Analog Devices, Inc. (NASDAQ:ADI) Q1 2023 Earnings Call Transcript

Analog Devices, Inc. (NASDAQ:ADI) Q1 2023 Earnings Call Transcript February 15, 2023

Operator: Good morning, and welcome to the Analog Devices First Quarter Fiscal Year 2023 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.

Michael Lucarelli: Thank you, Gigi, and good morning, everybody. Thanks for joining our first quarter fiscal 2023 conference call. With me on the call today are ADI’s CEO and Chair, Vincent Roche; and ADI’s CFO, Prashanth Mahendra-Rajah. For anyone who missed the release, you can find it and relating financial schedules at investor.analog.com. On to 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 and in our periodic reports and other materials filed with the SEC. Actual results could differ materially from the forward-looking information as these statements reflect our expectations only as date of this call.

We undertake no obligation to update these statements except as required by law. Our comments today will also include non-GAAP financial measures, which exclude special items. When comparing our results to our historical performance, special items are also excluded from prior periods. 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 release. And with that, I’ll turn it over to ADI’s CEO and Chair, Vincent Roche. Vince?

Vincent Roche: Thanks very much, Mike, and good morning to everyone. Well, I’m very pleased to share that ADI continued to execute exceptionally well in the first quarter of fiscal 2023, despite continued macroeconomic uncertainty. Revenue was $3.25 billion, up 21% year-over-year, strength was broad based with all B2B markets, up single-digits. Gross and operating margins were 74% and 51% respectively and adjusted EPS achieved another record at $2.75. Our continued success is driven by a relentless focus on customer collaboration, a growing demand for our innovative technologies and strong operational execution. We play a long game and are excited about what the future holds for us to ensure that we capture the opportunity ahead.

We’ve been steadily increasing investments in R&D, manufacturing capabilities and in partnerships that deepen our value to our customers now and over the long-term. For example, in R&D, we’ve invested $1.7 billion over the trailing 12 months to strengthen our core franchises and capture market opportunities presented by secular growth drivers. Over the same period, we’ve invested $760 million in CapEx to enhance the resiliency of our internal semiconductor manufacturing operations. These investments not only increase our operational resiliency, but also modernize our fabs to better address our sustainability ambitions. As mentioned in our press release, our industrial and automotive businesses remain strong as we gain market share. So this morning, I want to focus specifically on our industrial business, which continues to grow significantly despite the macroeconomic backdrop.

Now, from a big picture perspective, the industrial market is the bedrock of ADI, representing more than half of our total revenue. It’s also our most diverse and profitable business segment with tens of thousands of customers and products that sustain revenue streams for decades. Additionally, ADI’s industrial revenue is derived from high performance technology in mission-critical CapEx-intensive equipment across the myriad applications. Our leadership position has been strengthened over the last decade as we intensified our focus in this market and invested over $5 billion in R&D activities to capture the opportunity across the hundreds of applications that characterize the industrial sector. This space is inherently fragmented and the unmatched breadth and depth of ADI’s portfolio uniquely allows us to address our customer’s needs across the full spectrum of applications.

With core component building blocks to application-specific solutions that encompass analog, digital and algorithms. Today, we’re seeing the rise of new industrial applications that require more sophisticated and more complex architectures as machines become more intelligent and more sustainable. This is driving more semiconductor content per dollar of CapEx, unlocking new opportunities for our portfolio. While this transformation is benefiting all of our industrial applications, including healthcare and aerospace, let me share how we’re winning an industrial automation and instrumentation more specifically and discuss the burgeoning opportunity across the electrification ecosystem. So, starting first with industrial automation. Here, our customers are upgrading their factories with more automation and connectivity to increase output with greater energy efficiency.

ADI’s broad portfolio helps customers create these more resilient and flexible footprints while lowering their carbon emissions on the journey to net-zero. As an example, at a leading U.S. robotics manufacturer, we’ve won additional content across power sensing and GMSL connectivity. Our systems approach reduced our customers’ design time and increased our content per cobot by 4x. Also in the last quarter, our IO-Link solution was designed in at multiple leading industrial automation customers. These solutions are critical for delivering robust connectivity to the edge of the factory floor. Turning our attention now to our instrumentation and test business. This subsector is highly aligned to secular growth trends from connectivity to AI-assisted compute to electrification to drug discovery and gene therapies.

The consistent thread across this diverse set of applications is the growing complexity that requires more advanced metrology and test. The results, our average content per system is now 2x to 3x higher. Further, the localization of semiconductor supply is providing additional tailwinds for our test business. We’ve secured multiple design wins in North America as well as Asia for memory and high-performance compute. And finally, on to one of our fastest-growing areas, the electrification ecosystem. The collective need for a more sustainable future is driving massive growth in electrical grid infrastructure. Now let me share two examples with you. First, industrial and automotive companies have announced more than $300 billion of investments in greenfield gigafactories, essential to the production of batteries to proliferate the electrification ecosystem.

These gigafactories will drive additional demand for our formation and test solutions critical to producing higher density batteries. Further, given the inherent safety hazards of using higher cell voltages, these factories will also provide new growth vectors for ADI. In our sustainable energy franchise, we’re leveraging our industry-leading automotive BMS solutions into energy storage systems for electrical grids and fast-charging infrastructure. We’ve won designs at leading EV infrastructure manufacturers in North America, Europe and Asia, putting us on a path to more than tripling this business in the coming years. Of course, while no market is fully immune to adverse economic cycles, our industrial business is highly diversified and aligned with secular trends.

This has translated to more durable revenue streams with sales in this sector increasing more than 25% over the trailing 12 months despite a weakening economic backdrop. But looking ahead, we see continued strength in this franchise as the breadth and depth of our portfolio, our deep customer collaborations and design win pipeline momentum underpin our new phase of profitable growth. So in closing, ADI’s business model is diverse, resilient and rich with opportunity. I’m very optimistic about what our future holds as we drive enhanced value for our customers employees and shareholders as well as society at large. And so with that, I’ll hand you over to Prashanth.

Prashanth Mahendra-Rajah: Thank you, Vince. Let me add my welcome to our first quarter earnings call. My comments today, with the exception of revenue, will be on an adjusted basis, which excludes special items outlined in today’s press release. First quarter revenue of $3.25 billion finished at the high end of our outlook, driven by continued share gains in industrial and automotive. Our B2B markets represented 89% of revenue, up 25% year-over-year and increased 2% sequentially despite our first quarter typically being down. Now let’s look at performance by end markets. Industrial, our most diverse and profitable end market represented 52% of revenue and hit another all-time high. This business has grown sequentially for 12 consecutive quarters.

All markets increased year-over-year, led by automation, sustainable energy, instrumentation and test. Automotive, which represented 22% of revenue, also achieved another record, increasing 29% year-over-year and 6% sequentially. All applications grew double digits year-over-year as our market leading positions across battery management and in-cabin connectivity continue to deliver significant growth. Communications, which represented 15% of revenue, grew 18% year-over-year. As expected, comms declined slightly sequentially as strength in wired was offset by softness in wireless due to the timing of 5G deployments. And lastly, consumer, which represented 11% of revenue, was down 5% year-over-year and declined 14% sequentially given weaker market trends and seasonality.

Now onto the rest of the P&L. Gross margin of 73.6% expanded 170 basis points year-over-year, unfavorable mix and cost synergies. OpEx was $733 million down slightly sequentially as we balance strategic hiring with the tight discretionary spend and synergy capture. Given our strong operating leverage combined with the synergy savings, our operating margin was 51.1%. Importantly, we have already captured nearly all of the $400 million cost synergy goals. As such, our communication will now turn to the revenue synergy opportunities from our combined portfolio and our complimentary customer base with Maxim. Recall that Anelise, our Chief Customer Officer, unveiled how we are strategically approaching these synergies during our Investor Day, and Vince has routinely highlighted some of these compelling opportunities over the past few quarters.

To that end, we are closely monitoring and measuring progress from opportunity to design win to new revenue. And while it is still early, design win momentum to date has exceeded our expectations. This gives us increased confidence in achieving our $1 billion plus revenue synergy opportunity that we outlined at our Investor Day. Non-op expenses were $60 million, and the tax rate was just over 12%. All told, EPS came in at $2.75, up 42% year-over-year and hitting a new record. Moving to the balance sheet. We ended the quarter with approximately $1.7 billion of cash and a net leverage ratio below 1. Days of inventory increase to 155, while channel inventory remains below our target level. Recall that last quarter, we outlined our strategy to rebuild strategic die bank and hold more finished goods inventory on our balance sheet as we moderate shipment into the channel during this time of inflection.

Moving on to cash flow. CapEx for the quarter was $176 million and $764 million over the trailing 12 months, representing 6% of revenue. We continue to expect CapEx to be high-single-digits as a percentage of sales in 2023 and then decline in subsequent years to our long-term target of mid-single-digit. These investments will double our internal revenue output exiting next year and support strategic swing capacity between our fabs and our foundry partners. The flexibility of our hybrid model across different geographies enhances our resiliency and offers our customers additional optionality. Over the trailing 12 months, we generated $4.3 billion of free cash flow or 34% of revenue. Over this period, we have returned $4.7 billion to shareholders or over 100% of free cash flow via $3.1 billion of buybacks and dividends of $1.6 billion.

We just raised our quarterly dividend by 13%, marking our fifth consecutive double digit increase, and 19 consecutive years of increases. This is a testament to our durable operating model that has generated positive free cash flow for 26 consecutive years. As a reminder, we target 100% free cash flow return. The dividend is the cornerstone of this policy, and we look to increase our dividend at a 10% CAGR through the cycle with remaining cash used for share count reduction. Now, similar to prior quarters, I’d like to give a brief update on the operating backdrop. First, on markets. Industrial orders, as Vince highlighted, remain the strongest followed by automotive, while comms and consumer remain weak. Given the rapidly changing environment, we are diligently working with our customers to remove orders that they may no longer require.

At the same time, we have increased our supply by growing our internal output and working with our foundry partners. These actions have reduced our lead times with half of our portfolio now shipping in under 13 weeks. Despite this, backlog coverage remains around one year of revenue. As such, we expect our book-to-bill will remain below parody over the next couple quarters as our backlog returns to more normal levels. Given these dynamics, we are guiding second quarter revenue to be $3.2 billion plus or minus $100 million. We expect continued sequential growth in our industrial and automotive markets and another sequential decline in our communications and consumer markets. At the midpoint of our outlook, revenue will be up high-single-digits year-over-year with our B2B markets up over 10% once again.

Operating margin is expected to be 51% plus or minus 70 basis points. Our tax rate is now expected to be between 11% to 13% for the year. This guide reflects the new U.S. tax requirement to capitalize R&D expenses for tax purposes, resulting in higher upfront cash tax payments, but lowers our effective tax rate temporarily due to the deferred tax accounting requirements. Based on these inputs, adjusted EPS is expected to be $2.75, plus or minus $0.10. In all, the macro backdrop remains uncertain. However, we remain cautiously optimistic on the near-term, given the resilient strength across our industrial and auto businesses, which represent over 75% of our revenue. Longer-term, we remain well positioned to drive growth enabled by our diverse high performance portfolio aligned with the key secular trends at the Intelligent Edge.

Let me now pass it back to Mike for our Q&A.

Michael Lucarelli: Thanks, Prashanth. Let’s go to the Q&A session. We ask that you limit yourself to one question in order to allow for additional participants in the call this morning. If you have follow-up question, please requeue. I’ll take your question if time allows. With that our first question, please.

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Q&A Session

Operator: Our first question comes from the line of C.J. Muse from Evercore ISI.

C.J. Muse: Yes, good morning. Thank you for taking the question. I guess the €“ my question really would center around the industrial strength that you’re seeing. You talked in great detail around kind of emerging new markets as well as increasing content yet, I think a lot of investors are focused on kind of declining PMIs around the globe. And so we’d love to hear your thoughts on why your business is, acting so very different from, maybe some of the larger macro trends. And perhaps more color on how much of it is content? How much of it is maybe emerging growth areas that are not reflected in some of these PMIs would be very helpful? Thanks so much.

Vincent Roche: Yes. Thanks, C.J. So, I think first and foremost, our success isn’t by dent of chance. We’ve been investing heavily in this market for more than a decade, and it’s really our focus. It’s our core, it’s the core of ADI and from both an R&D and customer engagement perspective, we’ve been really doubling down here over this decade plus kind of time span. And we’ve been gaining market share for sure. We have €“ compared to even kind of three years, four years ago, we have €“ we’ve always had a very strong position in the signal chain, the kind of data path processing electronics, but we’ve been able to, with the acquisitions of LTC and Maxim, we’ve been able to bring very strong competitive power portfolio to bear as well.

So, I think from a portfolio perspective, we’re in much better shape. I pointed out in the script as well that when we talk about industrial, it’s truly the industrial sector. I know many competitors talk about other kind of indescribable sectors or businesses that are not well understood, like consumer, for example, other consumers. So, I want to point that out as well. We have, as I said, many secular growth drivers in play. We see the average content per dollar of CapEx spend increased at a pretty meaningful level across all the applications, including instrumentation, factory automation is changing also. It’s bringing more sensing, more compute to the edge and all of that is driving content gain for ADI. So, I think they are the primary drivers of the business.

And yes, PMIs are, I would say, in the kind of retraction zone right now, but we see stabilization. And I think when China comes back as well, which is likely to happen, we believe, over the coming months, that will drive things even further into a positive zone.

Prashanth Mahendra-Rajah: C.J., this is Prashanth. I’ll just put one more thing just to help folks understand kind of the breadth of that growth. All of our submarkets were up double digits year-over-year, and most of them increased quarter-over-quarter. And if you look at it by geography, we had strength in America, Europe and Japan, again, all up double digits year-over-year, offsetting a weaker China. So this industrial strength was very broad-based.

Michael Lucarelli: Thanks, C.J.

Operator: Thank you. Our next question comes from the line of Vivek Arya from Bank of America Securities.

Vivek Arya: Thanks for taking my question. I actually had a pair of kind of related question, which is how long can book-to-bill remain on before it starts to become, ? And usually, if I look historically for ADI, generally, the second half tends to be better than the first half. What would support that view or prevent that from happening this year?

Prashanth Mahendra-Rajah: Okay. Yes. So Vivek, let me maybe take a walk through cancellations, backlog lead times to help answer that. But I do want to clarify, you said on book-to-bill. Our book-to-bill is sub one. I thought I heard you say it was one. Our book-to-bill is sub one. We told you that was happening a couple of months ago, and I’d expect to carry for another quarter or two as we get through this backlog. So on the backlog, we’ve been saying for a while now that we’ve got record backlog, and we are working with our customers and our disti partners to get this rationalized with what customers need today versus perhaps the orders they had placed on us six months or nine months ago when we had very long lead time. This progress is what is being reflected in that book-to-bill ratio below one.

I think that it will probably be below parity for another quarter or two as we get back to normal backlog. Lead times, the supply-demand imbalance is definitely getting better, slowly, but it’s getting better. We’re getting more wafers externally, thanks to the hybrid model. We have the flexibility to do that as well as the investments we’re making internally as we’ve talked about with our CapEx deployment to increase production. So, we have about 50% of the portfolio under 13 weeks today, meaning it can ship within the quarter, and that’s going to continue to improve over the €“ through the second half. So takeaway sort of given lead times falling, bookings getting higher quality compared to year ago as customers aren’t ordering for stuff way into the future.

And at the place backlog, and we feel this is positive for visibility, and we’re really getting to true demand.

Vivek Arya: And anything on second half, Prashanth, because it looks more like a soft take of then a soft landing from the trends?

Prashanth Mahendra-Rajah: So, I don’t want to go out too far, but I’ll just give you a couple of comments here. And if Vince wants to make any long-term comment. We feel good about the outlook for the second quarter given the resiliency in auto and industrial. As I said, 75% of our sales come from those two segments, and we still have a year for the backlog. Beyond the second quarter, it’s hard on the one hand to make a call, given that we have strong backlog coverage, but we also understand there’s a lot of macro uncertainty out there and things are changing fast. So, I’m not going to make any predictions one area to pay attention to, and Vince made a comment on this, is China. I think we and many companies are watching China. If demand accelerates in the second half given sort of the optimism on consumers and government that would be €“ that would be good for a number of organizations. Vince, anything more longer term, you want to add on that?

Vincent Roche: Well, I think, Prashant, we’ve clearly built a lot of resiliency into the way we run the company into the business model as well as the manufacturing operations. So, who knows what the second half is going to bring. But what I can tell you is that €“ we’ve been through many, many cycles before and never have we been better positioned in our history than we are now from a portfolio, from a customer engagement standpoint. So €“ this industry is likely €“ it’s taken us kind of 20 years to double from kind of 2000 to 2020, we’ve probably doubled the content that the industry builds over the next 10 years. And I believe ADI is very, very well positioned given the strength, as I said, of our portfolio, our customer engagements, and this hybrid manufacturing model that we’ve got in place to enable us to capture the upside and manage the downside.