Watching Texas Instruments (Nasdaq:TXN) over the past two years reminds me of that candy commercial where a kid asks how many licks it takes to get to the center of the candy. Revisions continue to head lower and investors have to be asking themselves just how much worse things can get before the turnaround finally happens. While I do believe TI has solid margin leverage to a chip recovery, the stock isn't cheap enough to entice me to brave the risks that the recovery takes even longer to achieve.

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Third Quarter a Beat, but...
Texas Instruments reported third quarter results that were better than expected, but there was a decided lack of momentum in the business. Although better than expected margins and cash flow were both welcome, neither are likely sustainable absent better growth. Revenue fell 2% from last year's level and rose about 2% from the second quarter. Analog and embedded revenues were both positive (each up about 2% sequentially as reported), while wireless revenue fell 5%.

Margins were surprisingly good. Due to a richer mix of analog and embedded chip revenue, as well as proceeds from an insurance settlement, gross margin improved a point from last year and almost two points from the second quarter. Reported operating income improved nicely (up 3% annually and 40% sequentially), while adjusted numbers saw a 14% decline from last year and 15% improvement from the second quarter.

Guidance Very Weak
Texas Instruments may have delivered a decent report for the September quarter, but the business got weaker as the quarter went on, with a notable deterioration in September.

Orders fell 5% for the quarter, leading to a sub-1.0 book-to-bill ratio. With weakness across many markets (and industrial markets getting worse), TI management revised guidance lower. Instead of the prior sell-side estimate of $3.24 billion, management guided to a range of $2.83 billion to $3.07 billion, a nearly 10% revision at the midpoint. While there are some non-operating aspects to that revision, the adjusted numbers are still on the weaker end of the range of sequential declines projected by other chip companies such as Linear Technology (Nasdaq:LLTC), Fairchild (NYSE:FCS) and Xilinx (Nasdaq:XLNX).

It Has to Get Better...Right?
The bull thesis on Texas Instruments has basically gone like this - TI remains a share leader in the analog space, and the company's new ultra-modern fabs should allow the company to not only improve peak margins, but also take on business that would have previously been too low-margin to be worthwhile. In other words, this was supposed to be a "win win"; TI could improve its margins while boosting revenue. That could still happen, but the timeline has clearly dragged out.

What's more, it's not inconceivable that this recovery could stretch on for years. Worries about the fiscal cliff have led companies to pull back on production and weak wage growth is not exactly stimulating consumer demand. It's not unthinkable, then, that Linear, TI, Analog (NYSE:ADI) and Fairchild could find themselves muddling through a twilight of poor revenue growth and weak margin leverage possibilities for longer than bulls currently expect.

In the meantime, TI has announced its intention to largely exit the smartphone/tablet app processor market. This business is currently about 8% of revenue, but there seems to just be too much competition standing in the way of attractive returns. This isn't the first time that this subject has come up; there were rumors last year that companies such as Broadcom (Nasdaq:BRCM) and Intel (Nasdaq:INTC) were looking to buy TI's OMAP business, so it'll be interesting to see if there's the same interest this time around. In any case, while this may seem like a disappointing retreat to some, other analog players such as Linear and Analog have done well for themselves in the past by being willing to walk away from business that didn't meet their minimum standards for returns.

The Bottom Line
Even if TI is undervalued today, it's not undervalued enough to capture my interest. I think the company will be hard-pressed to grow its cash flow at much more than a mid-single-digit rate, and that doesn't point to enough value in the shares to take the risk of a prolonged malaise. For TI's stock to offer substantial returns from here, investors have to be willing to project sustainable improvements in free cash flow (FCF) conversion on the order of companies such as Analog and Maxim Integrated (Nasdaq:MXIM), as well as consistent revenue growth.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

Tickers in this Article: TXN, LLTC, ADI, FCS, XLNX, BRCM, INTC, MXIM

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