All Signals Are Go for This Chip Maker

01/18/2011 1:12 pm EST


Analog Devices is poised to cash in on the booms in wireless infrastructure and auto sales, writes Paul McWilliams of Next Inning Technology Research.

Analog Devices (NYSE: ADI) merits a considerably higher valuation multiple than it receives today. The chip maker has realigned its business model and refocused on what I view as its core strengths, selling its handset and PC power control product lines. Wall Street reacted poorly to these changes when they were first announced, but has more recently recognized the value they have delivered.  

With the adjustments made, ADI was able to sustain operating margins in the mid- to upper teens even as its revenue sunk to less than $500 million per quarter during the first half of 2009. As revenue rebounded, margins quickly grew. For the July quarter ADI reported a record operating margin of 36.7%, only to top that with another record in the October quarter of 38.9%. Prior to these records, ADI’s highest operating margin was reported in Q3 2000 at 34.3%.

No Shortage of Catalysts
The catalysts I see for ADI remain (as I like them) very simple:

  • ADI serves an extraordinarily broad base of applications and has a high exposure to the industrial sectors. This has worked very well for the company during 2010, and will be a positive long-term catalyst.

  • I think we can accurately term ADI as the “gold-standard” for cell tower base station applications. To the best of my knowledge, there hasn’t been a base station built in the world that doesn’t have ADI inside. One of the hottest and likely most durable trends we’re going to witness during the coming three years is a continuation of the wireless build-out both domestically and internationally. Also notable is the fact that Semiconductor Industry Association (SIA) data for November (the first month in ADI’s fiscal Q1 2011) showed very strong digital signal processing sales into the wireless infrastructure markets. This suggests ADI saw a nice start to its new fiscal year.

  • ADI has a long history of being a major strategic supplier to the automotive market. Even though aggregate vehicle production has been soft this year, semiconductor sales into automotive applications have grown considerably. The short story here is the semiconductor content per vehicle is up substantially in the current generation of vehicles, and will go up substantially more in the next generation. I believe ADI is very well positioned to continue to capitalize on this trend.

  • While ADI has reported two successive non-GAAP operating profit margin records, I believe its operating model still has room to scale even more as revenue grows. While margins could easily fall back during the January quarter, I expect we’ll see them accelerate again later in 2011, and possibly crest over 40%.

Attractive Valuation
For fiscal 2011, Wall Street expects the company to grow earnings by 11.4% to $2.64 per share. I expect ADI will top this estimate by $0.15 to $0.30. If we use a range of earnings running from the $2.64 consensus to the rounded up midpoint of my estimate range ($2.87), a valuation multiplier range of 14 to 16, plus ADIs net current asset value of $7.72, the resulting estimated fair value range runs from $44.68 to $53.64. [Shares closed at $38.60 Friday—Editor.]

ADI trades at 11.7 times the 2011 earnings consensus plus the net current asset value. If we used ADI’s net cash value of $8.82 in place of net current asset value, the multiple would drop to 11.3.

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