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

[Audio Gap] here. I'm very excited to have Analog Devices join us have CFO, Prashanth Mahendra-Rajah; and Mike Lucarelli. Prashanth is the CFO of Analog Devices since September 2017. Prior to ADI, he was the CFO of WABCO Holdings, a global supplier of commercial vehicle technologies and previously served as division CFO and other financial leadership roles at Applied Materials, Visa and United Technologies. Mike Lucarelli is Vice President of Investor Relations and FP&A and joined ADI in 2015. And prior to ADI, he was VP of Semiconductor Research at a different sell-side firm. Right, so welcome guys, please have a seat. So I'm going to have -- I have a set of questions, so I'll lead a fireside chat. But I encourage everybody to please do. If you have a question, enter it into the app and -- or if you don't have the app, raise your hand and we will try to get to you with the microphone.

Okay. Great. So first of all, thanks again for joining us. Welcome. I think just to start out, there's been a lot of consolidation in the industry. You guys have been consolidators yourselves. You acquired Linear, Maxim. Why did you feel the need to make those acquisitions? How has it changed the position of the company?

Sure. Yes. So Mark, how we position ourselves with -- versus our peers really is being able to provide our customers a complete solution. So Vincent's philosophy since coming in as the CEO has been that with changes that are going in the industry, there is a need for at our customers for them to be able to look to their supplier to bring a more complete solution because those customers are spending their R&D dollars further up the value chain in areas such as digital, AI, machine learning, etc. So by putting more products into our portfolio, we are able to expand to scope of services we provide to our customers. We bring a more intimate relationship with them and that feeds upon itself because then we know where to drive our innovation based on what our customers would need. And for those of you who had a chance to watch the Capital Markets Day a couple of weeks ago, and I know you were there. Mark, I think one of the highlights and extremely, extremely rare in the industry is we had a dozen customers come to our Capital Markets Day to talk to our investors about why they'd like to be a partner with ADI.

Got you. And over the last 8 years, in conjunction with the M&A, you've seen your gross margins expand by 1,000 basis points, your operating margins expand by 1,800 basis points, which is a remarkable improvement in the profitability. What have been the biggest drivers of that margin expansion?

It's a few different elements. First, it is as we continue to move up the stack and provide more complete solutions. So as we move from being a component supplier to a supplier of subsystems and module of all the way to solutions, with that comes higher ASP because you put more intellectual property and you solve more of a solution set in what you're selling to your customer for there is clear margin expansion that comes from that. In addition, the scale that we have having done those acquisitions allows us to really leverage our manufacturing capabilities in a way that we couldn't as a smaller company. So that scale has also contributed meaningfully in our ability to drive cost synergies. So I would say those are the 2 areas. And perhaps the third is focusing on the right markets, focusing on the markets where there are clear secular tailwinds and there are hard problems to be solved. Our gross margins really are reflection of how hard a problem are we solving? For investors who follow us, you would know that almost all of customers and almost all of our suppliers are meaningfully less profitable than ADI. So we sit here in the middle of the supply chain with suppliers who look to us and say, "Hey, you're making too much money," and customers who look back at us and say the same. And the reason that model endures is because of the value that we are creating for those customers and their willingness to pay for that innovation.

Got you. And so talking about that level of profitability you're -- at your Analyst Day, I think it was a couple of months ago, you articulated a target operating model of 70% gross margin floor and operating margins of 42% to 50%. Now last quarter, you were at 74% gross and 50% operating margin. So after this long period of time where you've expanded the margins, it seems to be that you're signaling that you are at the high end of your target model, so you kind of have peaked out. So what leads you to believe that you just have achieved the peak and you are pretty much done? Or is that not the incorrect interpretation?

Right. I suppose I would take great offense with your use of the word peak. And I'll say -- let's come on a few things, right. 70% gross margins puts us clearly at the high end of the semiconductor universe, but even looking at our operating margins of 50%. We deliver operating margins that are in line with the average of most companies in the semi-conductors gross margins. So it is really an extraordinary profit model, that is a reflection of the innovation that we get paid for. We solve the hard problems, and we get paid for them. The investor thesis that we offer to you in the audience here is if you have an opportunity to own a company that can deliver high single digit revenue growth with these extraordinary profit margins, where the capital required to drive that growth is very limited and the commitment to you that all of that cash flow that's generated off that model is coming back to you either through dividends or through share repurchase, that should be a very investable thesis for you. So when we think about that model that you just referred to, Mark, it is really about delivering on the revenue growth and all else sort of being held in as a consequence of that math. So will there be some flex in that gross margin. There certainly will. Today's gross margin really reflects a lot of things going right. It includes extraordinary strong demand. So utilization at the fabs are at very high levels. It includes the benefit of the cost synergies from the acquisition that we did flowing the P&L. It includes the benefit of favorable mix. Our industrial business, which is really the hallmark of our business here and has extraordinary good profitability is now running at 51%, that's a little over 50% of the revenue mix. So you have a lot of tailwinds that sort of contribute to that very strong gross margin, but we tried to give investors confidence that through the cycle you can count on us to maintain our gross margins north of 7% or at to least start with the 7% and that the commitment that we're driving for is to deliver that high single-digit, maybe low double-digit revenue growth.

Got you. Okay, that's helpful. Now on your last earnings call, you noted record backlog. Can you talk about -- can you quantify this, like how much you're under supplying customers? And given the more recent concerns on the macro environment, have you noticed any changes with customer order patterns?

So the industry, but I can speak more specifically to Analog Devices. We are at an unprecedented time where the amount of content that is being added to manufacturing goods is increasing at an incredible rate. And the secular wins that if you believe in electric cars, if you believe in 5G communications being used for more than just mobile and data, if you believe that health care is going to continue to go digital in being able to deliver value to patients and to care providers, if you believe these trends, then I can go on forever about forever about these trends than this is a challenge that Analog Devices is going to face where demand for our products will continue to be well supported for a decade to come. We are very mindful, as we add that capacity, and we're doing it in modest pieces over the coming that on. But the backlog we face today is -- maybe a good way to think about it is at the beginning of a quarter in a normal environment, we have about 85% of that quarter's revenue in backlog, and we're looking for about 15% in the quarter to come from customers, who give us an order and say, "Please ship to me immediately." So 85% backlog, 15% book and ship. Today, I have 100% backlog coverage well into 2023. And so it's really an upside-down environment, where the demand for what we're offering is going to extend beyond this calendar year. Now in an uncertain environment like we are in today, where there are clearly some macro headwinds that we're facing both from Russia-Ukraine, from China, from the rising Fed rates, we know that there will be some reconciliation between that order book and what we will actually be -- what will actually be the demand on us. But even if I take a somewhat egregious example and say that maybe 30% of that begins to sort of evaporate as time marches on, that still covers us well through the end of this year.

Got you. That's very helpful. The industry has been in a supply-constrained situation for a while. Has this changed how you have thought about doing your business in dealing with your suppliers and dealing with your customers? A lot of times what we hear in the industry is long-term supply agreements. Can you talk about noncancel NC/NR orders, noncanceled, nonreturnable orders? Can you tell us how you feel about these kind of tools or techniques?

Sure. Sure. As a philosophy, we have not embraced what some of our peers have done in terms of locking up our customers for multiyear supply agreements. And there's a few reasons for that. The first is and Mark's got some great research on this if you need it, the majority of our products, once they're designed in, they can't be replaced. So there's low value to us trying to lock in a customer for a year. As soon as they've designed us in, they have sort of locked themselves into us for 5 years already at a minimum. These are not pin-for-pin replacement opportunities. So if you get the design win, you really have that customer secured and then it's about the quality of service. The second is long-term supply agreements disproportionately benefit large customers. They are the ones that have the risk or that can have the balance sheet to take the risk of saying, "I'm going to give you a take-or-pay. I will either take your products or I'll pay you in 9 months, 12 months into the future. Smaller customers cannot do that. Small customers are an incredibly important part of our profit portfolio. And our CEO has been very adamant that we want to treat all of our customers fairly, whether they are large customers, small customers, whether they are European customers, American or Asian. So it really has been the focus of ADI to be as fair as possible in our customer base during this supply-demand imbalance. And for that reason, we've shied away from long-term agreements.

Got you. Why -- do you have a view as to why the industry, why ADI, how do we get into the situation, the supply-constrained situation that we're in right now?

I think that the content growth has been building for a while, and there's been a level of underestimation on really that activity. And I remember you wrote a piece on it a couple of years ago, the renaissance of Analog, which I think is still a valuable read to folks. The other piece that I would say is the supply chain disruptions from COVID pushed so much demand into goods versus services, which again drove kind of consumption. So we're coming through what I believe is going to be a multiyear period of increased demand for semiconductor content really across all manufactured goods. There's so many examples out there of a product that just a few years ago, did not have semiconductor content or had very little, but today's version of that same product has substantially more. So even in a flat unit environment, you will still see growth in Analog semiconductor content. And certainly, we know from our pipeline that the opportunities in front of us remain very, very strong. The macro will be what it is. And we -- a good portion of our business is tied to the macro. So there will be some macro impacts on our business, but the underlying secular drivers are incredibly strong, and they're going to drive the growth of Analog Devices for years to come.

Got you. Okay. And you had mentioned your plan to increase your capacity. And I believe at the Analyst Day, you said the plan is to double your internal capacity. How quickly can you do that? And to what extent is this internal versus external or front-end versus back-end?

Yes. Yes. So we use a different model than many of our peers. We believe in a hybrid manufacturing model, which means that we want to use a mix of internal and external manufacturing for the front-end. The benefits of that model to us are: it allows us access to the breadth of technologies that we need to solve our customers' problems. So we go everywhere from 7 micron all the way to 7 nanometer, need the full spectrum to provide those solutions, first. Second is that by using a hybrid model, it allows us to flex based on where the demand is. And by flex, it means that I have the option of if we are building a product at a foundry and demand is falling, I have the option to call that foundry and say, we're no longer going to build that at your foundry, we're going to build that in-house, which allows us to keep that gross margin level high because it allows us to run our utilizations very high for the internal capacity, which is what gives us confidence in talking about a 70% gross margin floor. And similarly, in times of great demand, you can call on your foundry partners and you can add wafers at a rate that you otherwise wouldn't be able to if you're doing that internally. So today, we're roughly 50-50 between what we make inside and what we use on the outside. We are doubling our internal capacity over the next 2 years, which will allow us even greater flexibility as to when we use our foundry partners. But foundries will still remain a very valuable part of our overall manufacturing model; one, for the technologies; and two, for the flex that they give us.

Got you. The -- so you have discussed industrial and automotive as key growth drivers. You have multiple segments within each of those groups. Can you give a couple of examples of the segments that kind of epitomize the growth opportunities for ADI over the next 3 to 5 years? And what do you think in those segments, where will investors be the most surprised on the upside?

I could do that for an hour. So let me...

We got 12 minutes.

All right. I will do -- I'll do instrumentation and then Mike, you can pick one and do your favorite. So instrumentation and test. This is a business that requires high performance and high precision measurement of the equipment that is used by electronic manufacturers to measure the performance of their electronic goods before they go to production. So as you see more and more content being distributed, whether it be more advanced cell phones where at 5G, 6G is already in kind of early stages of design consideration, the industrial customers are already talking about putting 5G onto their manufactured goods. It could be the radars and the LiDARs and the cameras that are being used in electric vehicles, it could be the technology for digital health care, all of that electronic equipment needs to be tested and it needs to be tested at a high speed rate because it's tested as part of the manufacturing process. That's a space we own. We have the products that can measure with precision and speed and you need both because if you don't have the speed, then you slow down your customers' manufacturing process. If you don't have the precision, then you can't measure the high performance of their products. So that's a business for us that as long as this is a world that's going to continue to advance in its incorporation of electronic equipment, we're going to continue to be one of the key elements that helps drive that manufacturing process.

I think, Mark, you said industrial or automotive, correct?

Yes.

So I'll flip the auto side just to make it make it balanced. Look, electric vehicles, electric vehicles, for us, ADI, we are the leading supplier of BMS chips. So we measure the battery charge and discharge. And because we're so accurate, we are enabled the most miles per charge. That BMS business for us is kind of high-teens percent of automotive. So it's a significant business for us. It's a $100 million quarterly run rate. Our goal is to drive that to be a $1 billion franchise -- annual franchise, not in the quarter, maybe in the quarter. But over the next 5 years, what that means is that market should grow 25% CAGR units, but will additional content on top of that 25% and additional customers. Think about wireless BMS, for example. So ADI is the leader in wired BMS. We came out with a new metrology to measure the battery wirelessly. And that takes out weight from the car. It saves money for the OEMs. And we announced GM. We have 2 other OEMs and probably another one soon this year to use that wireless BMS technology that increases our content per car by 2x versus a wired system and it also has better gross margins. And well, like what EVs is everyone's were auto up, down, where is it going to go from here? I think everyone in the room and on the webcast can agree, EVs will grow a lot in the next 5 years and we'll be a big part of that growth. So it doesn't matter what autos do. As long as EVs are growing, we'll continue to grow in that business.

And can you play back -- so I remember when you demoed that system at CES several years ago, so this has gone from 0, and you have a projection for -- is it $250 million? Or could you play back the expectation for how big this business becomes -- and the...

Just wireless piece?

Wireless BMS. Yes.

We haven't quantified how big it could be. What we qualified is it's 2x the content versus a wired system. GM with the Ultium platform. The Ultium platform goes across all their vehicles, including bright drop, including some trains and there's also some OEMs they partner with like Honda. If they use the Ultium, it will use ADI BMS chip. So that's our lead customer. We have another customer, another large European customer that's adopted it. We've also had a [indiscernible] sport car adopted it. And we're looking for another OEM to announce this year, but we haven't said how big it could be. But you can do the math of GM ships, I think, 2 million cars a year. If they go all electric, that will be all ADI.

The value proposition is -- the ROI is incredible for the auto guys. I would be very surprised if this isn't the new standard in 5, 7 years. It's just -- there is no reason not to use it. It's so compelling.

Got you. All right. Great. So I'm hoping that you could indulge me and talk about the competitive environment. A lot of questions I get from investors, I think, put you and Texas Instruments and kind of this elite Analog group of companies. You both have phenomenal financial track record, very similar from a capital return standpoint and it seems like our targets. What do you say to investors who ask you to help them differentiate what -- how to think about Analog Devices versus Texas Instruments?

Sure. Sure. Yes. The -- I think that the investor community is getting more familiar with the differences between the 2. And I'd say there's absolutely room for both in the portfolio, depending on what you're looking for. So what are you getting in ADI? We make the markets, right? That is the core of that R&D is we have this uncanny skill of being able to know what does the customer want before they know that, that's what they want. We build the product and then they see, oh my gosh, I can't live without that. Audio to bits, which has rearchitected how the audio signal is moved in cars is a great example of that. The Tier 1s, Contis, Bosches, et cetera, would never have designed that product. Why? Because it reduces the amount of value add they bring because it's a lot less wiring which is how they generate revenue. But the OEs said there's significant value to what that technology brings. I didn't know I needed that and now everyone, every OE out there, 18 out of the top 20 and the only 2 that don't is because they're quite conservative in their adoption curve, so I know they will get there, is using that model. We created that space. In the -- in wireless 5G, it's the transceiver. We designed a way to -- for Sony -- sorry, for Ericsson and Nokia and Samsung, et cetera, to be able to provide their special IP onto the solution for the transceiver via software. Before that innovation, customer or suppliers like ADI or our competitors were building custom chips each of the 5G manufacturers and that was an unsustainable business model. So that innovation in creating a market is what is unique to ADI, that's reflected in our gross margins, and that is reflected in our growth rates. I think that is where you see the role that we play. And our competitor that you mentioned, they have a phenomenal cost model. And they are the volume guys, and you can see it in our ASPs. Our ASPs are a significant multiple of our competitors and that higher ASP is a reflection of us moving up the stack. We're not a component play. We are really about subsystems and solutions.

Got you. I wanted to ask you about the Maxim acquisition. You had talked about the cost synergies, your original estimate was $275 million, I believe you took it to $400 million. And now I believe that you're suggesting the potential for $1 billion in revenue synergies. And I think investors are appreciative of that because a lot of companies don't like to quantify a revenue synergy. How -- can you talk about how that revenue synergy manifests? When do you start to see it after you acquire a company? And then how long does it take you to get to $1 billion of revenue synergies?

Sure. Yes. So that $1 billion of revenue synergies was informed by what we learned on the Linear transaction. When we announced Linear, we talked about $1 billion of opportunity that we would chase and some percentage of that opportunity would actually convert to revenue. And as we postmortem and go back and kind of audit how we did, our sense is between 50% to 75% of that opportunity in Linear is actually now converted into recurring revenue. So based on that, with Maxim, we identified what the opportunity is, and we decided to be a bit more aggressive with investors since we now had our own data set that we could fall back on and give you a commitment to what is the annual revenue that we can generate off of Maxim, and that's where that $1 billion comes from. So that $1 billion is mapped back into a very long list of pipeline opportunities. Those pipeline opportunities are now tagged to individual sales reps who know what they are specifically targeting where there may be a Maxim customer who is not buying enough ADI and we know that we can get in there or vice versa. We've been very careful to exclude double count, so that we can really kind of hold the sales force feet to the fire for this. And I would say that across the organization, there's great excitement because we see how to make this happen given what we've learned from Linear. So just giving one specific example. In -- Maxim has a product called GMSL, which is a serial link technology, which think of it as this is the best answer out there to put a railroad track inside the car for moving video and data around. It is, by far, the best solution that an auto company could use. We have high confidence we can take that technology link and we can move it across the auto platform of all the OEs very similar to what we did with Linear on the BMS. When we bought Linear, BMS was a great product with a small customer base. Now it is, by far, the market leader across everyone. And we are confident we can do the same with Serial Link. We believe Serial Link alone is about $200 million of annual recurring revenue growth, which is 1/5 of that $1 billion target that we gave you. So it's all mapped down specifically.

Great. I think that's going to have to be the last word. We've run out of time. Prashanth, Michael, thanks for joining us today. Thanks for sitting down with us and chatting about the company.

Great. Thank you.

Thank you. Thanks, guys.