Linear Technology (LLTC): Nearing Dividend Aristocrat Status

LLTC is a high quality dividend growth stock that will likely become a dividend aristocrat by 2019. Despite being a technology company, its business model has proven to be extremely durable and throws off substantial free cash flow. We believe these favorable characteristics will persist and continue to reward shareholders for years to come.

 

LLTC’s presence in industrial (40%+ of sales) and automotive (20%+) markets positions it to benefit over the next 10+ years as objects become smarter and more connected, demanding more of LLTC’s products. While the stock doesn’t appear to be a bargain today, it does appear to be a wonderful company trading at a reasonable price. Therefore, we added it to our Top 20 Dividend Stocks portfolio this past summer.

 

Business Overview

LLTC was founded in 1981 and manufacturers analog semiconductor chips. These chips are used in virtually every electronics product to monitor, amplify, condition, transform, or regulate signals found in the real world such as temperature, pressure, light, weight, and sound. They are also needed to provide voltage regulation and manage power usage.

 

Not surprisingly, LLTC’s products span a wide variety of applications, including automotive electronics, factory automation, process control, industrial instrumentation, networking products, medical devices, cellphones, computers, military systems, and more. By end market, LLTC has reduced its exposure to lower-margin, more volatile consumer and cell phone markets over the last decade and now derives 44% of sales from industrial, 20% from automotive, 18% from communications, 9% from computer, 6% from military, and 3% from consumer.

 

Some of the company’s principal product categories are amplifiers (augment the voltage of a device), data converters (change analog signals into digital signals), voltage regulators (control the voltage of a device at a specific level), interface circuits (act as intermediaries to transfer signals within electronic systems), and battery management (monitor the voltage on individual battery cells that are connected in series – electric and hybrid vehicles are a popular application).

 

Precision, reliability, and speed are some of the most important factors demanded by customers across each product category. Industrial process plants such as oil refineries and pulp mills represent some of the harshest environments for electronics, but they need accurate temperature, pressure, and vibration readings across many hard to access places.

 

Many industrial and medical applications require complicated processing of real world signals as well and need to know extremely precise temperature levels. The automotive market also has demanding needs. Cars must be protected against overvoltage conditions and be able to withstand power surges to continue operating reliably.

 

LLTC targets the high performance segment of the analog market, tackling the most difficult challenges. As more objects become smarter and more connected, demand for analog chips and LLTC’s expertise should continue to grow.

 

Business Analysis

When LLTC went into business in 1981, the analog chip market was around $2 billion in size. By 2014, the market had grown to $44 billion, according to Texas Instruments. Unlike other semiconductor markets, the analog market is highly fragmented. Texas Instruments is the biggest player with 18% market share, and LLTC has less than 4% share.

 

In our opinion, the analog chip market is one of the few attractive areas within the technology hardware industry. Its pace of change is much slower because the chips that get designed into many applications must live for a long period of time. The chips used in industrial and automotive markets have long life cycles lasting for years compared with the rapid turnover in consumer devices such as smartphones. Importantly, the process technologies and assets used to produce these chips have long life spans, translating into higher returns on LLTC’s capital investments and R&D spending.

 

Price erosion and market obsolescence are also less significant risk factors within the analog chip market. Since most industry players (LLTC, Texas Instruments, Maxim Integrated, Analog Devices) are extremely well diversified by product and customer (e.g. LLTC sells to more than 15,000 OEM’s), they are more insulated from the rise or fall of a particular customer or market and can enjoy a longer tail of revenue.

 

Many of the products they sell also have long life cycles. When an analog company wins a slot in a customer’s product, the price is often fixed for the run of the product, creating better price stability than other chip markets that are more commoditized.

 

Within LLTC’s industrial (40%+ of sales) and automotive (20% of sales) end markets, many of the company’s products are mission-critical and must last for very long periods of time in harsh environments. Many analog products also contain high proprietary design content and are sole-sourced, with equivalent products only available from a small pool of other analog chip manufacturers. This further increases their stickiness and profitability.

 

High barriers to entry in the analog chip market add to its appeal. Designing analog chips demands an extremely specialized and creative skill set. Companies such as Texas Instruments have said that it takes 5-10+ years of experience beyond grad school to develop an analog engineer’s skills. LLTC has commented that its typical engineer has graduated from a top university with a Master’s degree in a chosen scientific field (generally electrical engineering) and has on average ten or more years of experience at LLTC. Acquiring, cultivating, and retaining this talent takes time and serves as an advantage because technical and creative analog designers are so hard to find.

 

From a technology perspective, LLTC has over 1,250 patents, and over 25% of its employees work in R&D. Each year, the company invests nearly 20% of its sales back into R&D, underscoring the significant investments necessary to create and commercialize new analog technology. The company’s culture is also unique in that the company only manufactures analog chips, keeping it extremely focused.

 

Customer relationships create another barrier to entry. LLTC has been in the analog chip market since 1981, establishing itself as one of the highest quality and most reliable manufacturers. With most of its products going into mission-critical applications that demand precision, durability, and longevity, most customers would balk at new entrants with a much shorter track record – why risk product quality to save a buck on one chip?

 

In many of LLTC’s markets, such as automotive, electronics are increasingly viewed as a competitive advantage. These customers should be especially reluctant to change vendors if they already have a long-running and successful relationship with LLTC. Design cycles in many of these markets last 5-10+ years as well, adding further challenges for new entrants desiring to break into the market.

 

Finally, according to McKinsey, most analog players exhibit high gross margins of 40% to 70% because lower levels of capital expenditure are required. While digital chips are primarily about minimizing size and maximizing speed by increasing chip densities (very costly process technology to remain “leading edge”), analog chip design focuses on precise matching and placement of chip elements and requires large feature sizes to achieve precision and high voltage operation.

 

For these reasons, analog chip manufacturing requires smaller capital expenditures and less replacement of manufacturing equipment, allowing for higher returns on invested capital. Other than the microprocessor segment, the analog segment has historically created the most value in the semiconductor industry when measured according to economic profit.

 

From a growth perspective, LLTC has a long runway to profitably expand with less than 4% market share of the fragmented analog chip space today. The company’s core industrial and automotive businesses (60%+ of total sales) are especially well positioned and in the early stages of semiconductor adoption. Electronics content is increasing across many products and applications within these markets as objects are getting smarter and more connected.

 

Within cars alone, many of the enhancements across safety, fuel efficiency, comfort, and automation are rooted in some sort of electronics. The rise of electric (e.g. Tesla) and hybrid vehicles provides major opportunity for LLTC as well – the company estimates that an electric car could have more than $100 of content for LLTC compared to single-digit to tens of dollars for conventional cars. LLTC touches a number of areas within cars, including their entertainment and navigation systems, emission controls, parking assistance, lane navigation, power steering, and more.

 

Outside of vehicles, LLTC has a presence in hundreds of markets that will see continued growth in electronics applications – smart grids, industrial plants, medical devices, and more.

 

Key Risks

The semiconductor industry is largely an unattractive space for long-term dividend investors to allocate capital. It is generally marked by a rapid pace of change, significant capital expenditures and R&D investments that have uncertain rates of return, intense price pressure, cyclical demand trends, short product cycles, and more.

 

As we have highlighted throughout our analysis, LLTC is a rather unique breed in the sector. Its primary end markets (industrial, automotive) are certainly sensitive to the ups and downs of the global economy, but the amount of electronics content going into each unit is rising, helping to offset some of the cyclicality. The company’s diversity by product type, geography, and customer further help smoothen out demand trends.

 

While demand can unexpectedly soften at any given moment, we remain confident that LLTC’s markets will be larger in 10 years as many objects become smarter and more connected.

 

Our bigger concern is the juicy margins most analog players have enjoyed for the last couple of decades. LLTC’s annual operating margin has not dipped below 42% over the last 10 years. Within the technology sector, this is especially impressive and has certainly caught the attention of many industry players.

 

While we continue to believe in the company’s competitive advantages, the environment can still change quickly – perhaps manufacturing technologies change, software advances to reduce the training requirements for analog engineers, new international competition emerges, competitors gain ground in the faster-growing auto and industrial markets, or something else.

 

These risks are at least partially mitigated once again by LLTC’s diversification, well established customer relationships, innovative culture, and long-lasting products (consumer markets are a small portion of total sales). The highly fragmented nature of the analog industry (Texas Instruments is the biggest player, but its market share is under 20%) also creates many profitable niches for LLTC to exploit.

 

We will keep our eyes open for anything that could impair LLTC’s long-term earnings outlook, but the company appears to be operating from a position of strength for now.

 

Dividend Analysis

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. LLTC’s long-term dividend and fundamental data charts can all be seen by clicking here and support the following analysis.

 

Dividend Safety Score

Our Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

LLTC recorded a strong Safety Score of 65, suggesting its current dividend payment is safer than most available in the market. The company’s moderate payout ratios, very healthy balance sheet, and wide moat support the favorable ranking despite the business’s cyclicality.

 

Over the trailing twelve months, LLTC’s dividend has consumed 56% of its GAAP earnings and 53% of its free cash flow. LLTC is a moderately cyclical business (sales dropped nearly 20% during the financial crisis), but its payout ratios provide plenty of protection in case the global industrial and automotive markets slow down.

 

Looking at longer-term trends in payout ratios can be even more helpful. Our dividend tools let you view a stock’s EPS and free cash flow payout ratios over the last decade. As seen below, LLTC’s payout ratios have generally remained below 60% for most of its history. Today’s payout ratio is similar to where it was before the 2008-09 financial crisis, reinforcing LLTC’s healthy position (the company grew its dividend during the recession).

 

Source: Simply Safe Dividends

 

For dividend companies with enough operating history, it’s always a prudent exercise to observe how their businesses performed during the financial crisis. LLTC’s reported sales fell 18% in fiscal year 2009, and its earnings dropped by 20%. Considering the cyclical nature of LLTC’s markets, these results aren’t too bad and further underscore LLTC’s higher quality relative to most semiconductor businesses.

 

 

High quality companies are able to generate free cash flow year in and year out. Rising cash flow is very important because it supports continued dividend growth without expanding the payout ratio. As seen below, LLTC has generated healthy free cash flow in each of the past 10 years while maintaining excellent operating margins in excess of 40% every year by focusing on the high end of the analog market:

 

 

While payout ratios, margins, industry cyclicality, free cash flow generation, and business performance during the recession help give us a better sense of a dividend’s safety, the balance sheet is an extremely important indicator as well. Companies with extreme amounts of debt and cyclical business operations could find themselves in a cash crunch if demand unexpectedly weakens and they have overextended themselves. They will always cut the dividend before missing a debt payment, so monitoring cash and debt levels is important.

 

As seen below, LLTC has paid off all of its long-term debt over the past eight years, leaving it with an extremely clean and healthy balance sheet that has over $1.2 billion in net cash ($5 per share). LLTC has plenty of flexibility to repurchase shares, grow the dividend, or opportunistically acquire technologies to enhance its market position.

 

 

Altogether, LLTC’s dividend is very safe regardless of how its cyclical markets turn in the coming quarters. The company’s sub-60% payout ratios provide a nice cushion, the balance sheet is very flexible, the industry has high barriers to entry, and LLTC’s main markets (industrial and automotive) will grow in value over the long-term.

 

Dividend Growth Score

Our Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

LLTC’s Growth Score is 54, meaning its dividend’s growth potential ranks higher than about half of all other dividend stocks we monitor. The company has grown its dividend for more than 20 years since it started paying one in the early 1990s and looks like it will join the list of dividend aristocrats by 2019.

 

As seen below, LLTC’s total dividends paid increased at a 12% annualized rate over the last decade.

 

 

Management remains very committed to the dividend, making the following comments during the company’s 3Q15 earnings call:

 

“Well, we actually are not guided by some kind of a payout ratio that we need to stay tuned basically paying out the dividend and growing it every year that sort of is what our first priority is with our cash. We started paying a dividend back in the early 90s and we have grown it every year since and we intend to do that as long as we are able to do it within our means.”

 

With safe payout ratios, a very healthy balance sheet, and large, growing markets to continue penetrating, we believe LLTC can grow its dividend at a high-single digit annual clip for a long time to come.

 

Valuation

LLTC trades at approximately 23x next year’s consensus earnings estimates, reflecting the high quality nature of its operations. The stock’s dividend yield is 2.7%, good for a Yield Score of 52. This means that LLTC’s dividend yield is higher than 52% of all other dividend-paying stocks, putting it right in the middle of the pack.

 

Going forward, we believe it is reasonable to expect LLTC’s sales and earnings to continue compounding at a mid-single digit rate given the long runway for content growth in automotive (20% of revenue) and industrial (over 40% of revenue) markets.

 

When combined with the company’s 2.7% dividend yield, the stock appears to offer total return potential of 8-10% per year at today’s price. Not a bargain, but perhaps an example of a wonderful business trading at a reasonable price. We are happy to buy and hold these types of companies forever and enjoy the predictable dividend growth they provide.

 

Conclusion

The technology sector is generally a dangerous place to play for most investors, and the semiconductor industry is no exception. The rapid pace of change, unpredictable technology trends, intense price competition, and heavy R&D spending create a challenging environment for the industry’s players. The nature of the analog chip market is different – reliability and durability are valued at a premium by customers, manufacturers are much more diversified by product and market, capital intensity is much lower, product design cycles are longer and more stable, and there is solid growth across many applications as electronics continue penetrating non-consumer markets. While LLTC’s 2.7% dividend yield might not be appealing for those living off dividends in retirement, we think the stock looks attractive for investors seeking long-term dividend growth and capital appreciation.