Can Analog Devices (ADI) Satisfy Investors' Lofty Expectations? - TheStreet

Investors have high expectations for Analog Devices (ADI) - Get Report going into its upcoming earnings report. The semiconductor company is scheduled to report its fiscal third-quarter results before the market open on Wednesday.

With the acquisition of Linear Technology, Analog Devices has become a monster semiconductor supplier. The company competes in every segment of the semi market, including automotive, industrial, consumer, and communications.

The Linear Tech merger expanded the company's total addressable market to $14 billion from $8 billion. The merged company will dominate the data converter and RF/microwave space. In power management, amplifiers and interface semiconductors, Analog Devices is the second-largest provider in the world.

The combined company will have a gross margin of 69% and a 38% operating margin vs. 62% and 23%, respectively, for Intel (INTC) - Get Report . Analog/Linear will also have free-cash flow of $1.7 billion and a free-cash flow margin of 31%.

Management projects a free-cash flow margin of 34% over 12 months, which means Analog/Linear would surpass at least eight other semiconductor makers. The board of directors has focused on returning cash to shareholders, with a long-term target of returning 80% of its free cash flow through dividends and share repurchases.

At the June analyst meeting, management said its consumer segment would post a 20% decline in revenue for fiscal 2018 (fiscal years end in October). Analysts believe Apple (AAPL) - Get Report designed ADI's Force Touch product out of the new iPhone, but management pointed out the Linear deal has already been accretive, adding 15% to earnings, about $1 billion in incremental revenue by fiscal 2019 and will produce $250 million in cost savings by 2022. Those benefits should far outweigh the potential loss of the Apple business. Last quarter, the consumer segment was approximately 21% of total revenue.

Analog Devices' industrial and automotive segments are poised to grow faster. According to management, by 2025, the company will have doubled its semiconductor content in automobiles to $600 per car with the addition of new technologies, such as lidar/radar, and possibly widespread autonomous vehicle adoption.

Industrial markets, such as factory automation and robotics are expected to grow at twice the rate of GDP growth. Last quarter, the industrial and automotive segment accounted for approximately 61% of total revenue.

Analysts are looking for third-quarter revenue of $1.4 billion and earnings of $1.15 per share. For the full year, the consensus sees EPS of $4.37 and revenue of $5.04 billion. Assuming the world economy continues to grow, revenue would be up 12.7% in fiscal 2018 as the combined company begins to experience the full benefits of the Linear Technology merger.

Back in December I thought the company's valuation was pretty low for such a high-quality semiconductor maker. I believe investors will begin to look forward to next year when Analog is expected to earn $4.63 per share. Margins should widen over the next few quarters as Linear's higher levels pull the average corporate margin toward 69%.

If you assume Wall Street EPS estimates for fiscal 2018 are likely to creep up toward $5.00 next year, ADI can trade in the mid-$90s.

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This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.

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