry leader and almost doubled Analog Devices' addressable market, and the firm is targeting $5 in non-GAAP earnings per share by the end of 2020. Over the long haul, the company is targeting 70%+ gross margins and operating margins in a range of 39%-45%, but it will no longer provide short-term margin guidance. Analog's net debt load of ~$5.5 billion as of the end of fiscal 2018 reflects considerable balance sheet deterioration from its net cash position of more than $2.3 billion at the end of fiscal 2016, though it has made notable progress in deleveraging since the Linear Tech deal as its net debt is down from $6.8 billion at the end of fiscal 2017.
Analog Devices' Dividend Cushion ratio has rebounded since it added debt associated with the Linear purchase, but it is not back to pre-deal levels. Investors should be cognizant of competitive threats and pricing pressure across its product line-up, as well as the increased debt load.
Here's what we say about its dividend in the dividend report, and as for its valuation, we think upside may be limited based on our fair value estimate range (see image that follows):
Analog Devices appears to be well-positioned for long-term success. Growing customer engagement and investments in innovative technology should help drive ongoing demand for its products, the vast majority of which serve the business-to-business space. The recent acquisition of Linear Technology has added notable debt but enhanced free cash flow generating capacity, and the firm is targeting gross margins of 70%+ and operating margins in the 39%-45% range. We like management's earnings per share target of $5 by 2020, but integration and execution risk remain. Though the company may very well have long-term dividend growth potential, its debt load is worth keeping a close eye on.
The purchase of Linear Tech decimated Analog Devices' Dividend Cushion ratio, but post-transaction deleveraging has helped it bounce back. The company targets net debt-to-adjusted EBITDA at 2.0x, and deleveraging initiatives are expected to continue for the time being. The company added $7.3 billion in debt to finance the deal. While we are generally fans of Analog's fundamentals, it is tied to spending in cyclical end markets (roughly 90% of its revenue is of the business-to-business variety), which can impact performance in times of economic weakness. Roughly half of the firm's revenue comes from industrial end markets and ~16% is generated in the cyclical auto end market as of fiscal 2018.
Image shown: Analog Devices is currently trading at $102 per share, and we don't see too much more room for capital appreciation based on the upper bound of our current fair value range for shares, which tops out at $104.
Skyworks (SWKS) - Dividend Yield: ~1.8%
Image Source: Marco Verch
Skyworks is an innovator of high performance analog semiconductors. The firm supports automotive, broadband, energy management, GPS, industrial, medical, military, wireless networking, and smartphone/tablet applications. Its products run the gamut from amplifiers to voltage regulators. Power management is a significant growth avenue for Skyworks, and the global trend to connect 'everything' is playing into its hands.
The total number of connected devices, for example, could reach an impressive 75+ billion by 2020 as the proliferation of connectivity continues across end markets. As a result, Skyworks is capitalizing on the strength of mobile and the Internet of Things, and it believes it is well positioned across all key growth vectors. Mobile devices are rapidly evolving to address the massive demand for data and speed, and the firm is well-positioned to help resolve such a complex issue.
However, Smartphone weakness and overall softness in China are weighing on expectations, and Skyworks has a notable degree of customer concentration risk. Apple (NASDAQ:AAPL) accounted for 47% and Samsung (OTC:SSNLF) accounted for 12% of the company's total fiscal 2018 revenue. Such concentration can impact near-term guidance, but management has solid long-term targets. Skyworks' long-term operating model includes target revenue growth above that of its addressable market, a 53% gross margin target, a 40% operating model target, and a 30% free cash flow margin target. Our projections are roughly in line with these targets, and management plans to return 60%-75% of free cash flow to shareholders.
Here's what we have to say about the company's payout, and as for our estimate of its intrinsic value, upside may very well exist for shares, which are changing hands in the lower half of our fair value range (see image that follows):
Skyworks serves an attractive array of end markets, and it believes it is well-positioned for future growth. We like the role it plays in power management, which will only become an increasingly important factor in helping the growing interconnected world run more efficiently. Its attractive long-term growth markets do not shield it from potential short-term downturns or relative disappointments, but we like the runway for growth. The company has impressive balance sheet strength, which provides a cushion for both its dividend and as protection against potentially transient hurdles it may face. As of the end of the first quarter of its fiscal 2019, Skyworks held roughly $1.1 billion in cash, cash equivalents, and marketable securities on the balance sheet compared to no debt. Free cash flow generation averaged $951 million over the past three fiscal years (2016-2018), which is enough to cover annual run rate cash dividend obligations of $243 million multiple times over.
We love the free cash flow generation and growth potential of Skyworks that are boosted by its attractive and growing end markets, and its strong balance sheet only adds a cushion for its future dividend growth prospects. However, the company battles notable competition, and risks beyond that of the typical competitive pricing pressure and obsolescence are present. Customer concentration is worth considering, and the highly cyclical industry in which it operates does not always provide the most reassuring backdrop for dividend growth investors. Management's willingness to grow the payout does not appear to be an issue, as the quarterly dividend has grown to $0.38 from $0.11 in 2014, but share repurchases (averaged ~$572 million over the past three years) have out-weighed capital allocated to dividends in recent years.
Image shown: Skyworks is currently trading at ~$84 per share, which is firmly in the lower half of our fair value range. We think shares have the potential to reach the ~$126 range based on the upper bound of our estimate of its intrinsic value.
Xilinx (XLNX) - Dividend Yield: ~1.3%
Image Source: Uwe Hermann
Xilinx makes FPGAs, SoCs and 3D ICs. These devices are coupled with a next-generation design environment and IP to serve a broad range of customer needs, from programmable logic to programmable systems integration. As with rival Altera, which was recently acquired by Intel (NASDAQ:INTC), Xilinx's strategy centers on the displacement of ASICs and ASSPs in the development of next-generation electronic systems.
The company strives to drive down cost and power consumption at each manufacturing process node, but investors in technology pay close attention to a firm's gross margin to get a read for product pricing pressures. We like Xilinx's focus on growing earnings and its cash-rich balance sheet, which provides its operations with a nice cushion. The firm's shares have benefited from reports that it may be a takeover candidate, and robust estimates of potential markets including autonomous vehicles and artificial intelligence for chip makers have been welcome news.
In this vein, the company is experiencing solid momentum in the 28nm market. Xilinx's quarterly revenue run-rate is growing, and demand for its 16nm and 28nm products is expanding thanks to end markets such as data center, automotive, test and measurement, wireless communications (early 5G and pre-5G deployments), and even space. However, it is worth noting that the company is heavily dependent on distributor Avnet (NASDAQ:AVT) for the majority of sales revenue and order fulfillment. Resale of product through Avnet accounts for 40%+ of worldwide revenue and for roughly 40% of total net accounts receivable as of the first three quarters of fiscal 2019.
Here's what we say about its dividend in the dividend report, and as for its valuation, we think there may be some upside for shares based on our fair value estimate range (see image that follows) even after its recent surge:
Xilinx is expecting expansion in the markets it serves thanks to 'multi-market high growth megatrends' including cloud computing, embedded vision, industrial Internet of Things, and 5G wireless. These dynamics add to the dividend growth potential embedded in the firm's capital-light business model, which drives solid free cash flow and helps maintain a healthy balance sheet. As of the end of the third quarter of fiscal 2019, the company had a net cash position of more than $1.7 billion, inclusive of current debt. Free cash flow generation averaged ~$781 million over the past three fiscal years (2016-2018), more than enough to cover annual run rate cash dividend obligations of just over $353 million.
Xilinx appears to have very little dragging on its dividend growth potential. Management has been very shareholder friendly as of late, having returned more than 100% of operating cash flow to shareholders via dividends and share repurchases in the past ten years. Competing capital allocation options in the form of share repurchases (averaged nearly $480 million from fiscal 2016-2018) have the potential to impact the pace of dividend expansion moving forward. Nevertheless, we expect the supporting secular trends to continue to fuel demand for Xilinx, and its solid free cash flow generation and impressive balance sheet health should drive ongoing dividend growth.
Image shown: Xilinx is currently trading at ~$113 per share, which is in the upper half of our fair value range. Nevertheless, we think shares have the potential to reach the ~$119 range based on the upper bound of our estimate of its intrinsic value.
On the whole, we are not particularly fond of the integrated circuits space, despite the attractive growth opportunities many companies within are currently presented with. We do, however, like operators with robust free cash flow generation and strong balance sheets. Analog Devices' recent acquisition of Linear Technology added a significant amount of debt to its books, and though we like its long-term financial targets and expanded addressable market, we think there are better options for dividend growth potential available.
Skyworks also has attractive long-term financial targets and an intriguing addressable market with an impressive potential runway for long-term growth, and its shares rallied following a strong fiscal 2019 first quarter report in early February. Management reassured investors on its capability to capitalize in compelling markets such as 5G, the Internet of Things, and automotive connectivity with an expanding footprint, but we're watching macro weakness in its mobile business with a cautious eye. Nevertheless, the company's balance sheet strength and free cash flow generation are worth noting.
Shares of Xilinx soared after it surpassed market expectations in its fiscal third quarter and provided compelling upside guidance for its final quarter of fiscal 2019. The company continues to be a tremendous example of free cash flow efficiency, and we think it makes up for its relatively small dividend yield with its robust dividend growth potential. This free cash flow efficiency is what forms the basis for our strong opinion of its dividend growth potential, and a healthy balance sheet only adds to our conviction. Xilinx is our favorite dividend growth idea in the space.
Disclaimer: This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we 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.
Additional disclosure: Xilinx is an idea in Valuentum's simulated Dividend Growth Newsletter portfolio.