Case Study - Linear Tech - Christopher Taylor - Sample (1)

5/25/2018 Case Study - Linear Tech - Christopher Taylor - Sample (1)

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Created by: Christopher B Taylor Page 1

Executive Summary

Entering the 4thquarter of Linear Technologys fiscal year 2003 the market continues to

show signs of improvement. The company has shown steady growth in the last year and revenues

are estimated to increase 19% over FY 2002. Based on this estimate, FY 2003 net income will

hit $222.7 million ($0.71 earnings per share); a 12.6% growth from the previous year. O

perating

cash flow; while lower than 2000 and 2001 has shown a modest increase since 2002 and

continues to be positive due to the companys variable cost structure. This is in-part is due to

more efficient working capital investments and other adjustments to income, awarding the

company a 10% increase in net cash flow year-over-year. Linear Technology has increased its

cash holdings to excess of $1.5 billion through employing cost savings initiatives, though these

holdings have only shown investors modest returns in the neighborhood of 4.25% ($0.10

earnings per share). While modest, investors have come to expect this form of conservativeness

and there has been little outcry of agency issues. Looking ahead, based on an analog fabs life

expectancy of 10 plus years, capital investments, for a new fab, will be requiredin the next one

or two years in excess of $200 million; leaving more than sufficient cash holdings while

requiring no leveraging. Based on these financials, Linear Technology should look to increase

its dividend payout by $0.01 per share. This has become the expected trend over the last 3 plus

years and any adjustment to this could show signs of weakening in the businesses outlook. This

increase would raise dividend payouts to an estimated $66 million, a 22% increase from the FY

2002. An estimated 8.5% increase in the payout ratio, from 27.31% to estimated 29.64%;

ranking Linear Technology higher than any other company in the SOX for the dividend-to-

earnings payout ratio.


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Potential Issues

Linear Technology is holding on to $1.5 billion in cash and short-term investments which

invests in low risk securities. This can be seen as an agency issue. By Linear Technology holding

onto all this cash and only placing it in short-term debt securities, they are only providing an

internal rate of return of 4.25% ($0.10 per share). See Exhibit 1. Investors may want to see some

of these current assets used to acquire other companies or invested in more R&D that would keep

the internal rate of return above the marginal cost of capital.

The company is faced with the option of keeping the quarterly dividend at $0.05 per

share or increasing the payout to $0.06 per share. If Linear Technology leaves the dividend

payout unchanged, investors could take this move as a sign of weakness. Acknowledging that in

January 2003 institutional holdings of the stock LLTC made up 84.93%; the companys move to

continue to be over-cautious with its current assets and not provide an increase in the dividend

payout may lead the investors to seek greater returns in other securities. By raising the dividend

payout, the company will be faced with a 29.64% payout ratio; the highest in the SOX. See

Exhibit 2. By spending an estimated 66 million on dividend payouts, the company will see a

percentage increase in operating cash flow payout of 26.13%, up from an operating cash flow

payout of 21%. See Exhibit 3.


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Methodology

It is suggested that Linear Technology uses pro-forma statements, value of cash holdings

statements, and dividend payout charts to determine if an increase in dividend payouts will be of

value to the company. Secondly, an overview of the dividend payouts and ratios from previous

years can be used to approximate the clientele effect information effect on investors.

Thirdly,

while a comparison of Linear Technology to the market and semiconductor industry will help

determine their position in various categories. Finally, an overview of economists and analysts

outlooks for the coming year in the analog market and semiconductor market can be helpful in

spotting future trends.

Data Requirements for Methodology

Initially Linear Technology will need to create a pro-forma statement for the 4thquarter

based on growth results over the last year. See Exhibit 4. In the exhibit provided, the pro-forma

statement for 2003 was developed based on a 19% increase in sales from the first half of 2003

verse 2002 ($287 million/$241 million = 19%) and adding an estimated growth of 19% to the

second half of FY 2002 figures ($271 million*1.19 = $323 million). The summation of these

figures gives us an estimated sales figure of $610 million ($287 million+$323 million). From this

we can create the pro-forma statements needed to determine net income and cash flows. This

allows the company to estimate dividend payout, dividend earnings, and earnings per share.


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The valuation of cash holdings can be completed by using figures from the balance sheet,

income statement, and current money market rates. See Exhibit 1. Using the valuation of cash

holdings, Linear Technology can see that they are only providing a return of $0.11 on every

$3.56 of investments; a 3.1% return. See Exhibit 4. This formula is used to see how much value

is being added through current asset investments and can be compared with IRR of potential

other projects.

Another tool the company can use is a dividend payout chart that will show the after-tax

percent return to investors dependent on dividend payouts, repurchases and tax rates. See Exhibit

5. Due to the possible overhaul of the tax structure for capital gains and dividends for the 2003

tax year, this chart can be useful in understanding the investors attitude towards the companys

use of cash. By using scenario analysis the company can compare various situations they could

embark upon.

Key Assumptions

This analysis is drawn upon some assumptions made by the author. These assumptions

are as follows: The estimated end-of-year income statement is mostly based on a 19% sales

increase year-over-year; except for other expense based on a 4% increase year-over-year. It is

also assumed that investors are considered Bird in the Hand investors; that they prefer the

certainty of a cash dividend to that of the company placing their investments in uncertainties.

Asymmetry is assumed to be invalid due to the possibility of lower taxes on capital gains and

dividends, hence removing the theory based on investors preferred choice in relation to tax

percentages.


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Analysis

The data shows that an increase of $0.01 in the dividend payout will put Linear

Technology at its highest payout ratio level ever, 29.64%. However, the company will be using

only 26.13% of operating cash flow, up 24.43% from the prior year. In many semiconductor

companies this may be seen as high, but Linear Technology has cash sitting in exce

ss of $1.5

billion and will still be contributing estimates of $48 million to this at the end of FY 2003, even

after $66 million is paid out to investors. If we were to compare the payout ratios to other

technology firms it would suggest that Linear Technology is over paying on its dividend and

should not make an increase. In this case the payout ratio would begin to decline, though

investors would begin to doubt the growth of the company, causing a clientele effect.

It must be mentioned in the analysis that institutional holdings makes up 84.93% of

Linear Technologys stock as of January 2002. See Exhibit 5. This is much higher than the

semiconductor industrys average of 42.09%in 2002. Taking this into consideration, the

company may be able to hear insight from the top institutional holdings to determine their take

on the dividend policy. This was already announced by Blaine Rollins, Portfolio Manager of

Janus Capital, when he made it clear that he was comfortable with the current dividend approach

and ideally liked the strong cash flows and repurchases of stock.


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Finally a look at the expected rate of return compared with the required rate of return for

Linear Technology tells us that by offering an increase in the dividend payout, the expected rate

of return comes in at 24.21%; much higher than the -0.45% required rate of return that the

company would see based on its correlation since the establishment of the SOX. See Exhibit 6.

By illustrating the various situations of dividend payouts, a payout that is based on no increase or

a decrease leaves the investor with a lower expected rate of return of 18.29% and 12.38%,

respectively. Meaning the company would be valued more highly by investors if it was to

increase the dividend.

Conclusion

It is recommended that Linear Technology increases their quarterly dividend up to $0.06

per share, from $0.05 per share. Current increased growth quarter-over-quarter in Linear

Technologys revenues andpredicted growth in the world market for 2003primarily China and

Taiwanprovides a solid footing for the future ahead. In times of uncertainty, investors are

looking for companies that continue to show stability. By following the trend of the companys

historic dividend policy, Linear Technology is showing confidence in their outlook going into

Fiscal Year 2004.


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Amount Invested in

Marketable Securities 1,113,000,000

Assumed Rate of Return 4.25%

Effective Tax Rate 30.00%

Before Tax Return 47,302,500

Taxes 14,190,750

After Tax Return 33,111,750

Number of Shares Outstand 312,400,000

Recent Stock Price 30.87

Investments/Share 3.56

Total Market Value 9,643,788,000

Per Share Return 0.11 % of Market Value

Value as a Perpetuity at 8% 1.32 4.29%

Value as a Perpetuity at 20 0.53 1.72%

Taxes Per Share 0.05 % of Market Value

Value as a Perpetuity at 8% 0.57 1.84%

Value as a Perpetuity at 20 0.23 0.74%

Exhibit 1 - Valuation of Cash Holdings of Linear Technology 2003

Based on 2002 estimated short -term debt security funds (4.67% - Federal Reserve Bank of

NY). Equation: 52 mil/4.67% =1,1 13 mil

Wall Street Journal 2003 Money Markey Rate

Company TickerShare

Pricea

Shares

(Millions)

Net

Income

Cash

FlowbCash

cLong-

Term Debt

Dividends

(in cents)

Stock

Repurchases

Dividend Initiation

Date

Operating

Cash Flow

Payout

Payout

Ratio

Market Cap

(Millions)

Rank by

Market

Cap

Linear Technology LLTC 30.87 316.2 197.6 239.3 1,552.0 0.0 54.00 221.6 October 1992 0.22565817 0.2732794 9761 5

Intel INTC 16.28 6,575.0 3,117.0 4,426.0 12,587.0 929.0 533.00 4,014.0 September 1992 0.120424763 0.1709978 107041 1

STMicroelectronics (d) STM 18.90 887.5 429.0 718.0 2,564.0 2,797.0 36.00 115.0 May 1999 0.050139276 0.0839161 16774 4

Motorola MOT 8.26 2,315.3 -2,485.0 732.0 6,566.0 7,674.0 364.00 0.0 November 1946 0.49726776 -0.1464789 19124 3

Texas Instruments TXN 16.37 1,730.6 -344.0 1,190.0 3,012.0 833.0 147.00 370.0 April 1926 0.123529412 -0.4273256 28330 2

0.4934

Source: Adapted from Compustat; Center for Research on Security Prices.

a - Share price on March 31, 2003.

b - Compustat operating cash flow (Item 308) less capital expenditures (Item 128).

c - Cash and short-term investments.

d - STMicroelectronics is an American Depository Receipt (ADR), based in France.

e - Figure taken from nyu.edu data page

Exhibit 2 - Data On Dividend Paying Companies In The Se miconductor Index (SOX) In $M (Exce pt Per Share Data), 2002

Semiconductor Industry (e):

Year 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003a

2003

Total Common Dividends - 5.30 8.30 9.80 11.90 15.00 18.30 22.10 28.00 41.20 54.00 47.00 66.00

Net Income for Common Stock 25.00 36.50 56.80 84.60 134.00 134.30 180.80 194.30 287.80 427.40 197.70 170.60 222.67

Cash Flow from Operations 28.70 42.50 62.40 103.90 164.70 150.80 266.90 280.50 442.30 559.50 257.20 189.90 252.54

Free Cash Flow to Equity 29.90 32.80 48.80 73.50 72.20 120.80 194.30 148.90 388.80 373.30 3.00 13.20 48.74

Dividend Payout Ratio 0.00% 14.52% 14.61% 11.58% 8.88% 11.17% 10.12% 11.37% 9.73% 9.64% 27.31% 27.55% 29.64%

Operating Cash Flow Payout 0.00% 12.47% 13.30% 9.43% 7.23% 9.95% 6.86% 7.88% 6.33% 7.36% 21.00% 24.75% 26.13%

Free Cash Flow to Equity Payout 0.00% 16.16% 17.01% 13.33% 16.48% 12.42% 9.42% 14.84% 7.20% 11.04% 1800.00% 356.06% 217.53%

Estimated figures based on 19% increase in sales and 0.06 dividend payout in 4Q

a - First th ree quarters of FY2003. ( 15.67/Q)

Exhibit 3 - Dividend Payout Ratios of Linear Technology


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Income Statement 2002 2003a

2003

Estimated

19%

Increase

Sales 512.30 440.80 609.64

- Cost of Goods Sold 144.70 114.60 172.19

- Research and Development Expense 79.80 67.00 94.96

- Other Expenses (estimate 4% of sales) 9.40 18.90 24.39

Income Before Taxes 278.40 240.30 318.10

- GAAP Income Taxes (30%) 80.70 69.70 95.43

Net Income 197.70 170.60 222.67

Common Shares Outstanding (Split-Adjusted) 316.20 312.40 312.40

Earnings Per Share (Split-Adjusted) 0.63 0.55 0.71

Stock Repurchase

Stock Repurchase Amount

Cash Flow Statement

Net Income 197.70 170.60 222.67

+ Depreciation and Amortization 46.30 33.50 44.70

- Working Capital Investments 42.00 14.90 14.90

+ Tax Adjustmentb 55.20 0.70 0.07

Operating Cash Flow239.30 189.90 252.54

- Capital Expenditure 17.90 9.80 17.90

+ Stock Issuance 39.30 27.40 27.40

- Stock Purchases 221.60 165.70 165.70

- Dividends Paid 54.00 47.00 66.00

- Other Itemsc 0.00 -18.40 -18.40

Net Cash Flow 3.00 13.20 48.74

Balance Sheet

Cash and Short-Term Investments

Source: Adapted from Compustat.

a - First three quarters of FY2003.

Exhibit 4 - Pro Forma Statement for 2003

b - The difference bet ween t he exercise price and t he market value of LLTC stock could be expensed for tax purposes,

leading to large tax adjustment s on the cash flow stat ement.

c - Other Items includes long-term investments and acquisitions (other than capital expenditures), extraordinary items,

and other adjustments to net income.


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Increase Dividend Repurchase Stock*

LLTC Share Price April 2002 45.93 45.93

LLTC Share Price April 2003 30.85 30.86

Capital Gain -15.08 -15.07

Dividend Paid 0.21 0.20

Pre-tax % Return -0.323753538 -0.323753538

Capital Gain Tax (stock sold) -2.262 -2.2605

Dividend Tax (stock sold) 0.0315 0.03

After-tax % Return (stock sold) -0.275190507 -0.275190507

After-tax % Return (stock not sold) -0.324439364 -0.324406706

* Repurchase of $3,124,000 of stock at $30.85 with no dividend increase.

Exhibit 5 - Dividend Policy Chart

Company Name Indust ry

Market Cap $

(Mil) Total Debt Firm Value Cash

Current

Revenues Current PE

Linear Technology Semiconductor $9,156.80 $0.00 $9,156.80 $1,552.00 $512.30 46.34

Correlation Payout Ratio

Reinvestment

Rate ROE Beta Insider Holdings

Institutional

Holdings

Fiscal Year

End Date

66.92% 31.51% -14.59% 11.09% 1.14 2.40% 84.93% Jun/30/2002

Exhibit 6 - Linear Technology Quick Details as of January 2002

* Items partially based on nyu.edu financial company databases and Professor Johnston's excel spreadsheets.

(Ks)

Expected

Return

=

[D(1+g)/P

] Expected

Dividend

Return

[+ g]

Expected

Growth

Return

(D)

Current

Dividend

(D)

Expected

Dividend

(P)

Current

Stock

Price

Dividend Increase 0.242101 0.0068071 0.235294 0.17 0.21 30.85

Dividend Neutral 0.182954 0.006483 0.176471 0.17 0.20 30.85

Dividend Decrease 0.123806 0.0061588 0.117647 0.17 0.19 30.85

(RRR)

Required

Rate ofReturn

(Rf) RiskFree Rate

(Rm -Rf)

RiskPremium () Beta

(Rm)

MarketRisk

LLTC -0.47% 1.02% -1.31% 1.14 -0.29%

Rf based on 2002 US Treasury Bill from P rofessor Johnston's Historical Equity Risk P remiums

Beta based on LLTC comparison to SOX (Oct. 94 to Jan 03)

Rm based on SOX (Oct. 94 to Jan 03)

Exhibit 7 - Expected v. Required Rate of Return

Documents

Case Study - Linear Tech - Christopher Taylor - Sample (1)