Wide-moat Texas Instruments reported predictably soft second-quarter results in line with expectations, but provided investors with a disappointing third-quarter outlook. We were discouraged by the report and earnings call, as TI’s revenue growth is lagging its peers, gross margins are deteriorating, inventory continues to rise, and we didn’t hear the strongest answers on how TI can turn the tide. We attribute TI’s underperformance mostly to its exposure to soft end markets such as personal electronics and communications equipment. We still view TI as a wide-moat firm with exemplary capital allocation policies, but recognize that investors have more reasons to question the company’s strategic steps than what we would have imagined a couple of years ago. Still, we maintain our $168 fair value estimate as our aforementioned concerns are minor for such a stout business. We view shares as slightly overvalued.

Revenue in the June quarter was $4.53 billion, down 13% year over year but up 3.5% sequentially and at the high end of guidance of $4.17 billion-$4.53 billion. TI saw soft business conditions in all end markets except automotive, which grew a low-single-digit percentage sequentially and, per our calculations, was up close to 25% year over year. On the downside, however, we calculate that personal electronics, communications equipment, and enterprise systems revenue, which made up 33% of revenue in 2022, were each down close to 40% or more year over year. Lower sales levels caused gross margin to dip 120 basis points sequentially and 540 basis points year over year to 64.2%. Inventory remains a concern, up to $3.7 billion or 210 days.

Revenue in the September quarter is expected to be $4.36 billion-$4.74 billion, which, at the midpoint of guidance, would be $4.55 billion, flat sequentially and down 13% year over year. We calculate that EPS guidance, at the midpoint of $1.80, implies further gross margin deterioration to the 63% range.

Texas Instruments is the world's largest analog chipmaker and a key supplier of analog and embedded chips into a wide range of applications. We remain encouraged with Texas Instruments' relentless focus on higher-margin 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 strong gross margin expansion, and while the "easy" expansion is over, we still foresee healthy 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 another tailwind for TI, as the company’s chips are key components in a massive array of new electronics devices with improved connectivity and processing power.

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.

Our fair value estimate for Texas Instruments is $168 per share, which implies a 2023 adjusted price/earnings ratio of 23 times, and a 2% 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 and 2022 with growth of 27% and 9%, respectively, to over $20 billion of sales at the end of 2022. We foresee these good times coming to an end, however, as we model a 10% revenue decline in 2023.. We view this revenue decline as part of a natural cyclical downturn in semis, although it’s possible that TI might be losing a barely perceptible amount of market share, as our 10% revenue decline projection is worse than peers. We project a rebound with 5.5% growth in 2024, a cyclical upturn with 15% growth in 2025, and on a midcycle basis, we model average annual growth of 7.5% 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 69% in 2022. We think lower sales levels will cause gross margin to fall to 64% in 2023, and manufacturing expansion may weigh on margin even further as we model a 64% gross margin in 2024. However, as sales levels recover and expand, we foresee TI’s gross margin reaching the high-60% range in the long run. Operating margin was a stellar 50% in 2021 and 52% in 2022. We think operating margins will come back to earth to 43% in 2023 and 2024, but we still project rising margins to the high 40% range in the long run.

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.

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. Haviv Ilan took over the CEO role in April 2023, succeeding Rich Templeton, the current chairman and longtime CEO. We view the transfer of leadership to Ilan as a natural and logical succession plan.

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 $1.24 per quarter. Excluding 2021, the company also bought back at least $2 billion of stock per year from 2014 to 2022. 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.