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Apple Juices Analog Devices' Outlook

The chipmaker is also exposed to favorable trends in the automotive end market.

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 Analog Devices (ADI) reported strong fiscal third-quarter results and provided investors with a bright fourth-quarter forecast, both of which are almost entirely due to ADI's design win in Apple's Force Touch, a technology that is expected to be deployed in Apple's upcoming iPhone 6s launch. Excluding Apple, we estimate that ADI's results were relatively in line with the soft financial performance reported by many peers in recent weeks, especially given ADI's exposure to the slumping telecommunications infrastructure end market.

Revenue in the July quarter was $863 million, up 5% sequentially and at the high end of the firm's forecast range of $825 million-$865 million. Consumer chip sales were again the highlight, up 90% sequentially; we estimate that ADI's design success with Apple's new iPhones boosted revenue by at least $86 million and perhaps a bit more. The shot in the arm from Apple more than made up for a 22% sequential decline in sales of communications infrastructure chips, as 4G network buildouts in China have taken a hefty pause. Industrial sales were down 2% sequentially, about in line with peers. Automotive sales were down 7% sequentially and flat with the year-ago quarter after a strong prior quarter. We remain optimistic about ADI's long-term secular content gains in the automotive end market. We find it encouraging that ADI's gross margins fell only 40 basis points sequentially, as we think it implies that pricing is holding up relatively well on its chip sales to Apple.

For the October quarter, ADI expects revenue of $880 million-$940 million, which would represent 2%-9% sequential growth. Most of the increase will again come from ADI's consumer business, which we think is again tied to Apple's upcoming iPhone launch.

Industrial chip sales may decline, but we find it encouraging that ADI views this decline as seasonal weakness rather than a swift deterioration in business conditions or a death spiral due to economic concerns about China. Such an outlook is modestly brighter than the commentary in recent weeks from firms like Linear Technology (LLTC) and Microchip Technology (MCHP). ADI attributes its rosier outlook to having exposure to specific vertical end markets in the industrial sector, such as aerospace and energy, where demand is relatively stronger than in other broad-based subsegments of the industrial sector. ADI conceded that broad-based industrial demand, excluding these specific verticals, is relatively weak. Meanwhile, automotive and telecom infrastructure chip sales should be flattish sequentially. ADI also expects to take a $220 million expense next quarter as it converts its defined-benefit plan in Ireland to a defined-contribution plan.

ADI remains confident that it can retain its business with Apple over the long term. We currently model that ADI will in fact retain this design win over the next five years, but that the firm takes a pricing hit each year after fiscal 2016 as it fends off competitors. This pricing hit will provide a modest drag on gross margins that brings margins down to the low end of the firm's long-term target range of 65%-68%. As we model future iPhone unit sales growth in the low- to mid-single-digit range after fiscal 2016, we foresee ADI earning a nice revenue and earnings boost from Apple in the remainder of 2015 and all of fiscal 2016, but we envisage limited consumer growth thereafter. That being said, if pricing becomes even more competitive and weighs on ADI's gross margins beyond our current projections, we can foresee a bearish scenario where ADI walks away from this business.

Well Positioned to Profit
Analog Devices is one of the world's largest analog chipmakers, with an especially strong position in analog converter and amplifier chips. We think ADI is well positioned to profit from more advanced--and higher-priced--semiconductor content in automobiles and industrial applications in the years ahead.

Analog chips are used to convert real-world signals, such as sound, temperature, and pressure, into digital signals that can be processed. We believe ADI has a wide economic moat because of its proprietary analog designs and high customer switching costs; since analog chips are neither particularly expensive nor do they require cutting-edge manufacturing techniques, high-quality analog chipmakers tend to retain design wins as long as the end product is being built, all while maintaining healthy pricing and strong profitability over time.

About 70% of the company's sales come from converters and amplifiers across various end markets, but these chips are especially needed in wireless base stations to turn analog signals from cell phones into digital data packets for processing. ADI's foothold in converter chips used in wireless infrastructure should allow the firm to retain its position as a leading component supplier into wireless 4G network buildouts over time. Yet an equally interesting end market for ADI continues to be the automotive sector, where ADI has seen healthy growth in recent years. Not only are traditional cars adding electronic content in their vehicles such as sensors, active safety systems, and advanced infotainment systems, but also hybrid and electric autos are doubling and tripling the amount of chip content inside each vehicle. We're seeing a similar trend of increased chip content in industrial applications, where ADI has tens of thousands of customers. Nonetheless, ADI still faces challenges in a fragmented analog market. The firm has many competitors with equally strong expertise in analog chip designs, and the semiconductor industry is highly cyclical. Regardless of new product releases, ADI's sales probably will continue to ebb and flow with the rest of the sector.

Switching Costs Are High
We believe ADI has a wide economic moat, thanks to a relatively large market share position as an entrenched supplier of high-performance analog data converter chips. Moats for analog chipmakers, such as ADI, tend to come from the strength of the firm's proprietary chip designs as well as switching costs that make it difficult to swap out analog chips for competing offerings once they are designed into a given electronic device. Analog engineering talent is difficult to come by, as greater emphasis is placed on digital chip improvements, and it often takes years to train up-and-coming analog engineers in the intricacies of chip designs. Thus, it is extremely difficult for startups to replicate the many years of analog expertise held by incumbents. Leading analog chipmakers also face stringent quality requirements in some end markets, such as the automotive space, where defects can be tolerated only as low as one part per million. Although the analog chip space is quite fragmented, it would be difficult for any startup to achieve this level of quality while still being able to satisfy high-volume production. Furthermore, analog chips tend to make up only a small portion of a product's bill of materials, so purchasing decisions tend to be based on performance rather than price, helping ADI retain pricing power. Automotive, industrial, and communications infrastructure customers, in particular, are unlikely to choose an inferior chip in order to save $0.50 on the cost of a piece of equipment worth tens of thousands of dollars.

We see other characteristics of the analog chip space that give us greater confidence that ADI will continue to generate excess returns on capital for at least the next 10 years and, more likely, the next 20 years. Once electronics manufacturers select an analog chip, they tend to stick with the chip for the life of the device because it is costly to redesign a device in order to swap in a competing chip that might not necessarily be compatible with the rest of the product. Analog chipmakers like ADI tend to benefit from these switching costs by having lower ongoing research and development and capital expenditure investments, which helps to contribute to healthy returns on capital for shareholders. ADI takes this benefit one step further by concentrating on end markets where product lives are measured in decades, as opposed to the increasingly short life cycles associated with consumer devices like PCs or handsets. ADI is also well diversified and is not overly reliant on any single customer or end market. Analog chipmakers that can sell in lower volume to a broader base of customers also don't have to make the types of price concessions seen by those that sell into the handset or PC markets, for example, where chip orders are made in the hundreds of millions rather than the thousands.

The analog chip space is highly fragmented, but ADI is the only firm with a substantial market share lead in any subsegment of the business. The firm has nearly 50% share of the market for data converter analog chips, which are widely used in communications infrastructure equipment, in particular, as they convert analog voice signals to digital signals for processing and vice versa. We believe ADI will retain its relatively dominant position in converters over time.

Cyclical Spending Is a Risk
Analog Devices' greatest risk is exposure to the highly cyclical semiconductor industry. The company's fortunes are also closely tied to the health of its various end markets. ADI generates about 25% of revenue from the communications infrastructure market, where spending by wireless carriers to build out networks is especially lumpy. ADI's revenue in this segment may ebb and flow with the size and timing of various networking buildouts across the globe. ADI also gains more than half of its chip sales from the industrial and automotive end markets, so weakness in these sectors could spell trouble for the firm. Further, ADI's consumer business may receive a near-term boost from design wins into Apple products, but sales could fall just as quickly if Apple were to ever switch to a different supplier. Finally, the company competes in the fragmented analog chip segment and faces several rivals with strong balance sheet positions and extensive product portfolios.

Stewardship Is Exemplary
We view Analog Devices as a well-run organization. It has done a good job of distributing cash to shareholders, recently raising its dividend to $0.40 per quarter, which results in a dividend yield close to 3%. ADI announced that it plans to distribute 80% of its free cash flow over the next five years to shareholders in the way of dividends and opportunistic stock buybacks, and we applaud both the decision and the clarity that management provided around this announcement. We also approve of the recently announced acquisition of Hittite Microwave, as we believe the firm paid a reasonable 30% premium for a highly profitable radio frequency chipmaker. We're not overly concerned about ADI's debt balance, as these bonds were sold at very cheap interest rates. We also like management's moves from a few years ago to shed some lower-margin product lines and focus on high-performance analog parts, which contributed to strong profitability in recent years.

Brian Colello does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.