At the Sweet Spot for Chip Makers

07/07/2008 12:00 am EST


Nikhil Hutheesing, editor of Forbes Wireless Stock Watch, finds a chip maker that makes big profits from the growth of analog chips along with digital.

As semiconductors are able to more quickly and less expensively digitize data, the need for analog chips is also rapidly growing.

Perhaps no company is seeing more growth from analog than Analog Devices (NYSE: ADI), which is the top vendor of analog chips. About 90% of its revenues come from its analog products and about 10% of those revenues come from Micro Electro Mechanical Systems (MEMS) chips, which detect motion and changes in orientation.

Besides shedding unprofitable businesses, ADI is well positioned in the wireless space-and is the only company that can provide a complete end-to-end solution for wireless baseband products.

By focusing on new opportunities, ADI has outperformed the broader analog chip market. Year to date, the stock is about flat compared to the Philadelphia Semiconductor Sector Index (SOXX), which has fallen 10%.

Even so, ADI still looks attractive. Its prospects and growth seem better than many of its competitors, yet that advantage is not priced into the stock. Shares of ADI trade at 18 times expected 2008 revenues and about 15 times 2009 earnings per share-both are in line with other analog semiconductor companies. ADI has a forward P/E ratio of 16.5-which is near the low end of both its one- and two-year historical 12-month forward P/E ranges of 14.9 to 26.9.

It's likely that when the economy improves and ADI's customers begin to spend more, its aggressive investment in growth opportunities should continue to pay off with further growth in revenues.

Already, the company had a good second quarter, [when] ADI generated revenues of $649 million, far exceeding an expected $627.2 million. Sales of amplifiers and converters were strong, with the communication and industrial end markets leading company growth. Earnings came in at 44 cents [per share], which was also above the expected 41 cents. ADI also has exceptional cash flow-its free cash flow margin is 63%.

I expect ADI to generate revenues of $2.6 billion in the fiscal year ending in October (up 7% year over year) and $2.85 billion in fiscal 2009 (up 10% year over year). Earnings per share should grow 14% in 2008-and maybe 17% if you include stock buybacks.

In addition to the share repurchases, ADI paid a dividend of 20 cents per share in the most recent quarter, translating into a yield of about 3%. The company has no debt. As a result, I believe that shares of this company should soon be trading at the upper end of their historical trading range of 20 times earnings per share. I expect ADI to generate earnings of $2.06 per share in 2009. At 26 times earnings, that would give a price target of $53 per share-an increase of 70% [from Friday's close above $30-Editor].

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