Texas Instruments' (TXN) gross margins declined from 53.6% in 2010 to 49.7% in 2012 during a period of significant transition for the company. The severe earthquake in Japan in early 2011 significantly reduced the revenue of both the industry and TI. Lower revenue and increased capacity underutilization charges (a common and unwelcome pairing in the industry) impaired gross profitability, as did the game-changing acquisition of its large analog competitor, National Semiconductor. Though the impact of Japan abated, acquisition effects continued into 2012, when revenue growth was further undermined by management's decision to exit the cellular application processor business (more on this below). That said, the company has emerged as a stronger, and notably more analog-centric company. Indeed, higher revenues combined with an improving product mix and better factory utilization increased TI's gross margins to 51.5% and 54.8% in the second and third quarters of 2013, respectively.
In this article we discuss why we believe TI's higher gross profitability will persist for the rest of our review period.
Higher Proportion Of Revenue From Analog & Embedded Products
Since its planned exit from the smartphone and tablet market, TI has been increasing its focus on differentiated analog and digital products. Eschewing high-volume digital products, it targets higher value and High Performance Analog products, as well as differentiated digital products it develops and markets within the Embedded Processing segment. As a result, though profitability will continue to vary with the balance of supply and demand, the company has a higher value offering. These are segments that it believes will offer it long-term growth and less volatility compared to the past. And we agree. It derived 80% of its revenue from these segments in Q3 2013 compared to approximately 72% a year ago.
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, its gross margins should increase marginally going forward, in our view.
Cost Savings From Exiting The Wireless Business To Help Improve Margins
In September 2012, TI declared its intention to end its smartphone and tablet Application Processor offering. Instead the company is expanding its OMAP footprint in embedded applications, which it believes offers greater potential for sustainable growth compared to mobile devices. TI expects revenue from the old offering to phase out by the end of this year. In November 2012, TI announced its intention to cut back 1,700 jobs to reduce expenses in the wireless business. The company estimates its restructuring initiatives will translate into annualized savings of approximately $450 million by the end of 2013. We believe that the savings incurred from restructuring will offset the negative impact of declining revenues from the wireless segment in the future.
Expanding Revenue Base To Improve Factory Utilization
With the acquisition of National Semiconductor and other fabrication facilities , TI has added close to $7 billion worth of incremental revenue generating capacity in the last few years. Though there is potentially excess manufacturing capacity, much of it is largely depreciated. Thus it remains a competitive advantage to the company in the long run. The increasing scale of operation also gives TI a greater control over its operational costs.
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 factory utilization, allowing high profitability to be increasingly manifest as utilization improves. TI's underutilization expense declined from $100 million in Q2 2013 to $70 million in Q3 2013. Though the company expects its underutilization charges to increase in the current quarter as revenue declines, it is a transient and seasonal trend, as we expect revenue to improve 2014 onward.
Because of TI's increased focus on the analog and embedded markets, we estimate TI's revenue base will expand year on year for the rest of our review period.
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. Our price estimate of $37 for TI is at an approximate 10% discount to the current market price of $42.