TIís Q4 Forecast Suggests That Demand in Most End Markets Has Peaked; FVE Cut to $158
TI’s Q4 Forecast Suggests That Demand in Most End Markets Has Peaked; FVE Cut to $158
Analyst Note| by Brian ColelloUpdated Oct 25, 2022
Texas Instruments reported solid third-quarter results but provided investors with a downbeat fourth-quarter forecast. We trim our fair value estimate for wide-moat TI down to $158 from $166, and despite shares falling about 6% after hours to the $153 range, we continue to view TI’s shares as fairly valued.
Sluggish demand for chips going into personal electronics devices like PCs was well known, but we’re troubled by the weakness that TI is seeing within industrial, its largest end market. The chip shortage is effectively over in this end market, as TI saw customer cancellations and further weakness ahead; we would attribute such softness to macroeconomic factors. Automotive chip demand still exceeds supply, but industrial demand also used to be more than supply in prior quarters; but we now see a decoupling of these end markets.
Revenue in the September quarter was $5.24 billion, up 1% sequentially, up 13% year over year, and toward the high end of guidance of $4.90 billion-$5.30 billion. Automotive sales were the bright spot, up about 10% sequentially. Disappointingly, industrial revenue was flattish sequentially. Predictably, personal electronics revenue fell about 15% sequentially with soft demand for PCs and similar gadgets. Gross margin dipped 60 basis points sequentially (albeit off of peak levels) to 69.0%. TI still generated a stellar 51% operating margin.
For the December quarter, TI expects revenue to fall to the range of $4.40 billion-$4.80 billion. At the midpoint, sales would be down 5% year over year and 12% sequentially, although the fourth quarter often sees a normal seasonal dip in revenue. We estimate that TI’s guidance midpoint of $1.97 of EPS implies a further dip in gross margin to the 66%-67% range and operating margins down to the 47% range. Such results would still be spectacular when compared to historical levels, but they would indicate that business conditions have already peaked.
Business Strategy and Outlook| by Brian ColelloUpdated Oct 25, 2022
Texas Instruments is the world's largest analog chipmaker and a key supplier of embedded chips into a wide range of applications. We remain encouraged with Texas Instruments' relentless focus on higher-margin analog and embedded semiconductors, and when combined with smart operational moves on the manufacturing front, we foresee robust free cash flow generation in the years ahead.
Texas Instruments has a leading share of the fragmented yet lucrative analog chip market. Analog chips are used to convert real-world signals, such as sound and temperature, into digital signals that can be processed. We believe Texas Instruments has a wide economic moat because it benefits from intangible assets around proprietary analog and embedded chip designs, as well as customer switching costs. Since analog chips are neither particularly expensive, nor do they require cutting-edge manufacturing techniques, high-quality analog chipmakers tend to retain design wins for the life of the product, yet maintain healthy pricing and strong profitability on such sales over time. Additionally, Texas Instruments' size allows the firm to compete across a broader spectrum of industries, without its fortunes tied to a single customer or end market.
Texas Instruments has spent much of the past decade focusing on its analog chip business, especially by producing its chips on more advanced 300-millimeter silicon wafers. This focus has led to healthy gross margin expansion, and while the "easy" expansion is over, we still foresee outstanding gross margins in the years ahead. Texas Instruments' embedded chip business is a bit more exposed to the automotive and communications infrastructure end markets, but should also see healthy growth over the next few years. The "Internet of Things" is an interesting tailwind for TI, as the company’s chips could be key components in a massive array of new electronics devices with improved connectivity and processing power.
Economic Moat| by Brian ColelloUpdated Oct 25, 2022
We have assigned Texas Instruments a wide economic moat rating, thanks to intangible assets around proprietary analog chip design and manufacturing expertise, as well as switching costs that make it difficult to swap out analog chips for competing offerings once they are designed into a given electronic device. As Texas Instruments focuses on analog chips and embedded products like microcontrollers, or MCUs, while significantly diversifying its customer base, we are confident the firm is more likely than not to generate excess returns on capital over the next 20 years.
We believe that leading MCU and analog chipmakers benefit from favorable characteristics that lend themselves to economic moats. Moats for chipmakers with analog and MCU expertise tend to come from intangible assets associated with the strength of proprietary chip designs, as well as switching costs that make it difficult to swap out analog chips for competing offerings once they are designed into a given electronic device. We believe analog engineering talent is difficult to come by, as greater emphasis is placed on digital chip improvements, and it often takes years to train up-and-coming analog engineers in the intricacies of chip designs. Thus, it is extremely difficult for startups to replicate the many years of analog expertise held by incumbents. Leading analog chipmakers also face stringent quality requirements in some end markets, such as the automotive industry, for example, where defects can only be tolerated as low as one part per million. Although the analog chip market is quite fragmented, it would be difficult for any startup to achieve this level of quality while still being to satisfy high volume production. Furthermore, analog chips tend to make up only a small portion of a product's bill of materials, so purchasing decisions tend to be based on performance rather than price, helping Texas Instruments and its peers retain pricing power. Automotive, industrial, and communications infrastructure customers, in particular, are unlikely to choose an inferior analog chip or MCU in order to save pennies on the cost of a piece of equipment worth tens of thousands of dollars.
Similarly, engineers loathe to swap out an analog or MCU from an existing design (again, only to save a few pennies on cost) because of the onerous re-design and re-testing costs associated with the switch. With MCUs in particular, customers also become accustomed to the software and development tools used to test and design a given product. Switching to a competing MCU may involve a bit of a learning curve in the design process. One can imagine the frustration and possible reputational damage to a product if a perfectly functioning electric toothbrush or thermostat were to fail because of an unforeseen change in how the MCU or analog chip interacts with the rest of the circuit board. Again, such damages would be amplified in far more expensive equipment like cars, planes, satellites, and so on.
TI and its chipmaking peers tend to profit from these high switching costs by having lower ongoing R&D and capital expenditure investments than digital chipmakers, which helps to contribute to healthy returns on capital for shareholders. In particular, buyers of analog semis typically don't demand smaller chips packed with more transistors, but rather, reliable products that deliver the desired accuracy and precision in power management or signal processing. Shrinking the chip might not necessarily enhance accuracy (and might even serve to reduce it), so analog chips tend to be made with lagging edge manufacturing techniques.
Texas Instruments and some of its peers take this benefit one step further by concentrating on end markets where product lives are measured in decades, as opposed to the increasingly short life cycles associated with consumer devices like PCs or handsets. About a quarter of Texas Instruments' total revenue comes from personal electronics devices like smartphones, tablets, and PCs. All else equal, we are less confident in outsize economic profits from chipmakers that serve the handset and PC industries, given the shorter product life cycles, intense competition, and customer concentration as a handful of tech titans exert tremendous buying power.
On the plus side, the size and scale of Texas Instruments' salesforce and field applications engineers allow the firm to reach a broader customer base than peers, which has translated into a share lead for Texas Instruments in the analog chip market. Texas Instruments generates enough revenue to adequately fund this large sales team that only a handful of chipmakers can match, yet its salesforce helps the firm reach more customers and generate additional chip sales that can fund further sales team expansion, creating a virtuous cycle for the company. We doubt that any other analog chipmakers will be able to assemble such a massive sales team in the near future.
Fair Value and Profit Drivers| by Brian ColelloUpdated Oct 25, 2022
Our fair value estimate for Texas Instruments is $158 per share, which implies a 2022 adjusted price/earnings ratio of 17 times, and a 5% free cash flow yield.
TI faced two subpar years in 2019 and 2020 because of U.S.-China trade tensions and COVID-19, but revenue snapped back in 2021 with 27% growth to over $18 billion of sales. We model additional revenue growth of 9% in 2022, thanks to the global chip shortage as industrywide chip demand exceeds supply. We foresee these good times coming to an end, however, as we model a 7% revenue decline in 2023 and a 2% decline in 2024. We view these revenue declines as a natural cyclical downturn in semis, rather than a projection that TI will lose market share or that its semiconductors will be less relevant within its core end markets. We project a cyclical upturn in 2025, and on a midcycle basis thereafter, we model average annual growth of 7% for TI thereafter. We model 8% long-term midcycle growth in the firm’s core analog and embedded chip businesses, thanks to rising chip content in automotive and industrial, offset by flattish revenue in the company’s “Other” businesses.
Texas Instruments has successfully expanded gross margins in recent years, first by focusing on higher-margin analog products and, later, by using the shrewd purchases of used equipment in prior years to gain a cost advantage going forward. For reference, gross margins expanded from 52% in 2013 to 67.5% in 2021. We model a 69% gross margin in 2022 and margins ranging from 65.5%-67% thereafter, with ebbs and flows depending on revenue cycles and TI's manufacturing expansion. Operating margin was a stellar 50% in 2021, and we model 52% in 2022. We think operating margins will come back to earth a bit thereafter, but we still project mid-to-high 40% operating margins for TI in 2023 and beyond, even during industry downturns.
Risk and Uncertainty| by Brian ColelloUpdated Oct 25, 2022
Although Texas Instruments competes in the cyclical semiconductor industry, we think its size and scale warrant a Morningstar Uncertainty Rating of Medium. Texas Instruments' biggest risk is exposure to the cyclical chip industry, which may provide headwinds from time to time. Furthermore, relative to some peers like Analog Devices, Texas Instruments has relatively greater exposure to more volatile end markets like PCs and smartphones. TI also faces some risk from U.S.-China trade tensions; if Chinese customers today choose (or are forced) to move away from U.S. suppliers, they may gravitate to some of TI’s European-based rivals, such as STMicro, Infineon or NXP.
We like Texas Instruments' moves to buy manufacturing equipment at pennies on the dollar a decade ago, which jump-started the firm’s efforts in production on 300-millimeter silicon wafers and enabled gross margin expansion. TI will most likely struggle to find such cheap equipment going forward, so future capacity expansion may come with relatively higher costs and some risk that TI will be unable to fill these factories. Meanwhile, the analog chip market is fragmented and based on proprietary designs, so market share shifts tend to be quite gradual, and it remains to be seen whether hearty growth can come to fruition. Additionally, Texas Instruments has revenue from other products, such as calculators, that are likely in secular decline and may weigh on the firm’s total top-line growth.
On the ESG (environmental, social, governance) front, we do not foresee any material ESG issues (MEIs) on the horizon. Perhaps the greatest risk is the scarcity of experienced analog talent within the industry, but Texas Instruments has a proven track record of innovation and developing analog engineers internally, in our view.
Capital Allocation| by Brian ColelloUpdated Oct 25, 2022
We assign Texas Instruments with an Exemplary capital allocation rating. The rating reflects our assessments of a sound balance sheet, exceptional investments associated with the firm’s strategy and execution, and attractive and appropriate shareholder distribution policies.
We view Texas Instruments as a well-run organization despite an embarrassing misstep in the C-suite in 2018. Rich Templeton was the longtime CEO of TI from 2004 until June 2017. He stepped away from the CEO role in a planned succession to Brian Crutcher, however, Crutcher was later found to have violated the company's code of conduct and was forced out of the role only a few weeks later. Templeton stepped back into the CEO role in July 2018, where he remains today. Templeton has also been the Chairman of TI consecutively since 2008.
TI has a sound balance sheet, taking on leverage at attractive interest rates and using such funds to aid in capital distributions to shareholders. We’re especially fond of the firm’s investments in 300-millimeter wafer production a decade ago, which enabled significant gross margin expansion over the past several years. We think TI generally does a very good job of making investments that add value to the firm.
Texas Instruments has some shareholder-friendly initiatives, such as providing investors with a capital-allocation strategy update in each of the past several years. The management team has done an excellent job in focusing on redistributing excess cash to shareholders, as the firm has raised its dividend to $1.15 per quarter. The company has also bought back at least $2 billion of stock per year from 2014 to 2020 (although Texas Instruments snapped this streak with fewer buybacks in 2021). We're also encouraged by management's goal to convert 25%-35% of its revenue into free cash flow and intentions to distribute 100% of that free cash flow (less debt repayment) to shareholders. Texas Instruments may tap the debt markets to boost these programs, as long as interest rates are below either the rate of inflation or the company's dividend yield. All in all, we applaud Texas Instruments' capital-allocation moves in recent years.