What's Driving Texas Instruments $35 Price Estimate?

| About: Texas Instruments (TXN)

Texas Instruments (NYSE:TXN) designs and manufactures semiconductors for sale to electronic designers and manufacturers. Barring 2010, its revenue has continuously declined over the last few years. Nevertheless, it still is featured among the top five semiconductor vendors in terms of revenue in 2011 and 2012.

In September 2012, TI declared its intention to stop focusing on smartphones and tablets and instead expand its OMAP footprint in embedded applications, which it believes offers greater potential for sustainable growth compared to mobile devices. Additionally, it incorporated a restructuring plan to reduce its overall expense base. With the increasing strength in its core business of analog semiconductors, the exit from the highly competitive wireless market and shifting focus on embedded processors, we believe that TI can witness a revival in its business 2013 onward.

TI has added around $7 billion worth of incremental revenue generating capacity in the last few years. While the excess manufacturing capacity might weigh on short-term growth, we feel the same will help TI further increase its market share as the economy stabilizes. Judging by the marginal decrease in TI’s operating expenses in Q4 2012, excluding restructuring charges, we feel that the company has been executing its operations fairly well in what is clearly a tough working environment.

Our price estimate of $35 for Texas Instruments is in line with the current market price. Here we provide a quick snapshot of the important segments that contribute to TI’s business, and the key trends that will help drive the stock in the future.

What Are the Important Segments That Contribute to TI’s Business?

In 2012, TI earned $13 billion in revenue and earned 50% and 15% gross margin and operating margins, respectively. Historically, the company’s capital expenditure as a percentage of gross profit has ranged between 10% and 17%. It has updated its equipment and made various acquisitions in recent years, including several fabrication units. Thus, we expect it to spend a lower percentage of its gross profit for capital expenditure in the future. Additionally, TI’s core focus areas of analog and embedded solutions do not require constant manufacturing upgrades.

TI’s R&D and SG&A expenditures as a percentage of gross profit are close to 30%. The company is relying on its R&D spending to come up with a new line of products in all its business segments in order to compensate for the decline in revenues due to its exit from cellular baseband and the wireless segment. TI already has a geographic presence in major end markets and a large sales and field application staff which caters to its diverse products and business operations. Thus, we do not see a significant increase in the company’s workforce for the period under forecast.

1. Analog Semiconductors: Analog semiconductors are used to change real-world signals – such as sound, temperature, pressure or images – by conditioning, amplifying and then converting them to a stream of digital data that can be processed by other semiconductors. TI’s analog product portfolio consists of high volume analog & logic, high-performance analog and power management. It caters to over 80,000 customers from various industries such as computing, wireless communication, infrastructure, automotive, telecom, etc.

TI derives 55% of its revenue from the sale of analog products and earns over 50% gross margin on the same. The global analog semiconductor market size is estimated to be approximately $43 billion in 2012. The analog market tracks the worldwide semiconductor market, which has declined 3% in 2012. However, with an improvement in macro environment, the semiconductor market is forecast to rise by 4.5% and 10% in 2013 and 2014, respectively.

TI accounts for over 15% of the analog market. It is the market leader in voltage regulators, which contribute around 29% to its analog division revenue. According to iSuppli, voltage regulators are set to grow at an annual rate of 16% compared to the overall analog segment’s rate of 6.3%. With the acquisition of National Semiconductors, a strengthening product portfolio and growth in high volume analog and logic segments, we believe that TI is well equipped to leverage increasing demand for analog products. Additionally, by increasing the product yield, its new fabs will drive down costs which will keep gross margins in check.

2. DLP Products, Calculators, and Royalty Revenue: This segment includes sales from TI’s smaller semiconductor product lines, handheld graphing and scientific calculators and royalties received for patented technology that TI licenses to other electronics companies. While buyers of TI calculators are primarily students, its DLP technology is mainly sold to projectors manufacturers.

Royalty fees, DLP products and calculators account for 20% of TI’s total revenue and is the most profitable with 2012 gross margins in excess of 70%. Calculators and royalties are stable revenue streams and average growth for the segment as a whole is comparatively lower.

3. Embedded Processors: Embedded processing products include DSPs and microcontrollers. Wheres DSPs perform mathematical computations almost instantaneously to process or improve digital data, microcontrollers are designed to control a set of specific tasks for electronic equipment. TI’s products are used in many different applications and custom embedded processing products used in specific applications such as communications infrastructure equipment and automotive.

In addition to the analog portfolio, embedded processors remain the main focus area for TI. The company earns 15% of its revenue from this segment and earns 37% gross margin on the same. The global embedded processor market is currently valued at $19 billion and we expect the same to track growth in the overall semiconductor market.

With new product launches, TI continues to expand its embedded portfolio every quarter. Exiting the smartphone and tablet markets, TI is now focused on expanding the OMAP footprint in embedded applications such as automotive, industrial equipment, enterprise communications, etc. The company feels that the embedded markets offer greater potential for sustainable growth compared to mobile devices. It intends to leverage its wireless connectivity solutions in a broader set of embedded applications which require fewer resources and less investment.

4. Application Processors and Connectivity: In 2012, TI generated 10% of its revenue from this division and earned the lowest margins (16%) on the same. TI’s market share in the global wireless market declined from 14.5% in 2009 to 4.3% in 2012. We expect the market share to decrease to less than 1% in the long run.

Historically, this segment included revenue from the sale of baseband products, application processors and wireless products for mobile devices. While TI exited its baseband business in 2008, it declared its intention to focus away from smartphones and tablets in September 2012. TI will now focus on leveraging its OMAP processors and wireless connectivity solutions in a broader set of embedded applications. Going forward, the company will start reporting its OMAP revenue in the embedded business division.

Disclosure: No positions.