Analog Devices, Inc. (ADI) Earnings Call Transcript & Summary

All right. Good morning, everyone. So I'm Chris Caso. I'm the semiconductor analyst for Raymond James. Thanks for attending the conference today. Our first semiconductor presentation of the conference is Analog Devices. Here to present, and you have a few opening slides, Prashanth Mahendra-Rajah. Hopefully, I did okay.

You did great, Chris. You did great.

Chief Financial Officer. So why don't you take us away with some slides, and we'll get into some Q&A?

Great, great. Thank you. Thank you, Chris. So good morning, everyone. Thank you for taking the safety risk to come out here today. I will do a few slides with the view that this is a bit more of a generalist conference. So consider this more of an intro to ADI. And then for -- we can use the Q&A session to kind of jump into stuff that you want to get into. I'll skip over the safe harbor. And for folks who are new to the story, just a reminder as to how to think about Analog Devices. We are a company that helps connect physical world to the digital world. So we are that -- we provide the technology that enable companies to build devices that measure real-world phenomena, convert that into a digital signal and then pass it on for further processing and really interpret the world around us. That is through RF, converters, amplifiers. And then most recently with our acquisition of Linear Corporation (sic) [ Linear Technology Corporation ], we now provide the power structure or the power rails over which all of this can flow. At a glance, we are about 55 years old. Revenues around $6 billion. We make a very serious commitment to R&D. What you'll hear about ADI is we are the technology leader, and that's reflected in our R&D. It's also reflected in the margins of the company, which I'll talk about later, which are really our measure of are we investing in the right R&D opportunities and is that bearing fruit through high-margin revenue for our shareholders. A very broad customer base, over 125,000 customers, and that is spread over about 45,000 SKUs. I'll talk about that in a bit. Quite global, over 16,000 employees, almost 17,000 now, with over -- or just under 4,000 patents. Operation, we are headquartered in Boston. But as most companies these days, we are quite global, and you'll find us in all parts of the world. Think about our end markets. I'm going to move sort of clockwise here. The biggest piece of our business is our industrial business. Industrial is really a bucket in which we include a number of different categories. So I think the way to think about it is industrial Internet of Things. So the ability to connect in a manufacturing environment, devices to the Internet, the ability to provide precision measurement in -- necessary for factory automation, necessary for high-speed test applications, health care, lab instrumentation. So wherever you have an environment where you have to take a precise measurement, convert that into a digital signal input to be further used, that's where you'll find ADI sweet spot. That is a very broad business, and that is -- the strength of that business is -- that really is represented by that very large customer base, over 100,000 customers. Industrial, contrast that to communications. Communications is what we refer to as a vertical. Really 2 application areas there, the wireless space and wired. We'll talk about that more in the Q&A. But to think about wireless, that gets a lot more concentrated. Majority of our revenue in the wireless space, you'll find spread across less than half a dozen customers. Automotive, I think, is a space that people are easier to relate with knowing kind of the OE space. In automotive, you'll find us as key enablers of electric vehicles. You'll find us very instrumental in managing the infotainment opportunities as cars become more and more like consumer devices and providing the safety cocoon around the car to help the journey towards self-driving cars. And then consumer is really in 2 spaces. One is portable devices, cell phones and as such. And the other is a very broad business, which is actually quite similar to industrial. Think of high-performance consumer devices, whether it be sound bars, amplifiers, high-end digital cameras, again, a broad business. Many, many customers and lots of opportunities in that area. That tends to be a stickier business, more similar to industrial. Contrast that with the portable business, which can be a little more opportunistic. What is perhaps the hardest thing for most people to appreciate about ADI as they get familiar with the story is how does the company maintain 70%-plus operating margins over such a long period of time. And the answer to that is really in the stickiness of our product. The way to understand that is when we get designed in on a particular socket for an opportunity, the effort that is required for that customer at a later date to look at an alternative to Analog Devices usually is not worth their time. So once you're in a socket, you tend to hang on to that socket for a very long period of time. And that's shown here in the chart of our revenue. So I'm going to just give an example for you to appreciate how to think about that. So if I take the dark maroon set there, you see the numbers 2006 to 2008. That band represents the revenue of products that we launched in the years 2006 to 2008. And you can see that while those products were launched over 10 years ago, they provide as much revenue today in FY '19 as they did back in FY '13 and even going back further. So it is that stickiness of once you win a socket with a particular opportunity, you tend to hang on to it for a long period of time, which is why our focus of our R&D is solving problems, getting into those sockets early, and then having that continue to build and cascade the growth of the company. Now what are those opportunities? And what are those products? And why doesn't someone else sort of take the same approach? The challenge is you're looking at that same revenue spread over 45,000 products. So the amount of effort that it takes for individual or competitors to attack specific opportunities, this itself becomes a meaningful barrier to entry because of the diversity. That revenue is spread over so many different products. And I think our largest one there is just a couple of points of revenue. I think it's 2 points, 2 or 3 points of revenue on an overall basis. So it is a -- it's a highly, highly diversified product base, which supports that revenue buildup that you saw on the previous chart. Priorities for the company simplified down to kind of 3 areas. It is -- our focus is on the partnerships that we build with our customers to ensure that we are solving their most complex and most challenging problems because it is only by solving the most difficult problems that we can earn that 70%-plus gross margin. It is deploying that capital efficiency. We are very aware of a significant investment we make every year in R&D and making sure that it's pointed at the best opportunities. Over 90% of our R&D is pointed at B2B applications. And then capitalizing on the secular trends that are really being driven by the technology revolutions, and that is automotive, industrial, communications. And you'll see that we are tied to just about every trend out there. If you haven't had the opportunity to listen to our most recent earnings call, you'll hear the CEO do a deep dive on the space business, which I know has been getting a lot of attention as well, but that's an area that we've been involved in and have a particularly strong position in and have had for many years. So how do we think about profitability? 5-year sales and operating income have significantly outgrown both the Philly SOX as well as the S&P. And through that period, we continue to be the top 10% on a free cash flow margin of the S&P 500. So that 70% gross margin translates into very strong free cash flow. We don't have a big use of cash to internally run the business. You'll see that our sort of -- our internal CapEx needs because of the variable manufacturing solution that we use is pretty limited, which means that all of that cash is really available for deployment to our shareholders. Shareholder return has outpaced the SOX, the NASDAQ and the S&P really since the SOX has been created. And I mentioned the operating model. So this is the model we've had now for 3 years. It's something that we still used to guide our decision-making process in the company and provide as a way for long-term investors to think about how to model out ADI. We focus on driving mid-single-digit revenue growth that is really grow with GDP, and then on top of that, have the benefit of increased content and increased share gain. Use that revenue growth to deliver very strong gross margins. Manage our OpEx spend to keep operating margins in that -- in the kind of mid-40, low-40 percentage, which should be accretive growth on EPS. Deliver that as cash flow, and then all of that comes back to shareholders after debt service. We most recently announced our annual dividend increase. And in the last month, we raised our dividend 15%. So I'm going to close before joining Chris for some questions just with a comment on ESG. I think this is -- most companies are now thinking about how to talk about their ESG story. This is something that's been part of ADI's DNA for many, many years. What I think is different as investors and particularly sustainable focused investors should keep in mind when they think about ADI is we do draw our box a bit differently, I think, than other companies. Of course, we work on what is immediately within our control, what are we doing within the constraints of ADI as a company. But I also think it's important to appreciate how our technology is used to drive and make a difference in the world we live in. And perhaps the best example of that is our -- one of our leading products is our battery management product, which is used in electric vehicles. We have the highest-performing product used in managing the batteries of a full EV product. It delivers 20% more performance, which means that as you integrate our product into a EV solution versus a competitor's product, you're able to drive significant more distant on the same charge due to the precision of our measurement. And I think that's a good example of not just thinking about what the company does and how we manage our manufacturing and our R&D and our employee base, but also how our products are used in the world we live in. So with that, let me join Chris here for some questions.

Absolutely. Thank you. It's very helpful. We got about a little under 20 minutes for some questions. And no surprise, the first question is going to be about the current fire situation, probably every presentation starting this way. What's unique about you guys -- you're an off quarter. You're a January-ending quarter, so you reported more recently. So you included some of the impact in -- for the virus in your forward guidance. Maybe just give an assessment of the current situation, talk then maybe some update -- I mean it's only 2 weeks ago, but...

Yes. Okay. Yes. So coronavirus, we are an off-quarter company, so we did have our earnings call just a couple of weeks ago, and we took the opportunity to reflect in the guidance for the coming quarter how we were thinking about the coronavirus. At the time, we knew there was quite a bit of unpredictability. So what we tried to do to be helpful to investors is not only give you our view on what the impact in the current quarter is, but also the assumption set that we put in to arrive at that. And that assumption set is basically a few things: One, for our China business, we assumed that our industrial, our automotive and our consumer business would basically bottom out near 0 for the month of February and then begin to return after that. And we looked at the 5G deployment activity and said some of that 5G deployment would be shifting just as the availability of employees to work in the technology companies necessary to build the products was going to have some level of delay. Though there would be some existing inventory, they will be able to come back a little bit faster. So we did assume that there was a slippage in that. We sized that at $70 million of impact to us for the quarter, and that's reflected in our guide of $1,350 million for the quarter. At this point, we are not changing our guidance. I think it's -- the world is evolving at such a rapid pace. It would be difficult for us to constantly be giving you an updated point of view. I would say that as you hear more and more semiconductor companies report their impact, you'll find that sort of on a relative basis, that seems to be in line with what everyone else appears to be saying, although we were a little bit early. But I think from what we've heard so far since that time, we feel good with where we are.

Right. And just, there was another semiconductor company this morning, NXP, that reported they also took down their guidance as well. They also mentioned some that -- they said the most severe impact was the 2 weeks immediately following Chinese New Year. And they said, actually, the order rate had gone back to where it was before Chinese New Year, over the most recent 2 weeks. And I'm not sure if that's something you wish to comment on [ that realm. ]

We're -- I appreciate the question, Chris. We are being careful not to update guidance during this conference here, so I'm not going to comment on near-term order activity. But I would say that we feel comfortable with the guidance that we put out there.

Right. That's fine. Maybe take a step back a little bit more too because the -- excluding the effects of the virus, at least it's been our call that we were starting to see some recovery in the industry generally after a downturn year. We had some excess inventories, typical semiconductor downturn. Maybe you could talk outside the virus impact, what you've seen in terms of, for example, your industrial markets, which are really important for the company.

Yes. Thank you. So in our fourth quarter, we had -- we had indicated that we believe the first quarter will be the trough for ADI and would begin to see sequential improvement outside of that. Take this near-term virus impact out, and we feel very consistent with that story, that first quarter represented our trough, and as we move forward, we would expect sequential improvements in the growth numbers and revenue. Our industrial business, I would just categorize it into a few areas. Our aerospace and defense business has been having a terrific run for several years now, growing at double digits. And we did not -- and we still do not see any abatement in that. I think we see probably more upside in that from the space activity that we highlighted in the first quarter. Again, I don't know that we can make -- take a position on the commercial viability of that end market, but certainly the race to test the feasibility of that market is going to be very good for ADI. In the high-speed test, we've been seeing pretty strong order activity. And I think that is -- that's consistent with what some of the other industry players who provide other technologies into memory test are seeing. So we feel good that that business is on a trajectory to have a very strong year. Factory automation was where we saw some significant headwind in 2019. The -- our sense is that, at some point this year, that will be returning to year-over-year growth. Probably closer to the second half, I think, would be our view as to when we start to see enough improvements in there. But overall, I feel that industrial was clearly on a path to getting back to growth and feel good about that market.

Right. One of the other considerations -- and you did the acquisition of Linear Technology a couple of years ago now. And because of the timing of the downturn, and one of the justifications for that or the expected accretion was going to be some revenue synergies from that. And of course, over the last year, because of the slowdown in the market, perhaps that was more difficult to realize. How does that play out going forward?

Yes. Thank you. So one of the challenges to the analog business is when you ramp into a production opportunity, that volume, as I'd showed on the previous charts, that revenue opportunity can stay with you for decades. The downside is the build into that revenue can also take a few years. So we knew that going into the Linear acquisition, we were very transparent with investors that it was going to be a few years before we begin to see that synergy because it is -- it's the design activity to win the sockets. The sockets have to go into production ramp, and then the production ramp has to hit kind of full-scale production at our customers. So we always expected that those -- that revenue synergy would begin to materialize in the 2021 period. And I would say we feel that we are absolutely on track for a trajectory that would double the growth rate of Linear versus at the time of acquisition. We should begin to see meaningful contributions from the Linear acquisition in 2021 and begin to start seeing some in the second part of this year. But we also had some tailwinds from that deal -- or sorry, some headwinds from that deal, post acquisition, where there were some -- there are some sockets that Linear had actually lost prior to the deal close, and those were manifesting themselves and kind of rolling through our business in the current year. So we're -- I feel we're passing through that, and now we're back into -- we're passing through the implications of some design losses that were pre-acquisition, and we are about to see the benefit of the revenue upside that comes from the wins post acquisition.

Okay. That's good. Maybe I'll pivot to the communications segment in 5G. And Mike, you could take a note that it's been 20 minutes into the conversation before I asked the 5G question. I appreciate that. But it's an important -- but it's nonetheless an important area for you guys. You've got very good market share. Maybe you could explain to the audience where you participate in that and where the growth comes going forward in that.

Right. Yes. Great. Okay. Yes. So there's been a lot of hype on 5G. And I think for folks who are evaluating investments in this space, it can be confusing because the carriers have, to some extent, marketed that 5G is with us now while it has yet -- has not yet truly deployed. So here's how I would guide folks to think about it. 5G is a set of standards. And one of the elements of those standards is the use of a technology called massive MIMO. Massive MIMO as a technology allows a wireless carrier to take frequencies that they have today, spectrum that they have today and use it more efficiently to serve more customers for the same bandwidth by using a different type of technology. This is a very logical economic trade for any wireless carrier when you're operating in an environment where you have more users than you can adequately speed given your existing infrastructure or your existing bandwidth capabilities. So for that reason, the move to 5G is very logical and rational for high-concentration areas where you see capacity constraints. The deployment of 5G has been moving at a pretty steady pace. It started in Asia. So we've seen 5G deploys in Korea, in parts of China and in Japan. Asia has been the first to move -- I think Singapore also has done some. Asia has been the first to move through that with the largest deployment in China is what folks are expecting to happen in 2020 and in '21, with the U.S. being behind that, probably late this year into early next year. Many of you may see 5G on your phone today and think, "I already have it." You don't. You will see the true impact of 5G when the U.S. carriers deploy in the coming quarters. Analog Devices' position in that is, I would say, to a great extent, we have enabled that technology through something that's called a software-defined radio transceivers. So we help take the signal from an antenna all the way to a bit stream that can be used for downstream digital processing. So we provide that key-enabling technology. As a result of the work that we've done with the wireless infrastructure carriers in helping to advance this technology, we have an outstanding share position at all of these carriers. So for us, it is really less about who deploys as more a question of when they choose to deploy. We're confident that that will be a meaningful impact to our revenue stream, and it's something that we've enjoyed in the early part of 2019. It paused as some of that was digested towards the end of this year, and we're expecting that to continue to roll out over the course of this year. Now having said that, clearly, the coronavirus will impact the timing of that to an extent, but it does not change the underlying economics for why the majority of wireless infrastructure -- sorry, wireless carriers will be deploying 5G in the coming quarters and years. And we will see a disproportional benefit from that.

Right. And you said last year, one of the customers you supply in that was Huawei, and that's not -- that's part of the restrictions going forward. But despite that, you're still confident in the ability to grow that going forward.

100%. Huawei is still an important customer to us. They were a mid-single-digit customer to us in the early part of the year as a result of some of the restrictions. They are now a low-single-digit customer to us. But Huawei's deployment of 5G will still use a number of key Analog Devices technology as part of their solution. So as they grow and deploy, we will be growing with them. But remember that Huawei is only 1 of 3 providers -- technology providers in China, and the other 2 are -- remain very strong ADI customers.

Okay. I just pause here if there's any questions from the audience. Keep going, but after that.

Yes. So in your response on Huawei, you were saying you do think the overall -- that overall area will grow this year. It includes [ Huawei? ].

We do. We were expecting the 5G or the wireless business to actually get back to a year-over-year growth in 2020. That was before the timing shift that was introduced by the coronavirus. So I'm not certain that we will see growth on a year-over-year basis this year. But certainly, the trajectory is still there. So it's just whether that's a shift in timing of when that activity comes back. But there is no doubt that the deployment of 5G will continue globally by Asia. And with that deployment, ADI will have meaningful revenue from that.

Yes. So I think there's some -- in talking about like growth on a year-over-year basis, it depends upon where you're starting in any new year. But from -- on a quarterly basis, it sounds like your trajectory is pretty encouraging.

We feel good. We feel very good.

Okay. Maybe you could pivot to some margins because that's one of the important areas in the semiconductor recovery. It's frankly one of the areas where the analyst typically underestimate the magnitude of that recovery. What can you tell us about margins going forward? And then specifically, maybe it's helpful to talk about the manufacture -- what you manufacture internally versus externally and how that affects the margin profile.

Sure. Sure. So as I showed on the chart, our gross margin model is a 70%-plus gross margin model. And despite some of the challenges of 2019, we finished the fiscal year on a 12-month basis in our operating model range. We've started this year slightly below the model. But as Mike likes to remind our investors, today's trough-level margins used to be our prior peak margin. So it's really a reflection of how we have -- we've grown the business. We have adjusted our manufacturing variable cost structure that allows us to weather the bit of cyclicality that this industry can face much better than in prior years. Our margins to us, really, they're a reflection of the value we add to customers. And they are, to some extent, what we feel rationalizes our high R&D spend. That R&D spend has to be pointed at the most challenging customer problems. And in return for solving those problems, we expect to be rewarded financially, and that's reflected in the margin structure. The way that I would sort of guide you for the margins on a go-forward basis here is we feel margins have troughed in Q1, and we would look for sequential increases in margin over the balance of this year. Part of the reason that margins troughed in the first quarter was a conscious decision we made to reduce the amount of inventory we had in the channel. So we intentionally chose to run some of our fabs at lower utilization rates to allow us to bring down some of the inventory in the channel. As a business, I would say that we really manage our business on sell-through. So we are really mostly concerned with what is the customer taking from either us directly or from our distributors. When the accounting policy required us to shift revenue recognition to sell in, we took a very simple approach to how we think about channel inventory and we said we will always sell in to be equal to what is sold through, which is what we did over the course of 2019. But as revenue fell, we felt that the inventory in the channel got a little bit higher than we were comfortable with. So in the first quarter, we took channel inventory down about $40 million. And we look to take inventory down again in the second quarter, and that's reflected in our guide. So if you think about it on a sell-through basis, our first quarter revenue was actually meaningfully higher. And our second quarter revenue will also be higher than we guided on true customer activity, not necessarily on accounting sell-in basis.

Okay. And I think we have -- for one more, if we could just kind of tie that into cash flow. And so how does that improvement tie to your cash flow targets? And how do we get that cash flow, flow back to the audience here?

Yes. Great. So you've seen the model as well in the presentation on how we think about our cash flow. And the way to think about our cash flow as a percentage of revenue, it's important to think about it on a trailing 12-month basis. We do have a couple of quarters on a regular basis at sort of peak and valley. So if you look at our cash flow, please don't look at it on a quarterly basis. It's important to look at it on a trailing 12-month basis. This is a company that generates an enormous amount of cash. What we need for internal use is pretty limited. We kind of think about CapEx representing about 4% of cash flow -- excuse me, 4% of revenue. So the balance of that cash after debt service is really available for our investors. For the current year, the way we would guide you to think about deployment of that is we announced a dividend increase last month at the high end of our dividend increase range at 15%. We have guided that we will repay roughly $300 million to $500 million of debt in this fiscal year, and the balance is going to be used for share repurchase. On a go-forward basis, we will continue to deploy some amount of our cash to debt reduction. But really, the focus on our cash flow beyond continuing to delever at a much more moderate pace is to return that to shareholders through the high increases in our dividend and share repo.

All right. I think that's it. We're out of time. Thanks, everyone. The breakout session is in Cordova 2. We'll see you there.

Great. Thank you.

Thank you.