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By Tom W. Smith, CFA and Amrit Tewary On Apr. 15, Linear Technology (LLTC
) reported earnings for the March quarter that met consensus forecasts. Earnings per share came were 19 cents, vs. 16 cents a year ago. Revenues rose 18% from a year ago, and 6% from the previous quarter, to $153.7 million. Despite difficult economic conditions and an uncertain geopolitical environment, Linear estimated that sales and profits for the June quarter would rise between 5% and 8% from the March quarter.
Like many other semiconductor companies, Linear offered little specific guidance beyond the current quarter. However, we at Standard & Poor's are encouraged by this analog chipmaker's ability to maintain high profit margins and generate positive net operating cash flow in the midst of a cyclical downturn. We think Linear will benefit from a gradual upturn for the overall chip industry that will last through 2005.
Linear (ranked 4 S&P STARS, accumulate) makes a broad line of high-performance standard analog integrated circuits (ICs) that address a wide range of signal-processing applications. Analog (or linear) circuits monitor, condition, amplify, or transform continuous analog signals associated with physical properties such as temperature, pressure, weight, light, sound, or speed -- and are vital to make electronic systems work properly.
PROPRIETARY EDGE. Linear's products include high-speed amplifiers, voltage regulators, data converters, interface circuits, and other linear circuits including buffers, battery monitors, drivers, and filters. They're used in applications in telecommunications, networking, satellite systems, desktop and notebook PCs, computer peripherals, video and multimedia, cell phones, industrial instrumentation, automotive electronics, factory automation, process control, and military and space systems. Linear's high-performance circuits have a high degree of proprietary design content, which helps keep its pricing stable.
In general, companies in the analog circuit market have smaller capital requirements, greater price stability and market diversity, and less competition from Asia than the digital IC segment. Indeed, companies like Linear are typically less cyclical than their nonanalog counterparts and can often better manage their businesses and make profits during downturns.
Linear continues to be highly profitable, with a 39% return on sales for the quarter ended Mar. 30. Return on equity dipped to 11% in fiscal year 2002 (ended June), after holding above 23% for the last decade. Linear has a healthy balance sheet, with no long-term debt. It increased its cash position by about $16 million in the quarter, after spending approximately $39 million to purchase 1.5 million of its common shares. At the end of March, cash and short-term investments totaled about $1.6 billion, or 87% of stockholders' equity.
ON THE RISE. In April, Linear raised its quarterly dividend from 5 cents to 6 cents per share (effective May 14, 2003). In fiscal 2003, it will pay 21 cents per share in dividends, and using our EPS estimate of 74 cents, this translates to a dividend payout ratio of 28%, which is high for a tech company.
Linear's shares have risen nearly 34% this year to a recent price of $34.44. The stock trades at 6.1 times its tangible book value, and its p-e of 42 times our calendar 2003 EPS estimate of 82 cents is higher than the broader market's p-e, but about in line with valuations for comparable chipmakers. Stock-option expenses, as estimated under the SFAS 123 accounting rule, were 20 cents a share in fiscal year 2002, which we view as moderate among its peers.
Given Linear's record of generating positive operating
cash flow during both strong and weak phases of industry cycles, we decided to value Linear shares using a
discounted cash flow analysis. Of the two commonly used models, the free cash flow to the firm (FCFF) model and the dividend discount model (DDM), we decided to use the FCFF approach since it values all of Linear's free cash flows, instead of just the portion paid out as dividends. (We at S&P believe the FCFF approach is more relevant for tech companies such as Linear that use a large portion, if not all, of their free cash flow to reinvest in core operations or buy back shares.)
BEST PROSPECTS. Our two-stage FCFF model includes a high-growth stage and a terminal growth stage. In our 10-year high-growth stage, we forecast free cash flow growth using 5-year semiconductor cycles. We assumed about 25% free cash flow growth in peak years and about 10% growth in trough years. We discounted free cash flows during the growth stage using a discount rate of 12.7%. In our terminal stage, we used a mature discount rate of 10.5% and a stable growth rate of 5.4%. Our model suggests that the intrinsic value for Linear shares is $40 -- about 16% higher than recent levels.
Over the next year, we believe chipmakers in the analog, digital-signal processor (DSP), power-management, and other categories that serve industrial, auto, and consumer markets -- as well as the communication and computing markets -- have the best prospects. We favor Texas Instruments (TXN
) (ranked 5 STARS, buy), which makes DSPs, high- and low-end analog, and a variety of other chips. Analog Devices (ADI
) (ranked 5 STARS, buy) and Maxim Integrated Products (MXIM
) (ranked 3 STARS, hold), which develop high-end analog chips, are also well-positioned for the near term.
Several of these high-end chipmakers have been initiating or raising dividends, proving to investors that they're confident about maintaining profitability and generating positive free cash flows through the ups and downs of market cycles. For instance, Maxim and Microchip Technology (MCHP
) (ranked 4 STARS, accumulate) each initiated a dividend in late 2002, and each raised it in April. We think this trend will likely continue in the long run. Analysts Smith and Tewary follow semiconductor stocks for Standard & Poor's