We’re about one-third of the way into the year, and 2013 isn't shaping up as a banner year for chip stocks. Although there is a widespread expectation that the industrial and automotive markets will improve, analysts are still unsure of the path for communications infrastructure, handsets, consumer electronics, and PCs. With Texas Instruments (Nasdaq:TXN) holding on to considerable margin leverage tied to utilization, industry-wide order and shipment volumes could well point to just how strong of a year this large chip company will have.
SEE: A Primer On Investing In The Tech Industry
First Quarter Results Not Quite As Good As They Appear
To be sure, Texas Instruments did not have a bad quarter … but neither was the quarter as good as the bulls seem to want to believe.
Revenue fell 8% from the year-ago period and 3% from the prior quarter, basically coming in in-line with sell-side expectations. Analog sales were down 2% and 8%, though, while embedded sales were up 4% and down 3%. What upside there was in this quarter was largely from the discontinued wireless business (as strength in high-performance analog was offset elsewhere), and that's why I quibble a bit with the quality.
Although TI looks like it should generate strong margin leverage (and I believe it will down the line), this was not the quarter for that. Gross margin declined two and a half points from last year and about a point sequentially, coming in just shy of the average estimate. Operating income fell about 1% from last year and missed expectations by about 5%.
SEE: Zooming In On Net Operating Income
Does Guidance Point To Market Recoveries Or Share Gains?
One of the interesting parts of this report was that TI's second quarter guidance was pretty solid. Readers might remember that Linear Technology (Nasdaq:LLTC) gave relatively pessimistic guidance a little while ago, and with that company's high exposure to industrial and auto markets it was feared that those markets were even more sluggish.
Now we have pretty solid guidance from both Fairchild (NYSE:FCS) and TI, though both of these two companies seem somewhat more margin-challenged than expected. Perhaps this is a sign that customers are looking for cheaper solutions. Linear Technology is pretty famous for turning away business that doesn't meet its margin targets, so if Linear's sales are a bit soft and Fairchild and TI's are stronger (but with weaker margins), perhaps there are dots to be connected here.
SEE: Can Earnings Guidance Accurately Predict The Future?
Will TI Stay On Target As A Focused Cash-Generator
In relatively short order, TI has rearranged itself as a dedicated analog and embedded chip company focused on free cash flow generation. In principle, this could be a smart move. Continuing to compete against the likes of Broadcom (Nasdaq:BRCM), Qualcomm (Nasdaq:QCOM), Nvidia (Nasdaq:NVDA) and the like in wireless was going to require an ongoing commitment to R&D that TI didn't seem to want to make (as well, perhaps, as continual pressure on pricing).
By comparison, companies like Analog Devices (NYSE:ADI) and Linear have amply demonstrated that focusing on high-performance analog chips can be very profitable and cash-generative. Assuming that TI doesn't change course again, TI should be able to generate significant operating leverage through its fab capacity and generate ample cash flow. That cash flow will, in turn, go toward repaying debt and paying for dividends and buybacks. It's a solid plan … provided that management sticks to it.
SEE: Evaluating A Company’s Management
The Bottom Line
Within TI's comp group, these shares have already done reasonably well – basically matching Linear and NXP Semiconductors (Nasdaq:NXPI) over the past year, while outperforming companies like Fairchild and ON Semiconductor (Nasdaq:ONNN).
Though I do believe TI will ultimately realize that hoped-for margin leverage, I don't see huge value in these shares today. I'm looking for admittedly modest revenue growth – in the neighborhood of 3% on a long-term basis – and I'm only looking for long-term free cash flow (FCF) margins in the high 20%'s. That suggests a fair value in the low-to-mid $30s. More bullish investors may want to note, though, that each point of revenue growth is worth about $3 of incremental value, while each point of long-term free cash flow margin is worth about $1 per share. Accordingly, if TI can generate growth closer to the mid single digits and/or free cash flow margin closer to 30%, these shares could sport a fair value in the high $30's.
At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.