Analog Devices Inc (ADI) — Q1 2024 Earnings Call Transcript

Good morning and welcome to the Analog Devices’ First Quarter Fiscal Year 2024 Earnings Conference Call, which is being audio webcast via telephone and over the web. I'd like to now introduce your host for today's call Mr. Michael Lucarelli, Vice President of Investor Relations and FP&A. Sir, the floor is yours. Thank you, Josh. And good morning, everybody. Thanks for joining our first quarter fiscal 2024 conference call. With me on the call today, are ADI’s CEO and Chair, Vincent Roche and ADI’s CFO, Richard Puccio. For anyone who missed the release, you can find it in relating financial schedules and investor.analog.com. Onto the disclosures, information we're about to discuss includes forward-looking statements which are subject to certain risks and uncertainties as further described in our earnings release, our periodic reports and other materials follow the SEC. Actual results could differ materially from the forward-looking information, as these statements reflect our expectations only as of the date of this call. We undertake no obligation to update the statements except as required by law. Revenue, adjusted gross margin, operating and non-operating expenses, operating margin, tax rate, EPS and free cash flow in our comments today will be on a non-GAAP basis, which excludes special items. When comparing our results to historic performance, special items are also excluded from prior periods. Reconciliation of these non-GAAP measures to the most directly comparable GAAP measures and additional information about our non-GAAP measures are included in today's earnings release. As a reminder, the first quarter of 2024 was a 14-week quarter. And with that, I'll turn it over to ADI's CEO and Chair, Vincent Roche, Vince?

Thank you very much, Mike, and good morning to you all. But before I begin, I'd like to welcome ADI’s new CFO Richard Puccio to the call, which is only a few weeks in, but we're very excited to have him on board. He brings tremendous financial experience and capability from complex technology sectors, which I think will be very valuable, as we continue to extend our leadership in the Intelligent Edge era. I'd also like to recognize Jim Mollica for serving as Interim CFO and thank Jim for his continued partnership and contributions to our success. Now on to the results for the first quarter. ADI delivered revenue of more than $2.5 billion, operating margins of 42% and earnings per share of $1.73, all above the midpoint of our outlook. As we previously discussed, the inventory rationalization that our customers began during the middle of 2023 is expected to continue through our second quarter. Encouragingly, first quarter bookings improved sequentially, growing our confidence that inventory-related headwinds will largely subside this quarter. That said, the macro situation remains challenging, and the shape and timing of a second half recovery will be governed by underlying demand. Importantly, the strength of our balance sheet, operational agility, and prudent capital management are serving us well during this downturn. We've invested heavily in R&D, customer engagement, activity, and manufacturing resiliency, fueling our future growth, even as we maintain the industry-leading profitability that supports our practice of robust capital returns. To that end, I'm pleased to highlight that we announced a 7% dividend increase yesterday, making 2024 the 20th consecutive year of higher dividends for shareholders. Now, digging a little deeper into our investment philosophy, we continue to focus on anticipating our customers’ future needs in what's becoming a software-defined AI-driven world leveraging pervasive sensing, Edge computing, and ubiquitous connectivity. The technological complexity facing our customers is compounded by their need to deliver solutions that are both secure and extremely power-efficient. So let me share a little more now about how we are strategically allocating our capital to deliver more solutions and value to our customers and further support their confidence in long-term supply assurance. Since our acquisition of Maxim, we've increased our engineering population by around 10%, complementing our world-class Analog talent with increasing levels of digital software, AI, and systems expertise. This breadth of engineering gives ADI the capabilities to tackle more of our customers' challenges and grow our sell-in across markets. In addition, as our engineers increasingly work shoulder to shoulder with our customers to co-architect their solutions, we further deepen our understanding of their technological and market complexities. This strengthens our ability to deliver increasingly stronger innovation from components to physical Edge systems. And I'd like to share now a few examples. In the industrial sector, digital transformation is driving investment in Edge-based connectivity and control platforms that enable secure, power-efficient monitoring and control of automation systems. Last month, Honeywell announced it will use ADI's Deterministic Ethernet and software-configurable IO solutions across their factory automation and building management offerings. Our portfolio enables customers to securely deliver end-to-end signal integrity between the Edge and the cloud in a power-efficient and highly flexible platform configuration. This system approach enables us to capture three times more value, and we expect additional design wins due to high customer interest globally. In the automotive sector, we've aligned our business to the trends of electrification, advanced safety systems, and immersive digital in-cabin experiences. For example, our Gigabit Multimedia Serial Link or GMSL Solution continues to gain broader adoption as customers seek to extend high-performance data and video capabilities across their fleets. We’ve recently increased our share at a top three global auto manufacturer, extending our position across all their brands and quintupling our GMSL opportunity at that customer. In datacenters, AI and machine learning computing systems require orders of magnitude more processing and thus energy, compared to traditional workloads. Our portfolio of high-performance power and protection solutions, specifically designed for vertical power delivery, is helping customers re-architect their datacenter systems to improve power delivery and system performance. Last quarter, we secured a significant design win from a large hyperscale customer for our multiphase vertical power solution that reduces power losses by 35% compared to conventional ones. In healthcare, this market continues to digitalize to enable more predictive and preventative treatment regimens. ADI has been at the forefront of this transition, and I'm pleased to let you know that we've recently received FDA clearance for a non-invasive remote monitoring platform that enables home-based management of chronic diseases such as congestive heart failure. This solution leverages our deep domain expertise, leading-edge capabilities across signal processing and sensor modalities, and unique algorithms that enable medical providers to act early, precisely, and effectively. As a platform, this also allows us in the future to use our data-driven AI algorithms to make this even more personalized. This advance unlocks a new growth vector for ADI, adding more than $5 billion of new sell-in. Switching now to the evolution of our supply chain, I'd like to share some of our progress in manufacturing resilience, which is a growing priority for our customers. Over the last two years, we've invested record levels of CapEx to expand our capacity and enhance resiliency. Now with line of sight to achieving our goal of doubling front and back-end internal capacity in 2025, we will begin to significantly reduce our capital spend. Notably, approximately 10% of our investments have been focused on implementing more efficient systems that will deliver sustainability benefits, including greatly reducing input resources and emissions, which over time will also lower our operating costs. These investments enable a more flexible hybrid manufacturing model and will increase our swing capacity to around 70% of revenue in the coming years. This unique ability helps us capture the upside in strong demand backdrops and better protect our gross margins during more challenging times. Complementing these organic investments, we also extended our foundry partnership with TSMC to secure additional 300-millimeter fine-pitch technology capacity at their Japan subsidiary. Our investments, combined with the support of our foundry partners, will enable us to manufacture our products in multiple geographic locations, enhancing our resiliency and giving our customers greater optionality and assurance over their supply chains. So in closing, as always, we're keeping one eye on the present and one eye on the future. I have confidence in the steps we're taking to preserve our capital and navigate the near-term challenges while ensuring that we make the necessary investments to increase our competitiveness and accelerate our business in the future. And so with that, I'd like to pass the microphone over to Rich.

Thank you, Vince. And let me add my welcome to our first quarter earnings call. I'm excited to have joined ADI and look forward to helping the company navigate the near term while ensuring we are well positioned to capitalize on the tremendous opportunities ahead of us. Despite continued challenging business conditions, we achieved first quarter revenue, which was slightly above the midpoint of our outlook, down 8% sequentially and 23% year-over-year. Industrial represented 48% of revenue in the quarter, down 12% sequentially and 31% year-over-year. As expected, we experienced broad-based weakness as customers continued to work down their inventory levels. Automotive, which represented 29% of revenue, was up 2% sequentially and 9% versus the year-ago period, representing 14 consecutive quarters of growth. Notably, our leading connectivity and functionally safe power solutions collectively increased double digits year-over-year. Communications, which represented 12% of revenue, declined 10% sequentially and 37% year-over-year. On a sequential basis, wireline fared relatively well driven by AI-related demand, while wireless decreased as global investments in 5G remain depressed. Lastly, consumer represented 11% of revenue, down 7% sequentially and 22% year-over-year driven by continued sluggish end demand across applications. Now on to the rest of the P&L. First quarter gross margin was 69%, down sequentially and year-over-year, driven by unfavorable mix, lower revenue, and lower utilization. OpEx in the quarter was $679 million, down 2% sequentially despite the extra week, driven by lower variable compensation, disciplined discretionary spend, and structural cost improvement. As a result, operating margin of 42% finished near the high end of our outlook. Non-operating expenses finished at $75 million, and the tax rate for the quarter was 11.8%. All told, EPS was $1.73, slightly above the guided midpoint. Now on to the balance sheet. Cash and equivalents increased more than $340 million sequentially and ended the quarter at $1.3 billion. Our net leverage ratio remained below 1. Inventory decreased nearly $90 million sequentially, driven primarily by finished goods, while days increased to 201 due to lower revenue. Channel inventory dollars declined again in 1Q, with weeks of inventory finishing slightly above our target range of seven to eight weeks. Moving on to cash flow items. Over the trailing 12 months, operating cash flow and CapEx were $4.6 billion and $1.3 billion, respectively. We continue to expect fiscal 2024 CapEx to be approximately $700 million. As a reminder, these are gross CapEx figures, not including any of the anticipated benefits from both the U.S. and European Chips Act. Over the last 12 months, we generated $3.2 billion of free cash flow or 28% of revenue. During the same time period, we have returned more than $4.2 billion through dividends and share repurchases. And since our Maxim acquisition, we have returned nearly $12 billion or more than 130% of free cash flow to shareholders, reducing share count by 8% while also increasing our dividend per share by 33%, including our most recently announced 7% increase. As a reminder, we target a 100% free cash flow return over the long term. We aim to use 40% to 60% to grow our dividend annually with the remaining free cash flow used for share count reduction. Now moving on to guidance. Second quarter revenue is expected to be $2.1 billion, plus or minus $100 million, once again, we expect sell-through to be higher than sell-in. At the midpoint, we expect all end markets to decline sequentially with the largest decline in industrial as we continue to meaningfully reduce channel inventory. Operating margin is expected to be 37%, plus or minus 100 basis points. This includes the impact of unfavorable mix and lower utilization as we further reduce balance sheet inventory. Our tax rate is expected to be 11% to 13%. And based on these inputs, EPS is expected to be $1.26 plus or minus $0.10. In closing, the actions we've taken to protect profitability in the near term, as well as the natural shock absorbers embedded in ADI, have enabled us to maintain strong profitability even as our quarterly revenue has fallen significantly from its peak. Importantly, with the strength of our financial profile and the growing importance of our technology, we will continue to invest confidently in our future, regardless of where we are in the cycle. I will now give it back to Mike for Q&A.

Thanks, Rich, and welcome to the call. Let’s get into our Q&A session. We ask that you limit yourself to one question in order to allow for additional participants on the call this morning. If you have a follow-up question, please requeue, and we’ll take your question if time allows. With that, we have our first question, please.

Great, thank you. You guys are guiding down now mid-30% year-on-year. If I go back to historic drawdowns, you haven't seen revenue fall that far other than 2001, 2009, where we had kind of significant demand destruction. So it kind of looks like the worst inventory correction maybe we've ever seen. Can you just talk to that? Does that reflect how much inventory excess there might have been? Or just any kind of sense check as we approach the bottom as to why the downturn looks kind of severe?

Yeah. Thanks, Joe. I think first and foremost, the events that caused the supply chain fracture were unique. Every single segment was impacted, every single customer, every single business. So this is truly the broadest base demand inflection I've ever seen in my 30-something years with ADI. And I've been through all those different perturbations. So I think that's the uniqueness of the event itself that has caused the level of impact. We saw everything compounded. We saw the supply chain fracture, followed by the shortage, and then we got the behavior typically seen in a shortage situation. You get double ordering and you get hoarding. We're seeing that everywhere. The area that we've probably seen the biggest correction is in the industrial market. Our sense is that it began in the second half of last year, and that will take four to five quarters to correct, I believe, from the beginning of the decline to when we start to see growth again. So I think that's pretty much it. But now we're in a situation where lead times are very uniform, and we got ahead of the supply chain issues faster than most. We've got our lead times back into better shape than most quite quickly. All that said, Joe, I think the underlying demand for our products and technologies in the years ahead remains very, very bullish, and I expect, as we've indicated, that we'll see a return back to growth in the second half of our fiscal year.

Thanks, Joe. Operator, next question please?

Hi, guys. Thanks for taking my questions. Rich, I was wondering if you could give us a little more color on the segment guidance next quarter. I know you said everything down in industrial is worse. But I mean like industrial has got to be down probably more than 20% sequentially, and that would probably still assume everything else is down double digits sequentially. Is that what you have in mind? And any further color you could give us would be great.

Yeah. I'll grab that one. It's Mike. So you're right to think industrial is the weakest. I would say 20% sequentially, sure, you can put that number in your model if you want to, 20% plus or minus sequentially. I would say comms is also probably worse in the midpoint of your guidance, so down more than the 16% we guided to. While auto and consumer probably do a bit better, but are both down pretty significantly sequentially as well. And really, the big driver on the industrial piece, as we laid out, is the channel reduction for the inventory in the channel, which is impacting industrial more so than in other markets. I hope that helps, Stacy. We’ll go to the next question.

Hey, thanks, guys. Just to follow up on that question. How much of this downturn do you think is just pure inventory correction versus demand? And then any comments you could have on just demand trends as far as what you're hearing from the distribution channel and your customers?

Sure. I'll start and then I think Vince will add some clarity also on it, but this really is a supply-driven demand correction what you're seeing here. Vince outlined that in the answer to the first question where the supply chain fracture led to extended lead times. Now our lead time is back to normal, so they're seeing them reduce their balance sheet inventory to match our short lead times so the cycle times can align. So really also a majority supply chain-related, some demand. There's some areas of pockets of weakness in demand, but overall, I'll call it more of a supply than demand correction in our business. And we talked about in the script and as well the press release that supply is normalizing here in our second quarter.

Yeah. I think, Chris, if we look at the two halves of FY24, I believe the first half is all about inventory digestion. As Mike said, we largely get through that part of the headwind by the end of our second quarter. In the second half, all the indications show our bookings are getting stronger, cancellations are abating. Our conversations with customers suggest that we'll begin to return to a growth pattern in the second half. The big question is the macroeconomic environment where that's positioned. At the margins, if I look at where we are this quarter versus last quarter, at least from a macro standpoint, maybe with the exception of China, we're more bullish than we were.

Alright. Thanks, Chris.

Thanks for taking my question. Vince, on the last earnings call, you mentioned bookings were stabilizing. I think this quarter, you're saying bookings are improving. I'm curious which end markets are showing the best recovery in bookings? Should we be assuming some kind of seasonal recovery, should we assume things flatten out first? And if I could attach kind of part B of that, which is what happens to gross margins as you start to see that flattening out and potential recovery? So just the shape of what recovery looks like in sales and margins if bookings flatten and now they seem to be improving?

I believe that once demand stabilizes and we return to a more typical growth pattern, everything will get better. Our utilization rates will increase. We have not supplied the channel or our customers sufficiently. The company is working diligently to ensure that when demand increases, we will have the necessary supply ready. We have a significant amount of finished goods and excess inventory, putting us in a strong position to respond to the recovery. Regarding your first question about where we are seeing improvement in bookings, it's happening across nearly all segments. In the industrial sector, the two sectors performing the best right now are aerospace and defense and healthcare, which have different drivers compared to factory automation or instrumentation. However, those two areas are faring better than others. Even in the more traditional industrial sector, such as instrumentation, the demand for new high-performance computing systems requires testing equipment, which is beneficial for ADI. Overall, it is accurate to say that, with the exception of our wireless business, most sectors are experiencing a return to a more typical bookings pattern.

And Vivek, I'll give you a little more color on the gross margin outlook. In the last call, we mentioned gross margin will be 68% to 69%. We came in at the high end, a good result given the large drop in industrial that we've been talking about, and with an inventory takedown of almost $90 million quarter-over-quarter. The 2Q outlook implies 67% plus or minus, a bit lower than what we thought would be given the weaker revenue, especially in industrial and the fact that we're taking down factory starts further in 2Q to reduce inventory by another $50 million to $100 million. If I think a little further out to the second half outlook, it's tough to predict right now as the revenue trajectory and its shape of recovery will be the governor on gross margin trajectory. Our best sense is gross margins will trend higher in the second half, as we don't see utilization going much lower while inventory continues to decline significantly at these start levels, and we will continue to leverage our swing capacity.

And Vivek, as you asked a three-part question, I'll chime in for a third-quarter outlook. I know you gave me the outlook question. It's hard to say, right? Our lead times are 13 weeks or lower, so we don't really have visibility into the third quarter today. But historically, if you look back over the past decade, our B2B markets are about flattish sequentially in the third quarter from the second quarter. Sometimes they're up a little bit or down depending on where we are in the cycle, while consumers start seeing some holiday builds beginning mid- to high single digits sequentially. That's kind of the historical context. We're not guiding in the third quarter, but that’s how we should frame it. To add on to what Vince said about bookings, bookings actually increased last quarter and the quarter before that. It's interesting; our bookings are approaching parity, which is a good sign showing that there is a pickup expected in the back half of the year.

Very helpful. Thank you.

Hi, good morning. Thanks for taking my questions. So if I look at fiscal '23, China was about 18% of your total revenues. It was the worst performing geography down about 13% for the full year. Because Lunar New Year was so late this year, it feels like this added a little bit of uncertainty at the beginning of this year. But obviously, now we're post-Lunar New Year. What are the demand signs out of this region? Are orders also growing sequentially in the China region? Are cancellations also showing signs of stabilization patterns as well? Maybe even signs of a potential pickup in the China region? Just want to get your views.

So if you take a step back from a geographic perspective, all regions are weak; North America, Europe, and China. China has been the weakest the longest. The rest of Asia is doing better than the big three but still remains weak. As I said, China is the weakest source of demand. Around Chinese New Year, there is really nothing unique about it that we called out. What Vince said in the last question essentially confirms that bookings are improving globally as well as in China before and after this year. So there’s really no significant impact from Chinese New Year based on our commentary.

Hi, good morning. Thanks so much for taking the question. Vince, I'm curious how you would characterize sell-through today versus sell-in. I think at a conference a couple of months ago, you had mentioned that sell-in was tracking 15% to 20% below sell-through. Is that still the right ballpark number? Is that what you're observing in the current quarter? If so, if the end demand environment doesn't deteriorate over the next six or nine months, could there be a quarter later in the year where your revenue run rate is tracking above $2.5 billion, $2.6 billion? Thank you.

I'll tackle the first part of that on the sell-in and sell-through part, Toshi. So selling and sell-through really relate to the channel. We reduced our channel inventory dollars the past two quarters, about a $50 million reduction per quarter. Embedded in our guidance is a much bigger reduction of channel inventory. If you want to put a number around $100 million or so in our outlook, that's probably what we're seeing. We're reducing a lot in the channel. Now as you look at the back half of the year, from a channel perspective, we think sell-in and sell-through should be better matched given the actions we've taken over the last three quarters. I'll pass it to Vince to talk about the customer inventory situation on the end customer side.

Yeah. On the customer side of things, we've been monitoring very carefully across the various segments our customer shipment rates, their inventories, and their ADI goods on hand. We're clearly under-shipping our customers' current demands. We feel that we've got a situation now in terms of our inventory position. Our customers are beginning, as Mike indicated, to replenish their order books with ADI goods. That gives us the confidence that as the book-to-bill approaches unity, we're seeing the worst of the inventory correction. In the second half, we will get back to a more normalized growth pattern. There’s a very good balance between the direct channel and the distribution channel regarding the inventory situation, but we're ready for the upsurge.

Great. Thank you.

Great. Thanks for taking my questions. I want to welcome, Rich, but direct a couple of questions to Vince, please. Vince, the more vertical capabilities that you talked about sort of suggest that you're needing to either partner more closely with a smaller number of customers or maybe you wind up pushing somewhat into their capabilities and are potentially competing with some of them. I wonder how you contemplate managing that dynamic.

Yeah. Will, thanks very much. Unfortunately, the line dropped. I think I caught your question about verticalization and potentially competing with our customers. Hopefully, you can hear me okay now. Look, we've been on a journey over many years to continue to build out our core component franchise while also adding more value to our solutions. Our business has become more solutions-oriented, particularly over the last decade in every single segment. That kind of domain application-driven engineering that ADI has been distinguishing itself with at the edge over the last decade will continue, and we're continuing to build that. I talked in the prepared remarks about this point of care acute healthcare solution that we've just brought to market, where we've got FDA approval. In some areas, we have a white space to address, but the truth is, even with our larger customers, more footprint capture has been taking place. Why? Because we tame our customers' complexity. I've previously mentioned the asymmetry of capabilities in the Analog space between what ADI can offer and what our customers can provide. They expect us to add more solution value and create more complete solutions while defining where their core value ends and where ADI's core values start. I think we're not competing with our customers, but we have vibrant discussions about delineating the boundaries.

That helps. If I can ask a follow-up. You talked a bit about AI. It's sort of a familiar topic to us lately. Maybe too much so. There's a narrative here where there are some creative capabilities that could potentially enhance engineering-focused capabilities that make it more efficient or productive. In a world where the story about Analog design engineer capability being so limited drives a significant advantage for ADI, I wonder if that story changes at all because of this capability. Have you started using this for circuit design, or do you anticipate that it could be used by others, either competitors or customers? Thank you.

Yeah, it's a good question. Everybody is trying to figure out the meaning of AI in their businesses. We're using AI today in our tool chains. We're using machine learning and AI in and around our products. We're starting to use it in our business as well. Anything that can be routine and can be automated—that's the way of technology. Technology automation will take over the more routine tasks. We play very much at the high end of the performance spectrum. Unless generative intelligence can outperform our imaginations, which I don't foresee happening in the near future, our intellectual property value and learning system at this company will matter more and more. We view AI as a tremendous opportunity. It will clearly help in the product development process, from how products are designed to the ingredients in our products. We're also incorporating AI into customer support tool chains. We believe that AI will act as an accelerator and co-pilot alongside our engineering population.

Thanks, Will. It sounds like from your cell phone line, we do need some more 5G coverage. So next question, please?

Hi, thanks a lot. Can you talk to any period costs versus underutilization charges that you’re taking? And how much of a headwind are those now? How much will they help you as they might reverse themselves coming out of the downturn? Thanks.

I think your question is on how much of the impact on our gross margins is from underutilization versus mix. If you look here, our peak gross margins were about 74%. Our outlook, as Rich pointed out, implies about 67%. That decline is really due to mix and utilization, roughly equal parts. As you look to the back half of this year, it depends on what the mix does. I think industrial is bottoming here, so that should help a little bit. From a utilization standpoint, Rich also pointed out our starts are low enough to meaningfully reduce inventory. We've been doing that and will do it again in 2Q. So I don't foresee starts declining, they may start to increase, which should provide a tailwind to gross margins. How fast the gross margins recover really depends on those two factors: how rapidly revenue picks up and how much relates to the industrial sector.

Okay, Mike. But I guess, are there any inventory charges? That's the question.

From inventories, yeah, good question. You're right, we have a lot of inventory as you can see on our balance sheet. There are no acceleration of inventory charges in our gross margins. The inventory charge reserve has been elevated for the past few quarters, and they will probably stay that way as you go into the back half of this year and into next year. But that's not a headwind anymore; it's already kind of built into the run rate. We will go to our last question, please.

Yeah. Thank you for taking the question. You talked about auto being down sequentially but seeing the best performance out of all the different segments. I'm curious if you can walk through what you're seeing from Tier 1 auto correction and whether you think that will be completed exiting April as well? Thanks so much.

Yeah. Sure. From the auto standpoint, C.J., I would say, yes, there is definitely an inventory correction going on in auto. Like other markets, as Vince pointed out, the supply fracture affects everyone, but it's not really because of the inventory. It's due to growth drivers in that business—whether it's BMS, GMSL, or functional safe power. The growth in those areas is offsetting the overall inventory digestion in the automotive sector. You're right to mention that on the Tier 1 side or the OEM side, there's some frothy inventory, but we're seeing that being digested. Whether it will be fully completed by the second quarter, we'll see, but I feel good about those growth areas continuing to perform well this year. For the full year, whether automotive will grow, I'm uncertain. It really depends on how strong growth is in those areas and how much of the overhang is on the inventory side. But net-net, we do feel good about the auto sector being our best-performing end market here in Q2 and for the full year '24.

All right. Thank you, CJ. Thanks, everyone, for joining our call this morning. A copy of the transcript will be available on the website. Thanks for participating, and have a great rest of the day.