Skip to Content
Stock Strategist

Linear's High-End Focus Results in Peer-Beating Returns

The demand picture isn't as gloomy as feared for this wide-moat chipmaker.

Mentioned: , ,

 Linear Technology (LLTC) reported solid fiscal second-quarter results and gave investors a relatively bright third-quarter outlook that in our view helped calm fears of a macroeconomic collapse, as the firm believes that the worst of a recent inventory correction is probably, but not definitely, behind it. Our long-term thesis for the wide-moat firm remains intact, and we would consider any pullback in the share price as a potential buying opportunity.

Linear's revenue in the December quarter was $347 million, down 1.5% year over year but up 1.5% sequentially and at the midpoint of the firm's forecast range of 0%-3% sequential growth discussed in October. Revenue from the transportation sector was the bright spot, up about 6% sequentially with good growth in China. We continue to view the secular rise in electronics content per car as the single-best growth driver for Linear and its peer group, and management also sounded confident in future tailwinds from autos.

More important, Linear eased some fears of a collapsing macroeconomic environment by forecasting 2%-5% sequential growth for the March quarter, slightly ahead of recent seasonality for the normally strong period. Industrial chip demand appears to be "less weak" than in recent months, as recent inventory drawdowns appear to be over and customers are resuming more normalized order patterns. Linear considers industrial demand in China to be "just fine." When combined with preliminary results from Microchip Technology (MCHP) and Advanced Micro Devices (ADI), analog chipmakers are painting a demand picture that is relatively less gloomy than what may have been implied by the market's recent sell-off. All else equal, we view any sell-off in Linear as the start of a margin of safety in this high-quality name, as the firm should be able to weather any future economic storms.

Cash-Generating Machine
No semiconductor firm has been able to consistently match Linear Technology's profitability, and we don't see that changing anytime soon. Linear specializes in high-performance analog, or HPA, chips, which require extreme precision and reliability in devices used in many industries, but especially industrial and automotive products. Because HPAs make up only a small portion of the total cost of these products, buyers in these end markets tend to make purchasing decisions based on performance rather than price. HPA design expertise is not easy to come by, so firms that have spent years developing proprietary designs have an advantage over new entrants. Meanwhile, HPA designs do not rapidly evolve and do not rely on leading-edge manufacturing techniques, so Linear's chips tend to have long product lives and low capital requirements. All of these factors lead to high profitability in the HPA market, and Linear's returns have outpaced its peers' over the past decade. The firm's HPA expertise and ability to retain its top engineering talent are sources of Linear's wide economic moat.

On top of its strong chip-design capabilities, Linear has maintained a disciplined approach to its product portfolio. The firm tends only to compete for design wins where high performance is absolutely critical, which in turn helps to support its pricing and profitability on such sales. In cases where an electronics manufacturer is willing to accept a lower level of quality for its analog parts (and pay a lower price in the process), Linear will often concede these opportunities to competitors. This strategy has made the firm a cash-generating machine, and we don't see it losing its foothold in the high-end HPA market anytime soon. Yet there are drawbacks to Linear's strategy. By forsaking lower-margin businesses such as the handset market, Linear has less of a presence in some high-growth industries. As rivals build relationships with leading consumer electronics makers, Linear runs the risk that walking away from a lower-margin design win today could shut it out of more desirable ventures in the future.

Design Talent and Solid Product Performance Dig Moat
This HPA chipmaker has built a wide moat around its business. Moats for analog chipmakers such as Linear tend to come from the strength of proprietary chip designs. 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, for example, where defects can only be tolerated 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 Linear retain pricing power. Automotive, industrial, and communications infrastructure customers, in particular, are unlikely to choose an inferior chip in order to save, say, $0.20 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 Linear 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. In turn, analog chipmakers like Linear tend to have lower ongoing research and development costs and capital expenditure investments, which help to contribute to healthy returns on capital for shareholders. More than most other chipmakers, Linear takes this benefit one step further by maintaining a devout focus on high-margin opportunities 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. Linear's intense focus on high-value-add niches allows the firm to achieve even higher profitability than its peers, albeit at relatively lower sales levels. Finally, Linear 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 typically 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.

We don't see many substitutes for analog chips on the horizon, as a variety of electronic devices will continually manage and regulate power, as well as convert analog signals, such as sound and temperature, into digital signals for processing. The analog chip landscape also remains highly fragmented and market share shifts tend to be gradual over time, so we don't see a newfound competitor that would pose a threat to Linear's business. Finally, we don't foresee a shift in strategy away from higher-margin industrial opportunities or any other types of reinvestment risk that might cause Linear to lose its wide-moat status anytime soon.

Industry Cyclicality Poses Risk
Linear's greatest risk is exposure to the highly cyclical semiconductor industry. The firm does not outsource production, so it is on the hook for the fixed costs associated with running chip manufacturing facilities, in the event that chip orders from customers grind to a halt. Linear competes in the fragmented analog chip segment and faces several rivals with strong balance sheet positions and extensive product portfolios. Finally, Linear's devout focus on high-margin design wins could leave the firm susceptible to missing out on some high-growth end markets in the years ahead.

However, we view Linear Technology as a well-run organization and give it an Exemplary stewardship rating. The company has done a good job of distributing cash to shareholders, raising its dividend to $0.30 per quarter, which results in a solid 2.9% dividend yield. We think Linear's priority for share distribution is to increase its dividend over time, but the firm is also authorized to buy back up to 10 million shares. Perhaps most important, we like Linear's devout focus on high-margin opportunities in the analog chip industry, which has enabled the firm to earn gross margins and operating margins well above industry averages, and we don't expect any other analog firm to generate similar returns anytime soon.

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