Thursday, August 13, 2009

Analog Devices - Stock Analysis for Dividend Growth Portfolio

Analog Devices, Inc. engages in the design, manufacture, and marketing of analog, mixed-signal, and digital signal processing integrated circuits used in industrial, communication, computer, and consumer applications. Its products are used in communications applications that include wireless handsets and wireless base stations, as well as products used for high-speed access to the Internet, including central office networking equipment.

ADI is not a dividend achiever and has started paying dividends since last 5 years only. The most recent dividend increase was in May 2008. I am impressed by ADI’s strong balance sheet and free cash flow. My objective here is to analyze if ADI has any potential to be a good dividend growth stock and how does it rate on my scale of risk-to-dividends.

Trend Analysis
Here I am looking at trends for past 10 years of corporation’s revenue and profitability. These parameters should show consistently growth trends. The trend charts and data summary are shown in images below.

  • Revenue: In general, a flat trend since 2000. The average revenue growth for last 10 years has been approximately 9%. Year 2001 and 2002 shows the significant dip which was the aftermath of the tech bubble. It may be intriguing that while revenue seems flat where is growth coming from? This is because, when we remove discontinued or sold business units, there is revenue growth from the existing business.
  • Cash Flows: Overall, stable to increasing trend for free cash flow and operating cash flow. It is good indicator that FCF is almost always greater than income.
  • EPS from continuing operation: In general, it has an increasing trend since 2002.
  • Dividends per share: Increasing trend since its start in 2003.

Risk Parameter Calculation
Here I use the corporation’s financial health to assign a risk number for measuring risk-to-dividends. The risk number for risk-to-dividends is 2.0. This is a medium risk category as per my 3-point risk scale. The increased payout factor and sluggish EPS growth rate (relative to its historical average) makes it a medium risk to dividends.


Quality of Dividends
This section measures the dividend growth rate, duration of growth, consistency over a period of past five years.

  • Dividend growth rate: The average dividend growth of 50% (stdev. 26%) is completely different that average EPS growth rate of 19.4% (stdev. 98%). The dividends growth rate is not supported by EPS growth rate indicating that it is going to slow down.
  • Duration of dividend growth: 5 years.
  • 4 year rolling dividend growth rate for past ten years: Not enough history.
  • Payout factor: In the past 5 years, it has been lower than 50%. This is another indicator that dividend growth is less likely or it does increase it will be high risk.
  • Dividend cash flow vs. income from MMA: Here, I analyze how the dividend cash flow stacks up against the income from FDIC insured money market account. The baseline assumption is (a) stock is yielding 2.93%; and (b) MMA yield is 3.4%. Last 5 years average dividend growth rate has been 50% which is unrealistic. My projected dividend growth rate is 6%. With my projected dividend growth of 6%, the dividend cash flow is 1.08 times the MMA income in 10 years time period. For dividend cash flow to be twice the MMA income, the pricing has to be $15.00 (i.e. yield 5.33%)

Fair Value Calculation

This section determines what price I should pay to buy a given stock
  • Net present value (NPV) price based on 15 year DCF: $14.1
  • Average high yield price calculated based on past 10 years: $42.5
  • Pricing based on past 10 year relative price-to-earnings ratio. $30.5
  • Pricing based on price-to-earnings ratio of 12: $19.0
  • Graham number: $16.3

The range of fair value is calculated as $18.6 to $24.5. I determined by taking average (for high value) of above five parameters and then subtracting it with half the standard deviation (for low value).

Qualitative Analysis
Analog Devices, Inc., is about 43 year old technology based company. It is built on the foundation of innovation by its founder Ray Stata who is still associated with the company. It has survived all the ups and downs of technology industry. One aspect that I like is its ability to command 50% gross margins on its products.

  • ADI’s revenue is pretty diversified in few different product sectors and geographical region. Close to half of its revenue comes from outside of North America. Overall, it has about 10000 products (including derivatives). Its major market sector is industrial electronics and hence is poised to grow with continued industrialization of emerging markets.
  • It has a very strong balance sheet with practically no debt and sustained free cash flow. Even in this recessionary market, it is able to command 50%+ gross margin on its products.
  • Its key strength is core competency in high performance analog chips. These are the chips that convert real world analog signals into digital signals which are further processed for clarity. Every electronics product in the market today will have some form of data converter. ADI has more than 60% worldwide market share in data converters. Its products have more than 8 years of life cycle.
  • One significant concern that I have is; being in lucrative market segment, it is likely that it may face increasing competition. Even Texas Instruments has regrouped to focus of higher performance analog market segment.
  • I believe it will remain highly profitable company, but with slower growth in revenue.
  • With respect to dividends, I believe ADI has sufficient financial muscle to continue its dividends and sustain mid single digit growth. However, I would be wary of managements’ dividend strategy. It does not have a long history of dividends.

Conclusion
I like ADI’s diversified revenue stream and geographical presence. Overall, it is a US based company that will provide hedge against dollar fluctuation and proxy for foreign developed/emerging markets. It truly has a very strong balance sheet that includes free cash flow and practically zero debt. I also like the fact that company continues to remain focused on its core competency which gives it higher gross margin products. I stop short of starting any position because of (1) my concern whether management will continue its dividend policy; (2) changing competitive landscape with more competitors joining in, which was not the case earlier; and (3) current pricing is higher than my fair value range. I would be willing to take dividend risk provided I get an opportunity to buy at lower end of my fair value range.


Full Disclosure: No position at the time of writing.


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1 comment:

  1. I just found this article that you guys may find interesting as it pertains to dividends:

    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1400371

    ReplyDelete

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