Business Context and Reporting Period
Analog Devices, Inc. designs, develops, manufactures and markets integrated circuits, reported as one operating segment. This Form 10-Q covers the three and six months ended May 5, 2012, compared with April 30, 2011. Fiscal 2012 is a 53-week year, so the first six months included one additional week versus the prior-year period. Results exclude the discontinued Baseband Chipset Business.
Financial Performance and Position
| Metric | Three Months Ended May 5, 2012 | Year-over-Year Change | Six Months Ended May 5, 2012 | Year-over-Year Change |
|---|---|---|---|---|
| Revenue | $675.1 million | Down 15% | $1.323 billion | Down 13% |
| Gross margin | 65.2% | Down 240 bps | 64.2% | Down 270 bps |
| Operating income | $212.9 million | Down 29% | $396.3 million | Down 29% |
| Operating margin | 31.5% | Down 620 bps | 30.0% | Down 670 bps |
| Net income from continuing operations | $162.9 million | Down 33% | $302.3 million | Down 34% |
| Diluted EPS from continuing operations | $0.53 | Down $0.25 | $0.99 | Down $0.49 |
Operating expenses declined modestly: research and development decreased 2% in the quarter and 1% year to date, while selling, marketing, general and administrative expense decreased 5% and 3%, respectively. The six-month period included a $2.6 million restructuring charge. The effective tax rate was 23.0% for the quarter and 22.8% year to date, versus 18.5% and 17.7% in the prior-year periods.
Six-month operating cash flow was $440.8 million, or approximately 33.3% of revenue, up 7% from the prior year. Investing activities used $950.7 million, primarily reflecting net purchases of short-term investments. Financing activities used $199.0 million, including $163.8 million of dividends, $122.4 million of share repurchases and $19.3 million of term-loan repayments.
At May 5, 2012, cash and cash equivalents were $695.1 million and short-term investments were $3.058 billion, totaling $3.753 billion of liquidity. Approximately $1.086 billion was held in the United States; a substantial portion of the remainder was held by foreign subsidiaries and intended to be reinvested indefinitely. Total debt was $862.5 million, consisting of $750 million of senior unsecured notes and a $145 million term loan, net of applicable carrying adjustments. The company had not borrowed under its $165 million revolving credit facility and was compliant with applicable debt and credit-facility covenants.
Inventory was $303.7 million, up 3% from October 29, 2011, while days of inventory increased to 118 from 105. Deferred income on distributor shipments increased $10.9 million during the first six months, indicating shipments to distributors exceeded their customer sell-through.
Material Changes Versus the Prior Comparable Period
- Revenue declined broadly because customers reduced inventories after the prior-year build-up associated with Japan earthquake and tsunami supply concerns. Management also cited the European debt crisis and broader global financial uncertainty.
- Quarterly end-market revenue decreased 16% in industrial, 20% in consumer and 22% in communications, while automotive revenue increased 10%. Year-to-date changes were industrial down 16%, consumer down 20%, communications down 20% and automotive up 18%.
- Gross margin contracted because of lower manufacturing utilization and a less favorable mix, including lower sales into higher-margin industrial automation, instrumentation and wireless-base-station applications.
- The federal research and development tax credit and favorable discrete tax items benefited the prior-year period but were largely unavailable in the current period, increasing the effective tax rate.
- The company acquired Multigig on March 30, 2012 for approximately $26.8 million of total consideration, including $24.2 million paid at closing and a $2.6 million holdback. The acquisition added $7.0 million of goodwill and $15.6 million of in-process research and development.
- The company terminated the interest-rate swap related to its $375 million 5.0% notes, received $19.8 million of proceeds including accrued interest, and eliminated the swap-related interest-rate exposure.
Guidance, Outlook, Commentary and Risks
Management planned third-quarter fiscal 2012 revenue to increase approximately 1% to 4% from second-quarter revenue, gross margin to improve by approximately 50 basis points, operating expenses to be approximately $231 million, and diluted EPS from continuing operations to range from $0.54 to $0.58. Management expected an effective tax rate of approximately 22.4%, excluding discrete items, for the remainder of fiscal 2012. Fiscal-year capital expenditures were expected to be approximately $140 million.
Management attributed the downturn to broad-based demand weakness, customer inventory reductions, European financial uncertainty, and production limitations related to Thailand flooding. The company stated that its variable cost structure and expense-management actions helped mitigate the impact.
- Principal risks include semiconductor cyclicality, uncertain customer demand, order cancellations, inventory obsolescence, pricing pressure, manufacturing underutilization and reliance on third-party wafer foundries and subcontractors.
- International operations expose the company to currency, geopolitical, regulatory, tax, credit and supply-chain risks. More than 70% of revenue was derived from international markets.
- Distributor arrangements involve price-adjustment credits and product returns. Significant increases in credits could materially affect revenue and gross margin.
- Cash held outside the United States may not be readily available for U.S. dividends, repurchases or other requirements without potential additional taxes.
- The company disclosed a potential $36.5 million tax liability related to an IRS Section 965 matter but stated that it believed an additional liability was unlikely and had not accrued one.
- Contingent consideration related to the Lyric acquisition was approximately $12.3 million at May 5, 2012, with payments dependent on achievement of defined milestones.
Investor Verification Items
- Verify whether the projected third-quarter revenue growth, 50-basis-point gross-margin improvement and $0.54-$0.58 EPS range were achieved.
- Monitor industrial, communications and consumer demand, distributor sell-through and the $244.2 million net deferred-income balance.
- Assess inventory levels, utilization and gross-margin recovery as demand conditions change.
- Review the timing and funding sources for the $450.6 million of debt principal payments scheduled for fiscal 2014 and the $375 million due in fiscal 2016.
- Track the availability and geographic location of cash, particularly the $1.086 billion held in the United States versus funds held overseas.
- Evaluate the potential effect of tax audits, discrete tax items, the pending Section 965 matter and the expiration of tax credits.
- Assess integration and development progress for Multigig and the remaining contingent consideration and royalty obligations associated with acquisitions.