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

Hello, everyone. This is Vivek Arya, Senior Semiconductor Analyst at Bank of America Securities. Thank you so much for joining us. And I'm absolutely delighted and honored to have Prashanth Mahendra-Rajah, the Senior Vice President and CFO; and Mike Lucarelli, Head of Investor Relations from Analog Devices, joining us this afternoon. Welcome to both.

And maybe, Prashanth, just to kick the session off, if you could just give us a state of the union. You reported very good results recently, despite all the headwinds that we are seeing from both a macro and a COVID perspective. So I thought it would be a good opportunity to just give us a quick state of the union, what you're seeing in terms of both the demand environment and if you're seeing any supply challenges given all these macro headwinds that the industry is going through.

Thank you. Thank you, Vivek, and good morning and good afternoon to the investors who are joining us from around the country and around the world. Maybe I'll just do a quick recap of what we messaged at our earnings call, which was just a couple of weeks back. So we had -- we sort of used the expression that we are planning conservatively and executing aggressively. And as part of that earnings call, we talked about the drivers for our EPS and why we feel that we're well positioned, despite kind of a pretty tumultuous background. And those EPS drivers, really, some relate to the markets that we're in. So clearly, we'll talk a little bit later about our 5G position we have there, our strength in wireline, our great share in electric vehicles, the boom that we're seeing in our health care business that we were on the front of and a very resilient defense business. In addition, over the past 6 months, we've been very aggressive with managing our channel inventory. So we've taken some significant improvements over the past 6 months, which we think position us well for the uncertainty that's in front of us. Across the organization, the diversification of ADI is a great shock absorber, as what we're seeing is really demand across about half of our business is holding up well. And we feel good that the secular trends that we are attached to are really going to be more meaningful when we're on the other side of this COVID environment.

Got it. So as we go through each of these growth opportunities, Prashanth, so you mentioned the magic word in 5G, help us just kind of segment your overall communications business, how much is wireless, how much is wired. And what are the different trends in each that you are seeing right now? And has -- have these COVID headwinds have actually -- have there been headwinds or tailwinds in just your overall communications business?

Yes. Great. Great question. So the way to think about our communications business is it's about 2/3 wireless and 1/3 wired. So on the wireless side, that is -- about half of today's activity is still our core strength legacy 4G, and about half of that is 5G. That 5G demand is strong, and that mainly relates to China. And we talked about that in prior earnings call. We have excellent share across the ecosystem, both at local players as well as international suppliers. So I don't know that there's a better play across 5G right now in terms of the breadth of our penetration than ADI. Beyond China, I would say Korea and Japan are probably a little weaker than we originally thought because of COVID, but we certainly see no change in the economic rationale for 5G, and we would expect those carriers to continue to deploy that in the second half. On the wired side, I think like many participants in the wired space, this work-from-home environment has been good for business. And our strength really is in optical. So we're seeing strong trends here really related to data center buildout, and this was -- this is broad across all customers and all geographies. So as we look forward, comms will always be a lumpy business. So we need to be cognizant that it will always go through peaks and valleys as it has for many years, but we feel good about the trends. We feel good about where we're positioned. And over a multi-quarter period, this is going to be a growth area for us.

Got it. On the 5G side, Prashanth, what is the content opportunity that you are seeing, as customers are going from 4G to 5G? And what is ADI's kind of unique positioning in a 5G radio?

Mike, do you want to…

Yes, sure.

Mike breaks -- I want to be careful that I don't share more than we normally do. So I'm going to have Mike give you our official answer.

Yes. Hi, Vivek, how are you doing? So when you go from 4G to 5G, if you think about there’s more radios, the differentiation’s happening in the radio itself. And on average, the radio comp goes up by 8x. That means we need more of our technology in that radio. And we say there's 4x the silicon dollar content in that radio. What we sell into the 5G radio, we sell a lot of transceivers. Like I said, every time there's more radios, we need more transceivers, and we're also bringing new technologies in there from our Hittite portfolio with the LNA switch and also from the linear portfolio to the power management stuff. So you put it all together, a 4G base station next to a 5G base station, we have 4x the silicon dollar content.

Got it.

The power opportunity -- sorry, Vivek. The power opportunity probably deserves just a little bit of a call out because, as a reminder to investors, that is a -- that's an area that Linear did not participate in, in that segment at all in the wireless side prior to the acquisition by ADI. So all of that penetration that we're having in the base station with power really is accretive growth for linear.

Got it. And when you talk of 5G these days, obviously, the rollout in China becomes extremely important. And I think, Prashanth, you referred to it. Talk to us about what your position is in China. How much is that Huawei versus non-Huawei? And given just the restrictions that the U.S. Department of Commerce and Defense, and they are trying to put in, how does that impact your overall 5G opportunity in China?

Sure. So I would -- let's start by saying that we have a very strong position across all of the infrastructure, both local and international. Our -- I think it's well known that the exception to that is really Huawei. So the impact of the -- of Huawei and their -- the restrictions that they are under with Commerce has limited impact to us because we've already sort of bottomed that business out in our forecast. Last year, Huawei was a mid-single-digit customer. We've recalibrated them as a low single-digit customer, and we've had that point of view for a while. That remains the case as we look forward, and that's really reflected both in our current guide as well in our outlook. So we don't see a real impact for us. The downside from Huawei, I would say that, potentially, as some of these implications of commerce may change Huawei's ability to effectively compete outside of China, that really represents opportunity for us because it will either be a -- an opportunity for us to sell more to Huawei as they need a better international solution or, if they’re unable to, and it goes to a non-Huawei provider, then we've got a very strong share position. So we feel good about kind of the opportunity, frankly, that this creates for us.

Got it. Are you seeing any greater competition from Chinese vendors than you did before, either from Huawei or from other suppliers in China?

That's a -- I'm going to take your question as a general question sort of across analog versus specific to communications. So there's clearly been a growth in the level of competition we're seeing in China for analog, but I think the real distinction there is that is really at kind of the lower performance, maybe standard product-type space. Where performance matters, it's not -- there really isn't a competition for us. That is -- it's not just our sweet spot, but it's also very hard for a domestic player to enter into that high-performance space just given the complexity of what it takes to be strong in analog design.

Got it. And one question that I saw from an investor was that, is there any ability to ship -- still continuing to ship to Huawei, if, let's say, the base station is installed outside China? Or does it matter where that base station is involved that you -- I understand you outlined your exposure kind of in that low single digit. But beyond that, does it matter where they're deploying the base station in terms of the state of restrictions?

Yes. I think I sort of answered that in the previous response, but let me be clear on that. To the extent that countries outside China rely on Huawei as a supplier for international base stations, we believe that will continue to represent opportunity for us. And to the extent that kind of the whole Department of Commerce rule is impacting Huawei's ability to be effective outside of the -- outside of China, that also represents opportunity for us because it's either going to be a non-Chinese designed solution, a more international standard, which requires the performance that we bring or it's going to be a non-Huawei solution, which will reflect the -- kind of the strong share position that we have.

Got it. Now one thing, Prashanth, as we kind of step back in the overall demand environment is that as the -- it's good to see that the supply chain is starting to come back up and normalize in a few places. Has that changed the booking patterns in any way? Or asked a different way, did you see any level of pull-in of sales just because people were worried about supplies and now, as the supply situation is starting to reverse, right, are the booking patterns changing versus what you had seen in the earlier days of COVID?

Yes. Yes. Definitely, it's been a very dynamic environment. So February, order activity was weak. March came back strong across really all markets and geographies, and strong is probably an understatement. It was led by strength from China because they were the first to recover, and we saw those economies kind of come back first. But I would say beyond China, we saw a large number of customers with concerns about supply chain disruptions, kind of put their orders in and sort of get in the queue because they clearly weren't -- were concerned about what the shelter-in-place rules would mean across the world. So following kind of that roaring March, orders began to fall in April and have kind of continued to decline through the month of May, but at a bit of a slower pace. So we do think it's starting to settle out. I would say that we had all of that considered in the guide that we gave. So our book-to-bill going into the quarter here now has been above 1 across all of our markets, except for auto, which is to be expected. We feel we have very good backlog coverage, much higher than we normally do. So actually, I think we've said publicly, we have 100% of our current guide covered by backlog, which, I think, on a normal basis, that's like 70% to 80%. So even with a deceleration in orders or cancellations or pushouts, our book and ship will more than cover us, so we feel good about the guide. But it certainly says that there's a lot of uncertainty out there. And kind of future quarters and beyond, we're going to have to see, now that the shelter-in-place rules are being lifted and industrial customers are relooking at what their demand requirements are, how that will flow through over the coming quarters. I mentioned in the opening remarks that our inventory is in great shape. So even with some challenges in end demand, we think we have rightsized our inventory for where we want to be in this state of uncertainty.

Got it. Do you think, Prashanth, the industry -- so not ADI-specific, do you think your industry today has second half visibility? Or like when can we say that, okay, calendar Q3 will be the first quarter where things start to get back to seasonal terms or you think the demand environment is still quite dynamic, as you phrased it?

Yes. I think the demand environment is very dynamic. Recall that for many years, ADI did revenue recognition on a point-of-sale basis. So we have the systems and the intelligence through our distributors to really track what's happening at the end customer's POS point. And beyond that, we have -- we've got a variety of analytics that we use because we really are sort of a microcosm for global manufacturing in almost all aspects of it where tech is involved. We have a number of analytics that we use to get a sense of where customer inventory levels are, and they had contracted over the course of 2019. So we think there's possibly some room for them to grow a bit, but that will -- that growth will only come if those end customers feel good about where the demand trends are saying. So I'm not confident that our industry has a view beyond really the kind of the next 90 days. That's always been the challenge of semiconductors.

Got it. And just one other question in terms of the potential for double ordering or pull-in. There is a perception that whether it is Huawei or whether it is other Chinese customers that -- not just in the last quarter, but over the last year or maybe since the trade tension started, right, the Huawei ban, I think, took place in May of last year, if I recall correctly. So here we are kind of at the 1-year anniversary, and there's been this constant perception of fear that there has been a lot of excess inventory pull-in, even though we have not really seen that big sales strength for your industry. What is your perspective, right, from an industry dynamic that have customers in China, kind of Huawei and non-Huawei, pulled in a lot of inventory that at some point needs to be unwound?

I think, Vivek, that with the increased uncertainty about Chinese customers being able to obtain what they need because of the ratcheting up of the trade war, there may be a demand -- or there may be a desire there for demand. But given that the whole industry is coming out of this shelter in place, there has been kind of a global constraint on supply. So I don't think that, that level of build has occurred in the Chinese market per se. Certainly, I can say that's the case for us. And I think that, in general, the industry's a lot more disciplined than they have been, right? It is not to anyone's advantage to over-ship into the Chinese market only to have that unwind on them at some point in the future.

Vivek, it's Mike. I'll add one thing to what Prashanth is saying. If you look at communications revenue, in the first quarter -- so 2 quarters ago now, we were at $240 million of communications revenue. That was the same level of communications revenue as 2017. So the thought that Huawei or CT over that time frame was building a lot of inventory, it'd very unlikely given that's at the same level as 3 years ago. And the demand we're seeing today is real. There's 5G being deployed broadly in China and other geos.

Got it. Instead of...

Sorry, Vivek, one more comment. For wireless specifically, people have to remember the lumpiness, right? Don't confuse the natural lumpiness of the production process with a -- with reading that as a mixed signal that there is over-shipment.

Got it. Next, if we start talking about your overall industrial business. Very diversified, very, very broad based. And I think sometimes we kind of lump industrial and autos together and just consider it very macro exposed. But your industrial business does have a number of end markets that have been very resilient. So maybe as a start, if you could segment the different end markets within your industrial business and what have you seen in terms of what parts have stayed resilient? And then importantly, what parts can actually start to do better as we go into the second half?

Yes. Let me unpack it in terms of what each of the elements are and then we'll speak to it. So about 25% instrumentation, about 20% aerospace and defense as well as about 20% for automation, 15% now for health care, a little bit under 10% for energy and then the rest is kind of broad market, other stuff. Now going back to that same list, instrumentation is enjoying the strength of memory test as well as some of the requirements for 5G. Our aerospace and defense business is disproportionately defense, very small commercial avionics in there. Mike might have to remind me what the percentage of commercial avionics is.

It's very small. At least 80% of that 20% is defense.

Yes. All right. So that defense is a very stable business for us and growing given the size of the growth in defense budgets, but overall stable. Automation has been under pressure for the last 12 plus months, almost 2 years now, so that's certainly the area that we think has opportunity. And there's some reasons why we feel really good about automation being a source of secular growth for us coming out of this. Health care, everyone's been enjoying the growth in health care as a result of kind of what's been going on globally with COVID-19. So I think most companies that have a participation in the health care instrumentation business have been enjoying some significant growth. So those would be sort of the recap of those.

Got it. Because we saw I think even in the results that you reported the industrial-related businesses have interestingly held up better than I thought the macro environment would suggest. And one thing I distinctly recall from the call is Vince and yourself talking about new areas in robotics and automation, which could accelerate as we emerge post COVID. So maybe if you could us a quick snapshot on what specifically ADI does in those areas and what kind of traction you're seeing.

Sure. So I'd say that we are still at the early stages of kind of the factory 4.0 process or migration. And with what's happening at a global level, there's a couple of trends that I think are very relevant for us. You are having the need for manufacturing facilities to have a lot more flexibility in the -- kind of the ability to move and ship products and what they're making quickly with less downtime, less wasted time. You are likely to see a continued interest in moving manufacturing into sovereign -- within country lines to avoid some of the challenges that came up, both from COVID as well as from the trade war. And in the effort to bring those manufacturing operations or to sovereign-ize those manufacturing operations, you have to overcome the benefit that labor arbitrage was giving you. And the way that you overcome that labor -- that cost of higher labor is through automation. You've got your more developed countries that have either a high cost of labor or an aging population or both. And the way to address that from a cost of goods standpoint, so the products you're making is through automation, and that's where ADI fits in. So it is in the sensing communications and power that is needed for robots, cobots as well as factory communications in these environments, whether it's on a retrofit or on a greenfield basis.

Got it. No, that's a very interesting point. I think when we have heard of all the reshoring trends that are being spoken about in the media and the U.S., in the U.S. push to kind of bring more manufacturing back, we always tend to think of the logic/foundry and then the semi cap complex, but kind of you're right in pointing out that your industry and your company could also feature as part of that new trend as it starts to happen. Maybe, Prashanth, if we move to the automotive area. It has not been the one area of strength for ADI in the past. If you could quickly recap why that hasn't been the case. But more importantly, what is going to change in the future, so automotive starts to become a growth area for ADI?

Yes. Sure. So the -- I just think the way to think about our investments in automotive, the areas that we're excited about are electric vehicles. We are the market share leader with the highest performing BMS products. Another area we're very excited about is infotainment. We have -- clearly, the audio processing heritage, which goes back decades for ADI, allowed us to develop this A2B platform, which we're now adding new applications to. I think we had a press release a couple of months ago for a large customer who is now bringing noise cancellation over that same A2B platform. And then the power opportunity where we're -- with the addition of Linear, are bringing in more power design wins across the vehicle. What has not been as strong for ADI has really been in the safety space. And we have begun to de-invest in some of those safety commitments. We actually made that decision pre-COVID, but it turns out kind of post-COVID world that was the right move because our -- the trends that we see look to support that. As the auto OEs are rationalizing where they can spend their R&D given the economic pressures that they are under, it is likely to be more in the electric vehicle space and less in the self-driving car space.

Got it. When we hear of the opportunity in electric vehicles, things like battery management systems, we hear about that same capability from a number of your competitors. So NXP has mentioned their pipeline, Maxim, Texas Instruments. What sets ADI apart in this battery management system business? I think you mentioned you are the leader. So what sets ADI apart?

Great question. So BMS is a term that a lot of companies throw around, so maybe let me help define why we feel so good about our particular BMS product. First, it is widely recognized by the industry as the highest performing product, and it makes a meaningful difference in the range of the car. And that's been well recognized by our customers. Our strength is in electric vehicles where management of the battery really makes the difference. In almost all cases, kind of the hybrid solution is there to help a car be recognized as green. But as most people know, you tend to drive most of the time on gasoline or diesel and not really get the benefit of the EV. The content of BMS in an EV vehicle versus a hybrid vehicle is dramatically different. So while there may be a larger number of hybrids being sold today, the content opportunity for an EV versus a hybrid is multiple. So our strong share position, the differentiation we bring in the full EV and the higher growth of EV -- a full EV versus a hybrid are all setting us up for this to be a great business. And then we have a significant lead from a technology standpoint with our most recent product, which is the wireless BMS, which is a -- we had an opportunity to display it for folks who were able to visit us at the Consumer Electronics Show in Vegas earlier this year. With that wireless BMS product, we've heard from the customers who have begun to test it, and we've got some design wins that the weight reduction that wireless BMS brings in, which is so critical in a full EV car in further extending the range is a meaningful component. I don't think we've been public on the percentage, but it is enough to really drive consideration of that wireless BMS just from the amount of weight you take off.

Got it. There's been a lot of media reports recently about a green recovery or just the move towards more EV adoption in China and Europe, right? There's a cash for clunkers program that's being considered as part of the various stimulus measures. How real are some of those things? When do you think this start impacting your business?

Well, I think that the most -- the best model to look at is actually in China, and you could see such a clear correlation between how the government was thinking about subsidies and the growth of EVs. So as subsidies -- again, this is pre-COVID when the economy was booming. As they began to wind down the subsidies, the EV activity also followed, which tells us that there really is a very good linkage between the 2. So I feel very good that as other countries begin to think about ways to encourage full EV through the cash for clunkers or other things, it's going to be a really strong linkage as well to sales. And again, we've got -- I think we've been public on this. Of the 15 highest selling on a unit basis, full EV vehicles, more than half of those are ADI.

Got it. Then finally, perhaps in the few minutes we have left, talk to us about gross margins. Understandably, the revenue levels are lower given all the macro headwinds, so gross margins are in that 67%, 68% range. What will it take to get back to your historical 70% plus levels? How much of it is going to be driven by top line, how much from mix or other factors?

Yes, yes. Great. Okay. So as a reminder to everyone, our model is 70% gross margins over the long term. And if you look back, during good times, we were above 72%. And in more challenging times, like today, we're in the high 60s. So through and through a cycle, the goal is 70%. Those gross margins to us are an important metric for us of our innovation. And we use that internally as a way to confirm that are we being paid for the innovation that we're bringing. And the best-performing products is what ADI strives for, and we need to get paid for it, and that's reflected in the gross margins that we target. The diversity of our product and our customers also helps gross margins. We have over 125,000 customers, with 85% of those sales coming from products that individually contribute a pretty minimal amount to the overall. So the stability of those products and the stickiness of them gives us a good stability in our gross margin portfolio. And then lastly, the -- as we have gotten more sophisticated with our ability to manage the data we have on pricing, it is considerably more stable than it has been for -- really, for years where, even through this downturn, we've had pretty limited erosion on pricing. So -- and then as we go forward, I want to remind everyone that we are shutting down 2 factories that we picked up as part of the Linear operation, one in Silicon Valley and one in Singapore. And those are bringing in an incremental $100 million of cost of goods synergies. And we're on track to deliver, I guess, it's $15 million by -- we're going to exit this year at -- with $15 million of that in our run rate -- exit this fiscal with $15 million of that in our run rate, and the rest of it will come in over the course of 2021. So that also adds tailwind to our gross margins.

Very good. I think with that, we are at the end of our time. Thank you so much, Prashanth. Thank you, Mike, for joining us and sharing your insights. And thank you to the audience for joining us. Have a nice day.

Great. Vivek, do I have time to make a plug for next week?

Yes, please.

All right. So for folks on the phone, we're giving you a unique opportunity to hear from Dr. Greg Henderson. He is our -- he's one of my colleagues who is in charge of, among many things, the communications business. So Vivek is going to have a one-on-one with him. I think it's sometime next week.

Tuesday next week.

Tuesday next week. So I encourage you all to listen in.

Absolutely. Looking forward to it. Thank you again, Prashanth, Mike.

Thanks so much.

Okay. You're welcome. Bye.