ANALOG DEVICES INC quarterly report, Q3 FY2020

Business Context and Reporting Period

Analog Devices, Inc. designs, develops, manufactures and markets integrated circuits, operating as one reportable segment. This unaudited Form 10-Q covers the three and nine months ended August 1, 2020, compared with August 3, 2019, within fiscal 2020. Results were affected by the COVID-19 pandemic, particularly in automotive, consumer markets and certain manufacturing operations.

Financial Performance and Position

Metric	Q3 FY2020	Q3 FY2019	9M FY2020	9M FY2019
Revenue	$1.456 billion	$1.480 billion	$4.077 billion	$4.548 billion
Gross margin	66.8%	67.4%	65.4%	67.5%
Operating income	$419.1 million	$446.7 million	$1.037 billion	$1.372 billion
Net income	$362.7 million	$362.4 million	$834.2 million	$1.085 billion
Diluted EPS	$0.97	$0.97	$2.24	$2.90
Operating cash flow	Not provided for the quarter	Not provided for the quarter	$1.336 billion	$1.595 billion

Third-quarter revenue declined 2%, while nine-month revenue declined 10% year over year.
Third-quarter net income was essentially flat because lower operating income and revenue were offset by lower interest expense and a $33.7 million discrete tax benefit. The nine-month net income decline was 23%.
Gross margin declined 60 basis points in the quarter and 210 basis points for the nine-month period, primarily due to lower factory utilization and, for the nine-month period, temporary COVID-19-related shutdowns.
Operating margin was 28.8% in the quarter versus 30.2% in the prior-year quarter, and 25.4% for nine months versus 30.2%.
Cash and cash equivalents were $1.090 billion at August 1, 2020, compared with $648.3 million at November 2, 2019. Approximately $423.5 million was held in the United States.
Accounts receivable increased to $681.7 million and inventory was $612.6 million at August 1, 2020. Reported days sales outstanding were 40 and days of inventory were 113.
Total debt principal was $5.625 billion, consisting of a $925 million term loan and $4.700 billion of senior unsecured notes. Current debt was $449.3 million and long-term debt was $5.144 billion.
The company was compliant with its debt covenants, including the applicable consolidated leverage ratio requirements, as of August 1, 2020.
Capital expenditures were $135.8 million for the first nine months. Management expected fiscal 2020 capital expenditures to be below 4% of revenue.

End-Market Trends and Material Changes

Third-quarter industrial revenue increased 3% to $774.4 million, representing 53% of revenue, supported by instrumentation, test, energy and healthcare demand.
Communications revenue increased 14% to $363.6 million, or 25% of revenue, driven by wireline and wireless demand.
Automotive revenue declined 29% to $162.5 million, and consumer revenue declined 13% to $155.7 million, reflecting COVID-19-related production and demand weakness.
For the nine-month period, industrial revenue declined 4%, communications declined 14%, automotive declined 22% and consumer declined 14%.
Research and development expense decreased 7% in the quarter and 10% year to date, primarily due to lower employee-related and discretionary spending. Management stated that significant future R&D investment remains important.
Third-quarter special charges were $31.8 million, including $33.2 million related to workforce repositioning, partly offset by a $1.4 million reversal related to manufacturing-facility closure actions.
The company continued actions to close its Hillview wafer fabrication facility in California and its Singapore test facility, with planned transitions to other facilities and external providers. Cumulative charges through August 1, 2020 were $130.5 million for workforce repositioning and $53.9 million for manufacturing-facility closures.
The company adopted the new lease standard in fiscal 2020, recognizing a $247.4 million operating lease right-of-use asset and $319.5 million of operating lease liabilities at August 1, 2020. Management reported no material income statement or cash flow impact.

Liquidity, Capital Allocation and Outlook

Operating cash flow for the first nine months was $1.336 billion, down from $1.595 billion in the prior-year period, primarily due to lower earnings and working-capital changes.
Investing cash outflows were $149.8 million, including $135.8 million of capital expenditures and $12.8 million of acquisition payments.
Financing cash outflows were $744.4 million, including $656.6 million of dividends, $237.3 million of share repurchases and $300 million of debt repayments, partly offset by the $395.6 million net proceeds from the 2025 green bond issuance.
The company temporarily suspended its share repurchase program because of the macroeconomic environment and the planned Maxim transaction. Approximately $1.9 billion remained authorized for repurchases, but future activity depends on liquidity, results, outlook and other factors.
On August 18, 2020, the board declared a quarterly dividend of $0.62 per share, expected to total approximately $228.9 million, payable September 9, 2020. Management stated that quarterly dividends were currently expected to continue, subject to board approval.
Management believed existing cash, future operating cash flow and available financing would fund operations, capital expenditures, R&D, Maxim transaction costs and dividends for at least the next twelve months.

Maxim Acquisition, Risks and Unusual Items

On July 12, 2020, Analog Devices agreed to acquire Maxim Integrated Products in an all-stock transaction under which Maxim shareholders would receive 0.630 Analog Devices share per Maxim share. The filing estimated merger consideration at approximately $20.0 billion based on the Analog Devices share price on August 14, 2020.
The transaction remained subject to shareholder approvals, antitrust and other regulatory clearances, and customary closing conditions. Analog Devices incurred $9.1 million of transaction costs in the quarter.
Termination fees include a potential $725 million fee in specified circumstances and a potential $830 million regulatory termination fee payable by Analog Devices in specified circumstances involving failure to obtain regulatory approvals.
COVID-19 remained a material uncertainty. Although manufacturing and supply-chain operations had generally stabilized at normal levels during the third quarter, management could not quantify the pandemic’s future effects on demand, operations, liquidity or results.
An Irish transfer-pricing assessment of approximately €43.0 million, or $50.9 million at August 1, 2020, remained under appeal. No additional liability was recorded; an unfavorable resolution could materially increase future tax expense and reduce earnings.
The third-quarter effective tax rate was 2.8%, compared with 7.0% in the prior-year quarter, primarily because of the $33.7 million discrete tax benefit, including a $25.9 million benefit from resolution of an IRS audit related to Linear.
Other principal risks include semiconductor cyclicality, customer and distributor demand volatility, manufacturing and third-party supply constraints, international operations and trade restrictions, debt covenant and refinancing risk, intellectual-property and product-liability claims, cybersecurity, and execution and integration risks related to Maxim.

Important Facts for Investors to Verify

Whether COVID-19-related demand weakness, particularly in automotive and consumer markets, persists or spreads to industrial and communications markets.
The sustainability of the 66.8% quarterly gross margin after factory utilization normalizes and restructuring actions are completed.
The funding plan, regulatory status, timing, dilution and integration economics of the approximately $20 billion Maxim acquisition.
Near-term debt maturities, refinancing needs and compliance with the 3.5-to-1.0 leverage covenant.
The outcome of the Irish transfer-pricing appeal and other global tax audits, including potential effects on the effective tax rate.
Whether announced facility closures and workforce actions deliver the expected annual savings of approximately $48 million and $60 million, respectively.
The timing of any resumption of share repurchases and the company’s ability to maintain dividends while funding the acquisition and servicing debt.