Linear Technology Corp (LLTC) is a designer and manufacturer of a broad line of high performance analog integrated circuits. Analog integrated circuits are circuits that convert real-world (also called analog or linear) signals such as motion or light levels into digital signals. The company produces power management, data conversion, signal conditioning, RF and interface ICs, and µModule subsystems for use in industrial, communications, networking, automotive, computer, medical, instrumentation, military, aerospace and consumer devices. Common products containing analog circuits include computers, vehicles (specifically hybrid and electric), security systems, digital cameras, GPS devices, medical equipment, mobile handsets and military and space hardware.
We can see that Linear is an excellent business from its very high returns on capital and returns on assets.
So why has it been successful, particularly in the last five or so years? There are several factors that set Linear apart from traditional digital semiconductor manufacturers and designers.
First, analog (or linear) circuit design involves a high degree of creative problem solving skills and the design depends more on the talents of the circuit designer than on CAD software. As you can see as sales grow, Linear needs to spend more money on R&D and on salaries for engineers and other technical professionals (roughly 25% of the companies 4000+ employees are involved in R&D).
Second, the design of digital circuits focuses more on repeating several design elements and making the elements as small and compact as possible to increase processing speed. With analog circuits the focus is on precise matching and placement of circuit elements. Additionally analog circuits are usually larger because of voltage and component placement requirements. This means that companies manufacturing analog circuits do not need state of the art fabrication equipment. Linear can use equipment that is generally cheaper and replaced less often. This translates into lower capital expenditure requirements. Linear owns and operates its own fabrication plants (as opposed to fabless semiconductor companies) and spends about 10% of its cash from operations on capital expenditures. By comparison, Taiwan Semiconductor, the largest fab operator, spends about 55% of cash flow from operations on capital expenditures.
Finally, analog circuit designs are usually produced in small quantities and are used in a wide variety of devices across all industries. This means analog circuit manufacturers are less dependent on one or more major customers and the cyclicality of any one industry or sector of the economy. This translates into stable sales.
Revenue and earnings per share did dip during 2009 but quickly recovered. Operating margins dropped in 2009 but still remained above 40% and gross margins only dipped slightly.
Because analog semiconductor manufacturing is generally a more attractive business than digital semiconductor manufacturing the company faces competition from Analog Devices (ADI), National Semiconductor (NSM), Intersil (ISIL), Maxim Integrated Products (MXIM) and Texas Instruments (TXN).
To date management has competed successfully and delivered better performance than competitors. Linear has higher margins and better return on capital and return on assets than its major competitors. Linear’s 10-year revenue and ten year earnings growth rates are 15.3% and 13% respectively. The highest revenue growth rate among competitors was Texas Instruments with 10%. Analog devices had the highest earnings growth with 14.3% (higher than Linear). All other competitors had flat to negative earnings growth. Clearly management has done well so far and there is no reason to believe that anything will change dramatically in the future.
With high returns on capital and great growth you would think Linear would be priced at a premium. Instead, Linear is trading at the low end of its historical valuation range.
It would be wise to discount some of the higher valuation numbers as they are skewed upward by the inclusion of the tech bubble years of 1998-2000.
Even though Linear has been clearly superior to competitors in creating shareholder value it still remains underpriced relative to its peers.
Linear trades at only 10.77 times earnings which is cheaper than all but Texas Instruments. In addition, Linear investors receive a dividend of 3.5% that is well covered at only a 38% payout ratio. Only Maxim and Intersil have higher dividend yield, but those are not as well covered with payout ratios of 49% and 60% respectively.
Linear is a well managed company competing in an attractive sector of the semiconductor market. Fears of a double dip recession, weak demand and overcapacity in the semiconductor industry have lead to depressed share prices. Indeed, slowing demand is already priced in to some degree as Fairchild Semiconductor (which makes some analog chips) lowered revenue guidance today (September 6), but the stock actually rose while the market was declining. While Linear wouldn’t be immune to a downturn it has fared well before. Additionally, with a healthy and growing (even in 2009) dividend as shown by the chart below, investors in Linear are getting paid to wait until sentiment on the economy and the semiconductor industry improves.
Disclosure: No position, however, Strubel Investment Management is considering initiating a long position.