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  • Higher revenues, combined with an improving product mix and better factory utilization, increased gross margin to 52.1% in 2013.
  • In Q1 2014, gross margin further improved to 53.9%.
  • The company believes that the analog and embedded segments offer long-term growth and less volatility compared to the past.

Lower revenue, increased capacity, under-utilization charges and the acquisition of its large analog competitor, National Semiconductor, impaired Texas Instruments' (NASDAQ:TXN) gross profits in the last few years. The severe earthquake in Japan in early 2011 significantly reduced revenue for both TI and the industry. Though the impact of Japan abated, revenue growth was further undermined by management's decision to exit the cellular application processor business. TI's gross margins declined from 53.6% in 2010 to 49.7% in 2012. However, higher revenues, combined with an improving product mix and better factory utilization, increased gross margin to 52.1% in 2013. In Q1 2014, gross margin further improved to 53.9%.

We believe that TI's gross margins will improve marginally over our review period. In this article, we explain our rationale behind this view.

Higher Proportion Of Revenue From More Profitable Analog And Embedded Products

Since its planned exit from the smartphone and tablet market, TI has been increasing its focus on differentiated analog and digital products. The company has increased its focus on 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 market conditions, TI has a higher value offering. It believes that the analog and embedded segments offer it long-term growth and less volatility compared to the past. These segments are more profitable and less capital intensive compared to wireless products.

TI believes that the analog and embedded processor market will keep growing as important markets such as industrial and automotive continue to embrace electronic technology. It derived 84% of its revenue from these segments in Q1 2014 compared to approximately 72% in the quarter ended September 2012.

Higher Revenue Base To Improve Factory Utilization

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 for 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 as utilization improves. TI's under-utilization charges declined from $100 million in Q2 2013 to to $70 million in Q3 2013. Though the company did not disclose the utilization levels in its Q1 2014 earnings materials, its did declare that factory utilization from a stats basis was higher compared to Q4 2013.

Because of TI's increased focus on the analog and embedded markets, we estimate its revenue base will expand year-on-year for the rest of our review period. Higher revenue will improve factory utilization.

Lower Depreciation In The Future

At present, TI's depreciation is $459 million ahead of its capital expenditures. The company expects its capital expenditure to remain at low levels (4% of revenue) for the next few years. As depreciation starts to work itself down over the next couple of years, it will boost gross margins.

Cost Savings: Annualized Savings of $140 Million In 2014

TI's ongoing restructuring initiative is a result of the ongoing assessment of its investments and the market opportunities that it addresses. For 2014, TI believes the following initiatives will result in annualized savings of about $130 million.

- TI plans to reduce costs in certain embedded processing product lines that either have matured or do not offer the return opportunities the company is looking for. It does not plan to exit any market or discontinue any existing embedded products, but is simply realigning its resources to better cater to market opportunities. It believes that these changes will accelerate a profit margin improvement in the embedded business while still maintaining its pace of growth.

- Lowering costs in Japan as a result of reducing resources to a level that meets opportunity in the country.

- Elimination of 1,100 jobs.

Disclosure: No positions.

Source: Texas Instruments: Here's Why The Company's Gross Margin Will Improve In The Future