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A Semiconductor Downturn Comes for Another Industry Giant. Time to Load Up on This Chip Stock?

Motley Fool - Mon Nov 27, 2023

In the current artificial intelligence-driven semiconductor frenzy, one industry giant -- Analog Devices (NASDAQ: ADI) -- gets little fanfare. That deserves to change, because this has been a top-notch chip business and a market-beating dividend payer for many years.

But why review Analog Devices now? It's become clear that a semiconductor industry downcycle has hit this leader, setting up what could be a great buying opportunity for long-term investors. Here's what's going on right now.

A not-so-good quarter, but profits remain healthy

As its name implies, Analog Devices is a large specialist in analog chips (or simply sensors), which interact with a physical-world signal like electricity, sound waves, or light. It's also a leader in signal processing that converts an analog signal to a digital one -- "digital" in this sense meaning the data that a computing system can utilize.

For its recently concluded fiscal 2023 (ended in October), Analog Devices reported that 53% of its revenue came from industrial markets, 24% from automotive, 13% communications, and 10% consumer electronics.

The last couple of quarters have been the start of a cyclical decline for the company, much as its peers (like Texas Instruments, for example) have also been reporting. In the fourth quarter, sales fell 16% year over year to $2.72 billion.

Business will decline further to kick off fiscal 2024 (which ends in January 2024), with revenue expected to be $2.5 billion at the midpoint of guidance, or down 23% from the same time a year ago.

As other analog and power chipmakers have been reporting, a tough global economy is contributing to too much inventory, led by the automotive space. It's an abrupt end to what has been a broad chip shortage for most industrial markets since 2021. Management believes this downturn, which will help customers use up that excess inventory, should last through the first half of next year.

The good news for Analog, though, is that it expects to remain highly profitable. Even with the big expected year-over-year sales decline to start its new fiscal year, it anticipates its operating margin under generally accepted accounting principles (GAAP) to be around 23%. That should provide enough cash (roughly $575 million in operating income) for Analog to cover its quarterly dividend, which cost $428 million last quarter.

ADI Operating Margin (TTM) Chart

Data by YCharts. TTM = trailing 12 months.

Is this top chip stock a buy now?

After the quarterly update, Analog Devices stock trades for 28 times trailing-12-month earnings per share, or 25 times trailing-12-month free cash flow. With the semiconductor market downturn now here for the company, expect these valuation metrics to worsen in the coming quarters (assuming the stock price -- $181 as of this writing -- remains constant while earnings decline).

Given the situation, I expect there to be plenty of turbulence for Analog stock until its customer inventory issues are resolved. Though the company remains profitable, margins will be under pressure, which could create some downward pressure for the stock over the next six months or so. Thus, I don't think Analog is a best-buy stock just yet.

However, given its long track record of profitable growth and doling out cash via its dividend and stock repurchases, Analog deserves to be on a watch list. This is a top chip stock, one that could be an opportune purchase early in 2024 as it manages what appears will be a normal industry downcycle before returning to long-term growth.

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Nicholas Rossolillo and his clients have no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Texas Instruments. The Motley Fool has a disclosure policy.

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