Analog Devices’ (ADI) fiscal third quarter earnings missed the Zacks Consensus Estimate by 2 cents, or 2.7%. Revenue also fell short of expectations, missing by around 2.9%.
Results were generally disappointing, missing management expectations on the top line and just about making it on the bottom line. Weaker revenue and margins and a higher tax rate contributed to the results.
Analog Devices has been exceeding expectations in the last few quarters and the miss in the last quarter was more on account of supply chain disruptions in Japan that had customers building excess inventories in the second quarter that they burnt off in the third.
Revenue
Analog Devices generated revenue of $757.9 million, which was down 4.2% sequentially, up 5.2% year over year and below management’s revenue guidance of $765-795 million (down 0-3% sequentially, up 6-10% year over year).
Around 23% of quarterly revenues were generated in the Americas (down 9.5% sequentially), Europe brought in 29% (down 6.7%), China 21% (up 2.1%), Japan 13% (up 4.8%) and the rest of Asia 15% (down 5.7%).
All except the consumer end market declined sequentially, with the biggest decline in computing. Both computing and consumer were down from the year-ago quarter.
Revenue by End Market
The industrial market generated 48% of Analog Devices’ total revenue (down 5.0% sequentially and up 7.2% year over year). This is a very diversified market for Analog Devices, including the industrial automation, instrumentation, energy, defense and healthcare segments.
The sequential decline in the last quarter was on account of the inventory correction, as well as some caution at U.S. and European customers. However, management stated that customers were planning for stability rather than declines.
Also, the industrial business in China remained extremely strong in the last quarter. Energy efficiency, productivity enhancements and security are fueling spending in the segment.
Communications generated 22% of total revenue, down 6.7% sequentially and up 7.1% year over year. Analog Devices’ communications business comes from both infrastructure and cell phones, although the focus is on the infrastructure side.
Order pushouts at Chinese and European customers were responsible for the sequential decline, which management attributed to shortage of components from other providers that resulted in customer inventory falling out of mix. The U.S. and Europe are likely to remain weak in the near term, although Asia is expected to be strong through the rest of the year.
Analog Devices’ converters, amplifiers and RF products are solidly positioned across all fast-growing geographies (particularly the U.S., Europe and China) and should generate substantial growth for the company.
Consumer generated 15% of revenue, up 4.9% sequentially and down 9.8% from a year ago. Analog Devices stated that the decline from the year-ago quarter was by design, as the company was increasingly going after more value-added business, which should generate better margins. The average selling price was steady. The sequential improvement is in line with normal seasonality.
The automotive segment (carved out of the industrial segment in the first quarter of fiscal 2010) generated around 13% of Analog Devices’ third quarter revenue, dropping 4.8% sequentially, while increasing 21.1% from the year-ago quarter.
Segment revenue is currently being driven by the growing content in automobiles, which has been satisfactory over the past year. Management stated that the company’s strong position at customers would ensure relatively steady revenue. However, we note that revenue was down sequentially in the last quarter, which could happen at any time, since automotive volumes will tend to vary depending on market dynamics.
The global recovery, better credit availability, as well as increasing electronic content per vehicle, especially in the areas of infotainment, safety and fuel efficiency remain long-term drivers. This, along with increasing demand for high-end vehicles that use Analog Devices products are positives for the company.
Computing accounted for the remaining 1% of Analog Devices’ revenue, down 18.2% sequentially and 21.2% year over year. Management has taken a policy decision to defocus this market, since it is given to commoditization, making margin expansion difficult.
Revenue by Product Line
Overall, analog products continued to grow from the year-ago quarter, while the growth rate dropped from a double-digit rate to a mid-single-digit rate. Growth from digital signal processing (DSP) products, although positive, continued to slow down in the last quarter.
Analog signal processing products (85% of total revenue) were down 4.9% sequentially and up 5.8% year over year. All product lines (converters, amplifiers and other analog products) contributed to the seuential decline and year-over-year increase.
Converters remained the largest product line for Analog Devices, with a revenue share of over 44%. Amplifiers followed, with a 26% revenue share, while other analog products accounted for 14% of total revenue.
Power management and reference products remained at 7% of revenue, down 2.1% sequentially and up 2.8% from last year. The strength in this product line is the result of management’s refocusing of the business over the last few years.
Digital signal processing products (8% of total revenue) were up 2.0% sequentially and up 1.6% year over year.
Margins
Analog Devices generated a pro forma gross margin of 67.2%, down 31 basis points (bps) sequentially, up 58 bps year over year, just short of management’s guidance of 67.5%. Gross margins have expanded sequentially in six of the last eight quarters and the sequential contraction was due to lower utilization of internal fabs as management reacted swiftly to the softer-than-expected demand.
Operating expenses of $230.8 million were up 2.1% sequentially and flat from the July quarter of 2010. As a result, the operating margin shrunk 95 bps sequentially while expanding 192 bps year over year to 36.8%.
On a sequential basis, R&D expenses increased the most as a percentage of sales, followed by cost of sales and then SG&A. All expenses declined year-over-year as a percentage of sales, contributing almost equally to the margin expansion from last year.
Net Profit
The pro forma net income was $219.9 million, or a 29.0% net income margin compared to $245.3 million, or 31.0% in the previous quarter and $200.3 million, or a 27.8% net income margin in the prior-year quarter. The fully diluted pro forma earnings per share was 71 cents compared to 79 cents in the previous quarter and 65 cents in the July quarter of last year. The EPS was just within management’s expectations of 70-75 cents.
Since there were no one-time items in any of the quarters, the GAAP and non GAAP net income and EPS were same.
Balance Sheet
Inventories increased 1.9% to $299.3 million, with annualized inventory turns dropping to 3.3X from 3.5X. Days sales outstanding (DSOs) went down to 45 from 48. Cash generated from operations was around $257.0 million. Analog Devices spent $37.0 million on capex, $14.0 million on acquisitions and $75.0 million on cash dividends and $66.3 million on share repurchases in the last quarter.
Guidance
Analog Devices stated that order trends indicated that the strong growth in communications infrastructure and automotive would offset the softness in industrial. As a result, Analog Devices now expects revenue of $715-755 million, representing a sequential decline of 0-6%, or a year-over-year decline of 2-7%.
Gross margins are expected to come in at 65-66% and operating expenses to be flat to down 3% sequentially, resulting in earnings per share of 60 to 68 cents. Analysts polled by Zacks expected earnings of 74 cents a share when Analog Devices reported, well over the guided range.
Our Recommendation
While Analog Devices is seeing improving trends for 2011, particularly in the industrial, automotive and communications infrastructure markets, the company has no exposure to the computing vertical, which is growing very strongly this year on the back of tablets from Apple Inc (AAPL), Samsung, HTC, Hewlett-Packard Company (HPQ) and the like. Analog Devices will not be able to participate in this growth.
On the other hand, its results were impacted by the disaster in Japan, so there is a certain amount of uncertainty with respect to its revenues from the consumer and automotive segments.
Analog Devices shares carry a Zacks rank of #3, implying a short term Hold recommendation.
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