Analog Devices

Analog Devices reported fiscal third-quarter revenue of $4.02 billion, up 40% year over year and above the high end of guidance. ADI expects October-quarter revenue of $4.3 billion, up 40% year over year and above FactSet consensus estimates of $4.08 billion.

Why it matters: ADI is firing on all cylinders with a strong cyclical recovery in industrial end markets and a data center chip business that doubled year on year and looks like it might double again in fiscal 2027. ADI is also passing along price increases to its customers, boosting gross margins even further. ADI’s communications segment, in which data center revenue comprises 80% of revenue, was up 84% year over year, as ADI’s high-performance parts are gaining traction in optical and power applications within artificial intelligence data centers. Adjusted gross margin was 72.5%, up 330 basis points year over year, thanks to higher sales levels and favorable product mix. ADI’s pricing actions and favorable mix and utilization should boost adjusted gross margin to 74% in the fourth quarter and, likely, several quarters thereafter.

The bottom line: We raise our fair value estimate for wide-moat ADI to $445 per share from $380 as we’re optimistic about ADI’s ability to come close to doubling its AI data center revenue in fiscal 2027, while maintaining excellent gross margins. Shares in this high-quality business appear undervalued. Shares were flattish on the earnings report, as we surmise that the market was already anticipating a beat-and-raise quarter. We think ADI’s high-quality analog business is well positioned to prosper in AI, and we’re encouraged with management’s bullish commentary on its AI design wins.

Coming up: ADI didn’t dismiss suggestions on the call that it might grow its revenue by 20% in fiscal 2027 and in the teens thereafter, thanks to booming AI chip demand. Meanwhile, we think ADI is well positioned in robotics and other physical AI applications as they come to market over time.

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Our fair value estimate is $445 per share, which implies fiscal 2026 (ending October) and 2027 price/earnings ratios of 34 times and 26 times, respectively, along with a 2% free cash flow yield.

ADI and its peers faced a chip industry downturn in the middle of calendar 2023, which led to the company generating only 2% growth in fiscal 2023 and a sharp 23% revenue decline in fiscal 2024. ADI saw a nice recovery in fiscal 2025 with 17% growth. We model 37% and 21% growth in fiscal 2026 and fiscal 2027, respectively, not only thanks to this cyclical recovery, but also from structural tailwinds from ADI’s strong position in data centers and automated test equipment. On a longer-term midcycle basis, we project that ADI will generate average annual sales growth of 12%, above management’s prior target of a 7%-10% compound annual growth rate. Our above-guidance estimate stems from ADI’s recent strength in data center products. We also foresee ADI benefiting from increased electronics content in automotive and core industrial products.

ADI provided guidance that investors should expect a 70% floor for adjusted gross margin. ADI fell below this during the trough of the cyclical downturn in demand. But strong growth in recent quarters has brought adjusted gross margin above the 70% floor, and we think ADI will stay above this floor in the long run. We model 73% adjusted gross margin in fiscal 2026 and 74% in each year of our five-year forecast period thereafter.

ADI earned a stellar adjusted operating margin of 49% in fiscal 2022 and fiscal 2023, thanks to higher sales, full internal factory utilization, and a healthy chip pricing environment. During the last downturn, this margin declined to 42% in fiscal 2025. We anticipate a recovery to 49% in fiscal 2026 and 50%-plus in fiscal 2027 and beyond, above the high end of management’s target of 42%-50%.

We believe that ADI has a wide economic moat, thanks to intangible assets around proprietary analog chip design and manufacturing expertise, as well as switching costs that make it difficult to swap out analog chips for competing offerings once they are designed into a given electronic device. We are confident the firm is more likely than not to generate excess returns on capital over the next 20 years.

We believe that leading broad-based chipmakers (which we consider to be those well versed in analog, mixed signal, and microcontroller semis) benefit from favorable characteristics that lend themselves to economic moats. First, we believe that engineering talent (especially in analog) is difficult to come by, as greater emphasis is placed on digital chip improvements, and it often takes years to train up-and-coming analog engineers in the intricacies of chip designs. Thus, it is extremely difficult for startups to replicate the many years of analog expertise held by incumbents. Leading broad-based chipmakers also face stringent quality requirements in some end markets, such as the automotive industry, for example, where defects can only be tolerated as low as one part per million. Although the broad-based chip market is quite fragmented, it would be difficult for any startup to achieve this level of quality while still being to satisfy high volume production.

Furthermore, broad-based semis like analog and MCU parts tend to make up only a small portion of a product's bill of materials, so purchasing decisions tend to be based on performance rather than price, helping firms retain pricing power. A lower quality tolerance might be acceptable in devices with shorter useful lives, such as smartphones, PCs, and consumer gadgets, but moaty chipmakers tend to have limited exposure to these end markets.

Regarding customer switching costs, we believe that engineers are loath to swap out an analog chip from an existing design (again, only to save a few pennies on cost) because of the onerous redesign and retesting costs associated with the switch. One can imagine the frustration and possible reputational damage to a product if a perfectly functioning electric toothbrush or thermostat were to fail because of an unforeseen change in how an analog chip interacts with the rest of the circuit board. Again, such damages would be amplified in far more expensive equipment like cars, planes, and satellites.

In our view, Exhibit A for our switching cost thesis is the global chip shortage of 2021 and 2022. Instead of finding untested suppliers or securing any reasonably performing chip they could get their hands on, automotive and industrial companies halted production of their gadgets until their key chip suppliers could get the proper, reliable, well-tested, well-designed parts into their customers' hands. We did not see any meaningful market share loss during the shortage, as customers again waited to receive the necessary chip, rather than redesign their products to take on a lower-quality chip instead.

In addition to these favorable moat sources, broad-based chips are trailing edge products that don’t require the hefty investments needed by digital processors to move down Moore’s Law. In turn, broad-based chipmakers profit by having lower ongoing research and development and capital expenditure investments, which help contribute to healthy returns on capital for shareholders.

Further, buyers of analog semis typically don't demand smaller chips packed with more transistors, but rather, reliable products that deliver the desired accuracy and precision in power management or signal processing. Shrinking the chip might not necessarily enhance accuracy (and might even serve to reduce it), so analog chips tend to be made with lagging edge manufacturing techniques.

ADI is well positioned as a supplier into data centers and automated test equipment, both of which are booming with the AI infrastructure buildout.

ADI has made shrewd acquisitions in recent years, as Linear Tech and Maxim Integrated have boosted its power management chip business.

ADI is well positioned to profit from the long-term secular trend of increased electronics content in automobiles, such as in-dash infotainment displays and safety sensors.

Despite its strong position and diverse exposure, ADI is still vulnerable to the cyclicality of the overall semiconductor industry.

If US-China trade tensions continue, customers in China may gravitate to analog parts made by ADI’s neutral Europe-based rivals or Chinese domestic analog suppliers.

ADI has especially strong exposure to the communications infrastructure end market, and spending by telecom makers on advanced networks has been notoriously lumpy.