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By Jeremy Glaser | 10-15-2010 03:57 PM

A Wide-Moat Bond Opportunity

Linear Technology's convertible bonds look attractive according to Morningstar's Mike Hodel and Brian Colello.

Jeremy Glaser: For Morningstar.com, I'm Jeremy Glaser. Linear Technology might not be the best known of Morningstar's wide-moat firms, but we think that there might be some opportunities in their bonds.

I am here today with equity analyst Brian Colello and associate director and credit analyst Mike Hodel to take a deeper look.

Gentlemen, thanks for joining me today.

Michael Hodel: Thank you.

Brian Colello: Thanks for having me.

Glaser: So, Brian, can you talk to us a little about the industry that Linear is in, which is analog semiconductors, something that I don't know if a lot of people are very familiar with.

Colello: Sure. Well, analog chips are in any sort of electronic device, and the reason why we like analog chipmakers, a lot of them are very profitable because there's high switching costs associated with their chips. These chips and these companies have a lot of proprietary designs and expertise. So, when an electronics maker – and it could be of any type, whether it's a phone or a PC or a thermostat in your house, when they're designing these devices, they tend to choose these chips based on performance rather than price. The chips themselves aren't very expensive, but it's very expensive to switch to another one. Again, just because every type of chip is just a little bit different.

So, when a chipmaker actually has a chip in their product, you don't see a lot of them being switched out, and so they stay in the product for the life of it. And so that leads to very good profitability over time because pricing remains stable, you don't have a lot of ongoing R&D after the fact, and you don't have to reinvest in a lot of capex, and so all of those things give these chipmakers good profitability.

Glaser: So, looking directly at Linear, how did it manage to carve out this wide moat? What's its niche?

Colello: Well, they focus on the high end of chips, and where they've done well is they've really taken a devout focus on high-margin opportunities, and they'll walk away from business if they're not getting the margins that they think they deserve.

An example right now is, they have a chip in the Apple iPad, which is a consumer product, of course, but it's not something – that's not an area that they traditionally play. And so, we think maybe five years down the line when the iPad 5 is out, Linear might not be in there because pricing pressure might come in and competition might come in and others might want that business more. Linear will just walk away. These are the sorts of things that allow the company to have really good profitability, but may inhibit a little bit of growth over time, but that's really how they've carved out the wide moat.

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