We are decreasing our 4Q05, FY05, and FY06 EPS estimates, as we over-estimated revenue growth after exiting the inventory correction. Our 4Q05 estimates are at the lower end of management guidance as we believe channel inventory levels will stay depressed.
We believe investors should focus on three areas of ADI's 3Q05 earnings report:
(1) Backlog was up 11 percent quarter-to-quarter, but revenue growth was forecast (1-to-4 percent quarter-to-quarter) under bookings growth, indicating that backlog coverage expanded without a significant increase in shipment demand. [This could indicate a slowdown: Equipment builders say, "hold off on the shipment of existing orders..." But this not Doug Freedman's interpretation.] We believe this signals a healthy start to a new semiconductor growth cycle as customers grow more comfortable with end market demand and [are willing to] place extended orders [several quarters out].
(2) ADI management is very focused on its operating margin goal of 30 percent, with substantial expense reductions during 3Q05. Guidance said expenses were projected to be flat in the fourth quarter of fiscal 2005 after R&D and SG&A (sales and general admministrative expenses), each down 5.9 percent and 1.6 percent respectively quarter-to-quarter. We believe that spending controls could drive expenses below our initial estimate.
(3) ADI had another strong quarter of cash flow generation (cash increased by $167M, or about $0.44/share), which should flow back to shareholders in future quarters in the form of increased share repurchases and dividends.
We are, however, growing concerned with ADI's new product execution as competitors are offering increasingly competitive products in the "bread and butter" data converter market. We would note that market share shifts in this market will take 5-10 years to calculate as data converter designs are seldom changed mid product cycle. We believe any negative market share shift calculations will prove premature and maintain our Buy rating on shares of ADI.
July 2005, fiscal 3rd quarter results
ADI reported revenues of $582.4 million. Our estimate of $584.4 million (with appropriate earnings-per-share) proved slightly aggressive on the revenue line — but conservative on the gross and operating margin lines. ADI was able to exceed its earnings-per-share estimate as a result of a higher gross margin of 58.1 percent (versus our estimate of 57.7 percent). Our operating expense estimate of $206.5 million was $3 million above actual of $203.5 million. During the quarter the company modified its operating plan and throttled back R&D, as well as limiting the inventory built during the quarter.
Inventory decreased by $4 million to $344 million (128 days), down sequentially from $348 million (124 days), but up in days as sales fell faster. Three-month backlog increased 11 percent quarter-to-quarter and should support a lower level of turns required to meet the October quarter guidance.
October 4th quarter, fiscal 05 guidance
The forward guidance for 4QFY05 suggests revenues will be $588.2 million to $605.7 million. Our estimate was looking for $596 million (with EPS of $0.33), while Wall Street consensus was looking for $606 million with EPS of $0.33. Our new estimates are for EPS of $0.34 on sales of $594 million as operating expenses are held at lower levels on lower sales expectations.
As expected, the company continues to control operating expenses and capital expenses. Operating expenses are expected to remain unchanged at $203.5 million. The gross margin was guided up slightly for 4Q05 as a result of FIFO inventory accounting which lowers the cost of goods sold. The gross margin is expected to benefit from higher yields and improved mix.
Our estimates require no bookings growth in the October quarter to achieve a positive book-to-bill ratio and build backlog. Our estimates are at the lower end of management's guidance as we do not believe customers will ramp shipments ahead of demand. Our anticipation of (43 percent turns down from 47 order) a high conversion rate from bookings into sales seems reasonable given the company's inventory position.
Order and revenue inflection point
We believe the inventory correction is, as management has described, behind us. We feel this way for several reasons:
What has gone wrong in ADI's DSP markets?
- Long term CAGR for the high performance analog sector over the last eight years has been 12 percent. For ADI to achieve this metric in FY06 it would need to ship about $2.75 billion in revenue (our present estimate is slightly reduced to $2.6 billion from $2.62 billion).
- We believe that ADI revenue growth has been moderated by share lost by its cellular handset customers and slower DSP growth than expected.
- High inventory levels at semiconductor manufacturers will keep lead-times short for the next few quarters, delaying any rapid increase in order rates above consumption levels.
- We believe that delinquencies are required before double ordering and inventory builds can occur.
We believe that ADI is running into two separate issues in terms of DSP revenue growth. On the low-end, handset dominated market, there are more alternatives and more competition in the end markets from tier one suppliers and manufacturers. In the high-end segment, TigerSharc products are running into stronger products from Freescale and FPGA-based solutions. These solutions are able to offer lower cost processing and higher levels of support than ADI.
The result is that ADI is going to have a hard time justifying the R&D and SG&A dollars to support the revenue potential of these products. Management was not very direct in terms of pending actions, but did lay out a plan to move the target market of these products into less competitive arenas.
Why we believe ADI management will take the required cost reduction steps: Over a four-quarter period, from January '01 to January '02, ADI reduced operating expenses from $207 million/quarter to $157 million/quarter, while revenue declined from $772 million/quarter to $393 million/quarter. The actions required to deliver profits FY06 are far less severe. We would characterize the required actions as pruning and refocusing R&D, not severe cuts that could cause company-wide morale issues.
The Bulls Will Point to:
The company's gross margin increased to 58.1 perceent.
Revenue is expected to recover in the October quarter with year-to-year growth in the January '06 quarter.
Wireless and ATE revenue is at a trough level.
The stock is trading at an attractive valuation of 21 times our FY07 EPS estimate of $1.80, not including $8.01/share in cash. Trough valuations are complicated by the large cash balance as in prior cycles ADI had zero net cash.
Distributor inventories declined for the third straight quarter.
The book-to-bill was above one (we estimate 1.06).
The company was able to ship 47% turns orders.
The Bears Will Point to:
- Revenue levels were below consensus estimates for the October quarter
- The deferred Income from shipment to distributors declined by $2 million quarter-to-quarter, while accounts receivable only decreased by $24 million quarter-to-quarter.
- The Asian Handset market continues to hurt year-to-year revenue growth.
- Turns of 43 percent are required to meet October quarter guidance.
- Short lead-times and limited visibility put revenue and EPS projections at risk.
- ADI reported strength in the Computing sector, with Dell just reporting weakening demand.
We are slightly decreasing our EPS estimates on lower revenue levels; we believe the risk/reward remains intact to maintain our Buy rating on shares of ADI. We believe that ADI's management will take the required action to allow the company to earn $1.59 in FY06. We are somewhat disappointed by the company's revenue decline and required market shift in DSPs. We are however, maintaining our Buy rating on this company.
www.amtechresearch.com Semiconductors— Doug Freedman