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

Good morning, everyone. I'm Chris Caso, Raymond James semiconductor analyst. So thanks for attending today. We're all excited to be here live. Our next presentation here is Analog Devices. With us today from ADI is ADI's CFO, Prashanth, I'm going to make sure I get it, Mahendra-Rajah, so I make sure I pronounce it correctly; and Jeff from Investor Relations. Thank you very much. So you're going to start from a couple of prepared remarks using a couple of slides, and then we'll get right into the Q&A.

I can do that. Yes. I'm going to go quick. These are available up on our website, and I really want to spend the time up here with Chris and his questions. But for those who may be a little less familiar with the story, just a few takeaways I want you to remember from ADI. So -- all right, see if you can try to figure it out, but -- all right. Takeaways. We're a technology powerhouse. What's core to ADI is the investments we make in engineering and how that engineering helps connect the physical to the digital world. So when you think about semiconductors and you think about the different categories of semiconductors, where do we fit in that space? We are the guys that help measure, sense and interpret the data so that you bring in from the measurements and then you pass that off to the digital world. So that is analog mixed signals, it's RF, it's power, it's converter, it's amplifiers. We can spend a lot more time on that if you have an interest in the engineering side of it. The key takeaways, because we are so engineering focused, talent is a huge piece of our value proposition, and that is 25,000 employees, almost half of which are engineering around the world. A very significant portfolio breadth. And the second takeaway that I'd like you to remember is, this is a very durable business because of some of the things I'm going to cover. We have significant high barriers to entry that includes an incredibly wide breadth of portfolio, over 75,000 SKUs, an incredibly wide list of customers, over 125,000 customers. And that market -- thanks, Jeff. And that business is broken into multiple end markets there. So we do most of our business in the B2B segment, that's the green circle there, 85%, split between industrial, automotive, communications; and the remaining 15% in consumer. That industrial really is the powerhouse of this franchise. It is a very stable and durable business, very long life. I'll talk about that in a minute. We're also incredibly diverse, very well represented in all geographies. So you've got a $11-plus billion of revenue that is spread quite well across all geographies. If you can take us to the next slide, Jeff. Thank you. And what is unique to our portfolio is when you think about our products by their vintage, the -- what's unique about the analog portfolio is that when products get designed in at a customer, they tend to be designed in for an incredibly long period of time. So you can see that we today continue to have a sizable percent of our portfolio, noticed there in the purple, products that were launched 10 to 20 years ago, that are continuing to be designed in into new customers. But also once you have a socket, you tend to hang on to that socket for a very long period. That again represents one of those high barrier to entries, which is reflected in our financials. And such a diverse product SKU allows us to say that more than 80% of our revenue comes from products that are less than 0.001%. So again, significant barrier to entry because of that diversity of portfolio that we have built over the last 55 plus years. I'm going to jump ahead here momentarily, talk about manufacturing. I know manufacturing is a big issue today in semiconductor. So just to share our model, we believe in a hybrid manufacturing model, which means that we split our manufacturing between internal and external. That internal manufacturing allows us to provide that breadth of technologies that include some of the more legacy node technologies, and we go externally where we need high volume or where we need access to the most advanced process technology. So a spread of manufacturing gives us, again, the ability to flex our business based on what the external environment is. And all of this comes together in extraordinary high gross margins. So 71% for the trailing 12 months, operating margins of 42%, and because we have that hybrid manufacturing model, which is light on CapEx, it allows us to convert a significant amount of debt to cash flow. So 33% of revenue converted to cash flow. So with that, I think I'll wrap here. The full slide deck is up on our website, and we can get into the question and answers with Chris.

Here we go. So thank you. So maybe start just some housekeeping. You made an announcement of appointment this morning. Maybe you could -- give you the opportunity to talk about that and what that means for the company.

Yes. Thank you. Thank you. Yes. So this morning, we announced that Gregory Bryant would be joining Analog Devices as Executive Vice President and President of the Business Units. Gregory was formerly with Intel, where he led their PC business. I think it really is a -- it's a commentary on the size and scale that has -- that ADI has built up over the last couple of years that we were able to attract someone of Greg's capabilities. What he brings to us really is, he has experience scaling businesses, and that's the stage of [ peak ] that we are at now with ADI is we are a much larger enterprise following our organic growth and the acquisitions that we've done and bringing someone who has that expertise to really help continue to scale the business, I think, is a great addition. For the avoidance of doubt, I appreciate the question, Chris, because it allows me to clarify for everyone. This does not change our leadership structure. So Vince is going to continue as CEO. As a matter of fact, he doubled down -- he doubles down this week with the -- with our shareholder meeting this week, where he will also be appointed as Chair of the company.

Okay. And I'd say, Greg, at Intel, a very senior guy, he probably could have taken a CEO position at different places. So I suppose could we see this in some sense of long-term succession planning as well given Vince, now Chairman and that, but Greg is younger than Vince.

Sure. It's a fair question. Probably a more appropriate question for Vince. But I think what I would say is that Vince's goal is really to build out the strength of the leadership team. We have multiple internal candidates who I think would be solid contenders when we reach that point. But I want to just reemphasize, Vince is in this business for the long haul. So I'm not looking -- I don't think anyone should be looking for a change in the near term.

It's not today. We're not going to be looking for any properties in Florida for Vince anytime soon. Well, that's fine. Maybe talk about a little bit of the business to get started. And first question to all semiconductor investors right now is about the semiconductor cycle, the supply constraints. And this cycle is very different than so many of the other cycles that we've seen in the past because of these supply constraints. Maybe you could talk a little bit about that and how ADI is dealing with that and the effect on the business.

Yes. Yes. So I think one of the lenses that we have on the market demand that might be different from some of our peer companies is, as I showed in the charts, the diversity of our business really has us represented in essentially all manufacturing markets and in all geographies. So when we think of today's environment and the demand that we have on our products, it really is a reflection of what's been happening over the last few years for the secular drivers that are really increasing the amount of content in all manufactured products for semiconductors. And as I noted on the chart, we play that critical role of bringing information into the digital world. You have to pass through that Analog barrier. So our demand profile continues to be very strong. I feel confident that I can reiterate what we said in the earnings call just a couple of weeks ago that we're expecting sequential growth for the balance of the year, likely into the early part of 2023. I think that 2023 is probably going to be more a reflection of us getting that opportunity to put some healthy stock back into the channel. About half of our business goes to the channel, and the channel really is bone dry today, well below what we would like to have there. So being able to rebuild some of the buffer stocks that we have there to help bring lead times back to normalcy. So we know this is not going to run forever, but I feel very good, at least for the visibility that we have out for the next year plus.

Right. And once get that visibility and obviously, strong customer is, one of the things we've noted now in this cycle has been different in the past is customers more willing to give firm commitments to you, and maybe you could speak to that as well?

Right. The -- our business model requires that our customers are given optionality at multiple times to reconfirm the orders they have on the business. So we're not asking for a long-term commitment to go out, say, 9 months or 1 year. Because our concern on that is if you lock a customer into those types of long-term commitments and their demand profile changes, then all you're doing is shifting the timing of revenue where they may be required to take product in advance of when they need it, which is either unhelpful for their balance sheet or a revenue timing issue that you're going to deal with at some point in the future. Demand is healthy enough right now that we're really going back to customers on a regular basis, asking for recommitments and where we do get some opportunities to change, it allows us to move products to another customer who is really anxiously waiting deliveries.

No matter what, what we've heard from a number of other companies as well, to the extent they're actually going out and getting capacity and a large part of your capacity is outsourced. Those external partners are requiring commitments from you. So how do you kind of balance the commitments that your manufacturing partners are requiring from you with the commitments you're getting from your customers?

Yes. With the scale that we have today, we're really one of the largest procurers of legacy manufacturing among the foundry business. So that gives us the opportunity to have those conversations with founder partners without making those long-term financial commitments. So I do not have take or pays with any of the foundry partners, except for in one instance where we did a back-to-back to match a customer who specifically wanted a long-term buy-in commitment for us. So to hedge that risk, we did a back-to-back with a foundry partner. But other than that, we don't need to do long-term commitments to our partners. We've got deep relationships with them and we are of meaningful scale in how they think about filling out their customer requirement. But I also want to emphasize that only about half of our business goes externally, right? And the other half is done internally at our fabs, where we are spending capital to increase our capacity. We're spending capital in -- here in the U.S. and in Ireland, and all of that will again add to our ability to supply.

Right. And one of the places you're doing so is with the newly acquired Maxim assets, which I think is probably the tightest part of your business now because Maxim was arguably underinvesting during the period of the acquisition. So maybe you could talk about that. And so -- and then we'll have some revenue implications, too, because that lack of capacity constrains revenue in that part of the business.

That's right. That's right. So Maxim has an excellent facility in Oregon that we are expanding upon. That Oregon facility is particularly exciting for us because it allows us to take our manufacturing down to a technology node that is more advanced for us than we could do internally on our own as legacy ADI. But what's particularly exciting about that space is as part of our negotiations with some of our foundry partners, we have obtained permission from them to bring those certain process chemistries in-house, if we need to. So while we are expanding capacity in Oregon, in the Beaverton facility, the capacity that we're expanding is what we call swing capacity, which means that at some point in the likely distant future, if there is a turn in the economic environment and volume or demand should change, we are able to take production out of our foundries, put it into the internal facility, which allows us to keep our utilization levels up, which allows us to maintain the delightful margins that we have even through an economic [ term ].

Right. And maybe how much of your business is fungible like that? So I mean, to what extent -- there's always some -- in a downturn, some margin degradation that happens. How much of the business is able to be buffered in that matter?

We have swing capacity both in the Beaverton facility in Oregon as well as in our Ireland facility. We don't talk as a percentage, how much of it is swing, but I can say this with confidence. When you look back at ADI through the cycle, through the trough in the cycle, we would fall to about 68% margin, again, still extraordinary high margin for any company in semiconductor, but we would fall to about 68% and then we would peak about 72%. As we go forward, we're pretty confident that in the trough, we are not going to break our 70% floor.

Pretty good. Okay. Kind of rounding out some of the supply -- the cycle changes. The other thing that's been notable in this cycle has been pricing. And largely, it's because companies such as yours, seeing price increases from their suppliers, then being able to pass them along. To what extent has that been a benefit to you over the -- since it's happened over the last 4 quarters? And how much of that is in the rearview mirror? How much of that's still to come?

Yes. Our philosophy on pricing, a little bit different from others, is this was a -- this was certainly an environment where companies could take significant advantage of customers and be quite aggressive on pricing. We have been more moderate and we've been really solving for margin neutrality. And part of the reason for that is given the length of relationships that we have with our customer. When you are designed in on a socket and that customer relies on you to be their supplier of a particular chip for 10, sometimes 20 years, it is important for us to look at that over the long run and that relationship over the long run. So in 2021, our price increases were slightly ahead -- sorry, the price increases to us or the cost increases were slightly ahead of the price increases that we pushed out. So costs were a net tailwind in '21. And now in '22, you'll see the reverse of that, where we're picking up more gain from pricing versus cost increases. But what we're solving for really is we're solving through that margin model to be able to hold to our margin model of north of 70%. And really, it's on a pass-through basis to our customers. And that's really the conversations that we've had with them is that we're not -- we're not trying to be egregious in this environment. We're really trying to solve for the margin neutrality, which is what we need to continue to invest in our business.

Right. And one of the questions we get with regard to that is how sticky do you consider those price increases to be because I think there's a point of skepticism and says, at some point in time, the business will slow down, there'll be plenty of capacity, and those prices will start to reset again. What's your response to those sorts of questions?

I think we solve for margin, right? I mean, as investors think about pricing, their concern on pricing is what does this mean for future trajectory of the margin? We haven't been looking for pricing to be accretive to margin. We've been looking for pricing really to maintain that investor model of margin. So if there is a point in the future where the costs from our scale allow us to be more effective, then we'll adjust accordingly. But I expect pricing to be pretty sticky on a go-forward basis. It's a different environment than it ever has been.

Right. Maybe you talk with regard to pricing is what's kind of different from you because in certain parts of the semiconductor industry, such as memory, you get too much capacity prices come down and normalizes. It's different from your business, but maybe that's helpful to explain that.

Yes, thank you. Thanks for giving me the opportunity. I think as Chris mentioned, why variety in products? So we're looking at over 75,000 SKUs. And when we get designed in on a product, a customer is making a decision to use us for a generation that's out there of what they're launching. And because of the performance that we bring, they -- it ends up being instrumental to how their product performs. And therefore, it is very disadvantageous for them to design us out because as a percentage of the bill of materials, we represent a very small portion and a disproportionate amount of value that we bring them. So what that means is if you win the socket, you tend to hang on to the socket for at least a decade, sometimes 2 decades, which means that when we think about pricing, it is ensuring that we have the right price that's needed to obtain the socket. And then after that, it's really focusing on our manufacturing cost efficiencies as where we get our margin leverage from. We typically do not see the volatility in supply and demand or in pricing that other parts of the semiconductor industry do. And I tried to highlight that in some of the earlier slides is, it's a very, very fragmented business, and that fragmentation is actually a significant barrier to entry, which is what allows us to have these extraordinary high margins.

All right. Maybe along those lines, and it's an anecdote, one of my first meetings as an analyst, when I started being analyst, with Jerry Fishman, a former CEO of ADI. And I made the mistake in one of the meetings of comparing ADI to another analog company that I'm not going to mention. But you had 2 competitors, Maxim and Linear Technology, and they're both part of ADI right now, which is kind of interesting. Maybe you could talk about how those 2, like putting it all under the same umbrella, what does that mean for the company? What does that mean for the growth rates?

So when we think about -- when we think about M&A, it is -- it comes back to what is the value we are bringing to our customers. And that value for our customers is really in -- through the lens of how can we provide them a more complete solution. So we are not acquisitive for scale. We are acquisitive because we believe that a broad portfolio of high-performing products allows us to provide a more holistic solution to the customer. And through that holistic solution, we're able to extract value because we're solving the harder problems. We are not really looking for the standard products or the commodity products. We are looking for the high-end challenging problems. So what Linear brought us was high-performance power, some -- an extraordinary franchise that was struggling for growth, but was able to solve some incredibly unique power problems. And included in that acquisition was the highest performing battery management systems used in electric vehicles. But with Linear's -- with Linear's size, they had some challenges in manufacturing and they had challenges scaling that BMS to the robustness that was needed for the evolving needs of the electric vehicle industry. And that's where that ADI skills and capabilities really came in. We transferred the manufacturing, made that more robust. We improved the quality of the product and brought in some more technologies, including making it the first-ever wireless BMS solution. So you get all of the functionality of being able to monitor the batteries in the fuel cell of the car, but all the communication back to the brain of how each battery cell is performing is now done wirelessly. We've had a number of very large customer wins. General Motors has been very public. Lotus has been public. We also have a European OE, and we don't name that one, but I'll say that it is closer to a General Motors than it is to a Lotus in terms of size. And I expect another one probably towards the later part of this year.

Okay. One of the things, as you acquired Linear, you talked about the growth rate. And I know one of the goals had been to kind of maintain the market -- the margin structure, which was best in the industry, but yet grow it faster. Have you been able to -- you're not breaking out layer revenue anymore, it's all integrated with ADI. Maybe give us some sense of where did that go?

Right. So actually, I'm going to go back to our first major acquisition, which was Hittite, and we've been able to double the size of the Hittite business in 5 years. For Linear, again, we don't report it out, but we have been able to double the growth rate of Linear since we've acquired it. And what we're going to share at Investor Day, our first Investor Day in 4 or 5 years, next month is our plan for how we're going to really accelerate the growth of the Maxim franchise that we brought in, which is -- we're taking a pretty big challenge. We're pretty excited about the opportunities we see for growth. So the model, I think, that Vince really drives is he is looking for high technology, high class operations that he can really inflect the growth curve. And for Linear, Hittite, these were both spectacular franchises, but they didn't have growth. We've been able to correct that. And Maxim, I would say, also has been a great franchise, but it hasn't really shown the growth that's capable in this industry. And I think you'll see us deliver on that as well.

Right. So is it really -- I mean I guess it's coupled with Maxim and foreshadowing the Analyst Day, which is at Fenway -- well, there's an event at Fenway before that, that I'm a little concerned about being Yankee fan. But is the focus on that in terms of what's fixable at Maxim, not that there is anything necessarily broken, but what's improvable at Maxim is mainly the growth rate, is driving better growth rate of that business in the same way that you did with Linear and Hittite?

Yes. I think Maxim was a well-run company, and I -- the leadership did a great job of meaningful improvement in margins over the last couple of years, focused on manufacturing. And we were impressed by the caliber of that manufacturing team, which is why Maxim's manufacturing leadership is now leading ADI's manufacturing business, where we believe there's really an opportunity to add value for our shareholders is in changing the growth rate of Maxim. And clearly, there are some areas where the combination of the R&D portfolios are going to be pretty compelling. There's -- I think, again, we'll talk about it in a couple of weeks, so I don't want to get ahead of the story here, but Maxim has a particular product portfolio that's referred to as GMSL, which is, you can think about it as it's the train tracks in the vehicle that move data around. And it's very analogous to what ADI has in the audio to bits, which is a track or a circuit that we put in the vehicles, it moves the audio around and has an incredibly compelling value proposition. It's been -- it's really been sweeping through the industry from a share standpoint. We believe similar growth potential in GMSL. When we put -- when we put the engineering teams at Maxim and ADI together, we think we can create another BMS story.

Right. And what about -- just rounding out Maxim. You talked about some cost synergies from the acquisition. I think you've largely achieved what you've set out for that. Are there additional savings on cost as you grow that revenue and get additional scale?

Right. Right. When we announced the deal, we had indicated, you should think about the synergies in 3 phases. There's Phase 1 cost synergies, what can we reasonably do in a 2-year window? Phase 2 cost synergies, what are those synergies that, due to more complex nature, will take a little bit longer to achieve? And then there was Phase 3 revenue synergies. So what we'll share in a few weeks is an update on all of those. For Phase 1 cost synergies, we had talked about $275 million. We've got about $100 million of that in our run rate at the end of second quarter. So I'll update you on what that total number will be. It's going to be in excess of $275 million. Vivek, our Global Head of Manufacturing is going to talk about those Phase 2 synergies and what can he do for the manufacturing organization given that he's taken Maxim and ADI, brought them together and where is there opportunity for him from a scale play to deliver more cost synergies. And then our Chief Customer Officer, Anelise Sacks, is going to talk about those revenue synergies and what is she committing to from a revenue standpoint over the next couple of years from the combination.

Okay. That's good. And I'll point out if anyone would like to ask a question, raise your hands. We're all here live now. So let's take advantage of it. Tom, would...

You mentioned a couple of wins in automotive, [indiscernible].

I'll repeat it for the webcast. It's a question about automotive supply chain, supply and demand, what's happening there?

Yes. Yes. So start big picture. Significant increase in semiconductor content across the auto industry. So that has been a real inflection. I think that for folks who haven't been following auto, where semis is closed, probably have missed just how much content growth has been driven by auto. And even within auto, the shift from combustion to electric is another big change, right? And when you move to electric, not only does your semiconductor content increase, but also the quality of that semiconductor content needs to change because you want the most efficient products, every little bit of efficiency that you can eke out translates into further range on the vehicle. So where -- a simple analogy that you might have been okay with a more mediocre LED product for your headlight, on an EV, you want high-performing LED because you want to make sure that there is no electricity being wasted in the car. All of that is translating into further range. So what has been happening in auto because of the challenge in semiconductor content is, and I think most people know this, the auto manufacturers have really been focused on the higher-end vehicles. The higher-end vehicles in addition to having great margins are also semiconductor rich. So they're seeing some phenomenal P&L results. I don't think the auto industries have done as well as they have during this crisis as we've seen in a long time. But they are continuing to be looking for content. We refer in the industry, we're referring to the concept of the golden screw, where there is a -- they have a great deal of what they need in various pieces, but there is still one element that may be missing, which is preventing them from completing the vehicle. So we continue to see escalations across the industry, ADI included, for where a customer is looking for a particular component. But more broadly, we still feel confident that their overall inventory levels have not increased. And one data point I'd share with you is for the inventory that we have on consignment with our auto suppliers or our auto manufacturers, inventory consignment levels on a dollar basis are still below where they were pre-pandemic, which means that at least for those customers that we have on consignment, they have not built huge stores of inventory while they're waiting for the 1 piece. Their overall inventory levels are still at a level where they would like to get back to a healthier -- does that help?

Talk a little bit about margins and the margin structure. And you're now at the targets, a little above the targets, I think, on -- that you set in the next Analyst Day, which means always good for time for an Analyst Day when you've hit that. Maybe you can give some broad strokes about what you're thinking. And I know some of our prior conversations, there was this trade-off a little bit about margin structure and the growth rate. And how do you balance that?

That's right. That's right. Our thesis is that if we can prevent -- if we can provide to you, as investors, a $11 billion to $12 billion franchise that has meaningful organic growth, that is able to generate 70-plus percent gross margins, continue to be very capital light and allow significant cash flow generation of that capital, then that should be an investable thesis that you are comfortable with. So we're looking to find that right trade-off for where does it make sense to make some concessions on pricing in order to drive revenue growth, but clearly not give up that gross margin model. So the goal is how can we present a company that is bigger than it ever has been, but is growing faster than it ever has been and is still having a gross margin profile that is higher than it ever has.

Right. Okay. That's it. So thanks, gentlemen.