Analog Devices Ready To Leverage A Long-Term Inflection In Chip Demand
Summary
- The combination of recovery demand and content growth is driving exceptionally strong demand for the chip sector, and Analog's broad exposure gives it good leverage to this upcycle.
- Lead times will eventually shrink from the very elevated levels of today, but that correction will be just a dip along a longer-term path of significant multiyear chip volume growth.
- Given long design cycles and the lack of transformative market/product exposures, the benefits from the Maxim deal are likely to materialize over a number of years.
- Very few high-quality chip companies are undervalued today, and Analog is no exception as cyclical enthusiasm has driven stretched multiples.
Only by the bubbly standards of the semiconductor sector could Analog Devices’ (NASDAQ:ADI) performance since my late August piece be thought of as disappointing, as the shares have risen almost 40% - lagging the SOX index by around 10 points and likewise lagging other high-quality analog peers like Microchip (MCHP) and NXP Semiconductors (NXPI), with the latter almost certainly getting a boost from its greater leverage to an auto sector recovery.
Pretty much everything is going Analog’s way right now. There are supply constraints, but Analog seems better-placed than average to handle them, and while the communications end-market has remained volatile, 5G deployments are a “when, not if” driver. Meanwhile, auto and industrial demand is recovering, with a host of factors in place to drive content growth for several years.
There will likely be a rollover in the cycle at some point as lead times shrink (though maybe not until late in 2021 or early 2022), but that will be a pause in what I see as a strong “mega-cycle” of chip growth across multiple end-markets. On top of that, the Maxim (MXIM) deal should close this summer, giving the company some cost and revenue synergy opportunities.
Of course, valuation remains problematic. It’s not unusual for multiples to stretch in upcycles, and that’s what’s happening now. I won’t dismiss the possibility of a stronger-for-longer cycle, but I don’t think my 6% organic long-term core revenue growth rate, 45%+ adjusted operating margin, or 40% long-term adjusted FCF margin assumptions are particularly conservative, and the long-term returns just don’t look that exciting now.
Well-Placed For The Dominant Themes
Already a well-regarded, high-performing analog company, the dominant trends and themes in the industry today continue to work in Analog’s favor.
While not traditionally all that strong in autos, Analog has significant opportunities in battery management for xEVs, as well as leverage to other areas of electrification and ADAS. The Maxim deal will enhance that with additional power/electrification and ADAS content, as well as opportunities in infotainment and connectivity. I can’t say that I prefer Analog’s exposure to chip content growth in autos to Infineon (OTCQX:IFNNY), NXP, or STMicro (STM), but my point is more that Analog won’t be left out.
Industrial end-markets likewise offer a lot of secular growth opportunities across automation, test & measurement, medical, and renewable energy, and here too Maxim should improve the company’s exposure to power management and interfaces. Wireless infrastructure (5G) is another key opportunity for Analog in the coming years, particularly as massive-MIMO installations accelerate.
Analog is also relatively better off on the supply side. The entire semiconductor sector is straining under supply limitations, but Analog started building inventory last year in anticipation of a sharp demand recovery. On top of that, the company supplies about half of its wafer needs internally and is stepping up capex to add capacity, an option that not all of its peers have right now.
Maxim Will Pay Dividends Over Time
As I’ve said in the past, the Maxim deal is not exactly transformative for Analog from day one. Analog will benefit from increased scale, an important competitive factor in analog chips, and I expect the company to exceed its initial cost synergy targets, as it has done with its past deals.
Still, I do see an opportunity for some “slow burn” improvements over the long term. Maxim won’t really transform Analog in terms of end-market or product exposures, but it does still bring valuable capabilities to the table, including power management, interfaces, and laser drivers. Considering that Analog is going into production on synergistic products from the Linear deal worth about $500M/year in revenue this year, four years after the completion of the deal, the full benefits of the Maxim deal will take time to materialize.
“Super-Cycle” Or Not, The Growth Prospects Look Attractive
Sell-side analyst track records in predicting “super-cycles” for cyclical industries are roughly on par with economic analysts and interest rate forecasts – it’s more coincidence when they get it right.
I have no idea whether we’re in the early stages of a semiconductor super-cycle, but I do know that chip content continues to grow across every end-market. Auto chip content is growing massively with the shift to electrification, and further adoption of automation and more advanced motors is going to drive increased content in industrial applications, to say nothing of new indications like IoT. Content likewise continues to grow in handsets, medical devices, analytical equipment, communications infrastructure, and so on.
I said above, Analog doesn’t touch all of this, but they touch a lot of it. I do expect the record lead-times we’re seeing today to lead to an eventual down-cycle, but it may take longer than I expect to get there (customers will likely want to rebuild inventory buffers) and it will likely be a pretty modest “pause” along a strong long-term growth trajectory.
The Outlook
In keeping with that, I do expect Analog to leverage that underlying market growth and continue to gain some share, driving long-term revenue post-deal revenue growth in the neighborhood of 6%.
Integrating Maxim will initially depress margins some, but I expect Analog to get to mid-40%’s adjusted operating margins before 2025, and I expect long-term adjusted FCF margins to eventually reach 40%. It shouldn’t really be a surprise, then, that I think Analog can likely generate long-term FCF growth in the double-digits, and that will create billions of dollars to fund dividends and buybacks down the road.
The Bottom Line
All of that is already in the share price, as the stock trades at around 9.5x my estimate of combined FY’22 revenue. Strong as Analog’s margins are, they’re not strong enough to support that relative to what the market has typically been willing to pay for semiconductor gross and operating margins.
As I said, it’s not unusual for valuation multiples to stretch in the upcycles (in fact, it’s expected). With that, I feel like investing in most chip stocks now is volunteering to play a game of musical chairs ahead of eventual multiple compression. Analog can still work for long-term investors (depending upon your return expectations/needs), but the prospective returns at today’s prices don’t excite me.
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Comments (11)
which one do you like most out of these three as a long term investment (your personal preference and NOT recommendation): ADI, MCHP and NXPI? Thanks