Analog Devices Inc (ADI) — Q3 2017 Earnings Call Transcript

All right. Great. Thank you, Jennifer. Good morning to everybody on the line here. Thanks for joining the Analog Devices Third Quarter 2017 Earnings Conference Call. First, I'd like to get through our disclosures. Note that the information we're about to discuss, including our objectives and outlook, includes forward-looking statements. Actual results may differ materially from these forward-looking statements as a result of various factors, including those discussed in our earnings release and our most recent 10-Q. These forward-looking statements reflect our opinion as of the date of this call and we undertake no obligation to update these forward-looking statements in light of new information or future events. Today's commentary about ADI's third quarter financial results will include non-GAAP financial measures. When comparing our third quarter results to our historical performance, special items are also excluded from the prior quarter and year-over-year results. Available reconciliations of these non-GAAP measures to their most directly comparable GAAP measures and additional information about our non-GAAP measures are included in today's earnings release and in our web schedules, which we've posted under the Quarterly Results section at investor.analog.com. Our web schedules also include a historical view of what the combined ADI and Linear Tech would have looked like by end market, by quarter for the last 3 years. And lastly, please note that ADI's first quarter of fiscal '18 will be a 14-week quarter so you should adjust your models for an additional week of revenue and an additional week of expenses for that quarter. And so with that, I'll turn it over to ADI's CEO, Vincent Roche. Vince's comments are on a non-GAAP basis and exclude special items outlined in today's release. So with that, Vince, it's all yours.

Thanks very much, Ali, and good morning, everyone. Well, this is another very successful quarter for ADI, and I'm pleased to share our results with you this morning. Not only were our third quarter financial results stellar, but we're also making excellent progress in integrating Linear Tech from an organization and a synergy capture perspective. So let's start with our financial results for the third quarter. Total revenue was above the high end of guidance at $1.46 billion, primarily on broad-based strength in the highly diverse industrial markets. And this strong revenue growth, coupled with disciplined operational execution, delivered gross margins of 70.5% and operating margins of 40.5%. Importantly, the combined company has generated $1.9 billion of adjusted free cash flow over the past 12 months with associated margins of 34%, which are among the highest in the S&P 500. Now, I'd like to give you some details on our performance by end market during the quarter. The industrial market represented 49% of sales and demand across all industrial sectors and regions was strong. ADI's industrial business is now nearing a $3 billion annual run rate and we see numerous opportunities to drive additional dollar content and revenue growth as customers increasingly rely on ADI to make their applications more intelligent, more connected and more efficient. For example, in factory automation, our software configurable I/O solution is making the factory floor more flexible and configurable. The value creation opportunity is highly compelling. Customers have the potential to save more than $2 million per typical installation and factory downtime during line changeovers can be reduced by more than 8 weeks. As the factory floor further automates, ADI's opportunity in the area of robotics doubles with the addition of sensing, signal processing, power delivery, and connectivity. A new application such as collaborative robotics expands our available market by around $300 million over the next 5 years. Switching now to automotive. This market represented 16% of revenue and increased over the prior year. ADI's dollar content opportunity in a vehicle today is approximately $250, but we believe we can more than double this by 2025 from emerging megatrends such as autonomous driving and the electrification of the powertrain. For autonomous and semi-autonomous vehicles, ADI's 77 gigahertz radar solution delivers the highest levels of resolution and sensitivity, increasing spatial accuracy by a factor of 8 while making the radar 3x smaller. In addition, the desire to make cars more energy-efficient is driving the electrification of the vehicle powertrain. Here, ADI's battery management products are 3x more accurate than competing solutions, enabling more miles per battery charge. The communications infrastructure market totaled 18% of sales in the third quarter. By application area, sequential strength in wireline offset a slower wireless sector. ADI's portfolio of RF and microwave and high-speed signal processing, coupled with power, is unmatched in breadth and depth with products that span the entire frequency spectrum to 100 gigahertz and beyond. For example, our software-defined radio transceivers dramatically simplify the base station radio card through aggressive integration and software configuration. This solution enables higher channel density and reduces our customers' time-to-market. Today, ADI solutions are pervasive in 5G field trials and we are well-positioned to benefit from the wave of 5G deployments that we believe will begin in 2019. The consumer market represented 17% of sales in the third quarter, increasing both sequentially and year-over-year across prosumer and portable consumer applications. We've built a strong consumer franchise that focuses on solving our customers' toughest engineering challenges, providing them with a high level of differentiation and, in turn, driving very strong profitability and free cash flow for ADI. So in summary, this was an excellent quarter and we believe that we are better positioned than ever to drive long-term profitable growth and free cash flow. So with that, I'd like to turn the call over to Ali for details of our financial performance in the quarter.

Okay. Thanks, Vince, and good morning, again, everyone. Before we move to the quarterly results, please note that with the exception of nonoperating expense, my comments on the P&L line items exclude special items outlined in today's release and our web schedules can be found on the IR page. Okay. So as Vince just outlined, this was another really solid quarter for ADI with all line items of the P&L exceeding the high end of our guidance range on very strong business performance and operational execution. So total revenue increased to $1.46 billion with a $393 million contribution from Linear Technology. ADI's standalone revenue increased 6% sequentially and 23% over the prior year and this reflected strong and broad-based demand, particularly in the industrial market. Gross margins in the third quarter were 70.5%, above our guidance range, primarily on a higher industrial revenue mix and cost synergy capture. Dollars of inventory increased $40 million sequentially as we ramped production to match strong demand, but on a days basis, inventory was stable at around 106 days. Deferred revenue for shipments into distribution increased 11% sequentially and weeks of inventory in distribution were, again, at 7 weeks, which has been very consistent over many, many quarters now. Operating expenses in the third quarter were $437 million or 30% of revenue and, as a result, operating margins expanded to 40.5%, which was above the high end of guidance. Nonoperating expense in the third quarter was $68 million, reflecting a full quarter of interest expense with the financing related to the Linear Tech acquisition in place. Our expectation is for nonoperating expense to be approximately $65 million, both in the fourth quarter of 2017 and in the 14-week first quarter of 2018, and to decrease to $55 million to $60 million per quarter for the remainder of fiscal '18. Our third quarter non-GAAP tax rate was 10.8%. We expect our fourth quarter non-GAAP tax rate to be approximately 10% and for it to be approximately 15% in 2018. Diluted share count increased to 371 million shares in the third quarter, primarily due to the equity consideration relating to the acquisition. Excluding special items, diluted earnings per share in the third quarter of '17 was $1.26. That was $0.05 above the high end of guidance. During the quarter, we completed a restructuring of our legal entities related to the Linear Tech acquisition. This resulted in a one-time cash payment of $750 million. Excluding this item, ADI generated $322 million of adjusted free cash flow in the quarter and $1.9 billion for the combined company on a trailing 12-month basis. During the quarter, we paid down $600 million of the debt associated with the Linear Tech acquisition, which helped reduce our net debt-to-EBITDA ratio to 2.9x. We expect to pay down our debt at a rate of approximately $1 billion per year and are planning to achieve a 2x net debt-to-EBITDA leverage ratio by the first half of fiscal 2019. Once we achieve this leverage ratio, we plan to reinstate our share buyback program and target an overall cash return to shareholders of 80% to 100% after debt service. So moving on to fixed asset additions, which in the third quarter were $64 million for the combined company and are planned to be approximately $200 million for fiscal '17. And this is probably a good opportunity to also point out that our model is for CapEx to run at approximately 4% of revenue on an ongoing basis. During the quarter, we also paid $166 million in dividends and, earlier this week, our Board of Directors declared a quarterly cash dividend of $0.45 per outstanding share of common stock payable on September 19 to shareholders of record at the close of business on September 8. And that dividend payment now represents $1.80 per share annualized dividend payment. Okay. So with that, I'll turn it back over to Vince for our outlook for the fourth quarter of '17, which exclude special items outlined in today's release.

Thanks, Ali. After a strong third quarter, we're planning for revenue in the fourth quarter of 2017 to be in the range of $1.45 billion to $1.55 billion. By end market, we're planning for the industrial and communications infrastructure sectors to be approximately flat sequentially and for the automotive and consumer markets to grow from their third quarter levels. Gross margins are expected to remain stable at approximately 70.5% as cost synergies offset the anticipated mix of revenue. Operating expenses are estimated to be down 3% to flat sequentially. At the midpoint of this guidance, these inputs translate into an operating expense ratio of approximately 29% and operating margins of approximately 42% in the fourth quarter. Based on these estimates and excluding special items, diluted earnings per share are planned to be in the range of $1.29 to $1.43. As you likely saw as well, we recently announced our new CFO, Prashanth Mahendra-Rajah, who will be joining us at the end of September. I'm really looking forward to Prashanth's arrival and getting the benefit of his strategic insight and strong operational focus as we continue our long-term customer and shareholder value creation journey. We believe that our organization, portfolio, and customer relationships have never been in better shape and our technology never more essential to an ever more connected and intelligent world. Our operating model calls for some of the highest margins in our industry, and indeed, in the S&P 500. Operating margins that are in the range of 39% to 45% and free cash flow margins in the range of 34% to 42%. And we're only getting started. So with that, we will take your questions.

Thanks, Vince. Now let's move to our Q&A session. Operator, can we have our first question, please?

My first question is perhaps a bit more longer term for you, Vince. But as we now look at ADI, Linear and Hittite combined, can you give us any examples on how that combination really strengthens your barriers to entry? I mean, I know you're obviously working on a lot of new products with the 3 combined, but if you can give us any insight into how that positions ADI from a competitive perspective, that would be great.

Yes, Tore. If you examine the analog sector, we now have all the essential components needed to tackle the significant challenges our customers encounter in areas such as sensing, measuring, interpreting, and powering signal chains. This is the brand we've been cultivating at ADI over the years, which has also been developed independently by Hittite in the RF and microwave field and by LT in the power and mixed-signal sectors. Now, under one roof, we can address our customers' most difficult challenges in communications infrastructure, autonomous driving, and enhancing the intelligence and connectivity of our customers' existing factory automation and process control systems. This is the brand message we share with our customers, and it is the brand they are investing in across these various domains. We are now investing approximately $1 billion in combined R&D across all three enterprises, striving to enhance our competitive edge continually. We firmly believe we are better positioned than ever in diverse markets and with larger clients. Additionally, with LT's inclusion, we have the opportunity to engage directly with more medium-sized and smaller customers.

Tore, did you have a follow-up?

I have a follow-up on the communications segment. It's been somewhat mixed in recent quarters. I assume this is mostly related to wireless infrastructure, but you've mentioned that 5G is coming online sooner than I expected. Could you provide more details on when we might see more significant growth in the communications part of the business?

Yes, we are currently engaged in field trials with almost everyone in the 5G sector. I believe China and possibly Japan will be the first to introduce 5G systems. While there are various interpretations of what 5G entails, I anticipate that the initial systems will utilize massive MIMO technology, similar to 4.5, and will progress to much higher frequencies over the next five years, reaching into the gigahertz range, specifically the 20 to 30 gigahertz spectrum. I expect that 2019 will mark the beginning of deployments in Asia, and that it may take a bit longer for Europe and America to determine the precise standards and frequencies before entering the field trial phase.

Yes. And, Tore, I'll just to add, from a positioning standpoint, ADI's particularly well-positioned to benefit from these 5G deployments. Inherently, when you're enabling more bandwidth, you're going to need more radios, and that's really where we focus is on the radio. So the more radios that are out there, the better it is for ADI. And secondly, as you're moving to faster speeds and higher standards, you need to move up the frequency spectrum. And so with our addition of the Hittite portfolio, we're particularly well-positioned as we move up the frequency spectrum in areas like microwave and millimeter wave.

In automotive core ADI, the team has been achieving solid year-over-year growth over the past few quarters. Combined with Linear, there was mid-single digits year-over-year growth in Q3. Looking at Q4, which typically tends to be stronger, guidance suggests growth ranging from low single digits to mid-single digits year-over-year. Given the momentum and increased content on new model deployments, should we expect that your guidance indicates auto growth is leaning more towards the mid-single digits year-over-year range?

In the quarter, automotive revenues remained stable sequentially and exceeded our guidance range. There were two distinct trends in the automotive sector. While the standalone automotive business experienced a decline in line with seasonality, the LTC automotive business showed a strong recovery sequentially, particularly in the powertrain sector in China. Overall, when combining both businesses, we observed stable results for the third quarter. Year-over-year, the standalone ADI revenue increased in the high single digits, but appears as mid-single-digit growth due to the lower performance of the Linear Tech business in the powertrain segment. Currently, we are witnessing a good recovery in that sector. Regarding guidance for the next quarter, we can only share what we see in the order book, which indicates a seasonal fourth quarter, potentially reflecting mid-single-digit to high single-digit year-over-year growth. While there has been considerable discussion surrounding SAR, it's important to acknowledge that for us, as Tier 2 suppliers to Tier 1 suppliers serving OEMs, it is challenging to directly link SAR to our revenue. Our insights are based solely on the order book, which suggests a stable fourth quarter.

Great. And then, just a quick follow-up. Same question I had last quarter, which is obviously you guys talked about distribution inventory still being very disciplined on lead times. Again, looking at some of your peers, there appears to be some pockets of products that are seeing tightness of supply. Last quarter, you guys talked about being very comfortable satisfying customer demand within your normal 4 to 6-week lead times. I'm just wondering if that's still the case?

Yes. Good question. We obviously pay a lot of attention to that particularly because it is a customer service commitment that we have. And so absolutely, the lead times have remained very stable at 4 to 6 weeks and really not a whole lot of change there. We do have about 3.5 months worth of inventory on our own balance sheet. We have 7 weeks of inventory in distribution. And I'd say those metrics have been very, very stable.

My question is on the Linear integration. And it looks like some of the synergies, especially on the margin front, are showing up earlier, but if I were to pick something that, at least to me, doesn't look that positive is the free cash flow. And I'm not judging you on a quarterly basis. But even if I x out the one-time payment, free cash flow margin looks on the lower side. Could you please address that?

Yes, we closely monitor our free cash flow margins, which currently stand at 34% on a trailing 12-month basis, placing us among the higher end of the S&P 500. Considering the two businesses we operate, we believe there is significant potential to enhance our free cash flow margins further. Although we are at the top of the free cash flow range for the S&P 500, our model indicates we are still at the lower end, which spans from 34% to 42%. It’s important to note that evaluating free cash flow in any quarter involves numerous factors. The third quarter is typically a weaker season for free cash flow generation, influenced by certain activities. Last year, our free cash flow was around 25%, while this year is likely closer to 22%. This year, we are in a better business environment, which leads to increased inventory buildup and higher accounts receivable, affecting cash flow in the current quarter but converting to cash later. Additionally, we have a debt load from an acquisition that comes with two semiannual payments, one of which occurs in the third quarter, contributing to the reduced free cash flow this quarter. Overall, this quarter presented a challenging environment for cash flow, but we are well-positioned in the long term to achieve our target range of 34% to 42% for free cash flow margins. Do you have a follow-up?

Yes, I did. You addressed the auto question that Harlan raised. Similarly, in the industrial sector, we don't have a specific SAR number to reference that would indicate how your business should be performing. How would you describe what you're observing in the industrial end market, considering there are many factors at play?

I've spoken with many executives at our industrial customers over the last few months, and there is generally a sense of optimism. While people are practical about the capital expenditure environment, there is a prevailing belief that the economic situation in America is improving, particularly in terms of capital expenditures and enhancing the efficiency of existing machinery. This includes what our customers refer to as brownfield upgrades. Additionally, China's push for mass automation, known as China 2025, is significantly impacting our business in both China and Japan. Overall, there is strength across various sectors, including automation, aerospace and defense, and ATE, with all regions performing well at this time. There is also a healthy balance between the demand for our products and their supply.

Vince, I wanted to follow-up on a comment that you made in your prepared remarks regarding the automotive business and the potential for ADI content to double from now to the 2025 period. As investors look ahead to the next one to 2 years, where should they expect content to start to increase towards that $500 level from what is $250 now? What are the early signposts that they can look to for an increase in content?

Certainly, Craig. That's a good question. In terms of autonomous driving, we are gradually advancing towards a vehicle that increasingly utilizes predictive safety features. Our radar solutions are currently performing well, and we have an impressive lineup of new high-frequency products that offer exceptional spatial accuracy and a high channel count, making them highly integrated. This is one area where we expect to achieve significant market penetration. Additionally, our power solutions, particularly from LT, can be integrated into these applications, which could effectively double the market opportunity for ADI in the radar segment. We are also in the early stages of trialing a solid-state LIDAR solution, which we anticipate will contribute meaningfully to our revenue in about five years. We've recently launched new products, such as A2B, which facilitate efficient and cost-effective information transfer within vehicles. We have several generations and new variations of this product lined up. On the electrification front, we have developed an appealing portfolio of magnetic sensors for managing and measuring movement in vehicles, equipped with advanced precision signal processing. Furthermore, the introduction of LT's battery controllers is generating excitement among our global customers. We have a long history with many ongoing sockets in areas like infotainment and audio, and we are building a strong pipeline in all these sectors, which gives us a lot of confidence.

Great. Ali, the follow-up question is for you. I appreciate the heads-up on the extra week in the fiscal first quarter of next year. As a backdrop to that, can you just help us, as you look at the combined business, what would normal seasonality be for the fiscal first quarter with Linear Tech in the portfolio?

Yes. That's a good question, Craig. I would say the ADI B2B markets and the Linear Tech B2B markets are likely to behave similarly in terms of seasonality. We have also provided a schedule on our IR page that shows three years' worth of data for what the combined company would have looked like by quarter. You can use that data to calculate the seasonality as well. Generally speaking, the first quarter is fairly weak. It's a January quarter for ADI, so we not only have the December holidays but also the January holidays impacting that quarter. Typically, it's weaker for industrial, automotive, and communications infrastructure. On the consumer side, if you look at the fourth quarter guidance we provided for consumer, the year-over-year growth rate is actually down. I would expect that weakness to extend into the first and second quarters of next year. Regarding seasonality in the first quarter, because we anticipate an additional week of revenue, we include an extra week of revenue and OpEx. In the second quarter, we usually see a sequential recovery in the industrial and automotive markets, but this time, I believe the recovery will likely be more muted due to the extra week in the first quarter. On the consumer side, we often see a dip from first quarter levels. The third and fourth quarters tend to be fairly stable seasonally for the B2B markets, while the consumer sector typically recovers. That’s how you can think about 2018 and the impact of the extra week in the 14-week quarter of the first quarter of 2018.

First question on the consumer segment. It's good to see that it's now less than 20% of sales. But do you think it's at a point where your large portable customer have sort of stabilized somewhat on a content basis so we don't have to worry about any big fluctuations that are content-related? I understand the seasonal swings in consumer, but at what point can we start to finding normal seasonality and not have to worry about content swings at large customers?

Yes. As we discussed during Analyst Day, we believe our position in the portable segment is robust in the areas we focus on. The adoption and life cycles in this sector are generally shorter compared to industries like industrial. Therefore, we need to continuously compete for market share. However, as mentioned at Analyst Day, we are anticipating a level of stability at a lower run rate, possibly down 20% in the portable sector in the upcoming year. That is our plan and objective. There could be potential for growth beyond that, but that's our current outlook.

Yes. I'll just add, Vivek. It's obvious. We have really no visibility into what 2018 is going to do in consumer, although we do have a good sense that our content in these devices is pretty platform-specific. And our sense is that, that mix is going to be weaker next year. As Vince pointed out, frankly, we were asked at the Analyst Day as well, it's just very hard to model that business. And so I've heard estimates from analysts to be down, that business, 20% to 30%. Our sense is that 30% is probably a worse case scenario in the consumer space for next year. All righty. Thanks, Amit. Okay. So everybody, thanks for joining us this morning. A copy of this transcript will be available on our website and all available reconciliations and additional information can also be found on the Quarterly Results section of our Investor Relations site at investor.analog.com. So thank you very much for dialing in and have a great Labor Day, everybody.