Analog Devices: Auto and industrial weakness; consumer bottomed?; China inventory issues; fab investments

There is so much happening in semiconductors on any given day.  Following quarterly earnings calls and investor conference transcripts provides some good insight into the priorities of companies.  In this post, I try to highlight the key messages highlighted by Analog Devices in recent weeks.

Analog Devices (ADI) grew its revenue q/q for 13 straight quarters through 2QFY23 (ended in Apr 2023).  Auto and industrial segments are key pillars of ADI, accounting for 77% of its revenue.  Both auto and industrial segments managed to grow double-digit y/y through 2Q.  ADI's gross margins (73.7%) and operating margins (51.2%) held up well and one of the highest in the semiconductor industry.  Sometime back, the company noted 70% is the floor for gross margins, indicating the underlying pricing power.

ADI's latest quarterly results show that the company is not immune to weakness forever and indicated near term weakness in its core auto and industrial segments.  ADI says it will see muted growth for the next two quarters.  The company's auto and industrial revenue will decline low to mid-single digits q/q in 3Q (ends in July), while communications will decline 10%. 

Communications market tends to be a lumpy one with no seasonal patterns.  On the other hand, the company's consumer business seemed to have turned the corner and bottomed in 2Q.  As a result, it will post sequential growth in 3Q.  ADI has <15% exposure to consumer and 30% of consumer is prosumer applications and the rest comes from smartphones, wearables etc.  Many companies with consumer exposure have been undershipping for the last 3-4 quarters.

After 3 years of steady growth, customers are beginning to adjust their forecasts and rebalance their inventories.  This is most pronounced in Asia, while North America and Europe demand is moderating but at a more measured pace.  We expect this normalization of revenue will persist through the second half of 2023.  Importantly, given our customer conversations and proactive decisions to improve lead times and rightsize our backlog, we're in a position to deliver on our goal of delivering a soft lending.

Vincent Roche, CEO of Analog Devices (A quote from the 2QFY23 earnings call)

The company's book-to-bill ratio was below 1, and its lead times and backlog contracted.  ADI noted 70% of its portfolio on <13 week lead time (normal), driven by high inventories and reduced demand.  The company's backlog also took a hit but said it is in control of pricing.  ADI claimed its pricing is 3x of analog industry and 5x of the nearest competitor.  Unlike TI, ADI is a value play and charges a premium.

Industrial, the crown jewel of ADI, hosts a variety of growing sub-segments including healthcare (15%), energy (<10%), space (<20%), factory automation (25%) and instrumentation (25%).  For example, the company says its healthcare business grew for 7 straight quarters of growth through 2022 ($900m+) and will grow again in 2023.  In addition, the company notes, its defense business will grow for the next 5-7 years.  The company even notes that a sizeable portion of industrial is recession-proof.

In addition, Vince noted the industrial segment will recover rapidly.

But my sense is things will recover in the industrial market pretty rapidly.  And in automotive, it's a case of we're getting more and more share in the areas that count with our connectivity products, the electric vehicle portfolio that we've got.  And there's still reasonable demand, I would say, for mid- to high-end automobiles.  So we see this as a relatively short-term reset.

Auto, on the other hand, is likely to experience weakness for some time due to China EV weakness.  For what its worth, ADI's peers also noted automotive weakness in recent quarters.

So look, we've grown 10 quarters in a row, and the growth for the last quarter was very broad-based, again, across all applications.  As we think about the outlook, we are beginning to see some softening, though the underlying content growth continue and our top line should still prove to be a strong multiple of SAAR.  There is some decline that relates to our strong position in China EV.

Prashanth Mahendra-Rajah, CFO of Analog Devices (A quote from the 2QFY23 earnings call)

The company saw notable weakness from Asia during the quarter.  China is 20% of ADI's revenue and performed below expectations.  The company increased its inventory to capitalize on reopening but underperformed (similar to what some other companies noted).  Despite Asia weakness, ADI did well in Europe and North America in the auto and industrial segments.

Product obsolescence is not an issue for analog companies such as ADI.  50% of ADI revenue comes from 10+ year-old products.  As guided, the company increased the die bank inventory during the quarter, increasing its days of inventory to 168 days.  The company's inventory dollars peaked in 2Q.  In addition, the company has a highly fragmented portfolio and claims to be a small part of customers' bill of materials.  As a result, ADI's customers are not incentivized to replace its high-margin products, per the company.  80% of ADI revenue comes from products that individually contribute no more than 0.1%

We have products in the portfolio that are 45 years old.  Believe it or not.  They are lithography insensitive.  But we need a lot of process recipes.  We have been investing.  We've raised our capital, our CapEx spend over the last couple of years to enable us to build more of the, let's say, typically the industrial center products with very, very long life cycles to build them inside the company.  So at 180 nanometers and above, in our fabs on the West Coast of the U.S. as well as Ireland, we have capital.  We spent about $1.5 billion, $1.6 billion to enable us by the end of '24 to have doubled the output of those of 180 nanometers and above 85% plus of ADI's revenue today is on those nodes, 180 nanometers and above, okay?  But we still use external sources.

Vincent Roche, CEO of Analog Devices at Bernstein Conference

The company has a hybrid manufacturing strategy in place, with 50% of its wafers sourced from external foundries such as TSMC.  The company outsources 90nm and below product manufacturing.  Earlier, the company noted that the hybrid foundry strategy helps it bring production in-house during downturns, boosting internal factory utilization rates and gross margins.  The company claims to have a target to manufacture 70% of its product portfolio internally and externally.

On the CapEx front, ADI will increase its capital intensity to high-single-digit in FY23 before moderating it to mid-single-digit in the long term.  The company has plans to increase the capacity in its US and Ireland fabs.

Disclaimer:  This is not investment advice.  All opinions are personal only.