ANALOG DEVICES INC quarterly report, Q3 FY2019

Analog Devices, Inc. Form 10-Q Summary

Business context and reporting period

Analog Devices designs, develops, manufactures and markets mixed-signal integrated circuits. The company reports one operating segment serving Industrial, Automotive, Consumer and Communications end markets. This filing covers the three and nine months ended August 3, 2019, within fiscal 2019, a 52-week year. The comparable fiscal 2018 period included one additional week in the first nine months. Prior-period amounts were restated for the full retrospective adoption of ASC 606 revenue recognition.

Financial performance and key metrics

Metric	Q3 FY2019	Q3 FY2018	9M FY2019	9M FY2018
Revenue	$1.480 billion	$1.558 billion	$4.548 billion	$4.689 billion
Gross margin	67.4%	68.1%	67.5%	68.3%
Operating income	$446.7 million	$489.0 million	$1.372 billion	$1.433 billion
Operating margin	30.2%	31.4%	30.2%	30.6%
Net income	$362.4 million	$408.6 million	$1.085 billion	$1.102 billion
Diluted EPS	$0.97	$1.08	$2.90	$2.93
Effective tax rate	7.0%	5.1%	9.4%	11.5%

Q3 revenue declined 5%, gross margin declined 70 basis points, operating income declined 9%, net income declined 11% and diluted EPS declined 10%. Nine-month revenue declined 3%, while net income declined 2% and diluted EPS declined 1%.

Revenue by end market in Q3 was Industrial $752.5 million, Automotive $227.8 million, Consumer $183.4 million and Communications $316.5 million. Communications increased 7% year over year, while Industrial declined 4%, Automotive declined 9% and Consumer declined 18%. For the first nine months, Communications revenue increased 23%; Industrial, Automotive and Consumer declined 5%, 8% and 21%, respectively.

Management attributed the gross-margin decline primarily to lower utilization of internal wafer fabrication facilities. Research and development expense declined 4% in Q3 and 2% for the first nine months, while selling, marketing, general and administrative expense declined 5% for both periods.

Cash flow, liquidity and capital structure

Cash provided by operating activities was $1.595 billion for the first nine months, compared with $1.728 billion in the prior-year period. Operating cash flow was 35.1% of revenue versus 36.9%.
Capital expenditures were $224.3 million, compared with $168.9 million in the prior-year period. Management expected full-year fiscal 2019 capital expenditures to be approximately 5% of revenue.
Cash and cash equivalents were $612.2 million at August 3, 2019, including approximately $262.6 million held in the United States. Management stated that liquidity, expected operating cash flow and available financing should fund operations, capital expenditures, research and development, and dividends for at least the next twelve months.
Total debt principal was $5.725 billion, including $1.125 billion under a new unsecured term loan due March 2022 and $4.6 billion of senior unsecured notes. Current debt was $411.4 million and long-term debt was $5.279 billion.
On June 28, 2019, the company entered into a $1.25 billion unsecured revolving credit facility maturing in 2024; no borrowings were outstanding under that facility at August 3, 2019.
The term-loan agreement requires a trailing-twelve-month consolidated leverage ratio of no greater than 4.0 to 1.0, reducing to 3.5 to 1.0 beginning in fiscal 2020 if no significant acquisition or similar transaction occurs. The company reported compliance with its debt covenants.
Inventories increased 9% from fiscal year-end to $638.3 million, and days of inventory increased to 118 from 107. Accounts receivable increased 8% to $690.0 million.
The company paid $577.3 million in dividends and repurchased $440.6 million of common stock during the first nine months. Approximately $2.2 billion remained available under the repurchase authorization at August 3, 2019.

Material changes, outlook and unusual items

Revenue recognition changed under ASC 606: distributor sales are generally recognized when title transfers, typically upon shipment, with estimates for returns, stock rotation and price protection. Historical periods were restated.
The company adopted ASU 2016-16 for intra-entity asset transfers, increasing retained earnings by $331.0 million and increasing deferred tax assets and liabilities by approximately $1.7 billion and $1.3 billion, respectively.
Fiscal 2019 included $30.9 million of special charges through Q3, compared with $59.5 million in the comparable prior-year period. Charges included workforce repositioning and the planned consolidation of Linear Technology facilities, including the planned closure of a Hillview wafer fabrication facility and a Singapore test facility over one to three years.
The company recorded a $17.2 million tax benefit from a foreign subsidiary accounting policy change and an $11.2 million tax benefit from increased tax credits in Q3. The nine-month tax rate also benefited from a $5.1 million GILTI-related deferred tax benefit and a $7.5 million transition-tax benefit.
The company entered into an interest-rate swap related to up to $1.0 billion of future debt issuance. The swap had a fair value liability of $121.8 million at August 3, 2019. Floating-rate debt exposure was approximately $1.1 billion; a 100-basis-point rate increase would affect annual interest expense by approximately $11.3 million.
Management declared a subsequent quarterly dividend of $0.54 per share, expected to total approximately $199.5 million, and stated that quarterly dividends were currently expected to continue at $0.54 per share subject to board approval.

Risks and contingencies

Semiconductor demand is cyclical and the company cited weaker demand in automation, memory test, automotive and portable consumer applications. Forecast errors, order cancellations, excess inventory and manufacturing underutilization could pressure revenue and margins.
International operations expose the company to trade restrictions, tariffs, export controls, currency movements, geopolitical conditions and economic weakness, particularly involving China.
The company relies on third-party foundries, suppliers, assembly and test providers, and transportation providers, while also depending on internal facilities that are being consolidated. Disruptions could delay shipments and reduce capacity.
The company faces substantial debt-service obligations and financial covenants. Failure to generate sufficient cash flow or comply with covenants could restrict financing flexibility or accelerate repayment obligations.
An Irish Revenue assessment related to fiscal 2013 transfer pricing was approximately €43.0 million, or $47.8 million at August 3, 2019, excluding penalties and interest. The company disputes the assessment and has not accrued an additional liability. An unfavorable outcome, including effects on subsequent years, could materially affect future tax expense and earnings.
Distributor revenue estimates depend on judgments regarding price protection, returns and stock rotation. Changes in those estimates could adversely affect future revenue and gross profit.
Management identified no material change in internal control over financial reporting and concluded that disclosure controls were effective as of August 3, 2019.

Important facts for investors to verify

Whether Communications growth offsets continued weakness in Industrial, Automotive and Consumer markets.
Progress in restoring internal manufacturing utilization and the effect of facility closures on capacity, costs and gross margin.
Inventory levels, days of inventory and distributor-related credits, returns and stock rotation estimates.
Debt maturities, floating-rate exposure and compliance with the leverage covenant as it tightens in fiscal 2020.
The outcome and potential broader exposure from the Irish transfer-pricing assessment and related audits.
Whether operating cash flow can sustain capital expenditures, dividends, share repurchases and debt service while cash held outside the United States remains substantially reinvested.