Analog Devices (ADI) achieved the status of being the largest supplier of high-performance analog integrated circuits [ICs] in the world. Analog Devices achieved that status even before the acquisition of Maxim Integrated Products (MXIM). The acquisition strengthens the company further by offering customers a more complete set of solutions. The combined company has a good chance of achieving earnings growth that exceeds that of the S&P 500 (SPY) over at least the next five years.
The above-average expected earnings growth can help drive ADI’s stock to achieve above-average price appreciation. This growth can be fueled by multiple catalysts of new technology such as industrial automation, 5G, the internet of things [IoT], advanced vehicles, etc. ADI benefits from having their technology used across a diverse set of numerous industries.
Solid Q3 Earnings Report
Analog Devices just reported a positive quarter for FQ3. Although revenue declined by 1.4% as compared to FQ3 2019, the company exceeded revenue estimates by $30 million. GAAP earnings per share of $0.97 exceeded estimates by $0.06, while non-GAAP EPS of $1.36 exceeded estimates by $0.07. The gross margin of 69.9% exceeded estimates of 68.3%.
Overall, ADI held up well despite some weakness from the COVID-19 situation. The main weakness came from the Automotive segment (11% of total revenue) which experienced a year-over-year revenue decline of 29% in FQ3. This was a result of global factory shutdowns and lighter sales. However, this segment can bounce back as factories reopen and if sales pick up as more businesses reopen.
Industrial, ADI’s largest segment (53% of total revenue), achieved a 3% revenue increase for the quarter. Communications revenue increased 14%, with strength coming from 5G and optical connectivity for carrier networks and data centers (11% of ADI’s revenue). The Consumer segment revenue declined 13%, with the COVID-19-related slowdown (11% of ADI’s revenue).
It is noteworthy to point out that ADI generated $1.8 billion in free cash flow over the past 12 months. This comprises 33% of ADI’s total revenue, placing the company in the top 10% of the S&P 500. The free cash flow is important since the company is committed to returning 100% of it to shareholders in the form of dividends and stock repurchases. The stock currently yields about 2%. ADI targets dividend increases of 7% and 15% per year.
Analog Devices’ Free Cash Flow Growth
The positive takeaway from the quarter is that ADI held up well with the largest segments still achieving growth during the pandemic. ADI’s revenue diversity across multiple industries made this possible.
The Maxim Integrated Acquisition Strengthens ADI
The addition of Maxim will enable ADI to provide a more complete set of solutions for customers. Maxim was one of ADI’s main competitors, but now the companies will merge to form a larger entity. Maxim produces products for similar industries: industrial, automotive, consumer, and communications/data center. Therefore, the combined company is better positioned to benefit from growth in these industries.
Maxim brings over $2 billion in annual revenue, over $650 million in net income, and nearly $600 million in free cash flow (based on performance for the past 12 months). ADI expects to benefit from $275 million in cost synergies after two years of the merger completion.
The combination is likely to make ADI a clear go-to company for IC solutions. Together, the company will have over 10,000 engineers and $1.5 billion in annual R&D investments.
The Maxim acquisition is a part of ADI’s long-term growth strategy of gaining new markets/customers. Investors should watch for future M&A developments from ADI since this is an ongoing strategy.
Catalysts for ADI
ADI is poised to benefit from multiple growth catalysts. The global 5G market is expected to grow at a pace of about 44% annually from 2021 to 2027. ADI produces key technology that makes 5G possible. ADI’s focus is on delivering the important sensing and measuring technologies to get applications to the market quickly, cost-effectively, and with low risk.
The global IoT market is expected to grow at a rate of 25% annually to 2027. To connect the physical world to the digital world for numerous applications, components that sense, measure, connect, interpret, and analyze are needed. ADI supplies these components through its technology. Key applications include wireless vital signs monitoring, controls/monitoring/sensing/analytics for smart factories, building security, parking space occupancy detection, smart agriculture, and smart infrastructure.
Vehicles are another potential catalyst for ADI. Automobiles are designed with more advanced features as time progresses. ADI’s ICs are used in systems for stability/rollover control, radar & vision driver assist, airbag & crash sensing, power & battery management, transmission controls, fuel injection, audio amps, and more.
The auto industry is also moving from Phase 1 and 2 of autonomous vehicles. Phase 1 includes driver-assist features such as cruise control, lane keep assistance, and automatic braking. Level 2 includes controlling speed and steering. Most vehicles being built today have some Level 1 features and many have Level 2 features.
Reliable ICs are needed for current and future levels of vehicle autonomy. That’s where ADI’s ICs are needed now and in the future, as vehicles achieve higher levels of autonomous features – eventually with the possibility of getting to Level 5 (full automation) on a wide scale. ADI’s technology enables critical sensing used in RADAR, LIDAR, cameras, etc., to make driver assist and autonomous driving features safe and effective.
ADI is trading with a forward P/E of 24 and a PEG of 2.12. This is higher than ADI’s 5-year averages of a forward P/E of about 20 and PEG of 1.8. The current valuation of ADI has been stretched. Therefore, I don’t see this as the ideal time to start a position. I would rather see the forward P/E below 20 and the PEG below 2 for a better entry point.
Here’s how ADI stacks up with the valuation of Maxim and its peers:
|ADI||MXIM||Microchip (MCHP)||Texas Instruments (TXN)|
I included Maxim since it is likely to become a part of ADI. Maxim’s valuation is also stretched at this point. Microchip has the most attractive valuation, while Texas Instruments is trading with high valuation levels. Keep in mind that ADI is being strengthened by the Maxim acquisition, which puts competitive pressure on the remaining industry players.
The above graphic shows the total shareholder return as calculated by the share price appreciation plus cumulative cash dividend payments and the effect of reinvesting the dividends over 5 years.
Analog Devices’ Long-Term Investment Outlook
The competitive landscape has been improved with the addition of Maxim. ADI was already the largest supplier of ICs before the acquisition. The acquisition is expected to close in the summer of 2021. The addition of Maxim turns the company from a primary competitor to an important part of strengthening ADI. This better positions the company to take advantage of the growth opportunities of 5G, IoT, etc., in the market over the next 5 to 7 years.
Above-average stock growth is possible for ADI over the next 5 to 7 years, given these catalysts. The potential for the stock can be driven by the expected double-digit earnings growth (consensus) for FY21 and beyond.
Since ADI and the broader market as measured by the S&P 500 (SPY) are trading with above-average valuation levels, there will probably be an opportunity for a better entry point for the stock. I would rather be patient and wait for the next significant pullback in the market and ADI’s stock before starting a position.
Learn more about our top tech stocks and other investments.
Benefit from the insights of Kirk Spano, Dividend Sleuth, and David Zanoni. Get exclusive investment ideas based upon in-depth and up-close research that few others do.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. Business relationship disclosure: The article was written by David Zanoni for Kirk Spano’s Margin of Safety Investing service [MoSI].
Additional disclosure: The article is for informational purposes only (not a solicitation to buy or sell stocks). David is not a registered investment adviser. Kirk Spano is an RIA. Investors should do their own research or consult a financial adviser to determine what investments are appropriate for their individual situation. This article expresses my opinions and I cannot guarantee that the information/results will be accurate. Investing in stocks involves risk and could result in losses.