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

Okay. Good afternoon. Thank you for attending JPMorgan's 50th Annual Technology Media and Communications Conference. My name is Harlan Sur, semiconductor and semiconductor capital equipment analyst here for the firm. Very pleased to have the team from Analog Devices here with us today. Prashanth Mahendra-Rajah, Chief Financial Officer; Mike Lucarelli, Vice President of Investor Relations. Team reported strong results and guidance last week. So I've asked Prashanth to give us an overview of the April quarter results and the team's strong outlook, and then we'll go ahead and kick off the Q&A. So with that, gentlemen, thank you for joining us today.

Thank you, Harlan. All right, would like me to start?

Yes.

All right. Great. Yes. So we just reported our second quarter results, again, a very strong quarter, I would maybe set as context for folks. We are still in a supply-constrained environment. So our revenue was really a function of what we were able to manufacture in the quarter. But having said that, our demand continues to be quite strong. Our book-to-bill above 1 by all end markets, as well as by all geographies. Unfortunately, that means backlog is now -- continues to grow. And based on today's capacity is extending, probably somewhere into mid-2023. As we look over the balance of this year, what I shared at the investor call was we feel pretty good with the additional supply that we are adding that we'll be able to grow revenue sequentially into the third quarter and then even more into the fourth quarter. Typically, we don't give guidance that far out, but given the environment that we're in now, I think we have confidence that we can say that we're going to grow sequentially for a couple of more quarters.

Perfect. So as you mentioned, book-to-bill above 1, backlog grew sequentially, continuing to add incremental supply, on the demand side, can you just give us some color on your end markets as we look into the second half of the calendar year. Cloud spending is strong. Auto production is picking back up. 5G spending remains on a steady growth path, right, ex-China. So help us understand some of the drivers in the second-half, and maybe also maybe some of the areas where there might be some pockets of weakness.

Yes, that's a more difficult question to answer than normal because revenue really isn't a function of demand. There -- as I mentioned that we're in this unique environment where the revenue that we're going to print for the next couple of quarters, including by geography and by end market are purely an internal decision on where we choose to ship products to. So we are doing our best to be fair and equitable to all of our customers, both large and small, to all of our geographies, but it's a bit of our own construct as to how the end market reporting will be. I go back to what I said earlier, demand continues to be strong. So we -- we are not seeing any notable weakness as of yet in the order activity. We're mindful that the economic environment is certainly changing, and we would expect that at some point, that will begin to impact our business. But from where we sit today, we're cautious and we're -- we look forward -- we look out to see those indicators, but next 6 months look very solid to us.

Your larger analog competitor, obviously, you guys are #2 -- strong #2 market share leader in analog. Your larger analog competitor surprised the market, talking about the disruptions on China, taking a fairly big haircut for their numbers in the June quarter, you guys have been able to power through that, obviously, strong July quarter outlook. You noted on the call that China is only about 20% of revenues for the company and sure enough, like I looked at last year's 10-K and China was only about 22% of your overall revenues, while your larger competitor shipments to China make up 55% of their total shipments. So the lower exposure for ADI into China is probably helping you sidestep much of the supply chain dislocations in that region. First of all, would you agree? And even sort of the mix of business that you have in China appears to be quite different because you did say your China business grew and bookings were strong. So what end markets are you less exposed to in China, let's say, versus some of your other analog peers.

Yes. Yes. Harlan, maybe before I start, I'd like to correct that. While we may not be the largest in analog, we are #1 in RF, we are #1 in mixed signal, and we are #1 in high-performance power. So having made that clarification.

You're also #1 in converter, right? You're #1 in amplifier. So I stand corrected.

All right. Our China business represents about 20% of our revenue on a design-in basis. But if you look at it on ship 2, where the products are shipped, it ends up closer to 30%. Our China business really is -- it's analogous to the rest of analog devices where our industrial business is the largest and consumer will be the smallest. So consumer represents, call it, 10% of our China business. So much lower exposure, I think, than many of our peers. When we look back at the prior quarter, we had very strong growth in China on a year-over-year basis. But having said that, our consumer business that represented 10% of China did suffer as you would expect. We don't have manufacturing in China. So from a logistics challenge, we didn't have some of the same difficulties as some of the other competitors in that we were able to continue providing product into China just sending it into other regions of China outside Shanghai, which was clearly a lock down.

Your channel inventories are sitting well below pre-pandemic levels, right? Your target range is 7 to 8 weeks, you're well below that. Obviously, a reflection of the strong customer demand pull and the tight supply. Given your backlog visibility, your supply expansion targets, your channel partners, mid- to longer-term forecast, does the team think that they can improve channel inventories anytime this calendar year? Or is it probably more sometime next year?

Yes. I would say to the great dismay of our channel partners, it's unlikely that we're going to be moving channel inventory up this year. Our channel partners are an important part of our distribution model, and I certainly empathize with them where they highlight to us that they are losing revenue because they're unable to meet demand for our products because we are unable to give them products that they need to be able to fulfill that demand. But given the kind of the current state of the supply-demand imbalance, we're going to continue to supply our channel partners as best we can, but that is moving out as quickly as they get it, and we expect that to continue to do so for the balance of the year. So unlike to see -- unlikely that we're going to see stocking levels get back to, I think, what would be comfortable for everyone, probably maybe second quarter fiscal for us is when we might start to see some of that improve. But again, that's really me reaching for when I think supply-demand balance starts to improve.

No. Great color there. Before I move on from the sort of near to midterm dynamics, is there any questions in the audience? Sean, why don't you just wait for the microphone for 1 second.

Just 1 quick follow-up on your last comment on the channel inventory. You said your channel inventory customers are losing revenue. I'm just trying to figure out are they losing revenue in the sense that since they can't supply an ADI converter, RF or any of the other parts, their customer is using a competitor's part from -- so like if it's Arrow they're using...

No, thank you for clarifying it. More delayed revenue recognition. Yes, but as I learned long ago, if your revenue pushes out 1 quarter and that continues to happen, then that is -- that's the definition of a downturn, right?

Yes. I just want to make sure even that actually...

No. No, it's not -- we're not -- fortunately, for ADI, very little of our business is substitutable. So this is a timing -- a mistiming opportunity for our partners.

Any other questions? Let's talk about the synergies post the Maxim acquisition close. You guys have done an excellent job of pulling in those synergies, driving strong margins. Going back to the Analyst Day that you recently held, I think Vivek Jain, who's head of your Global Ops, actually did a great job of helping us understand the benefits of ADI's hybrid manufacturing model. But on that note, I know that Maxim at the time that you closed the acquisition was outsourcing about 70% of their wafer requirements. It's a great source of cost savings because as the ADI team brings part of this revenue stream in internally, I seem to recall the Maxim team saying that they could get like 15%, 20% cost benefit by moving this capacity into the Oregon fab. Has this initiative started? Is it part of the $400 million in synergies? Or is this actually a longer-term initiative and therefore, a source of continued margin benefits beyond the Phase 1 and Phase 2 synergies?

Great. Thank you. Thank you, Harlan. So let's break down all the pieces of that. When we announced the Maxim deal, we identified $275 million of cost synergies. At our Investor Day, we increased that to $400 million. And we also -- identified, and those are just cost synergies. We also identified an incremental recurring $1 billion of revenue synergies that would phase in over the next 3 to 5 years. So for the first 275, we will have most of that in our -- we'll have all of that in our run rate as we exit this fiscal year. We will achieve the remaining $125 million of cost synergies by the end of next fiscal year. We will have the incremental revenue synergies of $1 billion ramp in over the next 3 to 5 years. And Harlan, to your specific point, you are correct that as we bring more capacity internally into both our Beaverton fab as well as our Limerick fab, there is some incremental margin opportunity that comes with that, but that is not in any of the current model. So you should really look at that as potential margin tailwind, but really outside kind of the next 3 years window, so because it will take time for that production to ramp to the peak level.

So the good news there is there's a lot of more margin -- potential margin upside or flexibility on how you use that incremental margin beyond Phase 1 and Phase 2. As you scale in the Maxim products internally over time?

Not just Maxim, but also Analog Devices. So we will be adding ADI production into our Beaverton fab as well.

Perfect. And then we cover the front-end manufacturing equipment suppliers similar to your -- some of your industrial customers. I mean, they're struggling with component supply, some of the China lockdown. This is causing equipment suppliers to push out equipment deliveries, de-commit. It looks like they're probably shipping about, I don't know, 10%, 12% below their customers' committed shipment targets share in the first half of this year. Is this causing a slower capacity expansion either for your internal front-end manufacturing targets or your foundry partners expansion targets?

I believe we have that calibrated in the outlook that we provided. We have been consistent if you go back even to last year that we knew our capacity expansion was going to be back-end loaded, and that continues to be our comments. I hope that our -- the capital equipment guys understand the mutual beneficial scenario of giving us the tool so that we can give them the chips they need to give more people the tools. So clearly, I think we get some level of priority in the conversations with them because it is such an incestuous industry here and us trying to feed each other's equipment.

And if I look out over the next few years, and this is something that we've had a lot of discussions with investors about, which is, if you look at total semiconductor industry CapEx spending, it's a big number, and it's growing quite a bit. But when you talk with your foundry partners that are focused more on mature and specialty, what they'll tell you is that for the sweet spot of where you guys are from anywhere between 28 nanometers all the way to 0.18 micron, that if you actually partition out that part of the CapEx spend over the next few years, the supply coming online for the next 3 to 5 years is targeted to be lower than the actual demand curve for the analog, microcontroller and sensor players. First of all, do you agree with that? Do you actually see that as it relates to your foundry partners spending profile? And does this mean that for the next few years, I mean, things are going to continue to be tight for this part of the industry.

Yes. So there's a lot in that question. Let me break down a few pieces. I concur that from the discussions we've had with our foundry partners, much of their investment is going towards smaller geometry than you typically see or need for analog. That's certainly the case. It's not exclusive, but certainly that is the case. The analog industry has benefited historically from using equipment that had been previously sort of paid for by digital or more advanced node requirements. And therefore, that has helped amortize that spend off and what's left available analog would then come in to occupy. So investing just for some of these more legacy nodes is going to be a different decision for foundry partners and that's much more difficult for them to financially justify. For ADI specifically, we've talked about the investments we're making in 2023 and '24 to double our internal capacity. So we are investing significantly, both in Oregon and in Ireland to double our capacity, which we believe will give us a good bit of the runway we need to continue to grow. And I would also say that given our size and scale now, we have considerably more negotiating strength with foundry partners in getting access to capacity. So as the squeeze comes in on the analog industry, I do think that we're better positioned perhaps than some of the smaller fabless guys in being able to get our share of what's needed out there.

On the higher CapEx outlook for this year, 68% of revenues, how is this broken down between front-end wafer capacity expansion versus assembly and test expansion? And then Vivek, again, at the Analyst Day, a great overview of the operations, but he didn't give us a sense on the long-term target for wafer mix, internal versus outsourced when the full hybrid strategy is being implemented. So I'm wondering if you could also quantify that for us.

Sure. I'll take that question and then ask Mike if we've been public on the first. So for the -- in terms of our -- we like the hybrid model. We believe that the benefit of that hybrid model is by having your manufacturing accessible both internally and externally. In times of great demand, you can rely on your foundry partners to help you ramp quickly without meaningful additional investment, and in times where there may be some kind of pullback in demand, you have the option of bringing that manufacturing back in-house, keeping your utilization levels high which are great for your gross margins. And on a relative basis, it is a -- it's a much smaller impact to our foundry partners who are much better equipped to handle that impact on demand. So we are big believers that, that is the right model to have a mix of internal and external. I would also add that just given the level of solutions we provide to our customers, it requires us to have such a broad spectrum of technology access. It's something we could never do internally. Some of our most high-performance transceiver products require us to go all way down to 7 nanometers, we would never look to have enough capacity to justify that as an internal solution. As we look out, that 50-50 balance feels right for us. So I think -- look for us to continue to kind of solve around that 50-50 balance. And Mike, I don't know if we've been public on kind of the split between front and back end CapEx.

On the split in the CapEx, we said 6% to 8% this year, and it's elevated next year. The majority of that investment is going on the front end as you build out Beaverton and Ireland. We are spending money on the back end as well, but the majority will go to the front end. And if you actually rewind to 2021, actually more went on the back end. So we're investing in both areas. Back end was more last year, 2022 and '23 is more about the front end expanding that footprint.

Perfect. Before I leave the manufacturing and operations part of it, did anybody have any questions?

Could you go to some of your customers and say, we will guarantee that, that will be on our own internal manufacturing, so that you'll never be the swing vote, not getting what you need if you pass us another 5%, something like that where you're almost guaranteeing supply, where you could do it in these days, but you can't always do that...

So I'll repeat for the folks on the webcast. The question was, could we talk to some of our customers about getting a commitment that they will always be supported from an internal fab, so that they wouldn't be subject to being swing. So I think the answer to that is our customers are not -- they're not necessarily preferential to whether it's made internal or external. It is more about supply assuring. It is being able to get supply, whether it's -- whether we make it internally or externally. Our view on that has been consistent for a while now that, that we do not lock into long-term supply arrangements with our customers because the -- at the end of that, they're getting -- they're making commitments for demand, which they may or may not have, depending on how the market does materialize in the future. And then we're in that challenging position of having to -- to have that tough discussion with them. It says you were guaranteed this amount, you agreed to take it, so you're taking it even though you don't need it. And those take-or-pay conversations in the end are ones that we don't believe are beneficial. And the other part that is really important for us, as I mentioned, and this is something that our CEO philosophically feels very strong about is being fair and balanced across all of our customers. Our small customers never would have the ability to lock into those types of supply agreements. So they would naturally get disadvantage. Our broad market, which represents about half of our business, 50% of our business goes through industrial. Those broad market customers are the long tail. They are a very rich source of profitability because they tend to pay very well. They're very sticky. And ensuring that we are fair and balanced in providing what they need in addition to those who can sort of pound the table a bit louder because they're bigger, is a tough balance that we strike.

Got a question from online. And this revolves around the supply chain dislocations and the tight capacity supply in the industry right now. Has the elevated redesign activity to the supply chain impacted the team. In other words, auto companies talking about the importance of dual source and reducing costs. And a specific example about Cisco, for example, talking about redesign activity, as important to lever -- as an important lever to mitigating future supply disruptions.

Yes. So -- again, it comes back to the little banter that Harlan and I had early on. Where do we play? We play at the very high end of the market. And we don't have a lot of competitors. I would argue we don't have maybe any competitors that can perform at that same high end. So for us, the -- that risk of redesign for alternatives is not necessarily as prevalent as some of our competitors, who may be in more of the mid-tier commodity space. But having said that, I think the -- this is a reasonable kind of approach that many of the customers in this space are doing is being very conscious of what are the alternatives they have to supply. And given geopolitical concerns, that is also part of the investments we're making to increase our internal capacity so that there is more resiliency across ADI supply chain. So we have the ability to be able to supply from multiple foundries -- or sorry, multiple fabs to our customers to give them more assurance on that resiliency and not be as subject to whether it be geopolitical or COVID type issues that caused so much disruption over the last 2 years.

Let's talk about some of the product strategy. So at the Analyst Day, the team laid out revenue synergies with the Maxim product portfolio of about $1 billion, right? Spread across 3 focus areas over the next 5 years. Customer Synergies, Portfolio Synergies, Power Synergies. Give us some examples of these synergies. And how was the sales and marketing team being educated and trained to exploit these synergy and content attached opportunities.

Yes, Mike, you want to take first part? I'll take the second.

Sure. If you look at the first part, the customer, I'll give the example you gave at the Investor Day around GMSL. Really, Maxim has a great technology, GMSL. It connects radars and cameras across the car, transporting data. Great technology. We're going to invest more as a combined company with ADI, really supercharge that road map. At the same time, we look at the customer list, ADI is very strong globally with A2B and BMS. Our view is we can take that technology, Maxim has a great technology and bring it to those customers and cross-sell. That's really the big -- one of the big areas of the customer cross-sell. The other 2 areas to talk about, portfolio. They're just saying ADI is a leader in analog mixed signal. We're going to bring more massive technology into that leadership area, and empower is also kind of wrapped in that portfolio. But power for us at ADI, it is about a $2.5 billion business for us. Our goal is to double that kind of 5-, 7-year time frame. In order to do that, we need better cost structure, better pricing and opening up new markets. And we're doing that. At the Investor Day, we talked about looking at that middle market power. That's a $4 billion new SAM for us, and going after that market cost effectively and growing the business faster. That's kind of a high level how I think about it. And what that does, you wrap it all up, we think we should add $1 billion plus of revenue on the top line. And that's big. If you look at Linear, it as a $1 billion opportunity. With Maxim, we're talking about $1 billion revenue. So that's the difference between the two. It's a bigger number and it should help us grow faster in the future.

Then exploiting the -- how are you incentivizing sales and marketing to drive those synergies to drive that content?

So we're building off of what we learned from Linear. As Mike said, and I'll just restate that when we did the Linear deal, for those of you who have been with us, we identified a $1 billion worth of annual opportunities. And as we post more them back to how did we do against that, we kind of have land in sort of between 50% to 75% of those opportunities actually converting into a recurring revenue stream. For Maxim, we put a target as $1 billion of recurring revenue, which then means that the opportunity pipeline we've identified is much larger because we have the experience from Linear to feel confident, we can get to that $1 billion. So what have we done with the sales team is it's a very systematic approach, right? It is -- there's a very large opportunity pipeline, which our Chief Customer Officer, Anelise Sacks, tracks with her team, that is -- tell us what are those opportunities and what is the reporting frequency to be able to track those opportunities as they move from this is just an opportunity, to it's been a design in to, it is going to production to, it is hitting what we consider peak revenue. And that ability to now monitor that through our CRM system is all the scaffolding that there -- the finance team is in the process of putting in place. So I feel very confident, which is why we've given a revenue opportunity instead of a revenue -- recurring revenue target versus an opportunity target.

Let's talk about your automotive business. You guys expect your auto business to grow at a low teens CAGR over the next 5 years, right? There's a growthier portion of automotive, right, things like BMS, audio processing, data and video connectivity. That's about 35%, 40% of the auto mix today. How should we think about the growth of this high-growth portion of the auto business? And how would you rank order -- sort of the growth profile of these different subsegments?

Yes. So I think, actually, maybe a good way to think about that is to dissect the Q2 revenue performance. So if you look at our Q2 revenue performance on a year-over-year basis, very strong year-over-year revenue. What do we report, Mike, on a year-over-year for automotive?

Over 30%.

Over 30%. So let's break that 30% down into a couple of different buckets, right? So there is our BMS business, which is really a function of our strong share driven by the mix shift that's happening in the industry towards more electric vehicles. There is our BMS portfolio, which we've been talking about for many years, the numerous design wins. We've got 18 out of the top 20 OEMs who have selected the A2B portfolio and they're now in the process of designing it in so that it is continuing to ramp as more of those OEs shift their architecture of their vehicle to A2B. We have the GMSL or the serial link technology that we acquired from Maxim, which is so critical to how you architect all of the safety data technology, whether it be the radars, LiDARs, cameras, et cetera, that are being migrated from high-end vehicles down to really entry-level vehicles. If you back those elements of growth out of our Q2 revenue performance, as well as the impact of pricing, you'll see that the rest of the portfolio performed very much in line with SAAR and was actually down very slightly on a year-over-year basis. So we feel very, very good that the key secular trends that we keep talking to investors about are going to be the source of growth and then we have -- the rest of the portfolio, which will continue to be growing in line with SAAR.

On the Industrial business, that one is set, you guys are targeting growth of high single digits CAGR over the next few years, strong growth trajectory, factory automation, health care, instrumentation and test. The team provided numerous examples of SAM expansion right at the Analyst Day. And content gains, especially as you sort of migrate up the value chain from components to subsystems supplier to a full solution supplier. So help us understand how the mix of that business looks like today on components, subsystems for system solutions? And sort of how do you think about that mix going forward?

Yes. It varies so much by end market application to be able to give any meaningful kind of reflection there. I would say 1 way to think about it is if you look at our ASP relative to our peers, we are -- we're at roughly 5x from an ASP standpoint. And that is a reflection of our products incorporating more innovation and more of that subsystem and solutions into what we're offering customers. Some of the notable examples that we've talked about in the past, certainly, the photon to bits, which is really dramatically re-architected, how CT scanning is done, the micro module business that we acquired from Linear and have grown substantially, which has been very instrumental in a number of customers being able to compact more content into a single solution. I can probably go on here. But I would say the areas of that industrial business that we're probably most excited about in terms of their ability to continue to move towards solutions would be, digital health care is key because you have companies there that don't have as much experience with analog and they want solutions. So that is definitely very high on the list. I think automation is the other one that's a key one for us because again, you've got so much complexity being built into robots and cobots in terms of communication, safety, sensing and the isolation technologies. Again, those represent greater opportunities for us. Instrumentation, they're not looking as much for solutions, but the instrumentation, I think, represents an opportunity for us to sweep the board because what they want is they need performance at a certain level for their products to be able to work. That performance can come from standard products, but it's our ability to solve that problem with a set of standard products so that we take their concerns over are these going to work together. We give them the assurance that if it doesn't work, it's on us, and it allows them to focus on other parts of their product design.

Perfect. On the communications business, strong position, right leadership in RF, and millimeter wave for 5G radio infrastructure. So base station deployments are forecasted to grow sort of high single digits, low double digits this year, driven by global ex China deployments, right? U.S., Europe, Japan and Korea, to name a few. Given your share of deployments, I mean, does the team see sustainable growth trajectory of its 5G infrastructure business over the next several quarters well into next year.

We do. We do. I think someone had asked us earlier, what's our over-under on whether the wireless communications business would be a growth business for '23 versus '22. And I think we feel confident that we would be -- let me say it this way, we would be surprised if '23 wasn't a growth year over '22 given what we know that's going on with deployments in the U.S. and in Europe. Now I caveat that only because I'm unclear what the Russia-Ukraine situation is going to do with European deployments. So that is probably the 1 event that we haven't fully understood whether that slows down some of the capital investments that are happening in Europe. But barring kind of that as a possible impact to how Europe upgrades to 5G, we would feel very good that '23 will grow on top of '22.

Perfect. And then on the financials, obviously, last quarter, strong gross and operating margin performance in April, right? 74% gross margin, 50% operating margins. Help us understand what drove the 90% gross margin fall through on the incremental revenue growth? And then looking out longer term, post synergies, given the right mix of internal and external manufacturing, how should we think about the incremental margin fall-through as you drive within that sort of 7% to 9% sort of revenue growth CAGR that you targeted.

Right. So the -- our gross margin performance in the second quarter, 74% plus, really, it's a function -- factory utilizations are at all-time highs. We have a benefit of Maxim synergies running through the cost of goods line. We have the benefit of some very favorable mix. Our industrial margin -- our industrial mix now is north of 50%, which is -- runs above company average. So we have a number of elements that help drive that 74% gross margin. As we look forward, I think that gross margins for the next couple of quarters should continue to remain quite strong. I have been mindful about folks getting too optimistic about those gross margins continuing to go up because we want the flexibility to trade some gross margins for growth. So that means giving the sales team the opportunity where they -- where we have a released product. If they need some flexibility on pricing to win an extra socket, I want them to be able to have the pricing flexibility to get that socket because the R&D has already been amortized and to drive that incremental growth because that will still be very accretive to operating margins. But that impact is still probably 1 to 2 years out. So expect richer margins for probably a continued period of time here.

Perfect. Prashanth, Mike, thank you for joining us today. Great insights. And again, thanks for the participation.

Thank you, Harlan. Thank you, everyone.

Thank you.

Thanks. Thanks, Mike.