Can Analog Devices Meet Its Ambitious Earnings Goals?

Semiconductor maker Analog Devices  is the model of a remarkably disciplined company. Over the last several years, it has managed to get gross margins from below 60% into the mid-60% range, and operating margins, which used to hover in the mid-20% range, to over 30%. This trend looks set to continue, as the company has committed to growing operating expenses at no more than 50% of revenue growth.

Because of this discipline, Analog Devices has managed to increase earnings even in times of flat or decreasing sales. Now, revenue also seems to be picking up. As a result, the company is making a bold long-term prediction that it will achieve $4-$5 in EPS by 2020, compared to $2.14 in 2013. What are some reasons to believe that Analog Devices might achieve this ambitious goal?

The gross margin can still improve
Analog Devices' 2013 gross margin of 64.3% looks reasonable compared to industry peers, falling in between Texas Instruments'  52.1% and Linear Technology's  74.8%. If that seems like a giant spread for companies that are competing in the same market, Analog Devices CFO, Dave Zinsner, has said that the difference comes down to size. Analog Devices makes roughly twice the yearly revenue of Linear Technology, and if it focused only on its most profitable products, it could have higher margins. Similarly, Texas Instruments is a significantly larger company than Analog Devices, with 2013 revenue of $12.2 billion compared to Analog Devices' $2.6 billion, which accounts for Texas Instruments' lower gross margin.

Still, there is room for the gross margin to improve. According to management, all of the company's major segments generate high margins, so the reported gross margin does not depend on mix. However, Analog Devices' fabs are currently running at only about 70% utilization, and if sales pick up, utilization and the gross margin would increase also. Management believes this will happen, and is increasing its target gross margin to be in the 65%-68% range going forward.

Business segments are strong
Over the past several years, Analog Devices has been increasingly focusing on business, rather than consumer, end markets. Currently, three such segments, industrial, communications infrastructure, and automotive, account for almost 90% of the company's revenue. In the most recent quarter, all three of these segments grew from the same quarter a year earlier.

Management is also predicting continued growth throughout the rest of the year for its business segments. Thanks to focusing on the higher end of the market, Analog Devices' business products have stable prices and long lifecycles. Because of this, the company claims that each generation of new products basically provides an annuity that can go on for decades, something that can be seen in the following graph.

Revenue By Product Year. Source: Analog Devices.

Picking and choosing in the customer segment
Even though it's now focusing on business end markets, Analog Devices still has a presence in consumer applications. Considering the lower levels of investment here, this segment has contracted predictably over the last year, but management believes that this is bottoming out. In fact, consumers grew 5% sequentially in the most recent quarter, following four quarters of contraction.

While it's possible that Analog Devices will eventually wind down its consumer segment altogether, management said that it has sought to find consumer applications where the company's proprietary technology can make a difference and can be used for multiple generations. For the foreseeable future, Analog Devices will focus largely on consumer portables and audio/video prosumer applications.

In conclusion
Analog Devices has done a remarkable job increasing its margins over the past several years, and has recently announced an ambitious plan to drastically increase its earnings by 2020. As revenue from its stable and strong business segments continues to grow, so will fab utilization and margins. Also, the consumer business, which the company has considered a headwind for a while, has been trimmed down and should begin to contribute to profits also. For these reasons, Analog Devices seems well-positioned to deliver on its bold plan.

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Srdjan Bejakovic has no position in any stocks mentioned. The Motley Fool recommends Linear Technology. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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