Why did Analog Devices' revenue and earnings fall so sharply in fiscal 2002?

Demand for the company's products fell across several markets, particularly communications, as a cyclical semiconductor downturn that began in early fiscal 2001 deepened. Net sales dropped 25% year over year, and the decline was compounded by overcapacity in the industry that pressured pricing. Operating expenses were cut about 9%, but not enough to offset the revenue decline, so operating margin fell to 6.9% from 17.9%.

Is the company's balance sheet strong enough to weather the downturn?

Yes, by most measures. At November 2, 2002, cash, cash equivalents and short-term investments were $2.9 billion, roughly double the $1.27 billion of long-term debt, which consists mainly of the 4.75% convertible subordinated notes due October 2005. Management stated that existing liquidity and expected cash from operations should fund operations, capital expenditures and R&D for at least the next twelve months and beyond. Investors should note the notes are convertible at $129.78 per share, well above the $23.87 stock price at December 31, 2002, and the swap converts the fixed coupon to a floating LIBOR-based rate.

What is management doing to restore profitability?

Management pursued several initiatives: it transitioned production from older four-inch wafer fabs to six- and eight-inch facilities, which is expected to be complete by mid-fiscal 2003; it reduced workforce in manufacturing, sales and engineering; and it cut discretionary spending. The company expects these actions to yield roughly $60 million in annual savings, mainly in cost of sales, with the first full-year impact in fiscal 2004. Management also maintained R&D spending at $424 million, which it characterized as essential to long-term product leadership, and it increased field application engineers to help customers design in its newer products.

What are the main risks investors should consider?

The filing highlights several risks: the semiconductor industry's cyclicality and potential overcapacity leading to price erosion; reliance on sole-source foundries, principally Taiwan Semiconductor Manufacturing Company, under purchase orders without written supply agreements; risks from international operations, which generated about 70% of revenue; patent litigation, including the Townshend and Plasma Physics suits; and the execution risk of the four-inch fab transition, including inventory build reserves. Backlog of $262 million is also described as an unreliable indicator of future revenue, because customers can cancel orders without penalty.

How did the company's tax rate and goodwill accounting change affect earnings?

The effective tax rate fell to 25.0% in fiscal 2002 from 29.7% in fiscal 2001, mainly due to a shift in the mix of worldwide profits toward lower-tax Irish operations. Adoption of SFAS 142 in fiscal 2003 eliminates goodwill amortization, which management estimates will increase annual net income by about $54 million, and reduces amortization of intangibles to roughly $3 million. The company expects its fiscal 2003 effective tax rate to fall to approximately 22.0%, and it must complete a transitional goodwill impairment test that could produce a significant one-time charge.

ADI 10-K FY2002 Annual Report — Revenue, Net Income, EPS

01—Abstract

Summary

Summary of the 10-K filed January 29, 2003. Cited figures are marked; the original filing is the authoritative source.

Analog Devices' fiscal 2002 (year ended November 2, 2002) was a sharp downturn year.

Net sales fell 25% to $1.708 billion^a from $2.277 billion, and net income dropped 70% to $105 million, or $0.28 diluted EPS, from $356 million and $0.93 a year earlier. The decline followed the industry-wide collapse in demand that began in fiscal 2001, with the communications market hit hardest. Gross margin held up relatively well at 53%, though it fell 270 basis points, and the company reported operating income of $118 million, or 6.9% of sales, versus $408 million in fiscal 2001.

Management responded with four-inch fab consolidation, special charges of $48.5 million^b, and tighter discretionary spending, while R&D was maintained at $424 million (24.8% of sales) to protect long-term product leadership. Balance sheet and cash flow strength is the central investor takeaway. Cash, cash equivalents and short-term investments totaled $2.9 billion against $1.27 billion of 4.75% convertible subordinated notes due 2005, which were swapped to a floating LIBOR rate.

Operating cash flow was still positive at $226 million, capital spending was cut to $57 million^c from $297 million, and the company repurchased $98 million of stock. Management expects the restructuring to yield roughly $60 million in annual savings once complete, and guided fiscal 2003 capex to about $80 million with an effective tax rate near 22% after goodwill amortization ends.

Key risks include continued cyclicality and overcapacity in the semiconductor market, a pending patent suit from Townshend Intellectual Property, a new suit from Plasma Physics Corporation, the transition of production from four-inch fabs to six- and eight-inch fabs, and roughly 70% of revenue coming from international customers. Backlog rose modestly to $262 million^d from $210 million, though management cautioned that backlog is not a reliable predictor of future revenue.

02—Key points

Key Highlights

Net sales declined 25% to $1,707.5 million in fiscal 2002 from $2,276.9 million in fiscal 2001, reflecting a broad industry downturn led by the communications market.
Net income fell 70% to $105.3 million ($0.28 diluted EPS) from $356.4 million ($0.93 diluted EPS), with operating income down to $118.2 million (6.9% of sales) from $407.7 million (17.9%).
Gross margin remained solid at 53% of sales ($904.5 million), though it declined 270 basis points from 55.7% in fiscal 2001, aided by manufacturing restructuring and tight spending controls.
Special charges of $48.5 million were recorded for fab consolidation, workforce reductions, and investment impairments, with management projecting about $60 million in annual savings once complete.
The balance sheet remains strong, with $2.9 billion in cash and short-term investments against $1.27 billion of convertible notes, and operating cash flow of $226 million.
Capital spending was cut to $57 million from $297 million, and the company repurchased $98 million of its common stock during the year.
Ongoing litigation includes a Townshend patent suit (eight patents, filed October 2002) and a Plasma Physics patent complaint served in October 2002, with management believing neither is likely to have a material adverse effect on financial position.

03—Questions

Frequently Asked Questions

Why did Analog Devices' revenue and earnings fall so sharply in fiscal 2002?
Demand for the company's products fell across several markets, particularly communications, as a cyclical semiconductor downturn that began in early fiscal 2001 deepened. Net sales dropped 25% year over year, and the decline was compounded by overcapacity in the industry that pressured pricing. Operating expenses were cut about 9%, but not enough to offset the revenue decline, so operating margin fell to 6.9% from 17.9%.
Is the company's balance sheet strong enough to weather the downturn?
Yes, by most measures. At November 2, 2002, cash, cash equivalents and short-term investments were $2.9 billion, roughly double the $1.27 billion of long-term debt, which consists mainly of the 4.75% convertible subordinated notes due October 2005. Management stated that existing liquidity and expected cash from operations should fund operations, capital expenditures and R&D for at least the next twelve months and beyond. Investors should note the notes are convertible at $129.78 per share, well above the $23.87 stock price at December 31, 2002, and the swap converts the fixed coupon to a floating LIBOR-based rate.
What is management doing to restore profitability?
Management pursued several initiatives: it transitioned production from older four-inch wafer fabs to six- and eight-inch facilities, which is expected to be complete by mid-fiscal 2003; it reduced workforce in manufacturing, sales and engineering; and it cut discretionary spending. The company expects these actions to yield roughly $60 million in annual savings, mainly in cost of sales, with the first full-year impact in fiscal 2004. Management also maintained R&D spending at $424 million, which it characterized as essential to long-term product leadership, and it increased field application engineers to help customers design in its newer products.
What are the main risks investors should consider?
The filing highlights several risks: the semiconductor industry's cyclicality and potential overcapacity leading to price erosion; reliance on sole-source foundries, principally Taiwan Semiconductor Manufacturing Company, under purchase orders without written supply agreements; risks from international operations, which generated about 70% of revenue; patent litigation, including the Townshend and Plasma Physics suits; and the execution risk of the four-inch fab transition, including inventory build reserves. Backlog of $262 million is also described as an unreliable indicator of future revenue, because customers can cancel orders without penalty.
How did the company's tax rate and goodwill accounting change affect earnings?
The effective tax rate fell to 25.0% in fiscal 2002 from 29.7% in fiscal 2001, mainly due to a shift in the mix of worldwide profits toward lower-tax Irish operations. Adoption of SFAS 142 in fiscal 2003 eliminates goodwill amortization, which management estimates will increase annual net income by about $54 million, and reduces amortization of intangibles to roughly $3 million. The company expects its fiscal 2003 effective tax rate to fall to approximately 22.0%, and it must complete a transitional goodwill impairment test that could produce a significant one-time charge.

04—Continue

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