ANALOG DEVICES INC quarterly report, Q3 FY2018

Analog Devices, Inc. — Fiscal 2018 Third-Quarter Form 10-Q

Reporting period: Three and nine months ended August 4, 2018, compared with July 29, 2017. Fiscal 2018 is a 53-week year; the first nine months included one additional week. Analog Devices designs, manufactures and markets integrated circuits and reports one operating segment. Results include Linear Technology prospectively following the March 10, 2017 acquisition.

Financial performance

Metric	Q3 FY2018	Q3 FY2017	9M FY2018	9M FY2017
Revenue	$1.573 billion	$1.434 billion	$4.604 billion	$3.566 billion
Gross margin	68.1%	53.5%	68.2%	57.6%
Operating income	$499.0 million	$194.8 million	$1.368 billion	$606.9 million
Operating margin	31.7%	13.6%	29.7%	17.0%
Net income	$414.5 million	$68.9 million	$1.062 billion	$379.6 million
Net margin	26.4%	4.8%	23.1%	10.6%
Diluted EPS	$1.10	$0.18	$2.82	$1.10

Q3 revenue increased 10%, operating income increased 156%, and net income increased 501% year over year. Nine-month revenue increased 29%, operating income increased 125%, and net income increased 180%. Diluted EPS increased 511% in Q3 and 156% for the nine-month period.

Gross-margin expansion primarily reflected the absence of prior-year acquisition-related inventory fair-value step-up costs, which reduced cost of sales by $195.6 million in Q3 2017 and $316.7 million in the first nine months of 2017, together with improved manufacturing efficiencies. Nine-month margin was partially offset by higher amortization of acquired technology and depreciation on acquired fixed-asset fair-value adjustments.

Revenue mix and operating trends

Q3 end markets: Industrial $793.3 million, up 14%; Automotive $246.9 million, up 6%; Consumer $208.6 million, down 17%; Communications $323.9 million, up 27%.
9M end markets: Industrial $2.321 billion, up 43%; Automotive $739.4 million, up 32%; Consumer $646.5 million, down 12%; Communications $897.8 million, up 39%.
Management attributed growth primarily to broad-based demand, the Linear acquisition and, for the nine-month comparison, the additional fiscal week. Consumer weakness reflected lower demand for products used in portable applications.
Q3 R&D expense increased 6% to $291.6 million, while selling, marketing, general and administrative expense decreased 7% to $171.5 million. Nine-month R&D increased 25% to $869.7 million, largely reflecting Linear and higher operating costs.

Cash flow, liquidity and capital structure

Nine-month cash provided by operations was $1.728 billion, compared with $501.9 million in the prior-year period, equal to 37.5% of revenue versus 14.1%.
Investing cash flow was an outflow of $225.0 million, including $168.9 million of capital expenditures and $52.8 million for acquisitions. Prior-year investing outflow was $6.605 billion, primarily due to the Linear acquisition.
Financing cash flow was an outflow of $1.777 billion, including $2.050 billion of debt repayments, $523.9 million of dividends and $41.9 million of share repurchases, partially offset by $743.8 million of debt proceeds.
Cash and cash equivalents were $772.6 million at August 4, 2018, down from $1.048 billion at October 28, 2017. Approximately $369.7 million was held in the United States; the remainder was held by foreign subsidiaries.
Total debt carrying value was approximately $6.6 billion, including $22.5 million classified as current. Principal debt outstanding was $6.6 billion. During the period, the company repaid $1.0 billion on its three-year term loan and $750.0 million on its five-year term loan, and issued $750.0 million of senior notes.
Management stated that cash, expected operating cash flow and available financing should fund operations, capital expenditures, research and development, dividends and other requirements for at least the next twelve months. The $1.0 billion revolving credit facility was undrawn, and debt covenants were satisfied.

Material changes, unusual items and outlook

Tax effects: The nine-month results include a provisional $639.7 million benefit from remeasurement of deferred taxes under the Tax Cuts and Jobs Act and a provisional $687.1 million transition-tax expense on previously untaxed foreign earnings. The Q3 effective tax rate was 5.9%; the nine-month rate was 10.0%. The tax accounting remained subject to further analysis and regulatory guidance.
Restructuring: The company recorded $59.5 million of fiscal 2018 special charges, including $43.4 million related to planned closures and consolidation of the acquired Hillview, California wafer facility and Singapore test facility. The company expects approximately $60 million of annual savings once fully implemented over three to five years.
Revenue recognition: Beginning in fiscal 2019, the company planned to adopt the new revenue standard using full retrospective application. The principal expected change was earlier recognition of sales to certain distributors, with estimated returns and price adjustments recognized at shipment.
Capital allocation: Fiscal 2018 capital expenditures were expected to be $230 million to $270 million. The August 2018 quarterly dividend was maintained at $0.48 per share. On August 21, 2018, the board reinstated the share repurchase program and increased authorization by $2.0 billion to $8.2 billion in aggregate.
No specific revenue or earnings guidance was provided in the filing text. Management indicated that quarterly dividends were expected to continue at $0.48 per share, subject to board approval.

Key risks and contingencies

Integration of Linear may be more difficult, costly or time-consuming than expected, and anticipated synergies may not be realized.
Semiconductor demand is cyclical and sensitive to industrial, communications, automotive and consumer markets, pricing pressure, inventory fluctuations, competition and technological change.
The company relies on third-party wafer foundries, suppliers, assembly and test providers, and transportation providers; capacity constraints, disruptions or quality issues could affect production and shipments.
Substantial acquisition-related debt creates refinancing, interest-rate and debt-service risk. Approximately $2.0 billion of floating-rate debt was outstanding, with approximately $1.0 billion hedged; a 100-basis-point rate increase would affect annual interest expense by approximately $10 million.
International operations expose the company to currency, geopolitical, trade, tariff, export-control, tax and regulatory risks, particularly in China and other Asian markets.
Distributor arrangements involve returns and price-adjustment credits. Gross deferred revenue was $679.9 million at August 4, 2018; materially higher credits or returns could reduce reported revenue and gross margin.
Tax estimates remain provisional, including the transition tax, deferred-tax remeasurement, GILTI accounting, foreign earnings reinvestment assertions and ongoing tax audits.

Facts investors should verify

Whether revenue growth remains broad-based after separating Linear acquisition effects, the extra fiscal week and prior-year inventory fair-value charges.
Progress and realized savings from the Hillview and Singapore facility consolidation, including execution and supply-chain impacts.
Final tax accounting under the Tax Cuts and Jobs Act and the resulting cash-tax obligations and effective tax rate.
Debt repayment pace, floating-rate exposure, covenant compliance and liquidity available for dividends, repurchases and capital expenditures.
The quantified effect of adopting the new revenue standard on distributor revenue timing, deferred revenue and prior-period results.
Trends in Consumer demand, distributor inventory and price-adjustment credits, semiconductor capacity, tariffs and international demand, especially in China.