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

Good afternoon, everyone. Thank you for joining us today. I'm Stacy Rasgon. I cover the U.S. semiconductor and semiconductor capital equipment space here at Bernstein. Today, it's my great honor to introduce our guest, the President and CEO of Analog Devices, Mr. Vincent Roche. Before we begin, I want to mention if you have -- we'll have about 50 minutes for our Q&A today. If you have questions that you'd like to ask during the presentation, you should have a link to the Pigeonhole Forum where you can submit those questions on your screen, and we'll have time for that kind of Q&A again. Now what is ADI? ADI is known as an extremely high-quality franchise in the analog space, particularly as it relates to signal conversion and processing. And [indiscernible] so they've embarked on a rationalization program of their product portfolio and manufacturing footprint. They did a lot, they were smart enough to exit mobile early enough to actually get paid to do it, they're one of the few. They've increasingly focused their product offerings since then on high-value applications, whatever the end market as well as greatly increasing their presence in new markets, automotive, health care. They took early steps before many of their peers to shutter unnecessary capacity in the last cycle, and they seem to be handling things pretty well on this one. Their acquisition of Linear Technology was a -- it was the premium high-performance analog player in the industry, it's further extended their transformation, bringing a power management franchise into strong synergy with their classic signal chain offerings, brings their margin structures as well to new highs. And they're about to close on another acquisition of Maxim Integrated, which should further cement the story, especially in automotive and other application-specific areas as well as enable significantly and more aggressive capital return given the structure of the deal. So the company comes up a lot in my conversations. I've seen a lot of the conversations include, beyond the near term, of course, the impending Maxim deal but also the sustainability of the growth profile, especially in a post-COVID shortage plague world, an emerging EV story around battery management, an overall growth narrative that it seems like it's more industrial versus comm driven in the past. I don't think that's such a bad thing. We can talk about that. And of course, the broader question of the geopolitical environment as well. And the answer to these, and hopefully, many other questions, it gives me great pleasure to introduce Mr. Vincent Roche. Vince, thank you so much for being with us here today. Really appreciate it.

Stacy, thanks for having me and for that great introduction. Thank you.

You bet. In this format, I do like to try to stay away from the short term, but I don't think we can avoid it. I want to get it off as quickly as we can. But I do want to start out with the current shortage situation. It's fairly impressive. I mean, I've been working -- doing this job for over a dozen years. I've never seen anything that came quite close. You've been working in this industry quite a bit longer than I have. Just curious what you're seeing in terms of the situation. Are you seeing anything different by end market or broad-based, your own internal and external constraints, where are you seeing pressure and where are you seeing more cushion? And what actions are you taking right now to address it?

Yes. So good question, Stacy. Thank you for the many questions. The -- I'd say, first and foremost, what is unprecedented in this cycle is the number of secular trends that are driving the industry from -- Industry 4.0. And the pandemic, if anything, has shown us the fragility of the global supply chain. And we're going to use more automation, clearly to reshore, onshore and try to solve for some of the fragility. We're seeing digital healthcare take a real boost as a result of the pandemic but the process of digitalization has been slow, but at least it's been moving in healthcare, but it's certainly accelerating now. We're seeing more and more sophisticated communications. We've got 5G. We've got O-RAN coming. Silicon and software are the new value creation engines of automobiles. You mentioned EVs coming, that will be a transformative modality in the whole world of automotive. And we're using more and more gadgets. So consumer has had a great cycle through the pandemic, and it looks like it will continue. So we came into -- so we've got all these concurrent drivers of the industry and of ADI. If I look at kind of 2018, 2019, we were all petrified of a recession, we got a recession, but the cause was completely out of the blue. But right now, what we're seeing is in the first half of '20, we saw a huge uptick in demand for our consumer goods, gaming, advanced communication systems and healthcare. And I think those needs have continued. I mean, that demand has continued. And then in the latter half of '20, as we began to think about rebuilding supply chains and how to deal with the huge shift to online retail and what that means in terms of automation, process automation and so on, so forth. That, to me, is a multiyear cycle that will continue. So all these things have driven demand. And we're chasing supply. And my sense is we'll be chasing supply in the industry for at least another year before we get any kind of you -- I mean the choke point today is largely in the silicon fabrication side of things. And I think as long as the demand continues, we'll be chasing supply. And I think that will be for at least another year to 1.5 years from now.

Got it. I got the impression on the earnings call that your internal silicon fabrication was not necessarily the bottleneck. Is it actually more kind of foundry and back end? Or is it like across -- where are you actually seeing like some of the constraints right now?

Yes. I'd say today, most of the constraint that we're seeing is in terms of external third-party silicon procurement. Our back end, we got ahead of this cycle, and we've been putting a lot of capacity into our test facilities to make sure that outgoing test is well covered. And we still have some redundancy built in there. So yes, at this point, Stacy, I would say the biggest choke point for ADI is external silicon third-party supply.

Got it. Is that just a function of their just -- the industry hasn't really added a ton of like more mature node capacity over time? Do you think that they need to now?

Yes. I think there's no doubt about that, that we're seeing nodes like 40 nanometers, 0.18. I mean, one of the great facets of the analog industry is the sheer number of recipes that we use. There are specific [ choke ] points within, 40 nanometers happens to be an important node in the consumer business and in areas like automotive. So that's one particular area. But we're -- there is more capacity coming on bit by bit. And I would say our particular supply situation has been improving bit by bit as well over the last several months.

Got it. I'm going to ask one more short term and then we'll move on to maybe more interesting stuff. But you talked about like as long as the demand holds up, then we'll likely be supply-constrained like into next year or this for another year. How confident are you about the quality of the demand that we're seeing right now? Are you able to parse it? Obviously, everybody is worried about double orders, and they always would in this kind of a situation, but would you have any visibility into the quality of the demand that you're seeing? And I guess are you fulfilling whatever is coming in? Are you trying to sort of like parse out or try to control like the nature of the orders that are coming in?

Yes. It's really a good question. So I think, first and foremost, nobody is building inventory right now. I mean, automotive companies were shutting inventory in 2019 into 2020, but also our industrial customers have kept their inventories very, very lean over the same period of time. So right now, I think what we're doing is -- I mean, GDP is storming. And with GDP goes the industrial infrastructure segment. So my sense is, what we're seeing now is real demand, and we, as a company, use POS as our demand signal. So we use sell-through rather than sell-in as the planning signal, if you like, for our capacity, for our -- laying in our manufacturing plans. And we're paying very, very close attention to what the POS signals are telling us by sector. And if we do see anything out of kilter, we'll balance it and make sure that we've got supply in the places where the POS signals tell us the supply should be.

Got it. Okay. Let's move on to more interesting stuff. I want to start with some of the end markets. Obviously, industrial is your biggest segment. And again, I sort of got the impression a quarter or 2 ago that the nature of the growth -- or the growth story was changing a little bit. I mean you built -- and we'll talk about common a bit, but you had built a growth narrative around comm, and it really seemed to be shifting a little more toward industrial. I guess to start out, could you maybe talk us through a little bit about what industrial is for you? I mean, obviously, it's -- I always think about it as hundreds of end markets and thousands of products and tens of thousands of customers, but maybe a little more detail, which products or end markets within industrial are you most excited about, whether it's growth prospects or content increase or anything else? What are the key areas within that large business segment that you think investors really ought to be keeping their eyes on?

Yes. So first and foremost, the industrial sector is around half of the company's total business. And the sectors within that are factory and process automation, aerospace and defense, healthcare and what we call instrumentation, which is a mix of automatic test equipment, electronic test and measurement and scientific instrumentation. So there's many tens of thousands of customers across those 4 giant applications. Aerospace and defense is a little more concentrated, but all the others are highly diverse. So we supply tens of thousands of product SKUs to tens of thousands of customers across the globe with product life cycles that tend to be anywhere between 15 and 35 years. So it's a very, very durable, diverse franchise. When I think of factory automation, that, to me, is today about moving more and more digital technologies into these machines, connecting these machines, building more sensing on board. It's otherwise what people would call Industry 4.0. So it's using more and more automation routines in our -- in the automotive plants, in the pharmaceutical plants, et cetera, et cetera. These machines are becoming ever more instrumented and ever more sense. So that's a good place for ADI. Aerospace and defense, we largely rekindled our interest in that business when we acquired Hittite several years ago, 6 or 7 years ago. Roughly, I think, 40% of Hittite's business, which is microwave and RF, was centered in the aerospace and defense area. And as we know, there is more and more satellites being deployed. There's more and more automation being used in the defense sector. And all that is good for ADI, more connectivity, more sensing. The healthcare sector has been growing. It's a $400 million plus business for ADI.

That how big it is now? Okay.

Yes, it's well over $400 million these days. But growing about 10% a year for the last several years, and I expect that kind of growth pattern to continue for several years to come. And the instrumentation business has been driven by -- during the pandemic, it was the instrumentation used to test memory systems for cloud, advanced communication systems for interconnectivity and data centers, for 5G build-outs and so on and so forth. So it's all those applications combined in that multi-customer, multi-market, multi-product franchise. So that's a summary of industrial. And my sense is we should be able to grow that business over the next several years at kind of 5% compounded, I believe. And we are now connecting the LT power franchise as well to more of the sockets in the industrial area plus the other sectors that we're focused on. So that's another tailwind from a product perspective.

Got it. How do you sort of parse out that 5%? How do you think about like overall GDP market growth versus share gains versus content increase?

Yes. So we've always said that if GDP grows at 2.5%, the business share will grow 5%, but my sense is GDP will be somewhat better than that, at least through the full of 2022, probably into 2023. But I think also, we've been putting up share gains in the industrial area. So I think we can always depend on some multiple of GDP, and then perhaps a couple of points of growth through market share gain and connecting the LT portfolio and the Maxim portfolio when we get it on board.

I don't know. In that context, 5% feels kind of conservative to me.

Look, I hope you're right. I think when we plan, we plan our investments. If we can get 5% compounded on half our business for the next 10 years, I think that's a pretty good result.

Okay. So you're thinking that kind of a timeframe, by the way, like it's not like a 2-year target or anything like that, this is like a long compounding kind of thing?

It's a long-term target. In your prepared remarks, you talked about ADI is refocusing the investment portfolio about a decade ago in the B2B space, but the first call on R&D for ADI is the industrial market. So we have a great set of on-hand products and -- that make up a large portion of the opportunity pipeline, but with a lot of new stuff coming as well in sensing, connectivity, signal processing, power. And they continue to add more momentum to the portfolio.

Got it. Got it. Now what about comm? Like I know you had talked about -- I think when you were here last year, you talked about comm as sort of like a long-term double-digit grower. I know you sort of like took that down a little bit 3 months ago, just because of Huawei and like the current situation that's kind of going on in China. How do we think about like the long-term prospects for the comm business, especially given the 5G rollout, I guess, taking into account some of the changes in the nature of the customer base, given the China situation and all of that.

Yes. So let me try and unpack a little bit, Stacy. So today, our communications business is about $1 billion, and 40% of that $1 billion comes from what we call wireline communications. So it's things like metro, long haul, local, optical, communication systems, data centers, cloud activities, adding power management to these capabilities as well. And my sense is, I mean, that's been growing over the last few years in kind of high single digits. My sense is that is likely to continue given the opportunity pipeline we have and the new suite of products that we've got. The reason for changing the perspective on the long-term growth communications from kind of 10-ish to 7-ish is largely because of the change in the wireless business. And when I look at it today, we now view China as opportunistic to our business.

In comms or more broadly, by the way?

Just in wireless. Well, I would say just in comms, just in comms, more opportunistic. But the wireless business for ADI is more than 3x bigger in rest of world than China. So that's where the growth is likely to be, I think, centered in America. We've -- C-band auctions are complete now. Carriers are trying to monetize the spectrum. So my sense is we will see a multiyear build-out of 5G and O-RAN will have a position to play as well. We've seen some very good traction with our O-RAN business or the open radio standard business in Japan through Rakuten and so on. So Europe is about to build out 5G as well. They're going to skip. It looks like a couple of generations and get seriously into 5G in the 2023 timeframe. So I think they will be the growth drivers for ADI, classical 5G sub-6 gig microwave in America. Europe is yet to come. And then we have opportunistically business in China plus the rest of Asia. So I think that's how I view the structure of the business, at least geographic.

Got it. Can you talk a little bit about O-RAN, by the way? Like I know you've been talking about this a lot, but like exactly what is O-RAN? What does that word mean? And what does it mean for your business, for the folks on the line here, who may not be familiar with that?

Yes. So it's the open radio access network standard. And basically, what it is trying to achieve is, first off, an open platform that, in theory, carriers can use, classical carriers, and if you like, use the technology for their own needs, the traditional OEMs can use O-RAN. But it's a distributed radio network system that moves from kind of centralized carrier-owned networks. It moves the network closer to the edge. So in theory, you get more edge processing, you get more power where the base stations are centered. And -- but I think the key -- so there's -- the network is distributed around the radio, the distribution unit and then the central unit, but I think the key part of it is that the standards are open for anybody to get access to. And I think we'll see new entrants, particularly entrants that are maybe cloud-oriented or computing-oriented, who want to bring 5G radio type technology to private networks in areas like industrial businesses. The big promise of 5G has always been, yes, the consumer benefits with a lot more bandwidth, a lot more channel pipeline, if you like, a broader pipeline to get more rich data streams. But the other part has always been that we get the opportunity to bring very, very high quality, deterministic communications networking to mission-critical applications like factory automation, healthcare and automotive. So that's -- I think O-RAN gives that particular part of the value proposition, the B2B proposition, a bit more impetus.

Got it. So they'd be able to basically deploy their own like high-quality networking, brings new customers into the fold, like that kind of thing?

Exactly. Exactly. New use cases, new customers and new suppliers.

Got it. How long until it really gets going, do you think? What stage is this in?

It's starting. I mean, the first kind of public proclamation of 5G-level private networking is -- has been in Japan with Rakuten, the online retail system there. So my sense is, we'll start to see -- we're starting to see trials now. So somewhere in 2022, I think we'll see some earnest build-out of O-RAN.

Got it. Let's talk about automotive. So I guess just tactically, especially in the wake of the current situation. Obviously, that market for a variety of reasons has been impacted worse than others. Do you still think -- like how long do you think the industry takes until it gets back into supply demand balance? And I guess, presumably, this is one of those markets where you don't think inventory is yet being built. Do you think everything you're shipping right now is going into an automobile? It feels like that for a lot of your peers.

Yes. I think so, Stacy, I don't think -- I think automotive customers would love to build inventories. But I think it's pretty much hand to mouth now. But I will say, I mean, over the last several months, the supply line for automotive customers, from our perspective has been getting -- just edging better month by month. So -- but I think we'll be chasing supply across the board and including automotive for at least another year.

Okay. And I got to say like auto was one of those areas of your business that, for us, especially post-Linear, was a little challenged from a growth perspective for a while. Can you talk a little bit about why that was and what was causing it? Is it -- what is the situation today versus, say, a few years ago?

Yes. We had immense business that we -- that had largely commoditized and we had begun to really extract ourselves, we stopped the R&D several years ago. So that was a headwind for ADI for a period of time. So that has -- it's still a bit of a headwind, but we have significant growth drivers now, for example, in the in-cabin electronics area. First off, the automotive sector is stronger. There is more of our -- there's more ADI content in cars these days. If you just look at the in-cabin electronics side of things. We focus on premium audio media, for example, so we have a long heritage in selling DSP technologies. We have a lot of mixed-signal electronics. We're now attaching power electronics from the LT franchise. On top of that, we have added our A2B franchise, which is a very thin, low-cost, high-fidelity bus system that is now shipping into more than 20 OEMs globally. And also on top of those 2 technologies, DSP, audio and the A2B, we now have active road noise cancellation technologies that we're shipping as well. So there's a lot more sensors, a lot more signal processing. So that's the in-cabin side of things. Then if I look at the electric vehicle, that thing is growing fast. We have a very, very strong order book for these battery management solutions. We're on our fifth generation now. We have coverage from these wired battery management solutions to wireless. That's a new modality. And you probably saw recently the announcement that we did with GM, where they're basing the monitoring of their batteries, in their entire fleet with ADI technology. So when you consider that today, there's 2.5 million, 3 million electric vehicles sold a year, that's going to increase at least in order of magnitude between now and the end of the decade. So that's all yet to come in terms of growth. So I believe that the headwinds that we had have largely abated, and now we've got 2 or 3 strong tailwinds behind us in that particular business.

Got it. Let's talk about the BMS business a little bit. First of all, I guess, talk about a little bit of wireless versus wired solutions, like why is wireless better from your -- both in terms of functionality and then I guess, in terms of like your content, what kind of a premium are you getting on like a wireless solution versus a wired?

Yes. So there's going to be, at least for the foreseeable future, though, there will be 2 offerings, okay, or at least 2 streams of demand for our battery management products. The wired side requires -- it's the way batteries have traditionally been built where you use a wiring -- you use sensors with a wiring harness, you collect the data, you move it through a wiring harness to an aggregation point and then eventually to a central computing unit. What that means is that wiring harness decreases your flexibility. It's a fixed piece of metallic engineering, so it's a fixed harness. It decreases the flexibility in the -- in how you configure the batteries. It's susceptible to corrosion and reliability issues. On the wireless side, we've got this cognitive radio system that enables us to -- enables our customers to put sensors in very, very different configurations because they don't depend on the wiring harnessing, they have tremendous configurability flexibility. You don't suffer from the natural reliability issues of the wiring harness because you're moving your data wirelessly. And what it means for ADI is that we get anywhere between kind of 50% and 100% more content value for the wireless system than we do for the wired one, wired harness system.

Got it. How big is the BMS business today, by the way? Obviously, we're still at the dawn of the EV age.

Yes. Well, it's getting up now into double digits of the company's automotive business. So it's becoming significant. And as I said, my expectation is we can grow that in the pretty high single digits, I think, for several years to come.

Got it. And then we'll talk about Maxim in a little bit, but I mean, like Maxim obviously plays here as well. How does Maxim strengthen I guess, the -- talking about the rest, but the auto business in general and the BMS business, particularly because they also play in the space, correct?