Texas Instruments' Leverage - How Much And How Soon?

By Stephen D. Simpson, CFA | April 27, 2012 AAA

When the going got tough, Texas Instruments (Nasdaq:TXN) went shopping. Not only did TI buy some businesses outright (like National Semiconductor), the company also bought other companies' fabrications and equipment. Now TI sits with an extensive amount of chip-making capacity - if and when the recovery really kicks into gear, the margin leverage could be impressive, but that capacity will weigh on results if the demand doesn't develop as expected.

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First Quarter Better Than Feared
Texas Instruments warned the Street a while ago that first quarter results were going to be weakened than originally forecasted, but actual results proved a bit better than the company guided. Revenue fell 8% from last year and about 9% from the fourth quarter, but did come out a bit above the guidance range.

Analog was a strong bright spot this quarter, as revenue rose 8% sequentially. Embedded chip sales fell 12%, though, and wireless and "other" were both down sharply (36 and 25%, respectively). Although wireless results were impacted by the baseband business (which the company is exiting) and the problems at Nokia (NYSE:NOK), OMAP revenue was also down and that's less encouraging.

While sales softened sequentially, margins picked up. Gross margin improved nearly four points sequentially, while reported operating income rose 9%. This number is a little misleading due to some charges; adjusted operating income was down about 11%.

SEE: Understanding The Income Statement

Have We Seen the Bottom?
Calling the bottom is a favorite hobby for chip companies and their analysts, but TI management seems confident that the worst is in the past. More specifically, management believes that inventory depletion has run its course in markets like autos, industrial and infrastructure and that demand in consumer devices should pick up as the year goes on.

I'm tempted to believe this, but I would observe that while book-to-bill was positive, 1.04 is not exactly a stunningly strong number relative to recent declines. In other words, it's looking like a gradual recovery, not a "V-shaped" snap back.

Leverage, Please
With all of the capacity that TI has added, it's quite important for the company to make the most of it and drive utilization higher. With higher fixed labor costs, that capacity will turn around and bite the company if the growth doesn't materialize.

So far, though, the GM story is mixed. On one hand, management guidance suggests that the leverage isn't going to come in a big lump next quarter. On the other hand, TI would seem to have a lot more upside (relative to prior margin peaks) than other major analog names like Linear (Nasdaq:LLTC), Microchip (Nasdaq:MCHP) or Analog Device (Nasdaq:ADI).

All in all, though, I'm not sure this is the best play. Broadcom (Nasdaq:BRCM) and Qualcomm (Nasdaq:QCOM) seem better placed for growth in wireless/mobile, while Linear should stand to gain from that recovery in industrial and autos. Likewise, ON Semiconductor (Nasdaq:ONNN) has brought in quite a bit of capacity (the Sharp acquisition) and could be even more leveraged to a recovery. All of that said, if chips go into another strong bull cycle, TI's capacity and margin advantages could make this company shine - so it really comes down to how strong of a recovery you believe is on the way.

SEE: 5 Must-Have Metrics For Value Investors

The Bottom Line
If TI can grow its free cash flow over the next decade at a rate that is about 75% of the past decade's growth, the stock is fairly priced today. I wouldn't rule out the possibility that TI could trade higher on a stronger recovery (particularly if/when that margin leverage drops down through the income statement), but I think there are better ideas in chips today.

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

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