Texas Instruments Earnings Preview: Long-Term Growth Remains Intact

| About: Texas Instruments (TXN)

Texas Instruments Inc. (NYSE:TXN), a leading semiconductor manufacturer, reported its Q3 2013 earnings on October 21. At $3.24 billion, TI’s revenue grew by 6% sequentially but declined by 4% annually due to diminishing revenues from its legacy wireless business. However, excluding the wireless revenue, the company’s top line climbed by 10% sequentially and 3% annually and it marked its first quarter of y-o-y growth since Q3 2012. Additionally, backed by higher factory utilization and an improving product mix, TI reported record gross margin of 54.8%.

Due to seasonal variations, TI anticipates its Q4 2013 revenue to decline by around 8% (excluding wireless revenue). Despite the weak guidance, we believe in TI’s long-term growth potential. A robust product portfolio, one of the best sales and field application team and strong manufacturing capacity will help spur its top line. Additionally, as the company completely exits the comparatively lower margin wireless business and increases the proportion of profitable analog and embedded products in its portfolio, it can report improving gross margins going forward.

TI remains confident that its business model is well-positioned to generate $0.20 to $0.25 of free cash flow for every dollar of revenue that the company earns in the future. In Q3 2013, it returned $1 billion to shareholders via dividends and stock repurchases.

We are in the process of updating our price estimate of $36.37 for TI, which is at an approximate 10% discount to the current market price of $41.

Rising Proportion Of Analog & Embedded Products To Aid Growth

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 it long-term growth and less volatility, compared to the past. It derived 80% of its revenue from these segments in Q3 2013 compared to approximately 72% a year ago.

Backed by strong growth in power management and high volume analog and logic, TI’s analog revenues grew by 11% q-o-q. Its embedded processing revenues registered 8% q-o-q growth with processors up the most, followed by growth in microcontrollers and connectivity. TI’s legacy wireless revenues fell by $91 million to $57 million in Q3 2013 and now account for a mere 2% of the company’s overall revenues.

The continuous growth in communications infrastructure, automotive and industrial segments as well a revival in computing, game consoles and handset markets in Q3 2013 drove demand for TI’s analog and embedded products in the quarter. In the first half of 2013, communication, industrial , automotive, computing and consumer segments accounted for 27%, 23%, 13%, 23% and 11% of TI’s revenue respectively.

TI accounts for over 15% of the analog market and it expects to gain additional market share in 2013. 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.

With new product launches TI continues to expand its embedded portfolio every quarter. It 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%. Generating strong cash flow and investment returns, the two divisions will drive growth for the company.

TI Can Maintain Its Gross Margin At The Current Level

An improving product mix and better factory utilization supported by a higher revenue base increased TI’s gross margins by 3.3% sequentially in Q3 2013. TI’s under-utilization expense declined from $100 million in Q2 2013 to $70 million in Q3 2013. Though the company expects its under-utilization charges to increase in the current quarter as revenue declines, we believe that the company will manage to retain its current gross margins in the long run. Our belief is supported by the following factors -

- Increasing factory utilization: With an improvement in the macro environment TI can leverage its low-cost manufacturing capacity to cater to higher market demand. 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. Higher demand for its products will increase TI’s factory utilization, in turn lowering its under-utilization expense. The increasing scale of operation also gives TI a greater control over its operational costs.

- Higher proportion of revenue from analog and embedded products: As TI derives an increasing proportion of its revenue from more diverse, more profitable and less capital intensive 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.

- Lower depreciation in the future: At present, depreciation is running at around 400 basis points ahead of TI’s capital expenditures. As depreciation starts to work itself down over the next couple of years it will boost gross margins.

Q4 2013 Outlook

- Revenue in the range of $2.86 billion to $3.10 billion.

- Legacy wireless products to decline to approximately $50 million.

- Operating expenses to decline by 3% to 5%.

- Tax rate of 24%.

- EPS to be in the range of $0.42 to $0.50.

Disclosure: No positions