Texas Instruments Earnings: Amid a Cyclical Downturn, We Lower Our Fair Value to $155
Texas Instruments Earnings: Amid a Cyclical Downturn, We Lower Our Fair Value to $155 From $168
Wide-moat Texas Instruments reported predictably soft third-quarter results but provided investors with a gloomy outlook for the December quarter, as business conditions weakened among industrial customers and the company was no longer able to avoid factory underutilization expenses as it built up chip inventory. Based on our lower near-term outlook and modestly lower long-term revenue and gross margin assumptions, we cut our fair value estimate to $155 from $168. Shares appear attractively priced in the low $140 range after hours, although this latest industry downturn appears to be lingering a bit longer than prior cycles, likely as a hangover from the prosperous times from the global chip shortage in 2021 and 2022.
Revenue in the September quarter was $4.56 billion, down 13% year over year, but up 1% sequentially and at the midpoint of prior guidance. We’re encouraged that automotive chip revenue was still holding up well, as TI’s sales here were up about 5% sequentially and 20% year over year. Industrial chip sales were the concern, however, as demand deteriorated across many types of systems. Revenue was down about 5% sequentially and 15% year over year in industrial. Gross margin of 62.1% was disappointing, down 690 basis points year over year, as the firm absorbed factory underutilization costs due to weak demand.
TI’s guidance for the December quarter of $4.1 billion at the midpoint was quite light, relative to both our prior estimates and FactSet consensus estimates of $4.5 billion. Revenue of $4.1 billion would represent declines of 9% sequentially and 12% year over year. We estimate that gross margin will come in at no better than 60% next quarter, a far cry from the 70% earned during TI’s peak in the March 2022 quarter. We anticipate that factory underutilization charges will weigh on near-term results for the next few quarters.
Published on Oct 24, 2023
Texas Instruments Remains the Analog Industry Leader
Business Strategy and Outlook
We’re encouraged by TI’s 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.
TI 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. The "easy" expansion is over, but we still foresee healthy gross margins in the years ahead, even if TI has bouts of overcapacity from time to time. 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.
Published on Oct 24, 2023
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.
Rated on Oct 28, 2023, Published on Oct 24, 2023
Our fair value estimate for Texas Instruments is$ 155 per share, which implies a 2023 adjusted price/ earnings ratio of 22 times, and a 1.5% free cash flow yield.
Fair Value and Profit Drivers
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 12% 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 modest amount of market share too. We project only a slight rebound with 3.5% growth in 2024, a cyclical upturn with 18.5% growth in 2025, and on a midcycle basis, we model average annual growth of about 7% for TI thereafter. We model 7%-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 and factory underutilization will cause gross margin to fall to 63% in 2023, and manufacturing expansion may weigh on margin even further as we model a 62% gross margin in 2024. However, as sales levels recover and expand, we foresee TI's gross margin reaching the mid-60% range in the long run. Operating margin was a stellar 50% in 2021 and 52% in 2022, but we now fear that these are peak profit levels. We think operating margins will come back to earth to 42% in 2023 and 41% in 2024, but we still project rising margins to the high 40% range in the long run.
Published on Oct 24, 2023
Although Texas Instruments competes in the cyclical semiconductor industry, we think its size and scale warrant a Morningstar Uncertainty Rating of Medium.
Risk and Uncertainty
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.
Rated on Oct 28, 2023, Published on Oct 24, 2023
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 $1.30 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.