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Analog Devices: a Market Leader With Stagnant Growth

February 19, 2014 | About:

When it comes to wireless network equipment, analog converters and amplifier chips are the most needed products. As one of the world’s largest chipmakers, Analog Devices, Inc. (ADI)’s converter chips are sold amongst tens of thousands of customers, with over half of all sales coming from the industrial and automotive end markets. Sales in the automotive sector have been growing at a particularly healthy pace over the past few years, due largely to that industry’s product innovation. With traditional cars sporting sensors and in-dash displays, as well as hybrid and electric autos multiplying their chip contents, the company is bound to benefit from future sales.

In the article below, I will analyze Analog Devices' past profitability, debt, capital and operating efficiency, in addition to looking at which investors have recently bought the company’s shares this last quarter. Although the company has been dedicating many of its resources to grow in the power management chip segment, success has yet to arise. Furthermore, the semiconductor industry’s cyclical nature makes it difficult for any medium-scaled chip manufacturer to maintain long-term results, especially with competing rivals like Texas Instruments Incorporated (TXN)’s market shares.

Profitability Analysis
Profitability is a class of financial metric used to analyse a business’s ability to generate earnings compared with expenses and other relevant costs incurred during a specific period of time. Studying several profitability metrics, such as return on assets, quality of earnings, cash flows and revenues can help decipher if the company is really making money.

ROA - Return On Assets = Net Income/Total Assets
ROA is an indicator of how profitable a company is relative to its total assets. In simple terms, ROA tells you what earnings were generated from invested capital (assets).
The fact that Analog Devices' ROA decreased from 18.06% in 2010 to a current 11.22% is somewhat unsettling because the company's ratio is evidence of the company generating less from its assets than it did in 2010.

Quality of Earnings
In order to assess this firm's quality of earnings we will compare the level of income with operating cash flows. Analog Devices generated profits of $867 in 2010 and $867 in 2012, which translates into a growth of -19%. This growth surpassed that of the operating cash flow, which implies that earnings could have been created by inventory anomalies.

Working Capital
Working Capital measures both a company's efficiency and its short-term financial health, indicating whether it has enough short term assets to cover its short term debt. Anything below 1 indicates negative W/C (working capital), while anything over 2 means that the company is not investing excess assets.
Analog Devices’ current ratio (working capital measurement) increased from 8.35 in 2010 to 9.59 in 2012. This shows that the company has a strong balance sheet and can pay off its obligations, which qualifies it as a profitable long-term investment.

Wide Moat Rating
Apart from the annual balance sheet results, this chip manufacturer has some factors that grant it a wide economic moat, therefore making it eligible for a long term investment. Electronics manufacturers, one of the company’s large sub-segments, tend to select one chip for the devices entire life, as redesigning the product to adjust to a different chip is much too costly. Furthermore, this allows analog chipmakers to lower capital expenditure investments, leaving more funds for high returns on capital to shareholders. In fiscal 2013, for example, Analog Devices boasted an attractive 103.6% ROC.

Another favourable aspect of this company is its 50% share ownership of the data converter analog market. Since these chips convert analog voice signals to digital signals for processing, they are fundamental for all communications infrastructure equipment. The firm’s leading market position in this segment should guarantee solid growth levels in the long term future, as it established itself as the go-to company in the data converter market.

Gross Margin: Gross Income/Sales
The gross profit tells an investor what percentage of revenue/sales is left after subtracting the cost of goods sold. A company that boasts a higher gross profit margin than its competitors -and overall industry- is more efficient. Therefore, investors tend to pay more for businesses that offer higher efficiency ratings than their competitors, as these should be able to make a decent profit as long as overhead costs are controlled.

Over the past three years, Analog Devices’ gross margin has decreased from 66.4% in 2010 to 64.3% in 2012. This decreasing margin indicates that the company has been becoming slightly less efficient year-after-year.

Asset Turnover
Asset turnover measures a firm's efficiency in using its assets to generate sales or revenue - the higher the number the better. It also indicates pricing strategy: companies with low profit margins tend to have high asset turnover, while those with high profit margins have low asset turnover.
The fact that the revenue growth has outpaced the assets growth (-29% growth) on a percentage basis, indicates that the company is making money on its assets.

Institutional Sponsorship
NWQ Managers (Trades, Portfolio) is one of the institutional investors that has been buying ADI in the recent quarters. The hedge fund bought the stock in the past months at an average price of $47.95, revealing its confidence in the company’s profitability.

Analyst Outlook
Currently, many analysts have a good outlook for Analog Devices. While MSN money is predicting that the company will retrieve EPS of $2.25 for FY 2013 and EPS of $2.60 for FY 2014, analysts at Bloomberg are estimating revenue to be at $2.69B for FY 2013 and $2.89B for FY 2014, showing very slow company growth.

A worthwhile investment

Despite some negative results in the company’s balance sheet, regarding EBITDA and revenue growth, I’m confident in Analog Devices future profitability for investors. Not only does the company sport high returns on capital and a dividend yield of 2.70%, but with the stock currently trading at 24.40x trailing earnings, it sports only a minimum price premium relative to the industry average of 23.50x. Also, while revenue may not currently be on the fast-track in terms of growth, this may change as the company continues to develop and diversify its chip production.

Disclosure: Victor Selva holds no position in any stocks mentioned

About the author:

Damian Illia
A fundamental analyst at Lonetreeanalytics.com constantly looking for value and income investments.

Visit Damian Illia's Website


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