Analog Devices Stock: This Gem Is Worth Your Consideration (NASDAQ:ADI)

Investment thesis

I initiate my coverage of Analog Devices (NASDAQ:ADI) stock with a Buy rating. Analog Devices emerges as a compelling investment opportunity despite being overshadowed by flashier semiconductor companies. The analog semiconductor sector, though less publicized, has exhibited robust performance, with industry leaders like ADI showcasing impressive returns.

ADI, positioned as the second-largest analog semiconductor manufacturer globally, distinguishes itself with in-house manufacturing, fostering resilience against external risks. Its diversified revenue streams, spanning industries like industrial, automotive, communications, and consumer electronics, contribute to a reliable and low-risk financial profile.

While ADI currently faces challenges in the semiconductor industry’s cyclical downturn, its exemplary cost flexibility, strong customer relationships, and industry-leading margins instill confidence. The company’s commitment to innovation, evidenced by substantial investments in R&D, underscores its ability to maintain a competitive edge.

Looking ahead, ADI’s growth prospects remain promising, particularly in sustainable and high-growth industries. The company’s focus on returning value to shareholders through dividends and share repurchases, supported by a robust balance sheet, adds an attractive dimension to its investment case.

Despite near-term headwinds impacting the semiconductor industry, ADI’s strategic positioning, long-term margin targets, and shareholder-friendly approach make it a compelling Buy. While cautious in the short term due to industry challenges, the stock presents a potential avenue for both significant shareholder returns and financial growth.

The analog semiconductor is underappreciated but has a bright outlook

Analog semiconductor manufacturers like Texas Instruments (TXN), ADI, and Infineon (OTCQX:IFNNY) are not the most popular among investors despite the growing popularity of the semiconductor industry over the last decade. This is largely because these companies don’t generate flashy headlines or crazy growth rates like Nvidia (NVDA), AMD (AMD), or Micron (MU).

These analog companies are just not as exciting to the general public, but this does not make them bad investments. Most of these “boring” analog semiconductor manufacturers have easily outperformed the global indices over the last decade, with industry leaders TXN and ADI returning over 230% in share price appreciation alone. According to the Analog Devices website, shares have realized a total 10-year shareholder return of 350% when also taking into account dividends.

Furthermore, while they might not be as exciting or flashy, analog semiconductors are just as important for the functioning of our daily devices. To quickly explain the dynamic between analog and digital semiconductors, it is essential to understand how these work. For starters, digital semiconductors deal with discrete, binary signals—usually represented as 0s and 1s. They are fundamental to digital computing and information processing. Analog semiconductors, on the other hand, deal with continuous signals. These signals can represent a range of values, such as voltages, temperatures, or currents, and are used to represent real-world phenomena.

So, while digital systems operate with binary signals, they often need to interact with the analog world. Therefore, even though a system may primarily be digital, it may require some analog components to interface with the external environment. For example, digital systems often use analog components for tasks such as measuring temperature, converting audio signals, or interfacing with sensors that produce analog outputs.

Therefore, just as for the more popular GPUs and CPUs, the growth outlook for these analog chips is looking solid as demand for digital products grows. Driven by this importance, the analog semiconductor industry has even outgrown digital over the last ten years, averaging a 30% CAGR.

Going forward, digital will most likely grow faster due to innovation and change in the semiconductor industry (we are all aware of the general trend from analog to digital). Still, the analog segment will remain of crucial importance. Today, analog accounts for 15% of the entire $600 billion semiconductor industry, which is projected to hit over $1 trillion by 2030. Meanwhile, the analog industry is projected to grow at a 7.28% CAGR through 2028, delivering decent growth.

Analog Devices – A company introduction

Analog Devices, Inc. is an American multinational semiconductor company specializing in designing and manufacturing analog, mixed-signal, and digital signal processing (DSP) integrated circuits. Analog Devices develops a wide range of products that are used in various applications, including industrial automation, automotive, communications, healthcare, and consumer electronics.

The company’s product portfolio includes analog-to-digital converters (ADCs), digital-to-analog converters (DACs), amplifiers, voltage regulators, sensors, and signal processing solutions. Analog Devices plays a crucial role in providing components and technologies that enable the processing and manipulation of real-world signals, which are often analog in nature.

The company was founded in 1965 and has since become a prominent player in the semiconductor industry. Today, Analog Devices is the second largest analog semiconductor manufacturer globally, with a market share of 12.7% in the industry, only trailing Texas Instruments’ 19% market share. This market share is solidified by over 75,000 different products and over 8,000 patents.

The company also controls a large part of its manufacturing in-house, something I much prefer as it insulates it from outside risks and gives it more control over production innovation. Furthermore, this gives it great manufacturing and cost flexibility. For reference, according to management, over 70% of its capacity is flexible and can be turned on or off on demand, meaningfully supporting cost management during the regular cyclical downturns in the industry and preserving its margins.

Within the semiconductor industry, many companies are fabless, meaning they outsource manufacturing to the likes of TSMC (TSM), Intel (INTC), and Samsung (OTCPK:SSNLF). However, this makes these companies highly dependent on these foundries to produce their products, which is, of course, far from ideal. I, therefore, much appreciate the in-house manufacturing capabilities of ADI, among many of its analog peers. It simply massively improves the risk and cost profile.

In the case of ADI, this risk gets lowered further through excellent production and supply diversification, with manufacturing split over ten countries, 50 sites, and 20 partners. This excellent production diversification, again, lowers risks and creates stability, making this company a more reliable investment with limited exposure to local issues. Overall, ADI controls 45% of front-end manufacturing in-house, 80% of back-end, and 20% of assembly.

ADI has a very reliable and low-risk revenue stream as a result of great diversification

Looking at the company’s revenue growth track record, there is plenty of room for positivity. The company averaged a revenue growth CAGR of 16% over the last decade.

While this growth in itself is already impressive, it is even more remarkable when considering the incredible cyclicality of the semiconductor industry, which is clearly highlighted by the company’s YoY growth numbers. Cyclicality could not be more pronounced. Yet, crucially, the upcycles are clearly much stronger than the downcycles, supporting strong overall growth for the company.

Helping this is the fact that the company has exemplary revenue diversification in terms of customers, products, end markets, and geographies. The company’s sales are split by over 125,000 end customers, and no single customer accounts for over 5% of sales. This meaningfully lowers its risk profile.

Furthermore, the company focuses its products on four end markets: industrial, automotive, communications, and consumer electronics. As of FY22, the industrial market was the largest in sales for ADI, accounting for 51% of FY22 sales. Meanwhile, automotive accounted for 21% of sales, communications 16%, and consumer electronics for just 16%, which is a big positive as the limited B2C exposure in terms of sales insulates the company somewhat from the more volatile consumer health, somewhat protecting it in economic downturns.

In addition, the company has solid revenue diversification in terms of end markets, as highlighted above, and has been focusing on faster-growing and more promising markets, positioning itself for future growth. With the world pushing for renewable energy and sustainability through innovation, Analog Devices is a primary beneficiary.

Sustainable use cases currently represent about 1/3 of total revenue. ADI is a leader in sustainability-focused analog semiconductors, with its technologies used in 60% of energy storage systems across residential, commercial, and grid-scale networks.

Overall, at least 25% of the company’s sales are exposed to high-growth industries driven by secular trends like digitalization and sustainability. According to ADI management, this part of the product portfolio is expected to grow at a CAGR exceeding 20% as opposed to the remainder of the portfolio growing at just a 5% CAGR.

As for ADI’s growth expectations for its end markets, it expects to see industrial growth at a CAGR in the high single-digits, driven by factory automation, electrification, and a growing digital healthcare market. This segment accounts for over half the company’s sales, making it an important growth driver.

However, according to ADI management, it is not the fastest growing end market for ADI as automotive is projected to grow at a low teens CAGR. The company has a substantial market share in this market through its innovative products, perfectly positioning it for the growing adoption of electric vehicles and autonomous driving. For reference, its wired and wireless battery management systems are present in electric vehicles of 18 of the top 20 OEMs, and its automotive audio connectivity solution is used by 18 of the top 20 OEMs. This makes ADI a prime beneficiary of the growing importance of in-cabin technologies.

As for the remaining segments, management expects growth in communications around 10% and consumer electronics in the high single digits. This should support a group revenue growth CAGR in the 7-10% range, which is slightly above the projected industry growth.

Finally, in terms of geographies, the company is also exceptionally well diversified, with no single segment accounting for over 35% of sales, with the Americas accounting for 34% of FY22 sales, Europe/Middle East/Africa for 21%, Asia Pacific (ex-China) for 23%, and China for only 21%.

Especially the minimal exposure to China is a big positive here. Many of its peers have far more significant exposure to China, putting these cash flows at risk of US sanctions and the instability of the Chinese economy. With 21% of sales, ADI has relatively minimal exposure, again lowering its risk profile. I believe it is safe to say by now that the company’s revenue stream is pretty much as safe as it comes through stellar diversification and management aiming for the right direction in terms of development.

Yet, looking at the near-term performance, everything is not looking as rosy. ADI reported its fiscal Q3 results back in August and reported a continued deceleration in YoY revenue growth, slowing down from 21% in Q1 and 10% in Q2 to just 1% in Q3, resulting in revenue of $3.1 billion.

ADI is yet again facing a cyclical downturn in the semiconductor industry, something most of you readers will be aware of, and this is impacting the company’s top-line growth as demand for its products has slowed due to inventory corrections at customers. These accelerating inventory adjustments are the result of a weakening macro backdrop fueled by high and sticky inflation and high-interest rates.

To accelerate these inventory adjustments and safe production costs, ADI, in response, is shipping below end-market consumption in order to help normalize customers’ inventory more quickly and position itself for a quick return to growth in the coming quarters. Management has been quick in its actions here, and we will see this reflected in a resilient margin profile later on.

Furthermore, while the slowdown is far from great, its larger peer TXN has been reporting double-digit declines for multiple quarters now, driven by double-digit declines across most end-markets, including industrial. From this point of view, ADI is not doing so badly.

As for the end-market performance, industrial and automotive continued to be the growth drivers, growing 4% and 15%, respectively. In the case of industrial, this was driven by sustainable energy as well as aerospace and defense, which each grew double digits. Nevertheless, industrial weakened sequentially, with revenue down 7% after 13 consecutive quarters of sequential growth, showing the first sign of significant weakness. These two segments still represented 77% of revenue.

Communications, which represented 12% of revenue, decreased by double digits sequentially and YoY due to the broad-based inventory correction I flagged previously. Finally, consumer, now 10% of revenue, came in stronger than expected, finishing up 15% sequentially but still down 21% YoY. Despite continued weakness, a bottom in consumer electronics seems to be in.

Industry-leading margins and significant shareholder returns add to the attractiveness of the ADI for investors

Moving to the bottom line, the company performed well, showing cost flexibility by keeping margins relatively stable despite pressure on top-line growth. The gross margin remained strong, above 72%. This is down 190 basis points YoY and down sequentially due to lower utilization and product mix, but still really decent and industry-leading as it sits far above the sector median of 50%.

Furthermore, the operating margin was nearly 48%, down roughly in line with the gross margin, as operating expenses of $752 million were roughly flat year-over-year and up sequentially. As a result of these slightly lower margins, EPS declined 1% in fiscal Q3 to $2.49.

FCF was $818 million, representing a 27% margin, and did not fully cover shareholder returns amounting to $1.1 billion in Q3, comprised of $430 million in dividends and a little under $700 million in repurchases.

The company has consistently reported industry-leading margins, which also hold up relatively well during downturns, as visible in the most recent quarter. As indicated before, ADI is able to report very impressive margins, which sit far above industry averages. This is supported by incredible cost flexibility, its premium pricing, and strong customer relationships.

Important to understand is that the company’s products are incredibly sticky and have remarkably long life cycles. For reference, 50% of current sales are derived from products launched at least a decade ago, highlighting that the company’s products are innovative and customers rarely move to a competitor.

These dynamics allow it to be more resilient and to retain customers and premium pricing, supporting margins. As the company develops industry-leading analog chips, it will likely keep selling these for decades, and customers will likely stay. This is also why the company remains focused on investing in R&D. It has consistently invested 30% more as a percentage of sales in R&D than the peer average, allowing it to maintain its lead, innovate, create new revenue streams, and keep customers on board.

Ultimately, these strong dynamics allow for a mighty bottom line and margin profile. In the long term, the company targets reporting an adjusted gross margin of above 70%, an operating margin of 42-50%, and an FCF margin between 34-40%, all of which are industry-leading. This sets it apart from the competition and is another factor making ADI an interesting investment – margins aren’t just industry-leading but also resilient.

These long-term margin and revenue targets lead to a 2027 target of $15 in EPS and an FCF margin of 40%, which is ambitious but also realistic with room for upside.

And there is more to be excited about regarding ADI, apart from a strong and growing revenue stream and incredible margin profile. The company is also incredibly shareholder-focused as it aims to return 100% of FCF to shareholders, which is exceptional when considering the company’s industry-leading FCF margin.

ADI aims to return 40-60% of FCF in the form of dividends, targeting a 10% growth CAGR supported by revenue growth and FCF margin improvements. The company has already grown the dividend at a 10% CAGR over the last ten years and has grown this for 19 consecutive years, which is a testament to the company’s growth and stability.

Furthermore, the remainder of the FCF will be used to lower the share count through repurchases, which has been quite meaningful in recent years. For example, in 2022, the company reduced the share count by 4%. Overall, investors can expect significant shareholder returns ahead.

Based on my 2025 revenue expectation of $12.66 billion and a 36% FCF margin by then (below the 2027 target of 40%), this should result in an FCF of $4.56 billion or $9.12 per share. Based on management’s commitment to paying 40-60% of FCF in dividends, assuming this to sit at the midpoint of the range, this should result in an FY25 dividend of $4.55 per share, up 32% from today or representing a dividend growth CAGR of 15% and this is based on an EPS payout ratio of a very conservative 43%. Clearly, there is a lot of potential here and a lot for investors to get excited about, with dividend growth potential looking excellent, even as the company is facing significant headwinds in a low-demand environment. Shares currently already yield a respectable 2%.

Moreover, the remainder of the expected FCF, amounting to around $2.28 billion, according to management’s capital allocation plans, will be used for share repurchases. This means that based on the current market cap, ADI will be able to retire another 2.5% of shares in FY25 alone. Of course, these are simply projections based on estimates, but they illustrate what shareholders can expect, and it is looking great.

All these shareholder returns are supported by a strong balance sheet. ADI ended Q3 with $1.15 billion of cash, $6.5 billion in debt, and a net leverage ratio of 0.8x. Meanwhile, the company sees no need to lower its debt position as it sees its current position as healthy and targets a 1.5x net leverage ratio. The company is in excellent financial health, and the shareholders will benefit significantly.

Outlook & Valuation – Is ADI a Buy, Sell, or Hold?

For its fiscal Q4, ADI management has guided for revenue of $2.7 billion, plus or minus $100 million. This represents a revenue decline of 17% YoY and reflects the expectation of increasing weakness in all end markets, which are expected to be down sequentially.

We can look at the recent TXN results to understand what to expect from ADI next week, and it is not yet looking great. TXN saw broadening weakness in industrial with the decline in revenue accelerating. Furthermore, other segments also continued to be pressured by continued inventory corrections.

On top of this, multiple companies, including TXN and Qualcomm (QCOM), are starting to see some weakness in automotive semiconductors as demand is drying up and a shortage of automotive semiconductors lies in the past. While automotive will most likely remain strong in fiscal Q4 for ADI, I expect somewhat weak guidance reflecting a prolonged period of weakness in electronics demand.

Overall, we might see ADI slightly miss the consensus and see revenue come in at the low end of its guided range or even slightly below it.

As for margins, ADI expected to report an operating margin of 44%, plus or minus 70 basis points. This is down by four percentage points from fiscal Q3 and reflects the weakening top-line performance and resilient R&D levels. This margin weakening does not come as a surprise and is simply the result of temporary economic pressures. This should result in EPS of $2, plus or minus $0.10, representing a YoY decrease of 27%.

Based on my research, management’s growth goals, the Q4 guidance, and developments we are seeing in the industry, I now expect the following financial results through FY26. The operating environment for ADI continues to weaken, but I expect a bottom to be hit for ADI in its fiscal 1Q24. With ADI currently undershipping, a recovery should be more pronounced than expected for the overall industry. This is why I am slightly more bullish on FY24 than Wall Street analysts.

Based on these estimates, shares are currently valued at 18x this year’s earnings, which represents a discount of approximately 15% to its 5-year average of 22x, a premium multiple which, in my eyes, it fully deserves when considering all aspects discussed in this article.

Using a slightly discounted 20x P/E multiple (to account for some downside risk and temporary headwinds) on the FY25 EPS projection above, I calculate a target price of $210 per share. This means that from a current share price of $180, investors can expect annual returns of around 8%, which is not overly generous. However, taking into account the great dividend, investors are poised for total returns exceeding 10% annually, and while I would prefer somewhat higher returns, I am using a discounted multiple and conservative earnings outlook, so there is quite some room for upside.

Therefore, I rate shares a careful Buy today. Analog Devices presents a compelling investment case with room for significant shareholder returns and financial growth. However, I do recommend investors to DCA following a recent jump in the share price. I would start adding more aggressively below $173 per share.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.