Analog Devices, Inc. (NASDAQ:ADI) Credit Suisse 26th Annual Technology Conference November 29, 2022 11:35 AM ET
Company Participants
Mike Lucarelli – Investor Relations
Prashanth Mahendra-Rajah – Executive Vice President, Finance and Chief Financial Officer
Conference Call Participants
Chris Caso – Credit Suisse
Chris Caso
Good morning, everyone. Again, welcome to our next presentation. I’m Chris Caso, Credit Suisse Semiconductor Analyst. Our next presentation is Analog Devices, which you all know and hear from ADI is Prashanth Mahendra-Rajah. And I think finally pronounce your name correctly after all these years, so welcome. And Mike Lucarelli, Investor Relations. So gentlemen, thanks for attending today.
Mike Lucarelli
Thank you, Chris.
Question-and-Answer Session
Q – Chris Caso
So we’ve had a couple of presentations this morning. And obviously, we want to get into some of the long-term stuff, but it’s on the mind of investors right now is the old where are we in the cycle, and since you just reported, what’s been notable for ADI is that some of the stabilization comments that you made on the call. And you guys are a little bit on [Technical Difficulty], because you’ve just reported, so you’ve got the freshest information in the space right now.
Prashanth Mahendra-Rajah
Yes, yes.
Chris Caso
And so maybe you could speak a little bit to start about what’s different than what you saw in the summer, where you spoke of some cancellations and maybe some of those comments were a bit inflated and taken a bit larger than maybe what you would have intended. And — but now you’re seeing the stabilization, so maybe you could come comment on that?
Prashanth Mahendra-Rajah
Sure. Yes, maybe I’ll start with just a quick recap for the year, right?
Chris Caso
Sure.
Prashanth Mahendra-Rajah
We finished our fiscal ‘22 reported last week. Fiscal ‘22 at $12 billion in revenue was up about a little over 25% year-over-year. About half of that was actual unit growth, and about half of that was from pricing actions that have been taken over the course of the year. With that revenue, we generated industry-leading gross margins just around 74%, and we saw a sequential improvement in those margins over the course of the year as we were able to deliver more of the Maxim synergies and enjoying the high utilization rates for our internal manufacturing facilities.
And operating margins in kind of the mid-40s with a clear path here that I think for at least another couple of quarters to be in, kind of, high 40s, I don’t want to put a five-handle on for all of ‘23 yet, but we feel good about where we are. And over that year, we returned — like, we took out about 4% of our share count in addition to paying about $1.5 billion in dividends. So in the third quarter, we had noticed a change in the demand activity. And because we report a bit later than our peers, we caught a lot of attention by being one of the first companies to indicate that the environment was changing, that the cancellation of our record backlog had started to tick up.
And we were indicating that despite backlog growing and despite guiding up sequentially for the fourth quarter, we were seeing an inflection. And so that caught a lot of folks a bit by surprise because we were the first company to be reporting in that, and that has largely played out here for the fourth quarter. So as we reported in our fourth quarter, we’ve now guided down the first quarter sequentially. We’ve indicated that our book-to-bill has gone from being strongly above one to now sub-one about parity for our Auto and our Industrial markets, but below for comms and — for communications and for consumer.
The comment, I think, that’s — that we’re getting a lot of questions on now is we made — we’ve observed that our orders have stabilized, and so let me give some context on that. In the first half of 2022, we saw order activity well above our historical patterns and well above our revenue. Hence, we had several quarters of book-to-bill that were greater than one and growing into a pretty sizable backlog over — we still have over four quarters of backlog.
For the last, I’d call it maybe two months, eight weeks or so, including the early part of first quarter, orders have returned to more normal levels, and that’s a bit of what we’re highlighting. So I wouldn’t read more into it except to say that in the third quarter, we were, sort of, at the top of the roller-coaster looking down. We didn’t know how far it was going to go. And now, we’ve had eight weeks of kind of flattening out, and that is — that’s kind of the situation. So the spirit of our management team has always been to be very transparent, so we’re telling you like it is. Not trying to read, not trying to guide you in any direction, but just letting you know what we’re seeing.
We feel very good about the first quarter. I think on the earnings call, we said we are feeling somewhat confident into part of the second quarter, but we are absolutely not calling anything beyond that. So I wouldn’t want you to read this as ADI has said that the worst is behind us. We’re just telling you what we’re seeing.
Chris Caso
Right. And to go to the roller-coaster analogy, you don’t necessarily see far enough ahead to say if that stabilization, if the next leg is up, down or —
Prashanth Mahendra-Rajah
Correct. Absolutely not, absolutely not, right? We are trying to do — we’re trying to reconcile two very divergent inputs as it relates to our industrial business. Anecdotally, our customers continue to tell us on the — for our industrial business, they continue to be quite bullish. And our customer stories and discussions from — through sales, through executives, including the CEO, tend to be more optimistic. But all the macro data that we look at, and that I’m sure you look at, tends to be more pessimistic. So we’re trying to reconcile how those can be so different.
Chris Caso
Right, right. And so are we — all of us. One of the things in prior cycles, factory automation, for example, I remember that, I guess it was in 2018. It was one of the first, kind of, indicators of things slowing and other things came after that. Maybe you could speak to that, because it has served as a leading indicator in the past?
Prashanth Mahendra-Rajah
Yes, there’s no real story there, right? The factory automation is another example of where some customer conversations tend to be very optimistic. As a matter of fact, Mike was at a large customer — large customer’s Investor Day two weeks ago with our CEO, and Vince had an opportunity with that customer to talk about their business outside of their Investor Day. And again, he came back reporting that they are also remaining relatively optimistic about their — what they need to do. And that’s not inconsistent with what we’re hearing from our European or Japanese, right?
For factory automation, particularly. I mean, it is — that’s a Japanese and German-driven business. That’s where the majority of the products are made, although they ship globally.
Chris Caso
Right. And last one on that is where you did see weakness within your consumer segment? And I guess to clarify that your industrial segment doesn’t include consumer-related industrial, things like white goods and such, where others do, so?
Prashanth Mahendra-Rajah
Correct. I would be very surprised if we had any white goods at all in our business. I don’t think that — I think if you’re looking for analog capability for washing machines and dishwashers, there are better alternatives to get what you need than paying the premium for an ADI product. But our consumer business is built three pieces, it is what we refer to as Prosumer, which is the technology used for teleconferencing, it’s high-end consumer devices, cameras, home theater systems, et cetera.
It is hearables and wearables, so think of the explosion that we’ve seen in noise cancellation technology really being deployed quite broadly in the headphone space. And then in mobile devices, it’s really the high-end mobile devices. So — and those are roughly equal, each at about one-third. The — that first group, which we refer to as Prosumer, some of our peers will put that into their industrial business.
Chris Caso
Let me pivot away — pivot to products a bit. And one of the things I think is notable for ADI versus a lot of competition is a focus on what I’d say is big products. And there’s obviously a very sizable catalog business, which underpins the company, but then there’s a lot of other things such as A2B in Auto, battery management for electric vehicles. What you’re doing in 5G base stations, which are sort of big bets that you’ve taken. Maybe you could speak to the product selection process? How you allocate your R&D dollars such that you support both the catalog business and make some of the [Multiple Speakers]
Prashanth Mahendra-Rajah
Great question, right. So think of where our R&D portfolio is very similar to maybe a small portfolio manager in the audience. We are diversifying our bets. We think about the end markets, and we think about near-term, as well as more sort of breakaway that the — and it’s important for us to drive that level of diversification. But it is really in the spirit of where can we drive enough innovation that we can solve a very complex problem for our customers.
Sometimes, that is driven based on customer conversations where — as we’ve gotten to know our customers and their businesses quite well, we have insight into what do they need. In other times, and these are really where it can be quite extraordinary, is we have conviction that we know what a customer wants although they haven’t recognized that need yet, and we invest ahead of them.
So — to which I can give you multiple examples, but two more recent ones would be wireless BMS. So for those of you who might have come to the Consumer Electronics Show in January 2018, we had our first demo of the wireless BMS system, which was not, shall we say, well received by customers as they went through the booth as something that they would need. And now we’re four years later, and how many wins do we have, Mike? We have five, I think?
Mike Lucarelli
In the wireless side?
Prashanth Mahendra-Rajah
In the wireless side?
Mike Lucarelli
Four.
Prashanth Mahendra-Rajah
Four. We have four — three large, one smaller customer who’ve signed up for wireless BMS. But four years ago, they told us not of interest don’t see us having that need. So when you understand the value proposition of wireless BMS, I will be very surprised if that doesn’t become the dominant solution for automotive customers, because it is so compelling in helping their economics.
Similarly, on the transceiver, which many of you know, we have an incredibly strong position in 5G, and part of that was we made a decision to architecture our design around a software-defined transceiver. Again, our large infrastructure guy said, not something we want. We said this is the way that we’re going to design it. It has proved to be extraordinarily successful, scalable, and it really has allowed us to take extraordinary high share.
So what is so impressive about the ADI engineering team is their ability to see that future and make a market. So it’s — for us, it’s less about taking share from a competitor and more about creating a market. And then when we take that market, we own it, eventually, there will be competition in that market. But by then, we’ve moved on to create the next market.
Chris Caso
Right. And how does that apply to the Maxim business now? Because one of the things that stuck in my mind, a conversation with Vince, your CEO, at the Analyst Day was an intention to — for the Maxim business to take more risk. And I suppose is that the same thing as —
Prashanth Mahendra-Rajah
Very similar concept, right? So for Maxim, we acquired some very, very talented engineers, who had tremendous discipline in project execution, and that’s not surprising for those of you who knew the former CEO of Maxim. He was a very, very execution-driven leader. What we’ve taken that skill set is now and merged it with the ADI team, which has that deep insight into the customer, and I would say that’s something that Maxim did not have the same level of intimacy and knowledge of the customer.
So as those teams come together, we really are getting the best of both. We’re getting that great engineering execution focus from Maxim in the areas that they have particularly strong expertise and adding to it the knowledge base that we have of our customers. And we’re in our fourth acquisition now with — sorry, we’ve completed three acquisitions, and it’s clear to me from all of them that what distinguished ADI from all of those companies we acquired is how much knowledge we have of our — what our customers want. So we are — you really need to look at us not as a catalog company, but an engineering partner to our customers.
And we may solve that problem with catalog parts, right? Instrumentation and test is a good example of that where majority of our products in that market are catalog products, but they’re still provided in a solution setting, which allows us to have extraordinary high share there without having to build customized parts.
Chris Caso
Great.
Mike Lucarelli
Just to add one thing.
Chris Caso
Please.
Mike Lucarelli
If you look at we talked on the earnings call about GMSL, we’re taking a risk. Maxim is a great technology, GMSL went to automotive cars at the cameras. We’ve added more R&D to that budget, we present to new customers, and we’re also taking it into new markets. We talked about design win at an automotive customer, but we’re also taking that technology into the industrial market for robotics. And that’s taking risk with a proven technology that ADI is allowing Maxim to do.
Prashanth Mahendra-Rajah
Excellent example. There is a very large e-commerce company, I think the largest e-commerce company in the world, that is using GMSL, and Maxim never would have sold to them.
Chris Caso
Right, right. And how long does that take to materials? And maybe just speak to Linear business, which I think the changes you made with the Linear business were different, because my impression was always they were very close to their customers. They did endeavor to kind of get ahead of what the customer needs were. It was a different set of changes that need to be made there.
Prashanth Mahendra-Rajah
What Linear did really well is they found places where nobody else was playing and they pinpointed in those areas, right? They did it extraordinarily well, and that allowed them to get to get very, very good margins. Where Linear was perhaps — the greatest improvement we made to Linear is we disrupted their model of how they do projects where it was more traditionally one engineer to one project, and therefore, time was unconstrained. And what we have done with Linear is multi-engineers per project, so that you can be more reasonable in how long it takes to get a project done, and therefore, get to revenue faster.
Chris Caso
Right. And is that — do you feel that’s materialized now?
Prashanth Mahendra-Rajah
Very much so. In our Power business, and Mike can help me out here with the numbers, what have we said publicly about Linear, so I don’t say anything that’s off the record.
Mike Lucarelli
I’d say at the end of Investor Day, we talked about $2.5 billion. I’ll say now that the year is closed for ‘22, it’s closer to $3 billion for the full-year. We bought Linear we’re probably pass that $1.5 billion of power revenue. So you can see we’ve accelerated the growth, and that has to do with revenue synergies. Trying to talk with Linear and bring them to new customers, changing the way they went to market with their products and drive the growth there.
Chris Caso
Okay. Maybe we’ll take a pause here, about 10 minutes left. If there’s any questions from the audience, we’ll — I’ll let you think about it as we’re going there. We’ll pivot into margins a bit, and maybe starting there with what’s been going on with pricing, and pricing has obviously been a benefit over the last year. And it’s largely — what you’re doing is passing along your input costs.
Prashanth Mahendra-Rajah
Correct.
Chris Caso
Higher input cost to customers. Do you think that continues into 2023? With some of the weakness that you’ve seen in the consumer-related markets, is that sufficient to kind of flatten out the price increases, or do you think that’s still a favorable backdrop as you know into 2023?
Prashanth Mahendra-Rajah
Sure, yes. So first, we’ve said this several times, but I want to reiterate because it’s important. It’s important for us, given our intimacy with our customers. The margin expansion that you’ve seen over the last 12, 18 months, is primarily a function, almost exclusively a function of two things. Our fabs are running extremely hot, so utilization levels are terrific. And we have taken significant cost out with Maxim. And we’ve talked about that in cost synergies. I think $200 million, $250 million of cost of goods has been taken out on a combined basis, and that has all been accretive to our gross margin. So the pricing actions that we’ve done, and we’ve had very transparent conversations with our customers, are us passing on higher input costs, whether they come from foundry or internal manufacturing costs.
Now more broadly, how do we think about the pricing environment going forward? Historically, pricing has been a headwind for ADI, although it has been moderating over many years. The overwhelming majority of that pricing headwind would have been isolated to the Communications and the Automotive markets. Those were vertical markets which had a higher customer concentration, and as part of contract negotiations, those customers would typically ask for a contractual multiyear price decrease in return for locking us in on a multiyear product design cycle.
What has happened over the last couple of years and why in our Investor Day, we said we feel much better about pricing really being more flattish on a go-forward basis is that the — our position in that Communication space has increased to a point where we’re not really required to give those kind of price concessions as we’ve had in the past. There’s also been much more fragmentation of that market with introduction of O-RAN and alternative ways.
And then on the Automotive market, the biggest change we’ve seen is the relationships we have today are primarily with the OEs, and these were not customers that we would have called on several years ago. Our customer conversations would have been through their supply chain partners. Today, we call on OEs directly. We help them with their design solutions. The wireless BMS is an excellent example. All four of those design decisions were made at an OE level, although we will not be shipping a wireless BMS chip to any OE. But the design decisions are made there, with Tier 1s and Tier 2s responsible for the module assembly.
What that does is it really helps differentiate the pricing because when you’re talking with an OE, you’re talking about the value that your product is bringing. The overall — from a technology and their system cost level, and therefore, you’re not facing those same kind of price concession discussions. And for those reasons, we feel very good that on a go-forward basis, expect pricing to be more neutral.
Chris Caso
And what about as you go into 2023? And I know like right now, we’re in the midst of annual price negotiations with automakers, the U.S. automakers. Foundries are having negotiations as well. Our Asia team tells us that TSMC, for example, is looking at putting some price increases in for next year. So does that all gets us to a more favorable pricing environment still as we get into 2023?
Prashanth Mahendra-Rajah
Our model is unchanged. If our input costs go up, then we’re going to pass those price increases on to our customers. For 2023, we’re not making a claim on any pricing actions.
Chris Caso
Okay. See where it goes. One of the things you also have stressed again and again is the resiliency of gross margins, 70% gross margin floor. One of the questions I have is that ADI has largely been able to escape some of the take-or-pay agreements with the foundries that some of your competitors have had to take, and a rather extraordinary agreement with some of your foundry partners. You’re really able to pull some of their processes in [indiscernible] fab to mitigate the effects of a downturn. Why were you able to do that? Why were the foundries willing to be flexible with you on that, which obviously provides you that benefit?
Prashanth Mahendra-Rajah
Sure, sure. So it’s a — I guess a few things, right? If you are a foundry, in many ways, your — an analog company is your ideal customer. We use technology that has largely been paid for by digital companies, so it is fully depreciated asset. Once we use your process chemistry, we are a customer for five, 10, 15 years because our products have an incredible life to them, right? And in general, compared to some of your other semiconductor customers, our products have a lot more stability of demand. You don’t see the same level of volatility that you would see in other areas. So being the largest analog company and being in the sector that is most desired by a foundry partner, it puts us in a very good negotiating position.
In addition, we are very committed to the hybrid manufacturing model. So we have been very clear on that that there are benefits for us to have internal and external. So you can count on us not to move business away from you over the long term. We do want the flexibility that as the product — as demand cycles swing, we may rely less on you and bring more internal to keep our utilizations up. But in the scheme of your overall wafer starts, us pulling something out of a foundry is relatively minuscule impact to you and hugely beneficial to us.
So — and then the last is that if we’re going to truly be partners on this and you are not making investments in some of the nodes that are important to us, then you have to give us the flexibility to control our own destiny.
Chris Caso
Right. I’ll just check again if there’s any questions from the audience before I move on. Just with that, though, then how do you make sure that there is enough capacity for the next cycle? And I know that you’re making some internal investments, but I guess from your customer standpoint, after what’s gone on over the past couple of years, I’m sure customers want some assurance that when the upturn happens, that you’re going to have the product available. So how do you make sure of that?
Prashanth Mahendra-Rajah
Sure. So the investments we made in 2022 and significant capital spend that we’re adding in ’23 are essentially going to double our internal capacity capabilities and also give us resiliency where we will be able to manufacture about 70% of our volume on an SKU level internal, right? That does not change our desire to be a mix of roughly 50-50 internal versus external. It just gives us that flexibility.
So that helps us in a few ways, right? Economically, it helps our shareholders because it allows us that during periods of downturn, we can bring production internally and keep fab utilizations high, which gives us that confidence in giving you a 70% floor on our gross margin. For our customers, having that hybrid model gives you the flexibility that when things swing up, we can turn a lever very quickly and bring on capacity externally at foundries but also give you confidence of resiliency if you have concerns about where supply comes from. You know that in a dire situation, we have the ability to make your key products in multiple locations.
Chris Caso
Right. But what about that net foundry capacity? There’s been a reluctance on the part of the foundry industry to invest in lagging edge. It’s just — historically, it’s been lower margin for them. That’s — it’s better margin now, that’s why they’ve been raising prices. How do you influence the foundry partners to put capacity in place there?
Prashanth Mahendra-Rajah
I think that in the coming quarters, you’ll continue to hear from the foundry partners on their plans to invest in lagging edge capacity. We are highly confident based on our conversations that that’s on their road map.
Chris Caso
Okay. And maybe we’ll kind of wrap it up with free cash flow. And so where does that stand right now with the capital investments you’re planning to make into 2023? And obviously, moving to that, how does it all materialize in cash flow?
Prashanth Mahendra-Rajah
Yes. So I mean, it’s a tremendous cash generation machine, right? Because we are not capital intense, and our long-term commitment is to return back to sort of that mid-single-digit CapEx intensity as a percentage of revenue, then you have all of this cash flow that comes off of this. This high 40% operating margin company that is really being returned to shareholders, either through share repurchase or through dividends.
On the dividends, we’ve committed to a 10% growth through the cycle. It may not be every year, but on average, we’re committing to 10% EV growth, and then the balance is through share count reduction. So I mean for — at the opening of this conversation that in — for 2022, what was the repo number, Mike? It was $3.5 billion? $3.5 billion of share repurchase, and then an additional $1.5 billion of dividends. So $5 billion of cash return on a $12 million year is pretty substantial.
Chris Caso
Yes. And do you think the cash flow accelerates coming out of the next cycle? Because there’s an investment being made now, and so your CapEx is elevated. Who knows what happens to the macro over the next six to 12 months. And then coming out of that, it’s safe to assume that there should be some better capital.
Prashanth Mahendra-Rajah
I mean, our long-term goal is to get our cash flow margins to 40% of revenue. And we still feel confident that there’s a clear path to do that that comes with some leverage and some scale, but it through revenue growth. But some of the things that have impacted us more recently, such as the higher CapEx intensity subsides, the cash tax increase that we’ve seen due to the toll tax subsides, and some of the inventory build that we’ve added to try to improve customer service levels during this supply-demand disruption will also be neutralized.
Chris Caso
Okay. With that, I think we’re out of time. But gentlemen, thanks for attending.
Mike Lucarelli
Thank you.
Prashanth Mahendra-Rajah
Okay. Thank you. Great.
Chris Caso
Thanks, everyone.
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