Analog Devices: Get Ready for Upcycling (NASDAQ:ADI)

Electronics worker checking a component in a clean room — Monty Rakusen

Investment action

I recommended a buy recommendation for analog devices (NASDAQ:ADI), when I wrote about this two months ago, as I expected, FY24 will be a recovery year for ADI, with growth expected to accelerate in FY25. Based on my current Outlook and analysis, I recommend a buy rating. The most important update to my thesis is that after reviewing the second quarter results, I have greater confidence in the economic recovery cycle in fiscal year 2024. While the magnitude of the decline was greater than I expected, I believe it was a positive result as guidance management suggest that the lowest level will be the second quarter.

Review

Last week, ADI reported second-quarter 2024 earnings, with revenue down 14% sequentially and 34% annually to $2.16 billion. While the downward trend continued, this was the first time in the last 7 quarters that ADI exceeded consensus estimates. On a final basis, industry revenues were down 42% compared to last year; communication revenues last year it fell by 47%; consumer incomes fell by 12% last year; and revenues from the automotive industry decreased by 16% compared to last year. On the gross margin side, adjusted gross margin for the second quarter decreased 700 basis points to 66.7%, or 230 basis points compared to the first quarter of 2024. As a result, adjusted EBIT margin also decreased by 300 sequentially and by 12.2 percentage points from the prior year to 39%.

The biggest takeaway from this set of results is that Q2 2024 appears to be the bottom of the cycle, following a 34% decline in quarterly revenue from peak to trough, which can be inferred from two aspects.

First, management cited an improving booking environment, while noting that the book-to-bill ratio topped 1x in the quarter for the first time in over a year. The reason this 1x threshold is important is that it suggests improvement in underlying demand, which is a headwind for ADI recovery. As ADI is able to meet this demand, the improved backlog outlook paints a very positive picture for future sequential growth. The improving order book outlook is well supported by the encouraging project wins that ADI has recorded in various end markets. For example, ADI won new contracts in the areas of healthcare (surgical robotics and continuous glucose monitoring market), industrial automation and automation (ADI expanded its cooperation with GSML from 12 to 15 of its 20 largest clients).

Second, the 3Q24 guide includes an expectation of positive sequential growth (5% based on $2.27 billion in mid-year revenues) for the first time over the past year, reflecting customer inventories normalizing and supplies approaching final consumption levels . Importantly, management has seen improving trends across all segments and I believe this comment is highly significant given that the earnings announcement was made last week, meaning management already has 3Q24 data of approximately three weeks.

ADI has done a really great job managing the inventory. The stock is currently down 13% from $1.71 billion at its high point in the 2023 quarter to $1.48 billion at the end of the second quarter of 2024. This compares very well to other industry peers such as NXP Semiconductors (NXPI) and Microchip Technology (MCHP), whose stocks are down only 2% from peak to trough. Additionally, management stated that channel inventory was reduced to approximately 8 weeks at the end of the quarter and is expected to further reduce in Q3 2024 as it approaches the 7-8 week ADI target range. The reason I focus on inventory management is because it shows the potential for gross margin growth as ADI moves through the upcoming economic recovery cycle. The logic is that ADI is currently taking advantage of low utilization rates to reduce inventory, and if we reverse this, it means ADI has plenty of room to increase production (i.e. improve utilization rates), which translates into high incremental margins taking take into account the fixed cost.

Quotation

A screenshot of the automatically generated spreadsheet description — Author’s work

I believe that the visibility of the economic recovery cycle has increased significantly. Therefore, while I have lowered my expectations for FY24 by a large delta (from expected growth of 3% to now expected negative growth of 23%), I consider it a net positive. The reason for this large change is that I did not expect such a large scale of decline in 2Q24. I have modeled a full-year decline of 23% assuming that Q3 ’24 will see sequential revenue growth as expected and Q4 ’24 will see similar strength of revenue growth. As for FY25, I am now more confident that ADI will see recovery, and based on historical YoY growth trends, FY25 should see ~10% growth, followed by FY26 at 20%.

On the EBIT margin side, the large decline in Q2 2024 naturally resulted in a decline in margin, so I have adjusted my FY24 estimates to reflect this weakness (assuming we achieve Q1 EBIT margin in H224, because it is expected to grow positively). As ADI accelerates growth, I expect it to achieve ~50% EBIT margin, which it did at the peak of recent economic growth.

With greater visibility into the economic recovery cycle, ADI should continue to trade at a valuation higher than the historical average. ADI is currently trading at 29x forward EBIT, well above the average of 20x over the last 5 years, and while the premium is huge, I think it is justified as I expect EBIT to change by over 40% in the year financial 26 compared to LTM Q2, which implicitly means that ADI is valued at ~21x my FY26e EBIT (only 1x above the 5-year average; therefore, I don’t think the current multiple is too demanding ).

Graph with red lines. Description generated automatically — Author’s work

Red Line Chart Description automatically generated — Author’s work

Risk

I still quote this from my previous post because I still consider this a major downside risk to ADI’s investment situation. There is a risk that the economic recovery cycle will not materialize for any possible reasons, including those I mentioned earlier (Red Sea conflict, China-Taiwan conflict, Russia-Ukraine conflict, etc.). The only difference is that today’s valuation is much higher, and that also means that today’s downside is greater compared to the last time I wrote about ADI.

Final thoughts

My recommendation is a buy rating for ADI. I believe there are clear signs that the economic recovery cycle is starting. Revenues are expected to grow sequentially for the first time in a year in Q3 2024, supported by an improving booking environment and improved inventory situation. The Management Board’s comment also shows that positive trends occur in all segments. While the valuation is high, the potential for significant EBIT margin improvement over the next two years justifies the current multiple.