Wide-moat Analog Devices reported solid fiscal third-quarter results and provided investors with a healthy forecast for the October quarter, as the global chip shortage is ongoing, and it continues to see chip demand more than supply. The company did see some cancellations and some softening demand in consumer and communication chips, but demand for industrial and automotive chips remains strong and the company is still striving to catch up to its large order backlog. We maintain our $172 fair value estimate and view shares as fairly valued.

Revenue in the July quarter was $3.11 billion, up 5% sequentially, up 77% year over year because of the inclusion of revenue from recently acquired Maxim Integrated (24% growth on a pro forma basis), and above the midpoint of guidance of $3.05 billion. The largest segment, industrial, fared well with revenue up 4% sequentially, thanks again to broad-based demand. Consumer revenue provided upside with revenue up 11% sequentially, and management touted that this business remains focused on high-end consumer devices, such as home theatre systems, hearables, and wearables, with limited exposure to low-end smartphones and PCs, which are facing industrywide weakness. Adjusted gross margins and adjusted operating margins remained exceptional and were flattish sequentially at 74.1% and 50.1%, respectively.

The firm provided a modestly cautious forecast for the September quarter, with revenue of $3.15 billion at the midpoint, which would represent growth of 1% sequentially and 24% year over year on a pro forma basis. If macroeconomic conditions were better, the firm believes it would generate revenue in excess of this guidance, as it is ramping up its chip supply in order to catch up to its large backlog of orders to fulfill. However, management’s forecast includes some conservatism in case the macroeconomic environment was to weaken further and some customers may choose to delay some of its existing orders.

Analog Devices is one of the world's largest analog chipmakers, with an especially strong position in analog signal processing chips. We think it is well-positioned to profit from more advanced and higher-priced semiconductor content in automobiles, 5G wireless equipment, and industrial applications like medical devices and factory automation equipment in the years ahead.

Analog chips are used to convert real-world signals, such as sound, temperature, and pressure, into digital signals that can be processed. We believe Analog Devices has a wide economic moat because of its proprietary analog designs and high customer switching costs; since analog chips are neither particularly expensive nor do they require cutting-edge manufacturing techniques, high-quality analog chipmakers tend to retain design wins as long as the end product is being built, all while maintaining healthy pricing and strong profitability over time.

Most of Analog Devices’ organic sales come from data converters and amplifiers used in various end markets, such as wireless base stations, and the company expanded into power management chips via its acquisitions of Linear Tech and Maxim Integrated.

An especially promising end market for the firm continues to be the automotive sector. Semis are required to enable the sensors, active safety systems, and advanced infotainment systems added to cars today. Electric vehicles have even more chip content per car, and ADI is well positioned, with a market share lead in battery management systems for electric vehicles. We're also seeing a similar trend of increased chip content in industrial applications like robots, factory equipment, and medical devices. ADI has tens of thousands of customers in these end markets. Further, ADI's signal chain semiconductors continue to be prominent in 5G wireless network equipment.

Nonetheless, ADI still faces competition in a fragmented analog market against companies with comparable chip design expertise. Further, the analog chip industry remains cyclical and sales probably will continue to ebb and flow with these industry cycles over time.

We believe that ADI has a wide economic moat, thanks to intangible assets around proprietary analog chip design and manufacturing expertise, as well as switching costs that make it difficult to swap out analog chips for competing offerings once they are designed into a given electronic device. We are confident the firm is more likely than not to generate excess returns on capital over the next 20 years.

We believe that leading analog chipmakers benefit from favorable characteristics that lend themselves to economic moats. Moats for chipmakers with analog expertise tend to come from intangible assets associated with the strength of proprietary chip designs, as well as switching costs that make it difficult to swap out analog chips for competing offerings once they are designed into a given electronic device. We believe analog engineering talent is difficult to come by, as greater emphasis is placed on digital chip improvements, and it often takes years to train up-and-coming analog engineers in the intricacies of chip designs. Thus, it is extremely difficult for startups to replicate the many years of analog expertise held by incumbents. Leading analog chipmakers also face stringent quality requirements in some end markets, such as the automotive industry, for example, where defects can only be tolerated as low as one part per million. Although the analog chip market is quite fragmented, it would be difficult for any startup to achieve this level of quality while still being to satisfy high-volume production. Furthermore, analog chips tend to make up only a small portion of a product's bill of materials, so purchasing decisions tend to be based on performance rather than price, helping ADI and its peers retain pricing power. Automotive, industrial, and communications infrastructure customers, in particular, are unlikely to choose an inferior analog chip in order to save pennies on the cost of a piece of equipment worth tens of thousands of dollars.

Similarly, engineers are loath to swap out an analog from an existing design (again, only to save a few pennies on cost) because of the onerous redesign and retesting costs associated with the switch. One can imagine the frustration and possible reputational damage to a product if a perfectly functioning electric toothbrush or thermostat were to fail because of an unforeseen change in how the analog chip interacts with the rest of the circuit board. Again, such damages would be amplified in far more expensive equipment like cars, planes, or satellites.

ADI and its chipmaking peers tend to profit from these high switching costs by having lower ongoing R&D and capital expenditure investments than digital chipmakers, which helps to contribute to healthy returns on capital for shareholders. In particular, buyers of analog semis typically don't demand smaller chips packed with more transistors, but rather, reliable products that deliver the desired accuracy and precision in power management or signal processing. Shrinking the chip might not necessarily enhance accuracy (and might even serve to reduce it), so analog chips tend to be made with lagging edge manufacturing techniques.

ADI and some of its peers take this benefit one step further by concentrating on end markets where product lives are measured in decades, as opposed to the increasingly short life cycles associated with consumer devices like PCs or handsets. ADI likely earns less than 10% of revenue from personal electronics devices like smartphones, tablets, and PCs. All else equal, we are less confident in outsize economic profits from chipmakers that serve the handset and PC industries, given the shorter product life cycles, intense competition, and customer concentration as a handful of tech titans exert tremendous buying power.

The analog chip space is highly fragmented, but ADI is the only firm with a substantial market share lead in any subsegment of the business. The firm has nearly 50% share of the data converter analog chip market, and these chips are widely used in communications infrastructure equipment, in particular, as they convert analog voice signals to digital signals for processing, and vice versa. We believe that ADI will retain its relatively dominant position in converters over time.

Our fair value estimate for ADI is $172 per share, as we incorporate ADI’s acquisition of Maxim Integrated in an all-stock deal. Our fair value estimate implies a fiscal 2022 (ending October) price/earnings ratio of 23 times and a 5% free cash flow yield.

ADI grew 31% in fiscal 2021, thanks to a robust rebound in chip demand from the COVID-19 pandemic, as well as 9.5 weeks of revenue contribution from recently acquired Maxim Integrated. For fiscal 2022, including 12 months of revenue from Maxim, we model 45% revenue growth. While the full contribution of Maxim should contribute to most of the growth, we think ADI's organic revenue will remain impressive, in light of a global chip shortage and strong demand for the firm's products within industrial, automotive, and communications infrastructure applications. On a longer-term, midcycle basis, we project that ADI plus Maxim will earn average annual sales growth of 7%. We see the combined ADI continuing to benefit from increased electronics content in automotive and industrial products, while also benefiting from near-term tailwinds associated with 5G wireless infrastructure buildouts.

On an adjusted basis, ADI earned a 40% operating margin in fiscal 2020 and 42% in fiscal 2021. Based on higher sales levels and some expense synergies associated with Maxim, we anticipate adjusted operating margins rising to 44% in fiscal 2022 and remaining in the mid-40% range in the long term.

We assign ADI a medium fair value uncertainty rating. Analog Devices' greatest risk is exposure to the highly cyclical semiconductor industry. The company’s fortunes are also closely tied to the health of its various end markets. Analog Devices earns more than half of its chip sales from the industrial and automotive end markets, so weakness in these sectors could spell trouble for the firm. ADI generates about 20% of revenue from the communications infrastructure market, where spending by wireless carriers to build out networks is especially lumpy. ADI’s revenue in this segment may ebb and flow with the size and timing of various networking buildouts across the globe. Finally, ADI’s consumer business received a boost from design wins into Apple products, but sales fell sharply from fiscal 2018 through fiscal 2020 as Apple cut ADI out of some sockets within its iPhones.

An additional near-term risk is U.S.-China trade tensions. If Chinese customers today choose (or are forced) to move away from U.S. suppliers, they may gravitate to some of ADI’s Europe-based rivals, such as STMicro, Infineon, or NXP. Finally, we do not foresee any material environmental, social, or governance issues on the horizon. Perhaps the greatest risk is the scarcity of experienced analog talent within the industry, but ADI’s inorganic expansion has enabled the firm to acquire talent and reduced this risk, in our view.

We assign Analog Devices an Exemplary capital allocation rating, which reflects our assessment of a sound balance sheet, exceptional investments associated with the firm’s strategy and execution, and attractive and appropriate shareholder distribution policies.

Analog Devices’ balance sheet isn’t the cleanest, as the company took on leverage to fund acquisitions. As of August 2022, ADI held $1.52 billion of cash on hand versus $6.25 billion of debt. However, we think the acquisition was a very smart deal, and ADI generates tremendous cash flow, so we are unconcerned about the firm’s ability to reduce its debt obligations.

Vincent Roche, a longtime ADI veteran, became CEO in May 2013. He also became chairman in 2022, replacing Ray Stata, one of ADI's cofounders. Overall, this management team has done an excellent job of growing organically while also expanding inorganically. Recent large deals have been especially savvy. First, the firm made a smart move to acquire Hittite Microwave, as the firm paid what we consider a reasonable 30% premium for a highly profitable radio frequency chipmaker. We believe ADI will benefit from selling Hittite products into 5G wireless equipment in the years ahead. We also think ADI made another shrewd deal to acquire Linear Tech, the highest-margin analog chipmaker. ADI has taken on a relatively high degree of leverage to buy Linear, but strategically, the deal makes quite a bit of sense and we anticipate that ADI will generate healthy free cash flow in order to pay down the debt over time. Finally, we like ADI’s acquisition of Maxim Integrated in order to further boost its power management chip portfolio. We also like that the company did so in an all-stock deal rather than taking on additional debt.

Analog Devices has done a good job of distributing cash to shareholders, raising its dividend to $0.76 per quarter and targeting a 15% annual dividend increase. ADI plans to distribute 100% of its free cash flow to shareholders through dividends and opportunistic stock buybacks.