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This Chip Stock Pays a Nice Dividend, but Should You Buy?

By Harsh Chauhan – Apr 28, 2020 at 7:27AM

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A dividend hike makes semiconductor stock Analog Devices seem attractive.

Analog Devices (ADI 0.70%) management seemed confident of the company's ability to withstand the novel coronavirus-related uncertainties a couple of months ago. It also sweetened its dividend with a hike of 15%.

But Analog pulled its fiscal second-quarter guidance toward the end of March, citing supply chain disruptions and an uncertain demand environment caused by the COVID-19 outbreak. Despite that, the broader stock market rally has lifted the company's shares, making Analog Devices stock relatively expensive considering that its business was facing quite a few headwinds even before the pandemic started shutting the economy down.

ADI Chart

ADI data by YCharts

Not a great time to buy

Analog stock currently trades at a price-to-earnings (P/E ratio) of 32, which tops the five-year average multiple of 30. It may not be a great idea to buy the stock at its current valuation because, according to the company's last guidance numbers, its top line was supposed to drop 12% in the second quarter.

What's more, Analog's revenue in the fiscal first quarter that ended in February was down 15% year over year. The withdrawn guidance suggests that the economic impact of the novel coronavirus outbreak may deal a bigger blow to the chipmaker in the current quarter.

Money kept inside a trap.

Image Source: Getty Images

So don't be surprised to see Analog investors hitting the panic button when the company releases its quarterly results on May 20.

Another problem with Analog Devices is that the company's balance sheet doesn't appear to be solid enough. Its debt of nearly $6 billion easily exceeds the total cash position of $654 million, while free cash flow has been heading south over the past year.

ADI Free Cash Flow Chart

ADI Free Cash Flow data by YCharts

This means that Analog's free cash flow generation could keep going south in the coming quarters if the decline in its top and bottom lines accelerates.

That won't bode well for the company's dividend. Analog management pointed out over the last earnings conference call that the company returned "more than 100% of our free cash flow to shareholders through dividends and buybacks after debt repayments." In the first quarter, the chipmaker had bought back $106 million worth of shares and paid out $200 million in dividends.

For the full year, Analog expects to pay down between $300 million and $500 million in debt. The company will now have to think of using its cash more wisely, as the economic fallout of COVID-19 could squeeze its financials.

Analog's interest expense in fiscal 2019 stood at $229 million, and it repaid $850 million in debt. Its dividend payments for the full year came in at $777.5 million, and the company had bought back $613 million worth of its stock. Analog was able to meet these commitments thanks to nearly $2 billion in free cash flow that it generated during fiscal 2019.

Buoyed by last year's impressive cash flow performance, Analog hiked its quarterly dividend substantially in February this year, sending its forward dividend yield to an impressive 2.44%. So Analog may have to cut a few corners this year with respect to debt reduction and share repurchases if the cash flow performance takes a substantial hit. If Analog is unable to meet its debt reduction target, its interest expenses will be higher than what the company was originally expecting. Similarly, a slowdown in share repurchases means that its earnings per share won't be getting the boost that the company was aiming for.

All in all, it doesn't make sense to buy Analog Devices at current levels.

Is there a silver lining for Analog Devices?

Analog Devices management struck a confident tone back in February, even though the novel coronavirus-related headwinds were threatening. According to CFO Prashanth Mahendra-Rajah:

In the first quarter, we saw signs of stabilization as we expected. Orders trended better throughout the quarter and have overall remained relatively resilient into the second quarter.

However, Analog Devices gets nearly half of its revenue from the communications, automotive, and consumer businesses. The bad news is that all these businesses witnessed steep double-digit annual declines, ranging from as low as 16% to 31% in the first quarter. The industrial business, which supplies 53% of the total revenue, was the only bright spot with a relatively smaller decline of 7%.

The bad news for Analog Devices is that the auto, communications, and consumer businesses will continue to face headwinds on account of COVID-19. Auto sales, for instance, are already taking a big hit, while the deployment of 5G networks is also expected to run into delays. Demand for consumer electronics devices such as smartphones has collapsed as well.

A turnaround at Analog Devices looks unlikely amid all these challenges, making this dividend stock a risky bet given its relatively expensive valuation and a not-so-great balance sheet.

Harsh Chauhan has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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