Analog Devices (NYSE: ADI): 'Operational Elegance'
By: TheStockAdvisors.com Thursday, August 27, 2009 11:11 AM

Paul McWilliams is well-known for his in-depth and sophisticated analysis of stocks for tech-savvy investors in his Next Inning newsletter.

In addition to corporate metrics, he places strong emphasis on superior management. Regarding integrated circuit maker Analog Devices (NYSE: ADI: 27.26, -0.21) he notes, "CEO Jerald Fishman really knows how to run a company."

"The numbers posted by Analog Devices and the guidance provided for its fiscal fourth fiscal quarter of 2009 (ends October 2009) were both impressive. And, when taken together, exceeded my expectations.

"As I had expected, there was an inventory adjustment that resulted in a sequential decline in excess of 18% in its shipments to Chinese wireless infrastructure suppliers.

"However, due to stronger demand than I had anticipated from several other sectors, ADI reported stronger FQ3 results than I would have expected.

"This is good news on two fronts. First, the inventory adjustment for the Chinese wireless business is behind us and was offset by better than expected demand from other sectors and, second, we should see wireless demand improve in FQ4.

"Between this and other commentary ADI shared during its conference call, I think we can take its guidance for both revenue and earnings as being somewhere between conservative and very conservative.

"Initially, Wall Street has clearly focused on the wrong thing: a slightly lower than expected gross profit margin for FQ4. In the scope of things, this focus made less sense than a bookie handicapping an Olympic runner due to a hangnail.

"Among the many things Wall Street was failing to grasp here is that ADI is designed to operate efficiently at roughly $600M in revenue. Because it is operating at a lower level than that today, it is not fully absorbing its fixed costs.

"Between this and the fact that certain sectors that generate higher relative gross margins have been slower to recover than sectors with lower relative margins, aggregate gross profit margins are currently constrained.

"Worse yet than focusing on near term results and using year-over-year comparisons to judge ADI, there was apparently no attention given to where ADI has been and where it is headed.

"ADI was very early in realizing it needed to change its business model. What happened was ADI developed strong presence in both the handset DSP and PC power control markets only to see margins decline over time as the technology became easier to produce.

"However, to its credit, ADI sold its handset business and ADI has benefited by refocusing on high margin opportunities.

It's not that this model isn't working, it's just that its progress is masked by the combination of an unusual product mix attributable to the aggregate demand environment and the burden of inefficiently absorbed fixed costs.