Texas Instruments Just Out Of The Starting Blocks

By Stephen D. Simpson, CFA | July 23, 2013 AAA

I'm not going to say that every part of the semiconductor space is back on track, but the earnings and guidance that coming suggests that things are getting better outside of consumer electronics and PCs. That's good news for Texas Instruments (NYSE:TXN), particularly as the company is seeing stronger conditions in industrial and auto markets and better margins in the wake of moving on from wireless. Although the stock does not look cheap on a cash flow basis, I do believe the company's margin leverage, and subsequent improvements in ROE, are likely to send the shares higher over the next 12 to 24 months. On Target In Q2, But With Some Positive Underlying DriversGiven that Texas Instruments provides mid-quarter updates, big surprises in reported earnings are relatively rare for Texas Instruments, and this quarter was no exception. That said, there were some positive details to note, and guidance sounded pretty encouraging to me. Revenue fell 9% from the year-ago level, but rose 6% sequentially. Analog sales fell 3% and rose 6% over those periods, while embedded revenue rose 7% and 10%. It's too bad that Texas Instruments doesn't break out its end-market revenues, but management did indicate that there was strength in HPA, SVA, and MCU in the industrial market and ASSP, OMAP, and DLP in automobiles. SEE: Semiconductor ETFs For 2013 I think it's important to take note of the margins that Texas Instruments reported. Between improving utilization and the run-off of the lower-margin wireless business, gross margin improved two points from last year and almost four points sequentially, and I believe that with Analog Devices (NYSE:ADI), Texas Instruments has a lot to gain from margin leverage. On the operating side, TI reported that operating income rose 52% and 129%, with operating margin improving almost 12 points and 16 points. Is It The Markets Or The Products?TI's results, particularly in industrial and autos, should be encouraging for other companies like Atmel (Nasdaq:ATML), Linear (Nasdaq:LLTC), Analog Devices, Freescale (NYSE:FSL), and NXP (Nasdaq:NXPI). The one “but” I would offer is the question of market share growth. TI management believes that the company has been gaining share in growing auto chip markets like radar (blind spot detection), and some industrial categories as well. Nevertheless, I do believe the auto and industrial markets are recovering, though various consumer markets remain a little weak. At the end of it all, TI did report 6% sequential order growth and a book-to-bill above 1 (1.03), so I do believe the recovery is starting. Stepping Away From WirelessAs mentioned before, TI has largely moved out of the wireless business, as the company found the growth and margins available in the market to be comparatively unattractive. Going a step further, the company announced that it had reached an agreement to transfer some wireless connectivity IP to one of its former chip customers. There was no mention of the acquiring company, but the rumors seem to center on Apple (Nasdaq:AAPL), though that could simply be a result of the fact that most rumors seem to eventually involve Apple. If it is Apple, that's not exactly good news for Broadcom (Nasdaq:BRCM), but I don't think it's a major thesis-changing event. The Bottom LineI do believe that TI has the opportunity to see significant gross margin expansion over the next year or two, as improving chip end markets lead to higher utilization. With that, I see most of the gross margin leverage flowing through to the operating line and free cash flow, so I believe TI's free cash flow could accelerate relatively rapidly. Assessing that in terms of the stock is more challenging. On a discounted cash flow basis, even the assumption of a new peak in free cash flow margin isn't really enough to get the fair value much above $35 unless you believe the semiconductor market is somehow going to become non-cyclical again. Turning to a different, more controversial methodology, the company's ROE and price-book suggest that the shares could still have room to run. There is a pretty good correlation over time between ROE and P/B, and as TI's margins improve, so too will the ROE. Assuming that TI's ROE can move into the low-to-mid 20%'s in the coming years, the P/B ratio could move to around 5x, suggesting meaningful upside for the shares during this rebound/recovery. I realize that many readers will scoff at the idea of valuing a tech stock on the basis of price/book, but I would ask them to run their own historical correlation studies among S&P 500 and Nasdaq 100 stocks and see if they don't see similar relationships. As a result, while it's hard for me to say that Texas Instruments is a “traditional buy”, I do see a way for the shares to continue to appreciate from here.

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