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.Read Full Transcript
Glaser: They might not be the biggest, but they can certainly be the most profitable. So, what do they do with that cash? Have they built a strong balance sheet?
Colello: They have a strong balance sheet now. Mike will talk more about the $1-2 billion of debt that they have, but they have $1 billion of cash on hand. We project free cash flows of at least $400 million over the next five years, so the company has really done a good job of bringing in cash flow, steady cash flows over time, that they can use for a variety of purposes, but certainly some of that will be buying back the debt.
Glaser: So, Mike, when you think about this company from a credit perspective, how have we rated it?
Hodel: We have given the firm an A+ rating and that's in line with with Linear's analog peers, Maxim and Analog Devices. Linear's balance sheet, as Brian mentioned, is strong, but it's not as strong as some of the other analog chipmakers out there and other semiconductor makers generally.
Typically we don't see a lot of net debt on the balance sheet of semiconductor firms. They typically have more cash than debt. Linear actually has more debt than cash. That's a negative for Linear. But as Brian mentioned, we think this is one of the widest moat firms in the semiconductor industry and that balances a little bit weaker balance sheet for us. So again, we rated them A+, which is in line with where we have their peers as well.
Glaser: Why did they choose to have this debt versus their peers, who are debt free or have no debt, net debt?
Hodel: Well, the firm took on the debt a couple of years ago, two or three years ago, to buy stock before the financial crisis really set in. One thing we really like about Linear is that management has shown a willingness to forgo share repurchases since then to start paying that debt down, and we've seen them do that over the couple of years. Their debt balance has slowly come down, and we think that something that will continue over the next couple of years as well. They actually have a debt issue that's maturing or is puttable and callable, and in the near future they are going to be paying that down in November.
Glaser: So looking at the debt that's trading in the market, is it trading like an A+ credit or is that a little bit wider than that?
Hodel: It's actually a little bit wider than that. The firm has a convertible note that's puttable and callable in 2014, so about 3 1/2 years from now. It offers about a 2.4% yield, and while it may not sound great, a bond of that maturity, a Treasury, for example, would yield much less than that. These bonds are trading at about a 170 basis point spread over Treasuries, which is far wider than the 90 or so basis points you typically find for an A+ credit.
So, these are convertible notes, but ignoring the fact that they're convertible, as a fixed income investment, they look attractive to us.
Glaser: And then if we take a look at the convertible option, can you explain – this might not be as familiar exactly what that means, in particular, in the context of this company if that's attractive or not?
Hodel: Sure, the notes are convertible at about $45 per share. The stock right now is at $30. Our fair value estimate is $36. So, right now, we don't think there's a high likelihood over the next year or so that these notes are going to be convertible. But the conversion price on the notes will steadily decrease over the next couple of years, several years. As the firm pays dividends, the convertible price automatically adjusts to reflect those dividends, and we would expect the firm to naturally increase its value over time as well. So there is a chance down the road that this convertible option becomes valuable for bondholders.
Glaser: Why do you think these bonds are trading at such a wider spread than their peers?
Hodel: Well, Linear is a pretty small company, and bond investors tend to favor companies that are larger, more diversified. We think the fact that Linear has a very wide economic moat offsets its small size. The bonds are also not rated by any other major ratings agencies. So, it's a type of issue that a number of investors just wouldn't look at.
Glaser: Brian, Mike thanks for taking the time today.
Hodel: Thank you.
Glaser: For Morningstar.com, I'm Jeremy Glaser.