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August 2015

Driving Through the Fog Around Analog: We See Enduring Moats and Future Growth From Auto Electronics

We View Analog as a Hidden Gem Within Technology

Well-regarded investor Nelson Peltz recently said, "We like businesses that have moats around them,

and that is not the case with technology." We disagree. Although the sector will forever be subject to

rapid transitions in technology and the overarching threat of disruption, we can still find safe havens

among analog semiconductor firms that have carved out sustainable competitive advantages, or

economic moats.

We believe that many people still incorrectly associate the term "analog" with antiquated cell phones

from the 1990s and TV signals before cable. However, analog semiconductors handle the complex tasks

of managing real-world signals in virtually every electronics device in the world today. Many analog

leaders have carved out wide economic moats stemming from intangible assets and high customer

switching costs, which in turn allow the firms to generate excess returns on invested capital and pay out

a significant portion of free cash flow to shareholders.

More important, the analog industry is far from antiquated. Increasingly complex analog parts are key

components that process, regulate, and convert signals in the most futuristic of devices across several

industries. Most of all, we're excited about analog growth opportunities from the currently $28 billion

automotive semiconductor market. Chipmakers aren't just pinning their hopes on the quantum leap to

fully autonomous cars, but will provide key components in every incremental improvement in automotive

electronics along the way. We project that analog chipmakers under our coverage will generate average

long-term automotive revenue growth of over 10% per year, well ahead of current market expectations

and growth rates from other chip end markets. Our current top pick is Linear Tech, in terms of valuation

as well as our admiration of the firm's business model. We are also starting to see adequate margins of

safety in wide-moat Texas Instruments, narrow-moat Microchip, and no-moat Infineon, each of which

are on the cusp of 4-star territory.

Contents 2 Key Takeaways 3 Don't Fear the Fast-Paced Chip Space: Analog Moats Are Safe 5 Intangibles, High Switching Costs Bolster Analog Profits 14 Automotive Chip Growth Should Accelerate Past the Rest of the Pack 20 Safer, Greener, Smarter Cars Stoke Our Optimism on Auto 25 Behind Every Car Ad for More Bells and New Whistles, We See a Bevy of Analog Content 49 Non-Digital Doesn't Equate to Non-Growth, as Analog Trajectory Appears Promising 52 How to Choose Among a Host of High-Quality Analog Chipmakers 75 Investment Opportunities Arise by Navigating the Industry Cycles 80 Closing Thoughts: Switching Costs Have Kept Analog Firms Out of M&A, but Is This Changing?

Technology Observer | 10 August 2015

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Highlighted Companies

Name/Ticker Economic Moat

Moat Trend

Currency

Fair Value Estimate

Current Price

Uncertainty Rating

Morningstar Rating

Credit Rating

Market Cap (Bil)

Analog Devices ADI Wide Stable USD 59.00 60.70 Medium QQQ A+ 19.0 Linear Tech LLTC Wide Stable USD 46.00 41.52 Medium QQQQ 9.9 Microchip Tech MCHP Narrow Stable USD 46.00 43.83 Medium QQQ 8.9 Maxim Integrated MXIM Wide Stable USD 33.00 34.29 High QQQ A+ 9.7 Texas Instruments TXN Wide Stable USD 54.00 50.84 Medium QQQ A+ 52.2 STMicroelectronics STM None Stable USD 7.00 7.67 Very High QQQ 6.7 Infineon Tech IFX None Stable EUR 12.00 10.34 High QQQ 11.6

Key Takeaways

× Many analog semiconductor firms enjoy wide or narrow economic moats, thanks to intangible assets

and high customer switching costs, as well as other favorable industry dynamics that enable companies

to earn excess ROICs.

× Our favorite secular growth driver for the industry is the automotive space, as the push for safer,

greener, smarter cars is enabling increased electronics (and semiconductor) content per vehicle. We

project that analog firms under our coverage will earn over a 10% revenue compound annual growth rate

from auto over the next five years, well ahead of market projections.

× Chipmakers only need modest global auto production growth around 3% to achieve such revenue

growth. The inclusion of more advanced powertrains, infotainment systems, advanced driver assistance

systems, and connectivity solutions, thanks to government regulations and consumer demand, should

drive hearty growth in additional chip content used per vehicle.

× Based on our proprietary ranking of analog vendors, and independent of valuation at any given time, we

see Linear Tech as the highest-quality business and having the widest moat in our analog coverage

universe.

× Valuations have been stretched for many analog names for quite some time, but recent market concerns

about Greece and China have pulled most of our list back into 3-star territory. We think a near-term

cyclical peak has arrived, and downturns tend to provide long-term, patient investors with buying

opportunities.

× Our current top pick is Linear Tech, in terms of valuation as well as our admiration of the firm's business

model. We also like Infineon, as it has both the lowest price/fair value ratio and the most automotive

exposure out of the group. We have also recently seen adequate margins of safety in wide-moat Texas

Instruments and narrow-moat Microchip, both of which are on the cusp of 4-star territory.

× Sentiment in semis can change quickly, and wider margins of safety may appear in an instant (such as

the 13% one-week sell-off in October 2014). We'd be enthusiastic buyers of several moaty analog firms

if a further sell-off were to provide investors with sufficient margins of safety.

Lead Analyst

Brian Colello Senior Equity Analyst +1 312-384-3742 [email protected]

mailto:[email protected]


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Don't Fear the Fast-Paced Chip Space: Analog Moats Are Safe

Although the broader semiconductor industry is highlighted by rapid technological change and swift

movements in market share on the digital side, we find relative safety and sustainable competitive

advantages in analog that make this $46 billion-plus segment of the chip industry downright sleepy by

comparison. We find several compelling reasons for investors to take a close look at the analog semi

space.

First, leading analog chipmakers have valuable intangible assets associated with proprietary designs that

span multiple decades. Second, as analog semiconductors often make up a tiny portion of a product's bill

of material, and design wins are based on performance rather than price, analog firms are able to

prosper from long product lives and high customer switching costs. Third, since analog semiconductors

are required to handle real-world signals that digital parts (with their series of 0's and 1's) simply can't

process, we see no imminent substitutes for analog chips on the horizon. Finally, in analog, we find a

fragmented marketplace where several firms can earn outsized economic profits over the course of the

cycle.

In recent years, analog chipmakers have profited from favorable business conditions in the end markets

they serve, such as industrial growth as global GDP recovered from the aftermath of the credit crisis, as

well as telecom infrastructure associated with the smartphone boom. Yet the strongest growth driver for

firms under our coverage over the past few years has been the automotive space, and we expect the

good times to continue. In fact, we are even more bullish than general consensus on the automotive

chip opportunity, as we think the automotive sector represents a sizable tailwind that can drive

normalized top-line growth in excess of 10% from automotive customers for the next several years.

What Are Analog

Semiconductors?

Analog semiconductors are

essentially used to process real-

world signals. Examples of such

signals include temperature,

pressure, weight, light, sound, or

speed. In contrast, digital

semiconductors process electronic

signals, represented as a series of

0's and 1's.

In general, analog semiconductors

are divided into a few key buckets,

including: power management,

converters, amplifiers, interface,

and sensors.


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Exhibit 1 Analog Coverage Highlighted in this Report and Morningstar's Analog Vendor Ranking (See Page 52 for Methodology)

Source: Morningstar

Company Ticker Moat Price/FV Market Cap (Bil) SummaryAnalog Devices ADI Wide 1.03 19.0 Strong leader in data converter analog chips

Linear Tech LLTC Wide 0.93 9.9 Leader in power management with an intense focus on high-performance (and high-margin) analog designs

Maxim Integrated MXIM Wide 1.05 9.7 Leader in power management with broad exposure to both high-performance and high-volume end markets

Texas Instruments TXN Wide 0.96 52.2 Largest analog firm in the world that serves as a bit of a one-stop shop, with strength in power management, high-performance, and high-volume analog chips

Microchip Tech MCHP Narrow 0.96 8.9 Leader in 8-bit microcontrollers (MCUs) with a growing analog business and further growth opportunities in higher-end microcontrollers

Infineon Tech IFX None 0.86 11.6 Leader in simpler discrete power management chips, with a strong focus on automotive and chip card and security products

STMicro STM None 1.11 6.7 Europe's largest chipmaker with a solid analog and auto business, offset by less attractive digital chip segments

Criteria Weighting 0.20 0.20 0.20 0.10 0.15 0.15 1.00 Weaker<.60Stronger>.80

Linear Tech 5 5 5 4 5 4Vendor weighting 0.20 0.20 0.20 0.08 0.10 0.08 Strongest

ADI 5 4 4 5 4 4Vendor weighting 0.20 0.16 0.16 0.10 0.08 0.08 Strong

Microchip 4 5 4 4 4 4Vendor weighting 0.16 0.20 0.16 0.08 0.08 0.08 Strong

Texas Instruments 4 5 3 3 4 5Vendor weighting 0.16 0.20 0.12 0.06 0.08 0.10 Strong

Maxim Integrated 5 3 3 3 3 4Vendor weighting 0.20 0.12 0.12 0.06 0.06 0.08 Average

Infineon 3 4 4 4 2 3Vendor weighting 0.12 0.16 0.16 0.08 0.04 0.06 Average

STMicro 2 3 3 4 1 4Vendor weighting 0.08 0.12 0.12 0.08 0.02 0.08 Weaker

Positioning

0.78

0.62

0.50

VendorProduct

MixCustomer

DiversificationEnd Market Exposure

Revenue Growth Profitability

Capital Distribution

Overall Rating

0.86

0.76

0.72

0.64


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Intangibles, High Switching Costs Bolster Analog Profits

In analog, we find two primary sources of economic moat. First, we see significant intangible assets

stemming from libraries of proprietary analog chip designs, which have come about after decades of

research and development efforts that result in products that startups or outsiders cannot immediately

replicate. Many analog chip designs are proprietary in nature, and although leading firms often have

products that perform similar functions at similar quality levels, no two parts are exactly alike. Ultimately,

we view analog parts as more proprietary than digital chips, while still other types of semiconductors,

like memory chips, are essentially commodities.

Since analog chip designs involve a library of core IP blocks that are pieced together to form a chip, there

is an art of analog design that involves testing and understanding which blocks can work alongside one

another without generating excess noise, heat, or other factors that degrade signals and render chips

unusable. With engineering and design tools that are not as accurate as those used in digital chip

design, expertise often comes through trial and error, rather than a rigid process from a textbook or

training manual.

Meanwhile, as shown in Exhibit 2, many more R&D dollars were spent on moving digital chips down

Moore's Law (which states the trend observed in the industry that the number of transistors on a chip

tends to double every two years) over the past three years than developing new analog chips, both in

absolute dollars and, more important, as a percentage of sales. Thus, we find that university training,

demand for talent, and job availability are more robust in digital, and budding engineers naturally tend to

gravitate toward digital companies. In turn, we view analog designs as having a lower risk of disruption.


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Exhibit 2 Analog Chipmakers Generally Have Lower R&D Spending as a Percentage of Sales (3-Year Average, LHS) and in Absolute Dollars ($ Millions, RHS) Compared With Digital Chipmakers

Source: Morningstar; bars represent R&D spending as a percentage of revenue (LHS); markers represent absolute R&D spend (RHS)

Our second source of moat relates to high switching costs for customers, based on time, effort, and

additional R&D dollars for product redesigns. Most analog chips included on an electronics circuit board

are tested and verified to work with all other chips on the same board. By swapping out one analog part

for another, a customer needs to undergo a new round of testing in order to ensure compatibility, an

exercise that rarely makes sense from a cost-benefit perspective. Customers regularly cite FUD—fear,

uncertainty, and doubt—around how a new product might react if it were to replace an existing one, so

in practice, replacements rarely occur. Even if a new product offers a clear improvement, the customer

may simply include the new chip in the next version of a device but retain the lower-performing analog

chip in the existing product.

Product Quality Is Hard to Replicate and Becoming Increasingly Important

Leading analog chipmakers under our coverage universe have stellar reputations for product superiority,

enhancing switching costs. In particular, in the auto industry, defects can only be in the range of less

than 1 per million parts (by comparison, Six Sigma qualification requires less than 3.4 defects per

million). Maxim has even indicated that product quality may soon reach a "parts per billion" rate. In a

presentation, Infineon touted that it sold 10 million units of a given product with zero failures. This type

of quality is absolutely vital in mission-critical products. Analog chips must be tested to handle extreme

weather conditions (AEC-Q100 quality regulations call for devices to work within a temperature range of

-40 to +125 degrees Celsius) and wear and tear over the life of a car, which might be at least a decade.

One can imagine the potential liability associated with a chip that fails to adequately apply a braking

system or provides drivers with inaccurate real-time diagnostic information that could lead to a fatal

accident.

-

2,000

4,000

6,000

8,000

10,000

12,000

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

40.0%

45.0%

50.0%

INTC QCOM BRCM NVDA CAVM ADI LLTC MXIM MCHP TXN STM IFNNY

Digital Analog


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Exhibit 3 Leading Automotive Chipmakers Like Infineon Strive for Zero Defective Parts Per Million

Source: Infineon

Exhibit 4 Automotive Quality Requirements Actually Exceed Many Industrial Applications

Source: Analog Devices


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Analog chipmakers are only able to attain such high product quality by having the necessary process

technologies, funded by years, if not decades, of R&D efforts and design expertise.

For example, Maxim's entry into the automotive market was not easy. When Maxim developed audio ICs

to sell into the smartphone market, it gained invaluable expertise in design, such as determining building

block layouts and which sections of the chip may cause interference with one another. Maxim also likely

learned similar lessons in building high-performance analog parts for a variety of industrial end markets,

such as medical and factory automation. In addition, Maxim is well versed in manufacturing

technologies, knowing which die sizes and transistor nodes work best for this type of signal processing.

Ultimately, Maxim relied on all of this prior expertise in order to develop automotive-grade

semiconductors. This process took time, as Maxim started to be serious about auto in 2004 but only

began to earn over 10% of its revenue from the automotive market in 2014. Ultimately, we don't see a

short, easy path for any startup or less reputable analog chipmaker that would try to build mission-

critical parts for autos or other demanding end markets.

Analog Chip Sales Are Usually Based on Performance, Not Price

We believe it's important to consider that analog chips usually make up a small portion of a device's

overall bill of materials, and purchasing decisions are typically based on performance rather than price.

For example, average selling prices at Linear Tech, a leading high-performance analog chipmaker, are

steadily rising, but only to $1.89, from $1.65 at the end of fiscal 2010. For customers building expensive

pieces of equipment like industrial machinery, aerospace, automobiles, or telecom infrastructure

equipment, analog chips make up an almost immaterial portion of the product's cost.

Furthermore, in low-volume industries, customers cannot extract volume pricing discounts from

suppliers. These customers would rarely run the risk of inaccuracies or defects in their devices simply to

save a few cents with an inferior analog chip. Similarly, engineers at these customers will often direct

new business toward these reliable chipmakers. "Catalog sales," where engineers simply pick an analog

part out of a distributor's catalog, are a terrific business for chipmakers because their analog products

essentially sell themselves. All of these factors allow analog chipmakers to maintain pricing power in the

industry and support our view on economic moats in the space.

We view high switching costs as a main reason we continue to see hefty fragmentation in analog. Even

when firms merge, the product lines of both firms must be maintained because companies cannot

switch their customers to another part, which leaves far less room for synergies that would make such

deals worthwhile. Within this $46 billion market, TI has the greatest share, but only at 18%, much lower

than industry leaders in other technology or industrial manufacturing segments. European chip leaders

like STMicro and Infineon are next on the list with 6% share, highlighting the fragmented nature of the

industry. Meanwhile, moaty U.S. firms like ADI, Linear, and Maxim have a low- to mid-single-digit

percentage market share.


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Exhibit 5 TI Leads the Pack in a Highly Fragmented Industry

Source: Morningstar, IC Insights. Companies in bold are discussed in detail in this report. Skyworks is also covered by Morningstar, but we have not included a detailed discussion of radio frequency chips, Skyworks' primary business, in this report

Profitability and Moats Are Based on Customer Diversity and

Selective Exposure to Attractive End Markets

End market exposure is a key factor in determining excess returns on capital, sustainable competitive

advantages and, ultimately, our moat and moat trend ratings in the analog semi space. All else equal,

long-tail design wins in high-priced, low-volume electronics carry higher gross margins. In serving these

industries, like industrial, automotive, and telecommunications infrastructure, analog chipmakers rarely

have to give significant pricing discounts, while the life cycles of such devices are typically quite long,

allowing chipmakers to recoup initial investments and develop an annuitylike stream of revenue for the

life of the product. For example, a design win in a certain smartphone or PC model might only have a

shelf life of 12 months, but an analog design win in certain types of industrial equipment may last

decades. Exhibit 6 illustrates this through the lens of Analog Devices, which consistently touts that it is

still earning revenue on products built in the 1970s.

2014 2013 Percentage 2014 2013Rank Company Revenue Revenue Change Share (%) Share (%)1 Texas Instruments 8,104 7,194 12.6% 17.6% 17.0%2 STMicro 2,836 2,775 2.2% 6.1% 6.5%3 Infineon 2,770 2,550 8.6% 6.0% 6.0%4 Analog Devices 2,615 2,409 8.6% 5.7% 5.7%5 Skyworks 2,570 1,807 42.2% 5.6% 4.3%6 Maxim 2,035 2,055 -1.0% 4.4% 4.8%7 NXP 1,730 1,430 21.0% 3.7% 3.4%8 Linear Tech 1,437 1,317 9.1% 3.1% 3.1%9 On Semi 1,291 1,239 4.2% 2.8% 2.9%10 Renesas 910 975 -6.7% 2.0% 2.3%

Top 10 Vendors 26,298 23,751 10.7% 57.0% 56.0%Total Market 46,137 42,413


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Exhibit 6 ADI Still Profiting on Products Developed in the 1970s, Thanks to Long Product Life Cycles in a Highly Fragmented Pack

Source: Analog Devices 2014 analyst day

Analog chipmakers that supply certain industries like automotive also benefit from long product

development cycles. Automobile original-equipment manufacturers, parts makers, and chip suppliers are

all currently working on car models to be released in 2018. Thus, chipmakers with automotive exposure

have nice visibility into future revenue streams, supporting our general bullishness around automotive

chip growth.

Many analog firms have tens of thousands of customers spanning a wide variety of end markets. Rather

than having their fortunes tied to a single smartphone maker, for example, a company like Texas

Instruments has over 100,000 customers. Although Apple's tremendous growth across various products

has likely made it TI's single largest customer as a high-single-digit percentage of sales, the vast majority

of TI's business is diverse, which allows the company to better handle pauses in demand in any given

end market. Another example is Microchip, which touts its customer diversity by disclosing that its

largest customer makes up only 1.5% of revenue.

In contrast, we find that in highly competitive industries where continuous cost-saving efforts take

center stage, like the smartphone and PC space, customers will push for hefty volume discount

concessions from chipmakers or may sacrifice product quality for lower-priced parts, especially since the

life of the product could be quite short. Analog chipmakers we cover tend to have lower exposure to, if

not downright avoid, the PC and smartphone space for these reasons.


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Ultimately, all of these factors—dearth of new analog startups, switching costs associated with

redesigns, and analog chip design wins based on performance and quality rather than price—allow

analog chipmakers to maintain pricing power over buyers. Tech titans like Samsung and Apple may push

back on price for high-volume consumer products, but pricing on chips going into low-volume parts

across hundreds of thousands of customers worldwide tends to hold up quite well. We can look at gross

margins across the analog space (Exhibit 7) and see a relationship between the stellar gross margins

earned at companies with low consumer exposure like Linear and ADI versus modestly lower margins at

Maxim, which had 20% of fiscal 2014 revenue from Samsung, versus sharply lower margins from Cirrus

Logic, which earned 80% of its revenue from Apple.

Exhibit 7 Gross Margins in Fiscal 2013 and 2014 Are Inversely Related to Customer Concentration and End-Market Exposure Across Many Analog Chipmakers

Source: Company documents, Morningstar

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

70.0%

80.0%

90.0%

FY14 % Rev from Samsung or Apple FY 2013 FY 2014

CRUS

MXIM

ADI

LLTC


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Analog Cost Structures Are Also Compelling

In addition to solid chip pricing, the cost structures around analog companies are quite favorable. Not

only do high-quality analog chipmakers retain pricing power, but lower ongoing R&D and capital

expenditures translate to healthy profitability and cash flow generation.

Exhibit 8 Strong Pricing and Favorable Cost Structures Lead to Robust Analog Operating Margins vs. Digital Margins

Source: Company documents, Morningstar Research estimates Note: ADI's fiscal year ends as of October, Linear and Maxim as of June, and Microchip as of March, and results were restated (i.e., 2010 results pertain to Microchip's fiscal year-end in March 2011), Qualcomm margin relates to earnings before taxes for its chip division, QCT

In digital chips, leading firms have to continually spend on R&D to move down Moore's Law and pack

more transistors into a given chip in order to obtain greater processing power, energy efficiency, and

cost savings. In contrast, shrinking an analog chip doesn't necessarily make it better and in fact can

often make it worse—smaller transistors could lead to too much heat dissipation or other inefficiencies

that lead to poorer performance in measuring real-world signals. Thus, shifts in analog toward products

with lower transistor nodes are much more gradual. All else equal, analog chipmakers have lower

reinvestments in their core businesses than digital ones.

It is also important to consider that many analog chipmakers run their own fabrication plants, or fabs. In

the digital space, fabs are extremely costly; only Intel, Samsung, STMicro, and a few others maintain

their own digital fabs and aggressively spend on capex in order to move down Moore's Law. Analog fabs

tend to be much older, equipment tends to be fully depreciated, and firms don't need to buy the most

cutting-edge equipment in order to expand production. TI, in particular, has made shrewd purchases of

semiconductor equipment from bankrupt chipmakers over the past few years, often at pennies on the

dollar. TI now has $8 billion of excess manufacturing capacity that will allow it to take on new customer

orders and support revenue growth without needing to invest in significantly higher capex (see Exhibit

9).


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Exhibit 9 TI's Ongoing Capex Should Be Below 4% of Sales as Prior Shrewd Equipment Purchases Pay Off

Source: Texas Instruments

Furthermore, given the rise of outsourced manufacturers (or foundries) in the digital chip space, analog

firms can turn to these for production of newer analog products without being forced to buy expensive

pieces of equipment. Whereas foundries primarily invest in cutting-edge digital chip manufacturing and

charge digital chip designers like Qualcomm and Apple accordingly, outsourced analog chip production

again tends to be run on older manufacturing equipment within foundries that again requires relatively

lower ongoing investment. In turn, analog firms have proved that they are still able to obtain attractive

pricing from foundries.


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Automotive Chip Growth Should Accelerate Past the Rest of the Pack

Analog chips are sold to hundreds of thousands of customers in a wide variety of industries, like

industrial, telecom infrastructure and networking, automotive, and consumer devices like smartphones

and PCs. Of these end markets, we view the automotive chip space as the single most attractive for the

semiconductor industry over the next several years. Leading analog chipmakers have seen generally

modest revenue growth in recent years in total, but healthy gains in broad industrial markets and robust

growth in automotive chip markets. We expect these good times from the automotive market to

continue due to modest global auto production growth and, more important, increased chip content per

vehicle.

Auto Chipmakers Only Need Steady Global Auto Production Growth to Reach Their Goals

As we look at global light-vehicle production, we anticipate relatively steady growth over the next few

years at a 3% CAGR from 2015 to 2020, mainly driven by the rise of the middle class in emerging

markets like China and consistent with 3%-3.5% global GDP growth rates. Clearly, automotive

chipmakers can't thrive if car production hits the skids. However, the more important factor is that

chipmakers can thrive from increased content per vehicle and could eke out modest revenue growth

even if auto production were to disappoint forecasters and wind up flattish.

Exhibit 10 We Foresee Moderate Growth in Global Auto Production

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

-

20,000

40,000

60,000

80,000

100,000

120,000

2010 2011 2012 2013 2014 2015E 2016E 2017E 2018E 2019E

Global Auto Production

y/y % growth

Source: IHS, Morningstar Research estimates


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Electronics Content per Vehicle Is on the Rise

As we look one layer deeper into the automotive electronics market, Gartner forecasts a 5.5% CAGR in

automotive electronics growth through 2017. Content should rise not only from more cars being sold

each year (cyclical), but more important, a secular increase in electronics from roughly $1,300 per

vehicle a few years ago to $1,435 by 2017. An example of parts used in Gartner's analysis include air

bag modules and sensors, car radio head units, climate controls, dashboard instrument clusters, engine

control units, remote or keyless entry, and a large "other" bucket that includes safety systems, LED

lights, and many other items.

Exhibit 11 Auto Electronics Content per Vehicle Is on the Rise

Source: Gartner, IHS, Morningstar Research estimates

We're Even More Bullish Than Others About Rising Auto Chip Content

In light of such healthy forecasts for the car market and increasing electronics content per vehicle, we

are quite optimistic about the ability of many analog chipmakers to capitalize on these tailwinds and

generate solid revenue growth over the next few years.

We estimate that automotive revenue for the entire semiconductor industry rose at an 8% CAGR from

2011 to 2014, thanks to not only healthy global auto production growth and higher electronics content

per vehicle, but also higher-priced and more advanced semiconductor content used in each electronic

device within the car.

$1,200

$1,250

$1,300

$1,350

$1,400

$1,450

-

20,000

40,000

60,000

80,000

100,000

120,000

140,000

160,000

2010 2011 2012 2013 2014 2015E 2016E 2017E

Automotive ElectronicsRevenue (LHS)

Electronics ASP per Vehicle(RHS)


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Exhibit 12 Automotive Chip Content per Vehicle Is Rising, Driving Overall Automotive Semi Revenue

Source: Gartner, Morningstar Research estimates

Looking forward, Gartner is calling for a 5.5% rise in automotive semiconductor revenue. As we'll detail

below, we're even more bullish; we expect analog chipmakers under our coverage to exceed these

estimates and grow at over a 10% CAGR through 2018.

Outsize Growth Should Come From the Above Factors Plus Share Gains

Companies such as Texas Instruments, Infineon, and Maxim Integrated gained market share in the

automotive chip space in recent years. We think such share gains came at the expense of the auto

semiconductor leader, Renesas, which was formed from the combination of chip businesses from

Hitachi, Mitsubishi, and, more recently, NEC. We believe that Renesas has conceded market share in

recent years as Japanese car OEMs and parts makers are looking to diversify away from the firm.

Japanese car makers that used Renesas and NEC as first and second chip sources (so that 35% of

automotive chip revenue in Japan was earned by the new Renesas) were placed in a bind after the

tragic consequences from the tsunami that hit the island in 2011. In turn, Japanese firms are opening up

their chip supplier base to foreign firms.

Infineon has been a major beneficiary of this trend, rising from the sixth-largest automotive chip supplier

into Japan in 2006 to third today. We also think this trend has provided some incremental revenue

growth to Texas Instruments and other U.S.-based automotive chipmakers. That said, some of Renesas'

revenue declines in automotive can be traced back to depreciation of the yen relative to the U.S. dollar.

Looking at market share on a worldwide basis among leading players in Exhibit 13, Renesas and

Freescale have conceded share in recent years. Infineon's share has grown nicely, while STMicro's share

has stalled a bit.

$296 $324

$307 $309 $340 $346 $353 $360 $365 $373

$-

$50

$100

$150

$200

$250

$300

$350

$400

-

5,000

10,000

15,000

20,000

25,000

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35,000

40,000

45,000

2010 2011 2012 2013 2014 2015E 2016E 2017E 2018E 2019E

Semi Revenue (LHS)

Semi ASP Content per Vehicle(RHS)


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Exhibit 13 Infineon's Share Gains in Automotive Have Been Impressive

Source: Infineon company presentations, Strategy Analytics, Morningstar Research estimates

Looking at market share in North America and Europe as of the end of 2012, Texas Instruments has

proved to be a big winner in the auto space, thanks to its acquisition of National Semiconductor in 2010

as well as organic growth. Infineon has held on to the top supplier spot in Europe in quite some time,

and modest share erosion in Europe has been offset by gains in Asia. Meanwhile, STMicro's share has

been up and down in North America and Europe, but the company has nice exposure to car production in

emerging markets, especially in China, which is a key growth driver for global auto production as a

whole.

Exhibit 14 Auto Chip Market Share by Region Shows Strong Gains by TI in Recent Years

N. America ...2006 2009 2012 Europe ...2006 2009 2012Freescale 21.5% 16.7% 12.5% Infineon 15.0% 13.6% 13.0%Infineon 8.4% 7.8% 8.4% Bosch 10.8% 10.4% 11.3%Renesas 6.4% 8.2% STMicro 11.6% 10.5% 10.0%STMicro 8.0% 6.6% 8.1% TI 5.7% 5.9% 8.4%TI 3.0% 3.7% 7.4% Freescale 11.1% 8.5% 7.4%NXP 5.6% 7.1% NXP 8.3% 8.2% 7.6%

Source: Infineon company presentations, Strategy Analytics, Morningstar Research estimates. Freescale and NXP are slated to merge in late 2015.

The more important consideration for many of the semiconductor firms under our coverage that don't

appear on these lists is that market share is clearly shifting within the automotive chip space, as new

automotive chip opportunities are based on greenfield applications rather than trying to displace

incumbents in legacy products. Chip suppliers into cars into years past may be supplying basic features

used in power windows, door locks, AM/FM radios, and so on. In many cases, incumbent chip and

electronics suppliers are still supplying similar parts with flattish or perhaps incrementally increased

content. However, the more promising opportunities stem from new and emerging nonstandard

electronic features, such as infotainment, connectivity solutions and advanced safety systems. We see

plenty of room for relatively smaller players like Analog Devices, Linear Tech, Maxim, and Microchip to

profit from the rising tide of increased electronics content in cars.

Higher-Priced Content and Share Gains Should Put Chip Growth Rates

From the Auto Market Into Overdrive at Over a 10% CAGR

We project above-average automotive chip revenue growth for several firms, as the good times in the

automotive space continue. In light of Gartner's 5.5% forecast CAGR for automotive revenue for the

entire semiconductor industry, we expect average revenue growth from the subset of analog firms under

our coverage to rise at over a 10% CAGR from 2015 to 2019. Safer, greener, smarter cars, as demanded

Market Share 2002… ...2006… ...2009… ...2011 2012 2013 2014Renesas (incl NEC) 14.1% 14.3% 13.8% 14.2% 13.3% 12.0%Infineon 8.2% 9.5% 9.0% 9.8% 9.1% 9.6% 10.5%STMicro 6.6% 8.4% 7.7% 8.7% 7.9% 7.9% 7.8%Freescale 13.4% 11.1% 8.0% 7.9% 7.0% 7.4% 7.5%NXP 5.9% 6.1% 6.4% 6.4% 6.3% 6.5% 6.8%


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by both consumers and government regulatory bodies, should drive further electronic content per vehicle

in the long term.

Chipmakers should profit not only from solid automotive production growth, but more important, rising

chip content per vehicle, as shown in Exhibit 15. In this context, we think that in a bear case, automotive

chip revenue can be maintained even if production remains flat, but not grow, for a prolonged period.

Similarly, auto production upside would predictably make us even more bullish about auto chip revenue.

As we'll detail throughout this report, for a variety of reasons, we remain confident that a host of new

and more advanced electronic features will be added to vehicles (thus leading to increased chip content

per vehicle) over the next few years.

Exhibit 15 Analog Leaders With Increased Focus on Auto Should Thrive

Source: Gartner, IHS, Infineon, Company documents, Morningstar Research estimates

Looking at our auto revenue growth projections by company, we don't even see our robust auto growth

forecast for Maxim, as shown in Exhibit 16 as a huge outlier, as the firm has expanded its auto business

at a 30%-plus pace from a year ago and a 19% CAGR over 2012-14.

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

2014 2015E 2016E 2017E 2018E 2019E

Auto Production Growth

Auto Chip Content per Vehicle Growth


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Exhibit 16 Analog Leaders With Increased Focus on Auto Should Thrive With Above-Average Compound Average Growth Rates Over the Next Few Years

Source: Gartner, IHS, Infineon, company documents, Morningstar Research estimates. Note that Auto Electronics and Auto Total Analog revenues are based on a 3-year CAGR from 2015 to 2017. Linear's and Maxim's fiscal years ended in June 2015; estimates reflect fiscal 2016 to fiscal 2020. All other growth rates are CAGRs from 2015 to 2019.


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Safer, Greener, Smarter Cars Stoke Our Optimism on Auto

As summarized by Analog Devices, automotive customers, parts makers, OEMs, and even government

regulators see the desire for safer, greener, smarter cars. Each of these three paths will rely on vastly

more complex electrical content (and, in turn, semiconductors) to deliver the cars of the future. More

important, the opportunity for chipmakers isn't contingent on the much-hyped end game of a fully

autonomous car (either with an electric or internal combustion engine), but from incremental

improvements in today's prototypical vehicles over the next several years, if not decades.

× Safer cars: including a wide variety of advanced driver assistance systems, such as blind spot detection,

lane departure warnings, rear view cameras, and radar systems.

× Greener cars: not only electric and/or hybrid vehicles, but also stop/start engines and improved fuel

efficiency in gas-powered cars.

× Smarter cars: more advanced infotainment systems, not just in terms of improved entertainment

content and in-dash operating systems and software, but also in terms of a control center that allows

the driver to process more and more information captured by additional sensors and cameras in the car.

These secular trends in auto should lead to solid growth in a variety of semiconductor products for the

following reasons:

× Safer cars require additional sensors in and around the vehicle, chip content to capture, filter, and

process audio and video signals, and connectivity chips to reliably transfer data from sensors and

cameras into the infotainment system or instrumentation systems.

× Greener cars require reliable power management chip content to restart stop/start gas engines, as well

as manage voltage in cars with more advanced car batteries, in gas cars and certainly in hybrid and

electric vehicles.

× Smarter cars require advanced audio filtering content to allow for improved voice controls, high-end

microcontrollers (MCUs) or processors needed to run more advanced infotainment operating systems,

and connectivity to upload and download wireless content and connect to emergency systems like GM's

OnStar.


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Our Top 6 Reasons Automotive Chip Demand Will Thrive

1. Long Design and Product Life Cycles

As we think of semiconductor supply relationships, we should first note that car design cycles are long,

so chipmakers have excellent visibility into new car models (and, more important, the advanced

electronics inside of such cars) not just for this year, but two and three years out. Thus, we are confident

that the positive trends around increased chip content in cars will play out.

Exhibit 17 Analog Devices Outlines Its 2014 Development for Car Model Year 2018

Source: Analog Devices

Just as important, most vehicle programs have a 5- to 10-year life cycle, so chipmakers that earn design

wins are able to earn an annuitylike revenue stream over the life of the program. Combining the design

and production cycles, suppliers have a 6- to 13-year partnership with a given automotive program.

Based on these timelines, design wins in auto remain especially sticky, as car makers would incur hefty

switching costs to kick a chip supplier out of the program in order to develop and validate a new system.


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2. Government Regulations

We expect a series of government regulations will require car makers to improve their safety and fuel

efficiency over time. Most of these improvements will require more advanced electronics and, in turn,

increased semiconductor content.

× U.S. corporate average fuel economy

× Average mileage standard to rise to 39 miles per gallon for cars and 30 mpg for trucks by

2016, from the prior average for all vehicles of 25 mpg as of 2009.

× Average mileage standard for cars and light-duty trucks to rise to 54.5 mpg by model year

2025.

× U.S. National Highway Traffic Safety Administration

× The U.S. Kids Transportation Safety Act of 2007 requires vehicles built after May 1, 2018, to

have a backup rearview camera. For context, 44% of 2012 car models had standard rear

cameras and another 27% had them as options, per Edmunds.

× In 2007, the NHTSA mandated that all new cars sold in the U.S. had to be fitted with tire

pressure monitoring systems. Similar regulations are occurring in Europe and South Korea.

× Quality and safety standards for electrical components

× The Automotive Electronics Council, a coalition of auto-parts makers and chipmakers, has

developed AEC/Q100 stress-test qualifications for semiconductors that call for zero defects

and other criteria.

× The International Organization for Standardization has issued ISO 26262 for functional safety

standards in safety-related automotive systems.

× Europe

× The European Commission's Euro 6 standard calls for an 80% reduction in nitrous oxide from

the prior Euro 5 standard.

× Various regulations pushing for ongoing carbon dioxide reductions in autos.

× Europe's New Car Assessment Program

× Although not a steadfast government regulation, starting in 2014, cars that do not include

active safety as standard features are automatically excluded from receiving Europe's NCAP's

5-star rating.

× By 2017, such features will be needed in order to receive a 4-star rating.

3. Higher-Priced, More-Advanced Automotive Parts Going Into Cars

We also foresee auto-parts makers profiting from higher average selling prices for their products relative

to more commodity-like devices. For example, Autoliv, a leader in a variety of automotive safety parts

like seat belts and airbags, saw its revenue in the first quarter of 2015 grow 3.9% from the year-ago

quarter (excluding currency effects), 2 percentage points ahead of vehicle production. Yet revenue from

more advanced active safety systems rose 31% over the same time frame. Auto-parts makers have

plenty of incentive to provide their car OEM partners with better and better solutions in order to maintain

or increase pricing, as well as fend off competition as older parts become standardized and mature.


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Exhibit 18 Autoliv's 2015 First-Quarter Results Point to the Shift Toward Active Safety Features

Source: Company documents, Morningstar Research estimates

4. Car OEMs Will Use Safety Features as Differentiators

Car OEMs are increasingly using advanced driver assistance systems, infotainment, and other electronic

capabilities as differentiators in their vehicles. Typically, new bells and whistles are added to luxury cars

first, in order to offer buyers with a premium experience. However, these advanced systems are also

making it into mainstream vehicles quite quickly, again in efforts to differentiate among one another.

5. Consumer Interest in Safety Features and Advanced Technology in Cars Is Piquing

We also see favorable trends among car buyers who are increasingly demanding advanced electronics in

their vehicles, especially younger buyers. Linear Tech recently cited a survey by AutoTrader.com that

focuses on new car technology: 50% of car buyers are willing to wait for almost a year to get all of their

"must-have" features in their next vehicle, while 51% are willing to pay as much as an additional $1,499

to get these features. The survey also states that 69% of customers would rather have a vehicle with

the technology they want instead of the color they want. Backup cameras, USB charging ports, and

wireless device charging were at the top the list of new tech features. Similarly, backup cameras,

sensors, and on-board Wi-Fi are features that at least 40% of survey participants wish they had in their

current vehicle.

Perhaps surprisingly, just over half of customers think that car makers should improve upon their

internally designed infotainment systems rather than concede the in-dash system to be a generic

platform that would run smartphone-like operating systems from Apple or Android. Per an

AutoTrader.com survey in January 2015, 80% of customers would prefer to use a navigation system

built into their vehicle than one on their phone. Marrying our fourth and fifth points, car OEMs see clear

demand for more advanced infotainment systems, which should lead to ongoing development regardless

of global auto production levels over the next few years.

AutoLiv 2015 Q1 Results Revenue ($000s)

y/y % rev growth,

constant Fx Units (000s)y/y % unit

growth ASPSeatbelts 653,400 3.3% 36,700 2.0% 17.80$ Airbags 1,181,100 3.1% 33,300 3.4% 35.47$ Passive Safety 213,200 -2.6% 8,400 6.0% 25.38$ Active Safety Sensors 126,400 31.4% 1,400 42.0% 90.29$ Global Vehicle Production 22,100 1.9%


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Exhibit 19 Millennial Buyers Demand More Advanced Infotainment Systems in Vehicles

Source: AutoTrader.com

6. New Features Open Up Opportunities to All Chip Suppliers

We are also encouraged by fragmentation within the automotive supply chain, as automotive

semiconductor suppliers are selling into a large base of car OEMs and Tier 1 auto-parts makers. In turn,

no chipmakers are effectively shut out of this market. Although Japanese car OEMs like Toyota have

significant relationships with parts makers like Denso and chipmakers like Renesas, we believe these

OEMs are also opening up their supplier base to foreign chipmakers like Infineon. Further, any

chipmakers that are cut out of this loop in Japan have plenty of opportunity to break into parts makers or

OEMs in Europe, Korea, or even an emerging automotive supply chain like in China. Success for analog

firms won't be winner-take-all or based on forcing an incumbent out of a long-standing relationship, but

from winning new designs for emerging technologies across the globe; engagements at one or two

OEMs could be more than enough for many firms to achieve strong revenue growth.


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Behind Every Car Ad Touting More Bells and New Whistles, We See a Bevy of Analog Content

As we think about analog chipmakers that are best positioned to participate in automotive

semiconductor growth, we don't foresee a winner-take-all situation, either in terms of the electronic

device used in the car or the chipmaker that might win or lose a particular socket. Whereas a single

design win into an Apple iPhone can significantly boost a company's fortunes (or crush them if they lose

out in the next-generation device), we see dozens of opportunities for analog chipmakers to specialize in

certain applications and carve out defensible niches in the space in order to drive over 10% sales growth

for firms under our coverage.

We have identified and forecast growth across several key applications for the automotive chip industry

in the years ahead. Broad commentary from analog chipmakers is aligned with these forecasts, while

firms are most optimistic about growth in areas like advanced driver assistance systems, electric and

hybrid electric vehicles, infotainment systems, and increased connectivity solutions within the body of

the car. Again, automotive leaders in years past may have specialized in less advanced electronics

(power windows, door locks, and so on), but new applications could lead to a shift in the automotive

chip supplier base toward firms that weren't previously entrenched (such as Linear, Maxim, ADI, and

Microchip), all while increasing the overall automotive chip pie.

For each of the key categories we've highlighted, like ADAS and infotainment, we'll take a deeper look

into the opportunities for devices and chip content, as well as the chipmakers that are best positioned to

capitalize from growth.


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Exhibit 20 Morningstar's Ranking of Chip Suppliers Across Applications

Source: Morningstar Research estimates *Ratings for NXP and Freescale were assessed independently, despite their pending merger


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Advanced Driver Assistance Systems

Key Takeaways

× ADAS represents the single-most attractive growth opportunity for analog chipmakers within auto, rising

at a 17% CAGR.

× Demand: Driven by government regulation, car OEM differentiation, and consumer desires.

× Beneficiaries: Both early incumbents (Infineon, STMicro, TI) and newcomers (ADI, Maxim) appear to be

especially well positioned in ADAS.

ADAS represents the single-fastest growth opportunity for analog chipmakers. We think semiconductor

revenue can rise at a 17% CAGR as these systems are simply loaded with chip content.

At Morningstar, senior automotive equity analyst Richard Hilgert's report from June 2014 highlights the

tremendous opportunities for ADAS growth and active safety (a subsegment of the total ADAS market)

as part of the broader auto-parts market through the rest of the decade. Our report calls for a 25% CAGR

for the active safety parts market through 2020 and, more broadly, a 15% CAGR for ADAS-related

automotive parts. Strategy Analytics separately forecasts that distance warning systems and emergency

braking features will grow at a 25% annual pace through 2020.

Exhibit 21 Millennial Buyers Demand More Advanced Infotainment Systems in Vehicles

Source: Company documents from Autoliv, Continental, Delphi & TRW, IHS Automotive, IIHS, Morningstar Research estimates

What Products Are Included in ADAS?

The auto industry has essentially divided safety features into two categories: active and passive. The

difference between the two broad categories stems from how they handle a pending collision. Passive

safety systems include traditional items in most cars today, like airbags, seat belts, and antilock braking

systems, that deploy based upon the direction and severity of the collision.

Active safety systems go one step further by sensing a possible collision and potentially applying brakes,

steering, or other warnings in an attempt to avoid the accident. Examples include identifying potential

issues not only with other cars, obstructions, and pedestrians around the car, but also with the driver in

the car. Driver monitoring systems are beginning to use features like facial recognition and eye tracking


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technology to ensure that drivers are alert and focused on the road. Harman is also using human-

machine interface to provide tactile feedback and shake the steering wheel if the vehicle detects a lane

departure.

Active safety sensors tie in a few different applications, which we highlight in Exhibits 22 and 23.

Exhibit 22 Active Safety Features Encompass a Variety of New Technologies

Source: Gartner, January 2015


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Exhibit 23 ADAS Encompasses the Entire Vehicle


Why Is ADAS a Growth Opportunity?

As Hilgert wrote in his June 2014 report, nearly 300 traffic fatalities occur globally every day and over

1.2 million fatalities occur worldwide per year. The United States (NHTSA) and Europe have set

aggressive targets to reduce fatalities—NHTSA hopes to reach zero traffic fatalities by 2030, while the

European Union hopes to cut road fatalities in half by 2020 from 2010 levels. ADAS are critical

technologies needed to reduce these fatalities.


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Exhibit 24 Luxury and Mass-Market Vehicles With Active Safety Are Expected to Rise

Source: NHTSA, Morningstar Research Estimates

While the worldwide goal is for automotive accident reduction, changing driver demographics are

making progress all the more difficult. ADI has discussed several megatrends that have led to different

people behind the wheel than in years past:

× Elderly drivers are increasing as our worldwide population ages and life expectancies are extending.

× Distracted drivers are increasing thanks to the proliferation of smartphones and improved communication

technologies.

× Inexperienced drivers are hitting the road more often as cars are becoming more ubiquitous in emerging

markets.

× Congested driving is rising in overpopulated cities, particularly in China.

Thanks to these trends, ADAS won't be reserved for luxury automobiles any more. An interesting case

study for ADAS might be found in China. Hundreds of millions of people are rising to the middle class and

could become car drivers over time. Yet these people have little to no driving experience, while hundreds

of millions more will still crowd urban streets with bicycles or as pedestrians. ADAS could become vitally

important in the Chinese market in an effort to curb accidents and injuries in a region that might

otherwise see these disasters at an above-average pace without such safeguards. In developed

markets, one can imagine more and more parents buying new (albeit entry-level) cars for young,

inexperienced drivers with the latest ADAS features, instead of buying or passing down older vehicles.


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Who Are, and Will Be, ADAS Chip Leaders?

As an emerging category within safety, the ADAS opportunity for chipmakers is relatively greenfield, in

our view. Ultimately, these highly advanced safety systems will require semiconductors that offer

extremely high quality and performance capabilities.

We think ADI has potential for further growth in ADAS systems, both from sensors and data converters

built in house as well as its expanded radio frequency product lineup, thanks to its recent acquisition of

Hittite. Texas Instruments appears to be a leader today but anticipates robust ADAS growth in the years

ahead in a couple of different areas. First, TI has built and sold over 15 million ADAS system-on-chip

solutions as of July 2014. These SoCs integrate and process signals from a variety of camera and

connectivity interfaces in the car, in order to support front cameras, parking assist, and radar functions.

TI's broad product portfolio gives the company inroads into radar-based systems—the firm supplies

more powerful digital signal processors into long-range radar, while selling relatively lower-power MCUs

for use in short-term radar systems.

Maxim Integrated has a suite of ADAS-related products but doesn't appear to have much of an

incumbency role in the market today. Microchip's MOST connectivity solutions, which we'll discuss in

detail later, handle video processing mainly used in entertainment systems historically (backseat video

screens and so on) but can increasingly handle ADAS-related video as well.

As current auto market leaders today, STMicro and Infineon have broad auto-related product portfolios

and strong positions in all types of safety systems (both passive and active). ST recently stated that 8

out of 10 vehicles with ADAS incorporate ST's chip content in those systems. ST is also a key partner of

Mobileye's, as it is the design and manufacturing partner of Mobileye's EyeQ3 image processor for use in

its video-based ADAS systems, deployed in cars from BMW, GM, Volvo, Ford, and others.

Infineon's ADAS-related products include 32-bit microcontrollers used to process ADAS features, as well

as radar transceivers. Infineon recently touted that it shipped its 10 millionth chip used in radar systems,

while about 50% of 77 GHz radar systems (used in adaptive cruise control and collision warnings ) sold in

2014 included Infineon's content. Infineon conceded that such systems were built into premium and

luxury vehicles, but over the next year, such systems will be included in midsize and compact cars.


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Exhibit 25 Morningstar's Ranking of ADAS-Related Chip Suppliers

Source: Company documents, Morningstar Research estimates * Ratings for NXP and Freescale were assessed independently, despite their pending merger


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Car Infotainment Systems

Key Takeaways

× Chip content within car infotainment systems is expected to rise at a 7% CAGR.

× Demand: Consumer demand for advanced electronics is on the rise, and more advanced infotainment

systems are needed to process increasing ADAS data.

× Beneficiaries: TI, Maxim, ADI, and STMicro appear well positioned to increase analog chip revenue in

infotainment.

If ADAS represents the safer portion of the favorable safer, greener, smarter secular trends in

automobiles, more advanced car infotainment systems and instrumentation clusters represent the push

for smarter vehicles. Favorable trends in this market include the adoption of more advanced infotainment

systems in mass-market vehicles, as well as improvements in the infotainment systems themselves—

the ability to handle a much wider variety of applications and operating systems, process the data

captured from a variety of sensors (including from many aforementioned ADAS features), filter and

enhance audio signals in especially noisy automobile cabins, and improve connectivity within the car in

order to better and more securely pass audio, video, and data signals throughout the vehicle.

We anticipate that semiconductor revenue from car infotainment systems will rise at a 7% CAGR over

the next few years. Yet we've seen estimates from analysts like TechNavio that are even more

optimistic, calling for a 12% CAGR over the same time frame. Any bias to our revenue estimate could be

to the upside.

What Products Are Included in Infotainment?

At first, we wondered why the in-dash system won't simply be replaced by a mounted tablet or a similar

piece of dumb glass that would simply mirror one's smartphone operating system. We've since learned

that infotainment system designers face a host of nuanced challenges and obstacles when designing

their systems that leading smartphone and tablet makers simply do not encounter.

× Impeccable design needed to reduce driver distraction and associated liability.

Whereas smartphones and tablets take up a considerable portion of one's time and attention, many

expect infotainment systems to offer similar levels of connectivity, communication, and convenience but

with far less attention being paid to the system. Infotainment touchscreens, controls, and operating

systems have to be far more intuitive than other types of mobile computing devices. Meanwhile, such

systems now have built-in safeguards that disable certain functions while the car is in motion. Any

accident caused by a driver who was paying too much attention to an infotainment system could open

up car OEMs and their suppliers to a wave of legal liability, especially if any sort of error, bug, or

software crash led to such distraction. Similar to the product quality of zero parts per million defects in

semiconductors, software reliability is far more critical in infotainment systems than in handheld devices.

× Long development times lead to hardware challenges.

Whereas smartphones are designed, brought to the market, and rendered obsolete in just a couple of

years, automobile designers have far longer design cycles. Systems built on today's most advanced


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hardware and silicon during the design process might be relatively antiquated by the time such systems

hit the market in new car models. Infotainment software suppliers simply can't rely on a faster processor

to arrive that will make up for any sluggishness or bloated software in the operating system.

× Even longer product life cycles face the challenge of obsolescence.

Along these same lines, once infotainment systems hit the market, they essentially remain in use for the

life of a vehicle. Hardware, silicon, and operating systems simply aren't replaced on a two-year cycle

similar to smartphones in the U.S., so manufacturers must develop systems that will still provide drivers

with useful information for a decade, if not longer.

Why Is Infotainment a Growth Opportunity?

Similar to ADAS, perhaps the most steadfast driver for infotainment system growth is government

regulation. In particular, the U.S. National Highway Traffic Safety Administration requires vehicles built

after May 1, 2018, to have a backup rearview camera. Although we see instances where this video is

processed and displayed to the driver within the rearview mirror, the far broader trend is for this video to

be displayed in an in-dash system that displaces simpler car stereos used in the entry-level vehicles of

years past. Similarly, infotainment systems are required to process and display many of the active safety

features that are required by NCAPs to give 5-star safety ratings to vehicles.

Beyond regulations, automotive OEMs strive to build more powerful and elegant infotainment systems

as a means of differentiation among vehicles. Mercedes would be hard-pressed to maintain its luxury

position if the same exact infotainment system were used in an entry-level car from Kia. Thus, we

expect luxury car makers to continue to invest in infotainment development and push the technological

needle for these systems. Such improvements should involve not only more advanced software, but

most likely increased chip content as well.

Finally, similar to our ADAS discussion, consumers are demanding more electronic features per car. In

the AutoTrader.com survey highlighted in the ADAS section, car buyers actually prefer more advanced

safety systems than infotainment displays, but they also want elegant, simple solutions to control the

vehicle; 48% of participants have said they would walk away from a vehicle they liked if the technology

was perceived to be too difficult to use. Nearly half of vehicle owners (48%) think it should take less than

15 minutes to figure out how to use all of the technology features in a new vehicle.

Who Are, And Will Be, Infotainment Chip Leaders?

Infotainment systems are relatively less of a greenfield opportunity than, say, ADAS, but this technology

is changing rapidly and chipmakers see plenty of chances to make inroads with car OEMs, parts makers,

and infotainment software designers.

In the audio portion of the infotainment market, Maxim Integrated, TI and STMicro are all targeting

enhanced audio chip content in order to better filter and identify voice and noise signals. Maxim has a

relatively smaller auto business than the rest of the field, but its auto chip business has grown at a

strong pace in recent years, as the company is implementing its IP that was initially used for smartphone

audio chips (such as those that appear in Apple's iPad) and selling it into the auto space.


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Linear and Maxim are also faring quite well in supplying power management chips into infotainment

systems. As more and bigger displays are being added to the dashboard and instrumentation cluster,

more advanced power management chips are required alongside of the processors in these systems.

Maxim has noted that its power management chips also run alongside of Nvidia's processors used in

infotainment systems, so to the extent that Nvidia beats out a host of other digital firms in that area,

Maxim could be an even bigger winner. Maxim also counts Tesla as a key customer. Meanwhile, Linear

earns almost 40% of its automotive chip revenue from the infotainment section of the car.

As one-stop shops, TI has a variety of infotainment-related analog parts in converters, interface, and

power management in order to process a wide variety of audio and video standards. The company's

MCUs also provide cost-effective processing in displays used in rearseat head rests. STMicro is already

a leader in certain aspects of car infotainment, like digital tuners and audio-related parts. The company

recently touted 100% market share with Sirius XM satellite radio, which is pre-installed in a number of

vehicles today.

Exhibit 26 STMicro Already Holds Solid Market Share Positions in Infotainment

Source: STMicro 2015 analyst day


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Exhibit 27 Morningstar's Ranking of Infotainment-Related Chip Suppliers

Source: Company documents, Morningstar Research estimates * Ratings for NXP and Freescale were assessed independently, despite their pending merger

Infotainment (excl. Connectivity)

Coverage:

ADI

Linear

Maxim

Microchip

TI

STMicro

Infineon

Coverage, Non-Analog:

Qualcomm

Broadcom

Nvidia

Intel

Non-Coverage:

Renesas

NXP *

Freescale *

Current Leader, Well Positioned

Emerging Growth Opportunity

Potential for Some Revenue Growth

Not a Focus of the Company

None or Unknown


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Connectivity Solutions

Key Takeaways

× Chip content used in connectivity could rise at a double-digit CAGR over the next few years.

× Demand: More advanced connectivity solutions are desired by consumers in order to handle mobile data

and are also necessities in order to manage data (audio and video) from ADAS.

× Beneficiaries: Microchip should continue to grow as MOST connectivity gains adoption. Outside of

analog, Broadcom and NXP will tout automotive Ethernet, while Qualcomm will strive for both Wi-Fi and

cellular connectivity in the car.

Connectivity in years past has centered on standards used to pass simpler diagnostic information

throughout the car and, to a lesser extent, audio and video signals. Today and going forward, we see the

rise of connectivity electronics to pass audio, video, and data throughout the car, similar to favorable

trends in infotainment. We're expecting not only an increase in connectivity solutions within the vehicle,

but more importantly for individual stocks under our coverage like Microchip, a battle among different

connectivity standards in the car as incumbent networks are facing challenges from wireless standards

like Ethernet (typically used in traditional data networks) and cellular connectivity solutions (like 4G LTE).

General Motors has been especially vocal about its intentions to include 4G LTE in over 30 upcoming car

models.

What Connectivity Solutions and Standards Are Used Today?

Cars today incorporate over 2 kilometers of connectivity wiring per vehicle, as data from up to 200 nodes

throughout the car are wired together to process and send signals throughout the system. This wiring is

cost-effective, but in efforts to reduce the weight of vehicles in order to improve fuel efficiency, wireless

connectivity standards are being looked at. However—to repeat a common theme—automotive

connectivity standards and networks require a higher degree of quality and reliability than those used in

other types of devices. For example, a video feed from a rearview camera simply can't cut out at the

same pace as a smartphone dropping a call or a PC losing its Wi-Fi connection. Similarly, wireless

automotive connectivity has been designed to run at different frequencies than more ubiquitous

standards so that the airwaves are not congested with traffic from other types of technologies, such as

mobile phones or PCs.

Four different types of automotive connectivity are used today:

× Controller area network

Low-cost, low-data-rate wired connectivity standard that allows microcontrollers and electronic control

units to communicate to one another without the need for a host computer1.

× Local interconnect network

Another inexpensive, single-wire, even lower-data-rate protocol used for automotive body control

applications, such as roof, seat position, mirrors, doors, steering wheel, lighting, and climate control2.

1 CAN in Automation website June 2015 http://www.can-cia.de/index.php?id=161

http://www.can-cia.de/index.php?id=161


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Given its faster speeds and minimal wiring, CAN remains the primary interface for many automotive

applications, but LIN has offloaded some features from CAN.

× FlexRay

FlexRay is an emerging, relatively more costly, but higher-speed wired networking standard in the car

that is geared toward chassis, powertrain, and safety applications.

Exhibit 28 Freescale Highlights the Different Applications Based on CAN, LIN, and FlexRay

Source: Freescale

× Media-oriented systems transport

MOST is a high-speed multimedia protocol used for the communication of audio, video, voice, and data

signals within the car over plastic optical fiber or electrical conductor. As of July 2015, Microchip has

shipped 170 million MOST units into 184 car models since 2001.

2 Gartner January 2014 "Market Trends: In-Vehicle Infotainment Systems Drive Automotive Semiconductor Growth" and Gartner

July 2014 "Market Trends: Automotive Body Electronics Segment Is Poised for Growth"


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Exhibit 29 Microchip, via Acquisition of SMSC, Is a Leader in MOST Chip Content

Source: Microchip June 2013 presentation

From our perspective, both in terms of technology and our coverage of Microchip, we're most interested

in MOST adoption going forward. It is the incumbent media connectivity standard with terrific traction

with car OEMs thus far, and it is a critical technology for Microchip and its efforts to expand its revenue

growth within the car. We currently see Microchip's traction with MOST as ramping up, not down.

However, the standard faces competitive threats from two widespread technological standards that are

setting their sights on the car.

× Automotive Ethernet

Similar to the ubiquitous Ethernet standard used in traditional networking today, automotive suppliers

are seeking to expand the Ethernet use case into the automobile. Ethernet has been used in auto repair

shops to download diagnostic information, but is looking to move into the vehicle. Benefits of Ethernet

include its cost effectiveness, faster data rates (100 MB/s), and widespread support, but security

concerns persist around this use of such a broad-based technological standard.

In January 2015, Broadcom disclosed that its Broader Reach Ethernet product, which strives to extend

its Ethernet opportunity beyond just infotainment and ADAS and into telematics, satellite antennas, and

instrumentation clusters, has design wins with five automotive makers this year. Car OEMs listed on

Broadcom's website, presumably as partners, include BMW, Ford, GM, Hyundai, Jaguar, Land Rover,

and Volkswagen.


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× 4G cellular networks

Wireless chipmakers with roots in the mobile phone business are seeking to extend their connectivity

solutions into the car. Qualcomm's baseband chips have been the backbone of GM's OnStar service for

years, but as wireless networks improve to 4G LTE standards with much greater data capacity, cellular

firms are touting their capabilities to provide advanced wireless data throughout the car as it travels.

In April 2015, Qualcomm disclosed that it has over 40 connected car programs with over 15 OEMs, and

it announced two new baseband modem products, Snapdragon X12 and X5, which target automotive

sockets.

Why Is Connectivity a Growth Opportunity?

The growth opportunity for connectivity is similar to the case we posed in the infotainment section. First,

on the safety front, as more advanced safety systems are added to each vehicle, cars must become

better equipped to securely send the data, audio and video signals from these safety systems

throughout the vehicle and into the infotainment system. NXP even sees its ASPs for CAN and LIN

products rising from $3 today to around $10 in the future. We could also see increased connectivity as

more and more OEMs implement emergency systems in their cars, similar to GM's OnStar.

Second, from an entertainment aspect, consumers are constantly demanding faster data rates in order

to stream music and video. Increased connectivity in the car is not only required by a single device like a

smartphone or directly into an in-dash system, but also to send such feeds to multiple points within the

car (say, from the infotainment system into digital screens in the backseat so kids can view it as well).

Enhanced connectivity both within the car and to the outside world acts as a potential differentiator in

the auto market. In a recent report on the Internet of Things, Gartner estimates that the number of

vehicles with embedded connectivity will rise from 1.2 million in 2014 to 36 million by 2020.

Who Are, and Will Be, Connectivity Chip Leaders?

Again, Microchip has a prominent position in the MOST ecosystem and has regularly touted its

capabilities. Ultimately, we see Microchip squaring off against Broadcom and NXP, in particular, as they

promote Ethernet in the car. To a lesser extent, Qualcomm is also striving to push its Wi-Fi chip portfolio

into the car. Given the fragmentation of vehicle and auto-parts makers, we see room for all three firms to

gain some traction over time, but the battle among standards bears watching.

In general, Qualcomm is looking to extend all of its mobile technologies (processors, baseband, Wi-Fi

chips, augmented reality solutions) beyond smartphones and into the car. We think Qualcomm's best bet

to earn incremental auto revenue is to sell baseband chips into the car in order to enable 4G LTE-based

hotspots.

Looking at other analog firms under our coverage, TI's infotainment products also support a variety of

automotive connectivity standards and could be indirect beneficiaries of cars that adopt more advanced

connectivity solutions. STMicro also carries connectivity products that can be deployed in both

smartphones and the car, but it has not been a leader in this segment of the market.


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Exhibit 30 Morningstar's Ranking of Connectivity-Related Chip Suppliers

Source: Morningstar Research Estimates *Ratings for NXP and Freescale were assessed independently, despite their pending merger


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Powertrain, Electric Vehicles, and Hybrid Electric Vehicles

Key Takeaways

× Chip content within EV and HEV is expected to rise at an 11% CAGR.

× Demand: Analog chip growth in powertrain isn't contingent on a wholesale transition to EVs/HEVs, as

stop/start engines also rely on increasing chip content. However, EVs and HEVs use significantly more

chip content (especially power management products) per vehicle.

× Beneficiaries: Analog chip leaders under our coverage include Infineon, STMicro, and TI, yet powertrain

should be a nice growth driver for Linear Tech, Maxim, and ADI as well.

Another key area for automotive chip growth, in our view, is the automotive powertrain. We think that

traditional powertrain chip sales can rise at a mid-single-digit pace, but semiconductor revenue from

electric vehicles and hybrid electric vehicles can easily rise at a double-digit pace, depending on

adoption. Clearly, a shift toward EVs and HEVs would be a major positive for chipmakers, but not a

necessity. Our expectations for powertrain chip growth aren't reliant on a massive shift toward EVs or

Tesla dominating the industry over the next few years (not that Tesla has the capacity to do so), but

rather from incremental and steady improvements to cars with internal combustion engines over time,

as "greener" gas-powered cars also strive for enhanced fuel efficiency and fewer emissions.

What Products Use Semiconductors in the Powertrain?

Traditionally, semiconductor content is found in traditional internal combustion engines that have

features like advanced direct-inject fuel systems and multigear automated transmissions. The next trend

worth watching in ICE vehicles is the rise in adoption of stop/start technology.

A stop/start engine receives an electrical signal to turn off the engine (and thus save fuel while idle)

when the car comes to a stop. The battery enables the driver to still use climate and audio while

stopped. When the driver removes his or her foot from the brake, the engine fires back up3. In addition to

the electrical system around the engine, larger and more advanced batteries are also required to deploy

these systems. According to IHS, the technology is prevalent in Europe as 60%-70% of cars use it as of

October 2014, versus only 7% in the U.S.4

One area of pushback against stop/start in the U.S. has been a lack of awareness around the technology,

as drivers erroneously believes that their cars stall out when the vehicle is stopped. Another is that

heating and cooling may stop when the engine is turned off. Nonetheless, the technology is believed to

provide drivers with a 10%-15% increase in fuel efficiency, and stop/start engine adoption is anticipated

to rise at a nice pace in the U.S. going forward.

3 Car and Driver: April 2011 Issue http://www.caranddriver.com/features/engine-stop-start-systems-explained-tech-dept 4 Detroit News, Oct. 8, 2014 http://www.detroitnews.com/story/business/autos/2014/10/07/autos-stop-start-driver-

resistance/16893597/

http://www.caranddriver.com/features/engine-stop-start-systems-explained-tech-dept

http://www.detroitnews.com/story/business/autos/2014/10/07/autos-stop-start-driver-resistance/16893597/

http://www.detroitnews.com/story/business/autos/2014/10/07/autos-stop-start-driver-resistance/16893597/


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Another area of powertrain improvement is the deployment of larger 48-volt batteries (versus traditional

12-volt) in cars. This shift has been discussed by car makers for some time, but the industry might be on

the cusp of adoption sooner rather than later. Audi is one of the first car makers to adopt these

batteries, as 12-volt systems are struggling to handle the increasing variety of electronic systems being

added to cars. In essence, an increase in the size and quantity of batteries in the car often requires

increased power management chip content as well.

Beyond ICE-powered vehicles, we foresee plenty of growth in EVs and HEVs over time. In our initiation of

coverage of Tesla in September 2014, based on data from IHS, global HEV unit sales are forecast to rise

from 2.2 million units in 2014 to 6.5 million by 2020, representing a 27% unit CAGR. EV sales are also

expected to skyrocket off a small base, from 0.2 million units sold in 2014 to just under 1.0 million units

in 2020, a 20% CAGR. As of July 2015, we estimate that Tesla will sell about half of these EV units, or

about 460,000 vehicles, in 2020, with even further growth to 780,000 cars sold in 2024.

EVs and HEVs require significantly more power management content in order to regulate current and

power from a larger number of batteries in the car. Infineon believes that the jump from an ICE to HEV

would not only essentially double the chip content per vehicle, but that the vast majority of this rise in

content will come from power management solutions. To a lesser extent, additional microcontrollers,

sensors and other chips are also needed in EVs and HEVs, relative to ICE-powered cars.

Exhibit 31 Infineon Cites the Need for Significantly Higher Power Semiconductor Content in EVs and HEVs

Source: Infineon September 2014 presentation, Strategy Analytics


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Why Is Powertrain a Growth Opportunity?

Perhaps more so than in other parts of the car that we mentioned, government regulation is a driving

force in more fuel-efficient vehicles, which will ultimately require increased semiconductor content per

vehicle. In particular, U.S. corporate average fuel economy standards require average mileage to rise to

39 miles per gallon for cars and 30 mpg for trucks by 2016, up from the prior average for all vehicles of

25 mpg as of 2009. Furthermore, average mileage standard for cars and light-duty trucks is required to

rise to 54.5 mpg by model year 2025.

Stop/start adoption is already in full swing, with solid adoption rates worldwide and a mandate in Europe

to include stop/start in all engines. For chipmakers, IHS sees stop/start as a hearty growth driver, as chip

revenue from these products could rise from less than $1 billion in 2014 to more than $2 billion in 2019.

Navigant Research suggests that by 2024, 55% of vehicles will have stop/start engines, compared with

22% of worldwide vehicles in 2015. Ford has also stated that 70% of its North American car lineup will

have stop/start by 2017.

Also, consumers desire fuel economy regardless of body size, both to offset the environmental effects of

gas consumption and to counteract relatively high gas prices in recent years. Although gas-guzzling

SUVs were popular in the U.S. a decade ago, the U.S. market is seeing a swing back toward light-truck

models like crossover SUVs. Similarly, car OEMs continue to use fuel efficiency as a differentiating factor

in the market across all body types.

Finally, in a similar theme to infotainment and connectivity, semiconductors used in traditional and

alternative powertrains are also indirect beneficiaries of the rise in ADAS. Larger batteries and more

advanced braking systems will require extra chip content in the powertrain to process and react to the

information collected by the ADAS cameras and sensors.

Looking at alternative powertrains used in EVs and HEVs in isolation, Gartner expects semiconductor

content from these cars to rise from $0.8 billion in 2014 to $1.4 billion by 2018, an 11% CAGR. Strategy

Analytics is far more optimistic, expecting chip sales to rise from $0.8 billion in 2013 to $2.0 billion by

2017, a 25% CAGR. When overlaying these revenue forecasts with IHS's unit production forecasts for

EV/HEV vehicles, these revenue growth rates might even turn out to be conservative, as they look to

bake in some deterioration in chip content per vehicle. Presumably EVs and HEVs will come down the

cost curve over time, but as we've noted, chip content per vehicle, in general, has risen at a nice pace in

recent years and we intuitively don't see chip content falling in these vehicles.

We should also note that China remains a wild card in the EV and HEV space. Given vast government

control and the region's limited history with ICE vehicles, China could have the wherewithal to build out

the necessary infrastructure to enable EV adoption faster than in developed markets.

Who Are, and Will Be, Powertrain Chip Leaders?

On an absolute basis, powertrain and EVs/HEVs represent the largest application for semiconductor

content, with $5.5 billion of chips sold into these applications. Not surprisingly, the broad leaders in total

automotive chip sales are industry leaders in powertrain chip sales as well.


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IHS estimates that Infineon is the market share leader in powertrain, which is in line with our favorable

view of the company's broad portfolio of power products. In recent auto marketing materials, Infineon

disclosed that it has "over 30% of the market for cam, crank, and transmission sensing, over 34% of the

market for powertrain microcontrollers, and almost 20% of the market for power modules."

STMicro is also a powertrain industry leader, again with a strong product lineup of both analog power

integrated circuits, as well as discrete power products. ST's semiconductors are used in the powertrains

of three out of every four vehicles. Both Infineon and ST also appear well positioned to benefit from 48-

volt battery adoption.

Exhibit 32 Infineon and STMicro Lead in Power Products Across All Areas of the Car

Source: Infineon, Strategy Analytics April 2014

Nonetheless, firms with relatively smaller automotive chip businesses like Linear Tech and Maxim have

competed quite well in the automotive power management chip space in recent years, and we expect

these hearty growth rates to continue. Maxim has virtually no content in ICE-based powertrains today,


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but sells into Tesla and the Nissan Leaf among EVs and anticipates a solid market share position as EVs

gain adoption.

ADI should also profit from the powertrain by selling battery monitoring sensors and systems into the

car. Meanwhile, Texas Instruments remains the leader in overall power management analog ICs and has

a decent-size power management chip business in autos today, and we expect the firm to continue to

fare well as powertrains advance.

Exhibit 33 Morningstar's Ranking of Powertrain and EV/HEV-Related Chip Suppliers

Source: Morningstar Research estimates *Ratings for NXP and Freescale were assessed independently, despite their pending merger


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Chip Content Through the Rest of the Automobile Today

Rounding out semiconductor content in the car are areas like chips used in the chassis, instrumentation

clusters, and passive safety systems.

Chassis

Incumbent automotive chipmakers are key suppliers in various areas of the chassis, like tire pressure

monitoring systems, antilock braking, stability control, and "by-wire" systems like steering and braking,

which are replacing legacy mechanical and hydraulic linkages with electronics-based systems.

Infineon has an array of TPMS products, including sensors, power management chips, and optimized

MCUs. Antilock braking systems require all types of chip content (RF, processors, power management,

interface, sensors) and broad-based chip leaders in this area include TI, Freescale, and NXP. Finally,

steering and braking by wire products include power management and MCU products from a host of

firms.

Instrumentation

TI could be particularly well positioned in head-up displays within the instrumentation cluster of the car.

The firm is deploying its Digital Light Projector products, which have traditionally been used in overhead

projectors and televisions, onto the windshield of vehicles in order to provide additional information to

drivers

Exhibit 34 TI's DLP Products May Soon Offer Innovative Head-Up Displays



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Passive Safety

Traditional passive safety systems include seat belts, airbag control modules, and event data recorders

(that is, black boxes). Edmunds has indicated that 96% of new cars sold in the U.S. have black box

technology (with considerations to soon make them mandatory in the U.S.). In most cases this is

semiconductor-based and included in the airbag control module.

Airbag modules is an area where ADI is especially strong, as the company believes that only it and

Bosch are able to provide automotive-grade MEMS (micro-electro-mechanical systems) to airbag

manufacturers. ADI has been a supplier of airbag MEMS since 1992, as semiconductor-based products

began to displace laser-based legacy gyroscope systems. Similar to how MEMS in smartphones identify

whether the device is being held in portrait or landscape format, MEMS in airbag modules identify the

linear acceleration and angular rotation of cars. As vehicles move in directions they otherwise shouldn't

be (rolling, sliding, and so on), MEMS capture this information and sends signals, when needed, to

deploy the airbag. We expect ADI to remain a leading supplier into airbag modules, providing some

incremental growth above and beyond its targeted areas for even faster growth in ADAS and the

powertrain.


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Non-Digital Doesn't Equate to Non-Growth, as Analog Trajectory Appears Promising

The International Monetary Fund projects global GDP to be around 3.5% over the next couple of years

(3.3% for 2015, 3.8% for 2016), while we forecast 5.3% midcycle, pro forma revenue growth for moaty

analog chipmakers in our coverage over our five-year explicit forecast period through 2019, in line with

estimate for the analog industry as a whole. We should note that our average forecast growth rate

across our coverage would be 6% if we did not adjust for Infineon's recent acquisition of International

Rectifier.

Exhibit 35 We Foresee 5.3% Top-Line Growth Across Our Analog Coverage

Source: Company documents, WSTS, Databeans, Morningstar Research estimates. Linear's and Maxim's fiscal years ended in June 2015; estimates reflect fiscal 2016 to fiscal 2020. Infineon's CAGR adjusted to include International Rectifier in baseline fiscal 2014 results. Actual 5-year CAGR will be 12.9% for Infineon

Our Long-Term Midcycle Forecasts Are Above Recent Growth Rates

In the recent past, headline revenue, as measured by CAGR from 2011 to 2014, has not been at the

historical 2 times GDP pace (as evidenced by the line in Exhibit 36). However, we view this performance

largely as a function of company-specific situations rather than structural changes in the industry. For

example, ADI and Linear faced headwinds from de-emphasizing the consumer space. TI exited certain

wireless chip businesses while legacy products (calculators) also weighed on growth. Maxim hitched its

consumer chip wagon to Samsung and faced slumping sales as end-market demand for Samsung's

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

10.0%

CAGR '15-19E

ADI

Linear

Microchip

Maxim

Maxim Less Consumer

TI Analog Only

STMicro

Infineon Pro Forma

Average

Total Analog Market


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smartphones deteriorated. Even Microchip's outsize growth stemmed, in part, from recent acquisitions

as well as share gains.

So why do we think that the next few years will be different? First, despite the relative sluggish growth

for the entire analog chip industry and some of the firms under our coverage, we saw a sizable shift in

concentration toward higher-margin industrial and automotive chip sales, especially at Texas

Instruments. Meanwhile, automotive chip growth in recent years has also been stellar. Maxim's and

Linear's growth comes off relatively smaller revenue bases than peers like TI, STMicro, and Infineon.

Exhibit 36 Automotive Analog Chip Growth for 2011-14 in Our Coverage Excelled, Far Outpacing 2 Times GDP (Horizontal Line)

Source: IHS, Gartner, Strategy Analytics, company documents, Morningstar Research estimates. Individual firm CAGRs on a fiscal year basis. Maxim uses a 3-year CAGR for 2012-14, as the firm only recently split out automotive chip sales

Looking at analog's various end markets, shown in Exhibit 37, we are most excited about growth

opportunities in the automotive sector and anticipate robust demand from car OEMs and part makers

over the next few years. As we show in Exhibit 38, industrial is still the analog industry's largest

segment, and we foresee revenue growth from this extremely broad range of customers at roughly 2

times GDP over the next few years.

Telecom infrastructure has been a growth driver for the analog space at times in recent years, thanks to

robust 3G and 4G network buildouts in China, in particular. Yet we anticipate that worldwide telecom

capex may remain steady over the next few years but won't grow exponentially from here (especially

once China's 4G buildouts wrap up). In turn, we don't project robust analog revenue growth from the

telecom end market. Finally, some wide-moat names like Maxim and TI still have exposure to consumer-

related end markets like smartphones and PCs, but we again project little growth, if not outright revenue

declines, from consumer-related end markets over the next few years.


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Exhibit 37 We View Automotive as the Analog Industry's Most Attractive Segment for Revenue Growth From 2015 to 2019

Source: Company documents, Morningstar Research estimates. Note that Microchip does not break out revenue by end market. For Linear and Maxim, with fiscal year-ends in June, we use CAGRs from fiscal 2016 to fiscal 2020

Exhibit 38 Industrial Is the Largest End Market for Many Analog Firms, but Auto Exposure Matters

Source: Company documents, Morningstar Research estimates. Note that Microchip does not break out revenue by end market

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

ADI Linear Maxim TI STMicro Infineon

Auto

Industrial

Telecom Infra

Consumer

Computer

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

ADI Linear Maxim TI STMicro Infineon

Other/Commingled

Computer

Consumer

Telecom

Auto

Industrial


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How to Choose Among a Host of High-Quality Analog Chipmakers

As our analysis indicates, the favorable trends in the analog chip space can be played with any one of a

number of individual stocks. We view all of these tailwinds as a rising tide that will lift many, if not all,

boats in the industry. Yet independent of valuation, some fundamental factors might make certain stocks

a more or less attractive investment at any given time.

We have prepared the following proprietary analog vendor ranking to distinguish high-quality businesses

based on the following criteria:

× Product mix: Concentration on higher-margin analog products versus lower-margin digital and/or discrete

chip products.

× Customer diversification: Ability to avoid customer concentration and buyer power that may weigh on

profitability.

× End-market exposure: Firms that focus on industries that are willing to pay for higher-quality parts

(usually at lower volume) while also avoiding hefty exposure to a single end market, particularly

consumer-focused ones like smartphones or PCs.

× Revenue growth: Based on our revenue CAGR forecasts for 2015-19 (fiscal 2016-20 for Linear and

Maxim) for the entire business, including potential headwinds from non-analog product lines.

× Profitability: Based on our estimated average operating margins for 2015 to 2019.

× Capital distribution: Based on stated targets for free cash flow distributions to shareholders (either via

dividends or buybacks), as well as company records of paying out healthy, rising dividends.


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Exhibit 39 Morningstar's Analog Vendor Ranking

Criteria Weighting 0.20 0.20 0.20 0.10 0.15 0.15 1.00 Weaker<.60Stronger>.80

Linear Tech 5 5 5 4 5 4Vendor weighting 0.20 0.20 0.20 0.08 0.10 0.08 Strongest

ADI 5 4 4 5 4 4Vendor weighting 0.20 0.16 0.16 0.10 0.08 0.08 Strong

Microchip 4 5 4 4 4 4Vendor weighting 0.16 0.20 0.16 0.08 0.08 0.08 Strong

Texas Instruments 4 5 3 3 4 5Vendor weighting 0.16 0.20 0.12 0.06 0.08 0.10 StrongMaxim Integrated 5 3 3 3 3 4Vendor weighting 0.20 0.12 0.12 0.06 0.06 0.08 Average

Infineon 3 4 4 4 2 3Vendor weighting 0.12 0.16 0.16 0.08 0.04 0.06 Average

STMicro 2 3 3 4 1 4Vendor weighting 0.08 0.12 0.12 0.08 0.02 0.08 Weaker

VendorProduct

MixCustomer




Overall Rating

0.86

0.76

0.72

0.64

Positioning

0.78

0.62

0.50


Based on our proprietary rankings, and again ignoring valuation at any given time, we consider Linear

Technology to be the highest-quality analog chipmaker under our coverage, given it unparalleled

profitability while still being exposed to fast-growing, profitable end markets like industrial and

automotive where the firm does not face meaningful customer concentration. We consider ADI,

Microchip, and TI as strong, high-quality analog vendors on our list, given their large industrial exposure,

healthy profitability, and diverse customer bases. Although it is a wide-moat firm, we penalize Maxim

Integrated for its concentration in consumer products and with Samsung, while on the growth side,

we're pessimistic that Samsung's smartphone business will see exponential growth that will allow

Maxim to ride its coattails. We rate Infineon as a quality business, but a focus on lower-margin discrete

semiconductors puts the firm a sizable notch below the others. Finally, STMicro's poor profitability record

and exposure to unattractive digital chip businesses puts the firm at the bottom of our pack.

Based on current valuations, Linear Technology is also the most attractively valued stock in our analog

coverage. At recent prices of $40, we see an adequate margin of safety in the name, and we would be

even more interested in the stock if further price weakness were to arise. We are also starting to see

opportunities to buy Texas Instruments, Microchip Technology, and Infineon after a long stretch in which

we did not see attractive margins of safety in these names.

For investors looking for the greatest automotive exposure as a percentage of total revenue, which is

again our favorite trend in analog semiconductors, Infineon leads the pack. We should note that

Infineon's automotive exposure, as a percentage of total revenue, will decline due to the acquisition of

International Rectifier, but the firm's organic auto business should still see nice growth.


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Exhibit 40 Automotive Exposure as a Percentage of Total Revenue Continues to Rise Across Our Coverage Universe

Source: Company documents, Morningstar Research estimates. Microchip does not break out revenue by end market


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Analog Devices (ADI)

Wide Moat, Stable Moat Trend

Exhibit 41 Morningstar Vendor Ranking for ADI


Moat and Moat Trend

We view ADI's wide moat and stable moat trend as rock-solid, based on the firm's strong profitability

and strategic focus on higher-margin chip opportunities, even if Apple and relatively lower-margin

consumer-related chip sales become a larger part of its revenue mix over time. We discuss ADI's

consumer growth and exposure to Apple in Appendix 1.

Product Leadership Today

Unlike virtually every other product category in the analog space, ADI holds a dominant market share

position, owning virtually half of the data converter market. The company's product reliability and

reputation in converters are unparalleled.

Strategy and Differentiation

ADI expects to maintain its focus on products and end markets that will reward it for its signal

processing expertise. Most often, such customers and devices are in the industrial, automotive, and

telecom infrastructure end markets, but ADI still sees selective opportunities in consumer as well. ADI

has shed less profitable businesses in years past, such as selling off its wireless baseband business to

MediaTek, and we don't foresee it sacrificing gross margins far below its current 65% target in order to

achieve faster revenue growth. Its R&D push is to continually refresh its broad product catalog, as well

as build vertically integrated systems where the company can sell higher-priced content and/or

additional chips alongside of its core data converters.

Automotive Exposure

Today, ADI is a leader in MEMS used in airbag modules in the car. We have used ADI's marketing phrase

of "safer, greener, smarter" cars, and going forward, we see the firm attacking each of these three areas.

We foresee solid growth as ADI sells a variety of converters and RF content into ADAS systems, sensors

into battery management systems in ICE vehicles, EVs, and HEVs, and audio and video signal processing

content into infotainment systems. Predictably, ADI's geographical automotive focus is with European

luxury car makers, which continue to push the envelope on these more advanced systems, and the

North American auto market.

Criteria Weighting 0.20 0.20 0.20 0.10 0.15 0.15 1.00ADI 5 4 4 5 4 4

Vendor weighting 0.20 0.16 0.16 0.10 0.08 0.08

VendorProduct

MixCustomer




Overall Rating

0.78


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Other End Markets of Strength

Based on its data converter leadership, ADI is an especially important chip supplier into the

telecommunications infrastructure end market. ADI's telecom exposure has provided tailwinds at times,

but could provide headwinds at some point down the road, given the lumpiness of chip demand from

this end market. Yet we think ADI will maintain its leadership position in telecom going forward.

ADI could be one of the bigger winners in wireless carrier spending shifts toward small cells. For

processor and logic chip content, much higher unit sales volume from small cell deployment would

probably be offset by much less powerful (and lower-priced) chips. For ADI, however, we don't yet

foresee a drastic drop in chip ASPs from small cells, and rising unit volume might more than make up for

any ASP compression.

Product Gaps

ADI's strength lies in data converters, amplifiers, RF content, and sensors, while the company's power

management and digital signal processor businesses aren't especially broad and mostly serve to

compliment the company's core chip products.

Financial Health

As of May 2015, ADI held almost $3.1 billion of cash on hand versus less than $0.9 billion of debt. The

firm's goal is to pay out 80% of its free cash flow to shareholders via dividends and buybacks, and we

have little doubt that ADI will generate healthy ongoing free cash flow to cover these payments. About

75% of its cash balance is held overseas, however, so ADI may continue to take on debt (presumably at

reasonable interest rates) in order to raise its U.S. cash balance to fund such payouts.


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Exhibit 42 ADI Recent Financial Results and Estimates

FY 2013 FY 2014 Est. FY 2015Revenue 2,633,689 2,864,773 3,247,831

y/y % growth -2.5% 8.8% 13.4%

Gross Margin 1,692,411 1,830,188 2,147,025

GM % 64.3% 63.9% 66.1%

EBIT 783,143 815,826 1,053,533

EBIT % 29.7% 28.5% 32.4%

EPS 1.97$ 2.24$ 2.76$

Revenue by End Market

Industrial 1,216,700 1,338,700 1,502,366

% Revenue 46.2% 46.7% 46.3%

Automotive 483,400 525,200 549,823

% Revenue 18.4% 18.3% 16.9%

Communications Infra 529,800 673,300 703,930

% Revenue 20.1% 23.5% 21.7%

Consumer (incl handsets) 403,789 327,573 491,711

% Revenue 15.3% 11.4% 15.1%

ADI



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Linear Technology (LLTC)


Exhibit 43 Morningstar Vendor Ranking for Linear Tech


Moat and Moat Trend

In our view, Linear Tech is the widest-moat stock in our analog semiconductor universe, as its

profitability is unrivaled. Linear routinely generates 75% gross margins and operating margins in excess

of 45%. Even during the depths of the credit crisis in fiscal 2009, Linear was still able to earn a 42.5%

operating margin. We see virtually no scenario where Linear doesn't earn excess returns on capital well

into the future. If there is a knock on Linear as an investment, it may be because of its earnings stability;

free cash flow generation is better protected during downturns, but Linear sees less operating leverage

during cyclical upturns.


Linear is a leader in power management integrated circuits. More than any other chipmaker, the firm

targets opportunities where customers are willing to pay for the excellent performance of its parts and

rarely concedes on pricing. This focus drives stellar profitability, but makes Linear a bit of a niche player

in the market, whereas Maxim and TI, among others, have relatively larger power management chip

businesses but at lower gross margins. Of Linear's revenue, 60% comes from power management chips,

while 20% each comes from both data converters and amplifier/interface products for signal processing.


We expect Linear to stay in its lane and remain focused on high-margin opportunities in power

management. We don't foresee Linear taking a hit on pricing or a sizable step down in gross margins in

order to drive faster top-line growth. We're also skeptical that Linear will diversify outside its core

business via transformative M&A. The acquisition of Dust Networks may make Linear a larger player in

the Internet of Things, especially in industrial end markets.

Automotive Exposure

Linear's power management strength puts the firm in a particularly solid position to gain share and

increase revenue with infotainment systems and the powertrain, especially for battery management in

EVs and HEVs. About 40% of Linear's automotive revenue today comes from infotainment, as Linear's

parts regulate power within these increasingly complex systems, Today, Linear's top two automotive

end markets are Europe (again in luxury vehicles) and Japan. Linear has cited that the U.S. market is a

distant third, with Korea and China even lower. This exposure is not especially surprising, given Linear's

Criteria Weighting 0.20 0.20 0.20 0.10 0.15 0.15 1.00Linear Tech 5 5 5 4 5 4

Vendor weighting 0.20 0.20 0.20 0.08 0.10 0.08 0.86

ProfitabilityCapital

DistributionOverall RatingVendor

Product Mix

Customer Diversification

End Market Exposure

Revenue Growth


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niche position as a high-end chip leader, and we don't see Linear's lack of exposure to lower-priced

vehicles as an issue that could stunt the company's long-term auto growth.


At 44% of fiscal 2015 revenue, Linear has a greater concentration of industrial revenue than any other

analog firm under our coverage (unless we count Microchip, which does not break out end-market

exposure, but likely has significant industrial concentration as well). Since industrial and auto are poised

to be two of the faster-growing end markets in the analog space, we don't see Linear's top line being

hindered by a lack of exposure to consumer products or a sizable business in low-growing military or

satellite markets. That said, rivals like Maxim, ADI, or TI could increase revenue at a faster pace than

Linear by playing the smartphone boom in the consumer space.

Product Gaps

Although a majority of the firm's revenue comes from power management, Linear has more than enough

expertise in other analog chip areas, and we don't think it has any sense of urgency expanding its

product portfolio. Ultimately, any deal would be gross margin dilutive to the firm, in light of its stellar

profitability.

Financial Health

As of June 2015, Linear held $1.2 billion of cash on hand. Linear has not stated a clear target of free

cash flow payouts to shareholders, but since it earns about 75% of its operating cash flow in the U.S., it

should still be able to use U.S.-based cash to consistently pay out and raise its dividend over time, as

well as be more aggressive in share repurchases over the next few years.


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Exhibit 44 Linear Tech Recent Financial Results and Estimates


y/y % growth 8.3% 6.2% -0.2%

Gross Margin 1,049,806 1,119,412 1,113,768

GM % 75.6% 75.9% 75.6%

EBIT 639,730 682,699 680,309

EBIT % 46.1% 46.3% 46.2%

EPS 2.16$ 2.12$ 2.09$


Industrial 645,351 642,034 706,237

% Revenue 46.5% 43.5% 48.0%

Communications 280,267 277,242 263,380

% Revenue 20.2% 18.8% 17.9%

Computer 128,968 116,733 116,733

% Revenue 9.3% 7.9% 7.9%

Automotive 287,791 305,023 338,575

% Revenue 20.7% 20.7% 23.0%

Consumer- High End 44,254 43,775 42,462

% Revenue 3.2% 3.0% 2.9%

Military/Satellite 88,508 87,550 87,550

% Revenue 6.4% 5.9% 5.9%

Linear Tech



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Microchip Technology (MCHP)

Narrow Moat, Stable Moat Trend

Exhibit 45 Morningstar Vendor Ranking for Microchip


Moat and Moat Trend

We consider Microchip's narrow economic moat to be quite durable, and the firm is probably closer to a

wide moat than to no moat at all. Similar to pure-play analog firms, we see customer stickiness and high

switching costs in the MCU space. Meanwhile, MCUs also make up a tiny portion of a device's bill of

materials, and given additional redesign costs, customers have the same lack of incentive to switch to a

competing offering just to save a few pennies. MCU firms benefit from long product life cycles and are

able to generate revenue as long as the customer's device continues to be built. Finally, MCUs do not

require cutting-edge manufacturing or hefty ongoing R&D costs, so companies like Microchip are able to

generate solid profitability on each chip sale.

We effectively use our moat rating for Microchip to highlight the subtle differences in competitive

dynamics in the microcontroller and analog spaces, as we assign Microchip a narrow moat rating while

other broad-based analog firms have wide moats. Microchip earned 65% of revenue in fiscal 2015 from

MCUs versus 24% in analog, although its analog exposure will rise once Micrel is added to the mix.

Ultimately, whereas certain types of MCUs could become a bit more obsolete over time based on the

processing power needs of its customers, analog chips simply don't have this type of substitution risk, in

our view. We see no substitutes for processing real-world signals on the horizon, but in theory, digital

processors could displace MCUs. Microchip is the market share leader in 8-bit MCUs, but one perceived

risk around the firm is that customers will eventually add more processing power to their devices and

buy 16-bit and 32-bit MCUs instead. Microchip has offerings in both 16-bit and 32-bit and has seen nice

growth in these categories, but has relatively lower market share in both product lines. Similarly, a

device that uses a 32-bit MCU may need even more processing power and could trade up to full

embedded processors, sold by digital industry titans like Intel and Qualcomm.


Microchip is the industry leader in 8-bit MCUs and has gained share in this area in recent years. Its 16-

bit MCU, 32-bit MCU, and analog chip businesses have also grown nicely and are gaining prominence in

their respective product categories.

Criteria Weighting 0.20 0.20 0.20 0.10 0.15 0.15 1.00Microchip 4 5 4 4 4 4




Product Mix


End Market Exposure

Revenue Growth


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Microchip has been acquisitive in recent years, making deals to buy Standard Microsystems, Supertex,

ISSC, SST, and Micrel. We expect Microchip to maintain this strategy of buying complementary firms in

both analog and connectivity, in order to broaden its product portfolio. We still see plenty of room for

growth at Microchip, especially as an Internet of Things chip supplier, and expansion in analog and

connectivity that can be sold alongside of its MCUs can only aid the company's IoT efforts.

Automotive Exposure

Microchip does not break out its revenue by end market, as it has tens of thousands of customers that

mostly buy through distributors, so pinpointing exact end-market sales is challenging. Gartner estimates

that Microchip earned $354 million of revenue in calendar 2014 from automotive, which would be about

17% of Microchip's fiscal 2015 revenue. Microchip's automotive content is prevalent in the body of the

car—sunroofs, head units, seat belts, door latches. We'll be keeping a close eye on adoption of the

MOST150 standard in auto connectivity, as Microchip, via its Standard Microsystems acquisition, is a

leader in controller chips used to operate this technology.


In Microchip's case in particular, IoT could be a strong growth driver for the firm's MCU business.

Although the firm runs the risk of 8-bit MCUs being displaced by 16-bit and 32-bit products over time, it

may just as equally profit from devices becoming smarter and incorporating simple processing power via

8-bit MCUs whereas they previously had no semiconductor content at all. Meanwhile, Microchip won't

rest on its laurels and will still likely be in the mix for 16-bit and 32-bit MCU design wins.

Product Gaps

By essentially starting off in MCUs first, Microchip has plenty of room to expand its analog product

portfolio and drive consolidation in the industry. We expect to see additional acquisitions in the future.

Yet all of Microchip's recent deals have been relatively measured in terms of premium paid, and the firm

is willing to walk away from a bidding war, as seen during its attempt to acquire CSR, a Bluetooth chip

supplier that was ultimately bought by Qualcomm.

Financial Health

As of June 2015, Microchip held over $2.4 billion of cash on hand versus $1.86 billion of debt from

bonds and a line of credit. Relative to other chipmakers under our coverage, Microchip has focused on

its dividend first and foremost as means to distribute excess cash to shareholders. Microchip has

maintained a hearty payout through the years, even when its dividend yield was in excess of 5%, and we

think management fully recognizes the importance of its dividend to the investment community. We

anticipate that Microchip will earn strong free cash flow over time and spend this cash on the dividend

first, acquisition second, and buybacks thereafter.


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Exhibit 46 Microchip Recent Financial Results and Estimates


y/y % growth 22.1% 11.2% 3.8%

Gross Margin 1,128,743 1,229,564 1,273,747

GM % 58.4% 57.3% 57.2%

EBIT 556,422 605,206 613,631

EBIT % 28.8% 28.2% 27.5%

EPS 2.44$ 2.66$ 2.54$

Revenue by Product Line

Microcontrollers 1,261,371 1,404,954 1,343,929

% Revenue 65.3% 65.4% 60.3%

Analog 426,925 503,520 650,652

% Revenue 22.1% 23.5% 29.2%

Memory (incl SuperFlash) 135,136 131,967 125,342

% Revenue 7.0% 6.1% 5.6%

SST Licensing & Other 107,784 120,165 108,540

% Revenue 5.6% 5.6% 4.9%

Microchip



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Maxim Integrated (MXIM)


Exhibit 47 Morningstar Vendor Ranking for Maxim Integrated


Moat and Moat Trend

We view Maxim as having a solid wide moat, although it is the only wide-moat analog firm on our list

where we can conceive of its moat possibly eroding over time, given its outsized exposure to consumer

end markets relative to peers. We discuss Maxim's consumer exposure in more detail in Appendix 2.

Nonetheless, in our view, its proprietary designs in all end markets, including consumer, should still

enable the company to earn healthy excess returns on capital over time. Recently announced cost-

cutting measures and more efficient fab and capex allocations should help to support Maxim's ROICs

even further.


Maxim is another industry leader in the power management chip space, and given the fact that every

electronic device, by definition, requires electric current and thus power management chips to regulate

such voltage, we see plenty of room for Maxim to increase revenue across all end markets. The

company also has an especially tight relationship with Samsung and supplies the tech titan with a

variety of power management ICs and sensors for use in its high-end smartphones and tablets. Maxim's

consumer revenue has risen and fallen in recent years based on Samsung's high-end smartphone market

share gains and losses, and although the firm is diversifying its consumer business into Apple and other

smartphone makers, Samsung's rise or fall will have a direct impact on Maxim's revenue growth as well.


We expect Maxim to maintain its current revenue mix by continuing to focus on consumer-related chip

sales, rather than walking away from this business at Samsung and others to focus on higher-margin

opportunities. Whereas Linear has a smaller but higher-margin power management chip business,

Maxim has been willing to walk further down the road and accept lower pricing (mostly in consumer) in

order to drive higher sales levels. Accordingly, an investment in Maxim is likely to lead to lower ongoing

operating margins than at Linear, but provides the potential upside associated with consumer-related

chip growth, especially if further design wins can be gained at Apple beyond the Apple Watch and iPad

today (that is, the lucrative iPhone).

Automotive Exposure

Maxim's automotive exposure lies in a couple of areas—mainly power management for batteries,

especially EVs and HEVs, and a variety of infotainment products, including power management, audio

Criteria Weighting 0.20 0.20 0.20 0.10 0.15 0.15 1.00Maxim Integrated 5 3 3 3 3 4Vendor weighting 0.20 0.12 0.12 0.06 0.06 0.08 0.64

VendorProduct

MixCustomer




Overall Rating


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amplifiers, and serial/deserializers used to process high-speed video in ADAS. Maxim might be an

interesting derivative play on Tesla; although Samsung will probably be Maxim's most important

customer going forward, the company has supplied parts into Tesla in both the instrumentation cluster

and battery power management. Outside of Tesla, and similar to other analog firms, European luxury car

makers are the biggest buyers of Maxim's parts. Maxim cited Korea as a fast follower for more

advanced electronics content thereafter, followed by midrange European cars. Maxim has some traction

in Japan, but relatively limited penetration in the U.S. outside Tesla.


Again, Maxim offers investors with a nice balance of a wide economic moat and potential upside from

the booming smartphone space. Maxim has also carved out some defensible niches across its product

lineup, such as leadership in parts used in financial terminals, servers (via its Volterra acquisition) and

smart meters.

Product Gaps

Similar to Linear, we view Maxim as a power management chipmaker, first and foremost. Maxim may

continue to make bolt-on acquisitions, like Volterra, in order to acquire complementary products and R&D

teams.

Financial Health

As of June 2015, Maxim had $1.6 billion of cash on hand, versus $1.0 billion of long-term debt at

reasonable rates. Maxim has stated a target of paying out 80% of free cash flow to shareholders over

time, and we see it achieving this target via both dividends and buybacks without much of a problem.

Maxim's goal is to generate 40% of its free cash flow onshore so it can be used for dividends and stock

buybacks. About 60% of Maxim's cash resides offshore, which is actually a better situation than many

other tech firms, but we do see the possibility that Maxim issues more debt to raise its U.S. cash

balance over time.


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Exhibit 48 Maxim Integrated Recent Financial Results and Estimates


y/y % growth 0.5% -6.0% -2.5%

Gross Margin 1,384,765 1,271,867 1,245,682

GM % 56.4% 55.1% 55.4%

EBIT 501,863 442,030 494,383

EBIT % 20.5% 19.2% 22.0%

EPS $1.62 $1.52 $1.85


Consumer (incl handsets) 742,505 655,551 652,796

% Revenue 30.3% 28.4% 29.0%

Computer 127,450 100,287 100,287

% Revenue 5.2% 4.3% 4.5%

Industrial 621,660 630,826 693,909

% Revenue 25.3% 27.3% 30.9%

Automotive 275,013 374,504 419,444

% Revenue 11.2% 16.2% 18.6%

Comm & Data Center 540,236 487,987 463,588

% Revenue 22.0% 21.2% 20.6%

Maxim Integrated



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Texas Instruments (TXN)


Exhibit 49 Morningstar Vendor Ranking for Texas Instruments


Moat and Moat Trend

TI is another analog chip leader with an enduring wide economic moat, in our view. We raised TI's moat

to wide a couple of years ago once the firm exited the wireless baseband and processor businesses in

order to focus even more on higher-margin analog and embedded chip opportunities. We don't foresee

significant reinvestment risk in less profitable ventures but rather the opposite as TI generates gross

margin accretion via the shift to 300-millimeter wafer product and starts to carve out an even wider

moat.


We view Texas Instruments as a one-stop shop in the analog chip space, which should help the firm

retain its market leadership position in analog for years to come. TI believes that it has four competitive

advantages: (1) manufacturing and technological edge, especially at 300 mm wafer production in

analog, (2) breadth of analog and embedded products that makes the firm a one-stop shop and sell

adjacent products to customers, (3) significant sales channel reach, given a larger salesforce and more

"feet on the street" that allow TI to better service and sell into customers, and (4) diversity and longevity

of positions, both in terms of products and customers, so that a single design or customer loss isn't a

catastrophic blow to the firm.

We agree with the company about these advantages in terms of gaining customers, while our moat

thesis, which stems from proprietary designs and switching costs, enables TI to keep these customers

over time.


TI's focus on maintaining its broad-based leadership position in analog is strengthening rather than

weakening. The company made shrewd purchases of 300 mm wafer equipment in years past that will

give TI both gross margin accretion on current product sales and the capacity to take on additional

analog and embedded chip orders over time. We anticipate that TI's profitability will improve

incrementally over the next few years.

Automotive Exposure

As a broad-based chip leader, TI's automotive exposure is across the board. We foresee opportunities for

TI to increase its auto revenue in ADAS, infotainment, connectivity, and the powertrain. Similarly, TI isn't

Criteria Weighting 0.20 0.20 0.20 0.10 0.15 0.15 1.00Texas Instruments 4 5 3 3 4 5


End Market Exposure



Overall RatingVendor

Product Mix



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especially exposed to a single geographic area. As of 2012, TI was a top-five auto chip supplier in both

the U.S. and Europe, while Japan is an emerging opportunity as its car ecosystem is looking to diversify

chip suppliers beyond Japanese-based semiconductor firms.


In addition to analog, TI is particularly strong in embedded digital signal processors and 32-bit MCUs. TI's

"other" products, which include DLPs, telecommunications ASICs, and its well-known calculators, remain

cash-cow businesses where the firm is still earning solid profitability, but sales will probably decline over

time.

Product Gaps

TI made a hefty acquisition of National Semiconductor in 2010, not necessarily to fill in gaps in its

product portfolio, but to rectify a flawed sales strategy at National while acquiring sizable manufacturing

capacity. Relative to other analog chipmakers, we don't see many holes in TI's product portfolio.

However, the company still has $8 billion in unused manufacturing capacity, so it could make more of a

financially focused acquisition and bring another analog chipmaker into the mix simply to improve

utilization and drive value from gross margin accretion.

Financial Health

TI is in excellent financial health, with $3.5 billion of cash on hand as of June 2015. Perhaps more

important, 82% of this cash balance resides in the U.S. and is immediately available for dividends and

stock buybacks. Further, TI stated an aggressive goal of paying out 100% of its free cash flow (less debt

repayments) to investors. We don't anticipate TI having much of a problem achieving this target, and it

should do so with a reasonable mix of dividends and buybacks. TI is in a net debt position, but such debt

carries low interest rates, and the firm indicated that it will continue to take on low-cost debt as long as

interest rates are below either the rate of inflation or TI's dividend yield.


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Exhibit 50 Texas Instruments Recent Financial Results and Estimates


y/y % growth -4.8% 6.9% -2.8%

Gross Margin 6,364,000 7,427,000 7,352,036

GM % 52.1% 56.9% 58.0%

EBIT 2,984,000 4,226,000 4,190,704

EBIT % 24.4% 32.4% 33.0%

EPS 1.93$ 2.57$ 2.49$

Revenue by Product

Analog 7,193,000 8,104,000 8,140,200

% Revenue 58.9% 62.1% 64.2%

Embedded 2,451,000 2,740,000 2,737,912

% Revenue 20.1% 21.0% 21.6%

Other 2,560,000 2,201,000 1,800,442

% Revenue 21.0% 16.9% 14.2%


Industrial 3,661,200 4,043,950 4,189,663

% Revenue 30.0% 31.0% 33.0%

Automotive 1,464,480 1,695,850 1,950,228

% Revenue 12.0% 13.0% 15.4%

Personal Electronics 3,905,280 3,783,050 3,404,745

% Revenue 32.0% 29.0% 26.8%

Comm Equipment 1,830,600 2,217,650 1,774,120

% Revenue 15.0% 17.0% 14.0%

Texas Instruments



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STMicroelectronics (STM)

No Moat, Stable Moat Trend

Exhibit 51 Morningstar Vendor Ranking for STMicroelectronics

Criteria Weighting 0.20 0.20 0.20 0.10 0.15 0.15 1.00STMicro 2 3 3 4 1 4




Product Mix


End Market Exposure

Revenue Growth


Moat and Moat Trend

We assign STMicro a no-moat rating. Within ST, we see some quality businesses around analog, MCUs,

and other products sold into automotive, and ST believes that profitability on these products are on par

with many of its peers. However, ST is in other chip businesses, like discrete power management chips,

that are more commoditylike in nature and carry lower gross margins and a lack of pricing power. More

important, the firm's digital chip businesses have been a financial drain on the company for years. ST has

hinted that it might spin off its digital businesses if it can't achieve proper profitability. We think such a

move would be a nice first step, but even then, we'd need to see a sustained record of solid profitability

before we consider assigning ST with a moat.


As Europe's largest chipmaker, ST benefits from having an especially broad product portfolio as it can

sell entire solutions that encompass analog, MCUs, sensors and other parts directly to customers. ST

remains an automotive chip leader, particularly in infotainment and the powertrain. ST is also a number-

two player in digital TV set-top box system-on-chip solutions, but at subscale, as this business is

unprofitable.


ST's strategy appears to be to focus on earnings growth and shed unprofitable businesses. Such a

strategy is better late than never, in our view, as losses piled up in businesses like its ST-Ericsson

wireless chip joint venture and digital imaging products before ST threw in the towel. The next such

towel might be digital products like TV STB processors. In analog, ST will likely remain focused on the

automotive and industrial markets in particular.

Automotive Exposure

ST's broad product portfolio has served the company well in automotive, as it is the third-largest auto

chip supplier per Strategy Analytics. Infotainment is an area of particular strength for ST, and the rising

tide of more advanced infotainment systems in vehicles should serve ST well. Meanwhile, the company

appears well positioned in ADAS and powertrain products as well. ST also has broad geographical

exposure in autos. In its serviceable addressable market, ST is the number-two player in North America,

number two in Europe, number three in Japan, number two in Korea, and number-one in China. We see

China as especially important for ST. Whereas other moaty analog chipmakers are focusing on high-end


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autos in Europe, we still see opportunities for growth as car makers turn today's luxury features into

tomorrow's standard ones in mass-market cars sold into China


Besides automotive, ST has sizable businesses in analog, MEMS used in consumer devices, industrial

and power discrete products, and MCUs sold to a wide variety of customers.

Product Gaps

We also see ST as a chipmaker with a well-diversified product portfolio and few product gaps. If

anything, ST will more than likely shed businesses (particularly in digital), rather than fill product holes or

emerge as an M&A hunter.

Financial Health

ST is in decent financial health. The company had $1.8 billion of debt as of June but holds $1.9 billion of

cash and investments to offset the debt. Free cash flow generation has been shaky in recent years, but

we anticipate some improvement in the years ahead as ST becomes modestly more profitable over time.

ST also pays out an attractive $0.10 quarterly dividend. In general, we don't expect ST to have much of a

problem meeting its principal and interest payments.

Exhibit 52 STMicroelectronics Recent Financial Results and Estimates


y/y % growth -4.8% -8.4% -4.3%

Gross Margin 2,614,000 2,498,000 2,429,162

GM % 32.3% 33.7% 34.3%

EBIT (173,000) 52,000 61,582

EBIT % -2.1% 0.7% 0.9%

EPS (0.36)$ 0.16$ 0.06$

Revenue by Product

Analog & MEMS- AMS 1,306,430 1,102,000 1,154,808

% Revenue 16.2% 14.9% 16.3%

Automotive- APG 1,668,060 1,808,000 1,814,795

% Revenue 20.6% 24.4% 25.6%

Industrial & Power Discrete- IPD 1,800,510 1,865,000 1,734,128

% Revenue 22.3% 25.2% 24.5%

Digital Convergence Group- DCG 1,466,000 757,000 838,350

% Revenue 18.1% 10.2% 11.8%

MCUs, Memory, Security- MMS 1,366,000 1,507,000 1,530,240

% Revenue 16.9% 20.4% 21.6%

STMicro



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Infineon Technologies (IFX, IFNNY)

No Moat, Stable Moat Trend

Exhibit 53 Morningstar Vendor Ranking for Infineon Technologies

Criteria Weighting 0.20 0.20 0.20 0.10 0.15 0.15 1.00Infineon 3 4 4 4 2 3


VendorProduct

MixCustomer




Overall Rating


Moat and Moat Trend

We recently assigned Infineon a no-moat and stable moat trend rating. Admittedly, our call was a tough

one. Infineon has done a good job of shedding lower and unprofitable businesses in recent years, while

operating margins and returns on capital have improved. However, we don't equate Infineon's discrete

power management business, where the firm holds relatively less pricing power than in analog, with a

moaty business. Although the firm spends little on R&D in discretes in order to earn decent profitability,

we don't see a clear path to Infineon earning 25%-plus operating margins, as seen by other wide-moat

analog chipmakers. While we project that Infineon will generate excess returns on capital over the next

few years, we do not yet have enough confidence that these returns will hold up over a 10-year time

frame to warrant a narrow economic moat.


Infineon is a clear leader in the automotive chip market, as the number-two player behind Renesas (and

formerly number one before Renesas merged with NEC). Outside of auto, Infineon is now the clear-cut

industry leader in discrete power semiconductors and power modules with 17.8% share, as compared

with number-two Mitsubishi with 7.2% share, per IHS. Infineon is also the number-two player in smart

card integrated circuits with 22% share, behind NXP at 32% but ahead of STMicro and Samsung, again

per IHS.


Infineon doubled down on the discrete power management chip space by acquiring International

Rectifier, giving the company an expanded product portfolio in low-power discretes as well as

geographic diversification away from Europe and within the U.S. In automotive, Infineon remains focused

on the powertrain, although it will extend its MCUs and power management products into ADAS as well.

Meanwhile, the firm's chip card and security business has some nice growth opportunities on the

horizon.

Automotive Exposure

Again, Infineon's focus on power products should serve the firm well in ICE-powered cars, EVs, and HEVs

over time. Infineon is also targeting ADAS products but will have only limited exposure to infotainment.


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Infineon has disclosed its automotive revenue by region, earning 25% from Germany alone, 23% from

Europe (excluding Germany), 17% in the Americas, and 35% in Asia Pacific (including Japan). Of this

Asia Pacific revenue, 10%-15% is earned in China, both from domestic car makers and European luxury

car makers selling into the region. More generally, Infineon is a strong supplier into European auto-parts

leaders like Bosch and Continental, which sell their parts to car OEMs worldwide. In terms of market

share, Infineon believes it is the auto chip market leader in Europe and Korea and a rising number-three

player in Japan and a clear beneficiary from supplier diversification in the region.


Infineon does not break out all of its sales by end market, but it offers clear strength in power products

used in industrial automation, motor drives, and renewable energy. Meanwhile, the firm's non-analog,

chip card and security business appears poised to profit from the transition in the U.S. and China to both

chip-based credit cards and, looking ahead, mobile payments.

Product Gaps

Infineon's acquisition of International Rectifier filled in some product holes in discrete power products. In

theory, the company could expand its analog chip business over time as well. However, the firm has

shed more businesses than it acquired over the past decade, so we think it will continue to look inward

to drive revenue and earnings growth.

Financial Health

Infineon's capital structure improved a great deal in recent years, as the firm has shed some less

profitable business lines and paid down most of its debt. However, the firm has swung into a net debt

position in the near term after its acquisition of International Rectifier. As of June 2015, the company

held EUR 1.84 billion of cash and investments versus EUR 1.79 billion of debt. We believe that Infineon

will be able to satisfy these newfound debt obligations over time, especially as it pays out a nice

dividend each year (EUR 0.18 per share in calendar 2015).


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Exhibit 54 Infineon Recent Financial Results and Estimates


y/y % growth -1.6% 12.4% 34.2%

Gross Margin 1,323,000 1,647,000 2,032,932

GM % 34.4% 38.1% 35.1%

EBIT 325,000 525,000 484,152

EBIT % 8.5% 12.2% 8.4%

EPS 0.28$ 0.48$ 0.61$

Revenue by Product

Automotive (ATV) 1,715,000 1,964,000 2,351,790

% Revenue 44.6% 45.5% 40.6%

Industrial Power Control 652,000 783,000 977,070

% Revenue 17.0% 18.1% 16.9%

Power Mgmt & Multimarket 986,000 1,061,000 1,793,510

% Revenue 25.7% 24.6% 30.9%

Chip Card & Security (CCS) 464,000 494,000 661,440

% Revenue 12.1% 11.4% 11.4%

Infineon



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Investment Opportunities Arise by Navigating the Industry Cycles

Despite the presence of healthy economic moats and competitive advantages, investors in the analog

chip space (a $46 billion industry) must recognize the risk associated with cyclicality in the industry.

Analog's key end markets, like industrial, automotive and telecom infrastructure, also tend to be cyclical

at times.

Analog chipmakers tend to suffer from the bullwhip effect from these end markets—if a given industrial

customer either cuts production or was overly optimistic about future demand, the customer will not

only consume fewer chips but also draw down its chip inventory on hand to even lower levels. Similarly,

chip distributors, in response to an actual or even perceived slowdown, may also reduce inventory and

cut back on new chip orders. Once many customers undergo the same measures as part of an economic

slowdown, analog firms encounter order shortfalls at a much greater magnitude than their customers'

production and inventory cuts. As an example, U.S.-based analog chipmakers witnessed 9%-11%

sequential sales declines in the fourth quarter of 2012, mostly around concern about the U.S. fiscal cliff

and other macroeconomic considerations, yet GDP and industrial production did not fall at nearly the

same pace.


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Exhibit 55 Sequential Revenue and Changes at ADI and Linear Highlight Industry Cycles


Beyond looking at revenue, it is critical to consider that a good portion of an analog company's cost

structure (at least within our coverage universe) is fixed. Costs of goods sold pertain to the high fixed

costs associated with running fabs, and fewer orders lead to underutilized equipment. Further, since

analog engineers are hard to find and firms still need to invest in the future, R&D rarely gets slashed

during downtimes. Thus, analog firms tend to face operating deleverage during bad times and positive

leverage when business conditions are recovering.

On the bright side, because many analog chipmakers are running older, depreciated equipment and even

outsourcing some production, revenue would have to fall a tremendous amount before the bottom line

turns red. Recent history has shown that, even in the depths of the credit crisis in 2008 and 2009, high-

quality analog chipmakers stayed afloat and were able to weather the financial storm.


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Exhibit 56 Even in the Credit Crisis, High-Quality Analog Firms Weathered the Storm and Earned Healthy Operating Margins

Source: Company documents, Morningstar Research estimates Note: ADI's fiscal year-end as of October, Linear and Maxim as of June, Microchip as of March and results were restated (2010 results pertain to Microchip's fiscal year-end in March 2011)

For these reasons, we tend to view cyclical downturns and negative earnings revisions as buying

opportunities, as business conditions for high-quality names typically bounce back and secular, rather

than cyclical, drivers lead to a rebound in chip orders.

We Don't See Much More Room at the Top of the Current Cycle

As of the first quarter of 2015, analog business conditions appeared healthy but with cracks in the

armor. As of July 2015, these cracks appear to have widened, and it appears that the overall analog

cycle has peaked. Automotive chip demand remains the lone bright spot for the industry, as firms like

Linear, TI, and Maxim all saw healthy growth from auto in the calendar second quarter. Infineon cited

strong automotive growth in the U.S. and a recovery in demand in Western Europe, with solid demand

for premium European vehicles in both regions, offset a bit by a slowdown in demand from China. All in

all, we think this bodes well for our longer-term midcycle growth estimate for auto of a 10% CAGR—

even in periods of weak demand elsewhere, auto content per vehicle is still rising and providing support

to automotive chip orders.

However, industrial chip demand began to soften in the summer months of 2015, most likely in light of

concerns about the eurozone, volatility in China's stock market, and perhaps an underlying decline in

China's overall GDP growth. Such factors led Linear to forecast a 7%-12% sequential sales decline for the

September quarter, a bit worse than the normal seasonal slowdown that Linear sees in the summer

while Europeans, in particular, take vacation and have fewer manufacturing days. Maxim's forecast also

calls for a decline in its core industrial business. Meanwhile, Microchip's organic revenue is forecast to

fall 0%-7% sequentially in the September quarter as a result of tepid demand from Europe and China as

well as normal seasonal weakness in Europe during the holidays.

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

ADI Linear Microchip Maxim TI TI Analog Only

2007

2008

2009

2010


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Elsewhere, demand from telecom infrastructure customers has nose-dived as China's 4G LTE network

buildouts have taken a pause. In its second quarter, TI cited a 50% annual decline in wireless

infrastructure chip sales. After a year of hearty growth in 2014 as part of China's rollouts, 2015 appears

to be the start of a hangover.

Meanwhile, those chipmakers with PC exposure, either directly into the PC or indirectly via sales into

peripherals and hard disk drives, have also seen dismal demand. The smartphone market also appears to

have seen some weakness at the low end of the market, particularly in China. Yet Apple is still gaining

share in the premium smartphone market, so that analog firms with exposure to Apple (TI, STMicro) are

relatively outperforming those with exposure outside of Apple (Maxim, in particular).

Recent analog revenue forecasts have been in line with our thesis that the analog space is closer to a

cyclical top than a bottom, with some demand headwinds in the calendar third quarter, while the

calendar fourth quarter typically sees a seasonal decline during the holiday season anyway.

For the past couple of years, chipmakers have commented that chip inventory at customers was

relatively lean. However, as Linear's forecast suggests, there is still room for further chip inventory to be

cut. We view lean as the new normal, and perhaps chip inventory in the supply chain today is extra lean.

On the bright side, if the global macroeconomic picture improves, inventory could be boosted quickly,

leading to a snapback in revenue for chipmakers.

We saw similarly soft second halves of 2011 and 2012 for chipmakers, as both the U.S. debt downgrade

in 2011 and the U.S. fiscal cliff in 2012 led customers to become a bit cautious about future demand,

thus cutting chip inventory and orders. As the macroeconomic picture improved, chip demand recovered

in the first halves of the following year. From our vantage point in early August 2015, the current

downtick in demand looks like it will resemble these prior two mild cyclical downturns.

Nonetheless, we should note that all cycles are not the same, and prior volatility does not represent a

mirror image of business conditions today. Major downturns associated with the tech bubble in the early

2000s and the credit crisis in 2008-09 have unique circumstances in terms of severe supply/demand

imbalance. Milder cyclical downturns, such as the fourth quarters of 2004 and 2006, were at least

partially tied to inventory corrections in the cell phone market, especially with Japanese and Korean

basic phone makers. Firms like Linear and ADI simply have far less exposure to the cell phone market

(and especially basic flip phones) today than a decade ago. History may not repeat itself regarding chip

cycles, but it might very possibly rhyme.

Regardless of the near-term picture, we see long-term, midcycle analog revenue growth of 2 times

global GDP (6% or so) as a reasonable annual growth rate for the industry. As of July 2015, our individual

outlooks for firms under our coverage are slightly more pessimistic, around 5%, mostly because of weak

near-term business conditions in mid-2015 and other company-specific reasons.


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Valuations Looking Attractive for the First Time in a Couple of Years

Looking at analog stock valuations, we think analog has been a good place to hide for many investors in

a low-interest-rate environment. We've viewed the stocks as fairly valued to overvalued for the past

couple of years, with prices stretched at times (such as ADI reaching a 52-week high of almost $69 a

couple of months ago). Yet in light of Linear's soft guidance for the calendar third quarter and tepid

commentary from peers thereafter, stocks have pulled back to reasonable valuations.

Our current top pick is Linear Tech, both in terms of valuation and our admiration of the firm's business

model. We are also starting to see adequate margins of safety in wide-moat Texas Instruments, narrow-

moat Microchip, and no-moat Infineon.

Exhibit 57 Valuations Across Our Analog Coverage Have Pulled Back to Reasonable Levels, While We See Opportunities in Linear, TI, Microchip, and Infineon

Fair Value Current Market Morningstar Current PE Fwd PEName/Ticker Estimate Price Cap(Bil) Rating Ratio RatioAnalog Devices ADI $ 59.00 $60.70 $ 19.0 QQQ 21.4 18.6 Linear Tech LLTC $ 46.00 $41.52 $ 9.9 QQQQ 22.0 20.7 Microchip Tech MCHP $ 46.00 $43.83 $ 8.9 QQQ 18.1 16.7 Maxim Integrated MXIM $ 33.00 $34.29 $ 9.7 QQQ 17.8 16.2 Texas Instruments TXN $ 54.00 $50.84 $ 52.2 QQQ 21.7 20.2 STMicroelectronics STM $ 7.00 $ 7.67 $ 6.7 QQQ 126.1 26.4 Infineon Tech IFX € 12.00 € 10.34 $ 11.6 QQQ 19.5 16.2


More important, sentiment and outlook around the cycles can change on a dime, and wider margins of

safety may appear in an instant. Across our analog coverage, we saw a 13%-plus sell-off in just a one-

week span in October 2014 after a near-term warning by Microchip. Given their cyclicality, semis might

be hit first and hardest if another market pullback were to arise. Yet such a market correction, or even a

further downturn in business conditions, could provide attractive entry points in the blink of an eye. More

likely than not, we'd be enthusiastic buyers of wide- and narrow-moat analog chipmakers and even no-

moat Infineon if business conditions soften and multiples compress.


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Closing Thoughts: Switching Costs Have Kept Analog Firms Out of M&A, but Is This Changing?

Historically, we've seen very few large mergers and acquisitions in analog chips over the years, as firms

are often unable to generate clear-cut synergies that justify acquisition premiums paid. However, recent

chip acquisitions have been made with downright paltry premiums (30% or less). While we still struggle

to see many large analog deals making strategic sense in the long term, as we fear product overlap and

limited operational synergies, some brazen potential combinations can't be ruled out because economics

around such deals are more favorable now than perhaps at any point within the past 15 years.

In our view, switching costs can be credited (or blamed) for the slow pace of analog M&A over the years

in this highly fragmented industry. In general, when one analog firm strives to buy another, the acquirer

cannot simply streamline the acquiree's product portfolio, cut out redundant or overlapping products, and

switch customers over to the larger firm's product, all because of hefty switching costs borne by

customers. Furthermore, R&D staffs need to be maintained in order to support products from both firms.

Even shifting manufacturing to the acquirer's fabs takes time and effort. Thus, we see little synergies in

the cost of goods sold or R&D lines to justify many deals. An acquirer might be able to strip out some

selling, general, and administrative and other overhead costs, but likely not enough to justify any sort of

hefty premium paid to buy the firm out. Meanwhile, the acquiring firm probably picks up only a couple of

percentage points of market share and usually doesn't gain significant scale or cross-selling advantages

that could drive meaningful revenue growth.

Instead, the trend we've seen in analog over the years is for firms to make bolt-on acquisitions to expand

their product portfolios where they don't have strong expertise. Such deals include Linear Tech buying

Dust Networks, Maxim Integrated buying Sensor Dynamics, or Microchip buying firms like Standard

Microsystems, Supertex, and Micrel. In these cases, larger analog firms with stronger reputations and

more established customer relationships are able to expose the products of these smaller companies to

a larger customer base, as well as provide better financial and technical support. In such deals, revenue

synergies and faster growth help to justify the purchase price. In contrast, we doubt that one large

analog player that buys another will achieve such synergies.

The largest deal in our analog coverage universe in recent years was TI's acquisition of National

Semiconductor in 2010, which TI rationalized by (1) seeing relatively less product overlap than outside

observers may have expected, (2) National executing a failed sales strategy that TI could correct, (3)

buying underutilized fab capacity at National at a reasonable price, and (4) taking advantage of National's


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beaten-up stock price as a result of (2) and (3). In general, this confluence of factors tends to be rare in

analog, and we haven't seen much rationalization for any other transformative deal in the space.

ADI's recent purchase of Hittite Microwave was a relatively larger acquisition in the industry at $2.0

billion, but still a bit of a bolt-on deal, in our view, as the two firms had complementary strengths and

weaknesses in radio frequency chips. Further, Hittite was one of the few companies that would have

instantly boosted gross margins for a highly profitable ADI, all while ADI paid a reasonable premium for

the company. Infineon's acquisition of International Rectifier falls outside the realm of analog, as the deal

will give the combined company some scale advantage in discrete power semiconductors.

Outside of our coverage, the pending NXP-Freescale merger is especially noteworthy and should result in

a more powerful player in the automotive chip space, in particular. Both firms suggested that this merger

doesn't have as much overlap in analog, but neither firm is a pure-play analog chipmaker, and synergies

are expected in automotive products and microcontrollers. Meanwhile, NXP-Freescale did have overlap

in radio frequency power amplifiers, causing NXP to spin off this portion of the business to a Chinese

investment group. While we remain optimistic about automotive chip growth across our coverage list, a

larger NXP looms as a threat to many of these firms.

Our Outlook for Analog M&A

We see recent chip deals as being relatively measured, as premiums have rarely exceeded 50% of

recent share prices and have often been far lower. Smaller semiconductor firms (both analog and digital)

with strength in certain niche product segments and nice profitability records could be attractive M&A

targets. However, we wouldn't expect subscale analog players to be gobbled up just for the sake of

larger players trying to gain 1%-2% market share in the fragmented industry.

We still recognize the valid argument that the analog industry remains far too fragmented. Historically,

there have been few rewards for any single player to try and consolidate the industry. Yet with piles of

cash sitting on analog chipmaker books today and paltry premiums being paid out to make deals, the

economics are starting to tilt in the favor of additional analog deals. At a 20% premium, for example,

stripping out the acquired firm's SG&A alone might justify a deal, all else equal.

Looking across our coverage landscape, and assuming that deals can still be made with minimal

purchase premiums being paid, a couple of huge mergers might make sense. First, we've been skeptical

that TI would make another massive analog deal, as we would foresee hefty product overlap. Yet rumors

recently swirled that TI made a bid for Maxim last year. We see little strategic sense for such a deal and

would anticipate significant product overlap. However, it is important to consider that TI has $8 billion of

unused 300 mm fab capacity, while Maxim outsources 300 mm production to foundries. TI could justify

such a deal on the basis of becoming a de facto foundry for Maxim. Bringing Maxim's chip production

into TI fabs might lead to enough gross margin accretion for the Maxim segment to justify the premium

paid for the stock, even if no other synergies were found across the two firms.

Second, after ADI digests its Hittite acquisition, additional M&A for ADI in the power management arena

wouldn't be out of the question because such a deal might not have significant product overlap. The


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largest potential combination we could think of would be a merger of relative equals with a company like

Linear or Maxim, in order to form a broader analog powerhouse to rival TI. Again, such a deal would

make sense only at a modest premium, as we'd foresee minimal COGS or R&D synergies, but perhaps

some SG&A and revenue opportunities.

Third, Microchip is likely to remain acquisitive, but probably by picking up smaller analog firms at a

measured pace. This exemplary management team has made smart, accretive deals in its recent past,

and we anticipate that any future deals will also be done with financial restraint.

Across the rest of our analog coverage, we think Infineon will be out of the M&A market for now while it

digests International Rectifier. Meanwhile, we view ST as too large and too unprofitable to be a viable

acquisition target. Given its product breadth, we're also not sure that any other sizable chipmaker would

be a good strategic fit for ST without hefty product overlap.

Finally, we can't rule out the possibility of other non-analog chipmakers remaining aggressive on the

M&A front and making a deal simply to enter the analog realm. We're thinking in particular of Avago,

which made a major splash to buy Broadcom but is likely to be on the hunt for more firms to roll up.

Maxim was rumored as an acquisition target of Avago's before the Broadcom deal and could be a target

again. In Avago-Broadcom and a potential Avago-Maxim, we see little product overlap or synergies

beyond SG&A, but if such deals can be made at tiny premiums, SG&A head count cuts alone could justify

future deals.

All that said, if the chip M&A market cools off and future deals are only done at more significant

premiums around 50% as in years past, splashy M&A from TI or ADI would make far less sense (smaller

deals at Microchip would still be possible). Under a more traditional M&A market, we would expect

wide-moat analog firms under our coverage to go back to traditional acquisition methods and make bolt-

on deals when reasonable. More important, these firms will also likely focus on paying out 80%-plus of

free cash flow to shareholders via dividends and stock buybacks, as each management team has

targeted.


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Appendix 1: ADI May Face the Gift and the Curse of Rising Consumer Exposure

ADI's consumer sales dwindled from $606 million in fiscal 2010 to $328 million in fiscal 2014 as the

company became more selective in chasing consumer chip opportunities for certain products while

demand from other types of devices, like digital cameras, plummeted. Yet ADI's consumer business may

see a revival—in the April 2015 quarter, consumer revenue rose 40% from the year-ago period.

The rise stems from a design win in a portable device, and product teardowns indicate that ADI content

is included in the Apple Watch and, more specifically, the Force Touch feature in the touch screen that

enables a second level of gestures (press to select an icon, hold down to enter a different menu).

Perhaps more important, rumors are swirling that Force Touch will be added to future iPhones and iPads,

so sales of maybe a few million units for ADI in the Watch could suddenly rise to a couple of hundred

million units per year in the iPhone and iPad. We currently project that ADI's consumer revenue will rise

back up to the mid-$500 million range in fiscal 2016, with about half of this revenue coming from Apple.

The gift of this Apple design win is a clear revenue boost for ADI. Meanwhile, management still expects

to maintain gross margins within its long-term target range of 65%-68%. We suspect that gross margins

will track toward the lower end of this range as Apple becomes a larger part of ADI's revenue. Yet we

calculate that as long as ADI can hold on to 40% gross margins for this single product, it can still earn

65% gross margins for the business as a whole as long as the rest of the business, like industrial and

auto, can achieve gross margin accretion from higher factory utilization over the next couple of years.

However, the curse for ADI with this type of design win is a newfound need to fend off constant

competition in the long term and avoid revenue headwinds if Apple were to switch suppliers.

Management has reiterated that it is looking to sustain its consumer sockets "for generations to come."

But at this point, we're still skeptical that competitors won't catch up, concede on pricing in order to earn

this design win, and potentially displace ADI over time.

At this point, ADI's Force Touch potential reminds us of Linear Technology's one-off revenue boost from

the initial iPad launch in calendar 2010. Similar to ADI today, Linear is a wide-moat analog firm that

focused on broad-based industrial markets but profited from an opportunistic design win in an early

Apple product launch. However, Linear failed to follow it up with sustainable long-term revenue growth

as alternative suppliers swooped in. Despite management's optimism about its Apple design win, we

suspect that ADI may encounter a similar fate as Linear Tech.


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Appendix 2: The Curious Case of Maxim's Consumer Business

One company where we still see a wide economic moat but a conflict with our disdain for consumer

exposure is Maxim Integrated. Controversy has surrounded Maxim's consumer business in recent years;

a close partnership with Samsung drove outsize growth for Maxim in 2010 through 2012, but Samsung's

struggles in the premium smartphone market thereafter have provided recent growth headwinds.

Exhibit 58 Maxim's Consumer-Related Revenue Has Faced Peaks and Valleys


In turn, recent revenue declines have dragged on profitability, as adjusted operating margins dipped to

24% in fiscal 2014 and 25% in fiscal 2015, versus operating margins as high as 30% in 2011. This dip

has caused some investors to call for Maxim to exit the consumer space entirely.

In our view, unless its consumer business free-falls from here, we don't necessarily believe that Maxim

has to exit. Management has been adamant that consumer is still an excess return on capital business,

while R&D spent in consumer often leads to products sold in other end markets. A clear example is

Maxim's progress in audio amplifier chips used in car infotainment systems, a product that was initially

built for smartphones.


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Based on management's comments that consumer gross margins are only modestly below the corporate

average, we calculate that its consumer business (including the firm's computer segment) still generates

low 20s operating margins (on an adjusted basis) and excess returns on capital (since most of this

production is outsourced to foundries). On a GAAP basis, we still estimate that Maxim's consumer basis

earns midteens operating margins.

We should note that, perhaps counterintuitively, we actually estimate that Maxim's automotive business

has modestly lower profitability than consumer. Maxim has indicated that its automotive gross margins

are actually a shade below computer, which we attribute to a lack of scale (auto revenue is a fifth as

large as consumer/PC), product mix, and additional overhead costs needed to ensure exceptional quality.

Over time, we project that Maxim's automotive operating margins will overtake consumer.

Finally, Maxim has announced recent cost-cutting measures, as well as essentially setting up a sale-

leaseback arrangement with a foundry in order to better utilize its fab capacity. We estimate that both

tactics should propel Maxim's adjusted operating margins back into the low 30s in the long term, even if

consumer revenue remains sluggish. K

Exhibit 59 We Estimate That Maxim's Fiscal 2015 Consumer Operating Margins Are Lower, but Still Satisfactory



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