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Analog Devices Is Turning Around, But Investors Shouldn't Jump the Gun

By Harsh Chauhan - Sep 4, 2020 at 9:45AM

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The chipmaker delivered decent results but uncertainty persists.

Analog Devices (ADI -3.67%) has been navigating through challenging times this year. The chipmaker's business has taken a hit on account of cyclical weakness in the semiconductor space and headwinds brought about by the coronavirus pandemic.

But Analog's third-quarter results for fiscal 2020 indicate that things are getting better. The company has managed to arrest the slide in its revenue, and its guidance for the current quarter indicates that a turnaround could be in the cards.

The company's quarterly revenue of $1.45 billion was 2% lower than the prior-year period, a big improvement over the double-digit declines it has been witnessing of late. Analog's top-line performance is expected to remain flat year over year in the current quarter if it hits its revenue guidance of $1.44 billion. But it may not be a good idea to buy into Analog's potential turnaround just yet.

Representation of an integrated circuit.

Image source: Getty Images.

Analog Devices stock remains overvalued

With a trailing price-to-earnings (P/E) ratio of nearly 40, Analog Devices is not cheap considering that its revenue and earnings have been heading south for more than a year. Investors have bid the stock up despite a tepid performance, in anticipation that the company could take advantage of the 5G wireless network rollout.

ADI Revenue (TTM) Chart

ADI Revenue (TTM) data by YCharts

That has not been the case so far due to the weak demand for Analog's chips. For instance, the automotive business has been Analog's Achilles Heel of late as the COVID-19 crisis has thrown the industry out of gear. The segment accounted for 11% of Analog's top line last quarter, but it saw a massive annual revenue drop of 29% as vehicle sales remained weak and production was hampered by factory shutdowns across the world.

The quarter-over-quarter decline, however, was much smaller at 11% as the company saw an uptick in demand for some automotive applications. Analog now anticipates "strong growth" in the automotive business this quarter, but investors should wait for the company to walk the talk. The automotive industry is facing uncertainty on account of the economic fallout of the COVID-19 crisis and sales are expected to drop 20% this year, according to Moody's.

A recovery is expected in 2021, so Analog may have to face a few more quarters of pain in this segment.

Similarly, Analog's consumer business, which accounts for 11% of revenue, isn't in great shape either. Consumer revenue was down 13% annually last quarter thanks to soft end-market demand because of the pandemic. Analog supplies chips for digital cameras, smartphones, and audio products through this segment. The company anticipates this business to hit bottom this year, indicating that a recovery may be possible only in 2021.

A mixed road ahead for the industrial and communications businesses

The industrial business is Analog's largest segment by revenue. It accounts for 53% of the top line and has held steady of late. The company's industrial revenue was up 3% year over year last quarter, but it was not firing on all cylinders. CFO Prashanth Mahendra-Rajah pointed this out on the latest earnings conference call: "We experienced robust growth in healthcare, instrumentation test, and energy applications. This strength was moderated by weaker trends across our broad market and automation businesses."

Analog management also added that it is now witnessing good momentum in markets such as factory automation and aerospace. But it would be wise for investors to wait on the sidelines, as Analog needs to do better than low-single-digit growth in its largest business segment to justify its rich valuation.

Another point of concern is the anticipated slowdown in the communications business that accounts for a quarter of the company's total revenue. The segment recorded 14% year-over-year growth last quarter as demand increased thanks to 5G deployments and an increase in demand for optical transport from telecom carriers and data centers.

But the company has tempered expectations for the communications business in the current quarter. It says that a "slowdown in deployment" will hurt communications revenue this quarter and offset the growth recorded in the industrial and automotive segments.

In all, it can be said that Analog Devices is giving out mixed signals right now. So it would be prudent for investors to wait for the actual recovery to begin before committing to this semiconductor stock, given its expensive valuation.

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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