During our third quarter portfolio update, we profiled portfolio holding, Analog Devices, Inc. (ADI). Below is a replay of our live commentary on the company from our quarterly portfolio update WEBINAR and an excerpt from our QUARTERLY LETTER.

Analog Devices: Analog Devices, known in the industry as ADI, makes semiconductor chips that predominantly operate at the boundary of the physical world and the digital world, more commonly referred to as analog and mixed signal chips. These chips usually play a supporting role to the sexier “digital brain” that is the latest and greatest processor from Nvidia, Intel, AMD, Apple, or Qualcomm. While the digital brains get a lot more media attention, the supporting analog chips are as vital as those big expensive digital processors in driving value in electronic devices, which are becoming ubiquitous and intelligent throughout our lives.

Anything with an on-off switch requires lots of these analog chips if it is going to relay input and output information with the physical world as well as manage the electrical power supply feeding the device. While these analog chips are relatively inexpensive to manufacture and distribute, it takes a long time to design and build a catalog of literally thousands of specific products to create the scale that makes them economically attractive businesses with a reputation of dependability and quality.

What’s unique about this class of chips is that companies making them do not need to make the huge investment bets that digital chips require in both R&D and manufacturing to stay ahead on the Moore’s Law performance treadmill. Analog chips usually use manufacturing equipment that’s several years or even decades old, which are much cheaper to buy than the latest and greatest that digital chips require.

 

In addition, consolidation has reduced the number of players in the semiconductor industry to a few big players globally and just a handful in the US, with analog chipmakers demonstrating a focus on strong returns on invested capital, high levels of free cashflow, and good competitive advantages built on scale, reputation, and a cornered talent resource of specialized analog engineers that we’ll explore further.

To understand why we believe ADI is both different and valuable, we have to delve a little bit into the technicalities of semiconductors. While we think of chips as “thinking” in ones and zeros, the real world does not operate on ones and zeros. The forces in the physical world have more of a continuous analog waveform that is not binary – examples of these are light color and brightness, sound frequency and volume, pressure, temperature, etc.

Mixed-signal chips will take those continuous signals and transform them into digital data that digital processors and memory chips can understand. Then the digital chips can operate on that data to compute new information or activate an output signal, which are translated back for consumption in the physical world by a mixed signal chip. Analog chips perform a similar role, but usually in the realm of power regulation and communication. Analog and mixed signal chips are often made by the same companies and sometimes referred to interchangeably.

As technology has broadly penetrated our world and everyday lives, semiconductors have also done the same as the underlying hardware substrate. Moore’s Law has allowed their capabilities to grow, and their cost and energy consumption to fall at an exponential rate, which has driven their adoption and use in a broad range of applications in all industries, bringing us to where we stand today, on the verge of ubiquitous connected intelligence.

As devices are able to do more and become more intelligent, their semiconductor content has increased, relying on more sensors, power management, and communications capabilities. These devices and systems are dispersed throughout our lives… from smartphones to computers, cars, planes, microwaves, ultrasound machines, HVAC systems, cellular radio towers, data centers, factories, etc. Given their role, it’s important to recognize that the more powerful and capable the main digital processor is, the more data it needs to bring new applications and value to market.

A lot of these applications also leverage connected devices – think your smart bulbs or fridge or cars – and all of these applications that can do more, generally require more analog chips to do the “sensing” that creates the data that feeds the application or main processor. In the case of the latest cars, those with adaptive cruise control, fancy smart LED lights, and electric vehicles – which are basically getting close to becoming computers on wheels – the number of chips required is multiples that of vehicles just a few years ago and is 10-100x as many as traditional products we think of as technology products like iPhones, PCs, and game consoles.

Therefore, we believe that the analog segment of the semiconductor market can see faster growth ahead, but without the risk and high levels of ongoing cash reinvestment necessary for the sexy digital brain part of the industry. In analog, the pace of technological change is slower and product cycles are much longer, spanning decades in many cases. This results in sustainably higher returns on R&D and manufacturing investments, along with more consistent secular forecastability. In addition, the markets they sell into are global and across all industries making them relatively less dependent on one or two end markets, like smartphones or the data center.

Companies like ADI and Texas Instruments (which the industry refers to as TI), two of the largest analog companies, have built broad portfolios of tens of thousands of products, each with over a hundred thousand customers who make millions of products that sell billions of units. The product needs and lifecycles across all industries can vary from a year to decades, which is why ADI derives half of its revenue from products that are over ten years old! Historically, the prices of these chips have ranged from less than a dollar to a few dollars while volumes in the billions of chips result in $10-20 billion dollars of revenue for each of these companies at operating profit margins of 30-50%.

Once these chips are designed into customer products, it is generally uneconomical to switch them out for a competing chip because the average selling price is so low relative to reengineering costs, especially when you consider software that is built on top of the designed in hardware. This makes ADI’s products sticky once they are designed in, resulting in a competitive moat that spans across the scale of products and distribution, switching costs, and service capability.

Another source of competitive advantage and value to customers is that unlike digital chip design, there is a lot of “art” or experience-based know-how that goes into analog and mixed signal chip engineering that deals with its own unique set of design challenges. This results in an engineering talent pool that is hard to replicate at new companies or even at customers’ product design teams. Consolidation in the industry has meant that these resources are even more concentrated at the largest companies, which enable them to drive further efficiencies in product development.

Taken together, in most end markets outside of consumer electronics, all of these factors make it hard for a new entrant to build enough scale in any timeframe under a decade to become a profitable competitor.

While consolidation has mostly played out in the industry, increasing complexity, automation, and integration create other avenues to grow revenue and margins, one that ADI has been particularly focused on with the diversity of functional chips it has in its catalog of nearly 80,000 chips. Customers are coming to rely more and more on buying complete solutions from ADI, which is becoming more of a solutions partner rather than just a chip components vendor. This allows ADI to get closer to its customers’ engineering teams and help design and build subsystems comprised of multiple chips that its own engineers have integrated to perform complete functions. Historically, engineers at the customers’ design centers would be buying chips from multiple companies and integrating them onto system boards themselves.

Delivering more complete solutions has enabled ADI to increase its average selling prices and build a higher margin business over time, while also providing further protection from competition and deleterious price pressure effects in the future during more economically challenging times.

Examples of this are battery management and infotainment systems in autos, 5G cellular radio infrastructure, digital systems in healthcare instruments, and smart factories. ADI has targeted and successfully built systems level businesses in these high growth industries.

Based on what industry leaders like ADI and TI are saying and our own broader understanding of trends in various industries, including auto, energy, communications, industrial, and healthcare, it appears that trends in this part of the semiconductor industry is at an inflection point of acceleration. Whereas historically organic growth has trended in the mid-single digits, the next few years are forecasted to grow closer to 10%+ per year.  In fact, these companies are so confident in that forecast based on customer conversations that they are allocating billions more in capital to build out new manufacturing capacity to meet the demand.

In the meantime, valuation multiples in this area are reasonably cheap since the semiconductor industry, outside of booming AI related names, has been undergoing an inventory correction as a result of rebalancing from the COVID disruption years. We believe we are at the latter part of the cyclical adjustment that fluctuates around an accelerating secular trend.

The future is bright for analog leaders like ADI and TI, although they are pursuing that opportunity with different business strategies that lead us to currently prefer ADI over TI. However, we believe both could be winners at different stages as the industry evolves to capture the growth opportunity ahead.

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