Texas Instruments (NASDAQ: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 is still featured among the top five semiconductor vendors in terms of revenue in 2011 and 2012. 
Since its decision to exit the wireless business in September last year due to intense competition, TI’s stock price has climbed by more than 35%. Our valuation of $36 for TI is now at a slight discount to the current market price. Estimating continuous top line growth for the company over our review period, we think we have adequately accounted for the upside in our price estimate.
We believe that a robust product portfolio, one of the best sales and field application teams, and strong manufacturing capacity will be the key factors driving TI’s future growth. Witnessing a higher order rate for the second consecutive quarter this year, TI claims that its overall backlog continues to improve.
A Strong Analog and Embedded Portfolio Will Help Drive Future Demand
After its planned exit from the smartphone and tablet market, TI has been focusing on transitioning its operations to become a pure analog and embedded processing company, segments that it believes will offer long-term growth and less volatility compared to the past. TI now derives 78% of its revenue from these segments compared to approximately 72% a year ago. The company remains focused on building a diverse analog and embedded processing business across customers and markets.
TI’s analog product portfolio consists of high volume analog and 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 is the market leader in voltage regulators, which is expected to be a strong growth driver for the analog market. The segment contributes around 29% to TI’s total analog division revenue.
TI accounts for over 15% of the analog market, and we think that it has the potential to gain additional market share. With the acquisition of National Semiconductor, 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.
The company is now focused on leveraging its OMAP processors and wireless connectivity solutions in a broader set of embedded applications. With new product launches, it continues to expand its embedded portfolio every quarter. TI believes that the embedded markets currently valued at $19 billion offers greater potential for sustainable growth compared to mobile devices. Last year, TI expanded its product portfolio by almost 20%.
With an expanding product portfolio combined with the industry-leading sales force, TI has managed to consistently gain market share in the analog and embedded divisions in the last few years. Generating strong cash flow and investment returns, the two divisions will drive growth for the company.
Large Manufacturing Capacity Gives TI A Competitive Edge
TI has the strongest manufacturing capability in the analog market. Though the excess manufacturing capacity might be detrimental to TI’s short-term growth, we believe that it can provide a competitive advantage to the company as demand picks up. The increasing scale of operations gives TI greater control over its operational costs. TI’s capital management strategy has been to build its manufacturing base at an opportunistic cost and then position the same well ahead of demand. Moreover, TI claims that only half of its underutilization expense is cash-based, which reduces the negative impact on its cash flow.
Gross Margins To Improve In The Future
The declining revenue base combined with additional manufacturing capacity acquired in the last few years increased TI’s under-utilization charges, which in turn put pressure on its margins. TI’s gross margins declined from 53.6% in 2010 to 49.7% in 2012. However, higher revenues combined with an improving product mix increased TI’s factory utilization which in turn contributed to a significant improvement in gross margins in Q2 2013.
With improving factory utilization, exit from the comparatively low margin wireless business and saving incurred from the closing of two old factories (in Japan and Texas) by this year end, we believe that TI’s gross margins will increase over our review period.
Though its excess manufacturing capacity might be detrimental to its short-term growth, we feel it will serve as a competitive advantage to the company in the long run. With an improvement in the macro environment, TI can leverage its low-cost manufacturing capacity to cater to higher market demand. Higher demand for its products will increase TI’s factory utilization, in turn lowering its underutilization expense. The increasing scale of operation also gives TI greater control over its operational costs.
As TI derives an increasing proportion of its revenue from high-quality analog and embedded processing products, and lower revenue from the less profitable wireless products, we expect its gross margins to increase marginally going forward. The cost saving incurred from exiting the wireless business will further ease pressure off gross margins.
Disclosure: No positions.