Why Texas Instruments Is Slowly Going Private

Jul. 4.14 | About: Texas Instruments (TXN)


Very few firms have bought back 40% of shares in the past decade. Texas Instruments is one of them.

Texas Instruments is committed to returning cash to shareholders, and the firm's Valuentum Dividend Cushion score remains solid. It boasts a ~2.5% annual yield.

The company registers a 3 on the Valuentum Buying Index. We're waiting for a higher score, and prefer highly-rated companies in the Best Ideas portfolio.

For many students and those that loved math, most think of Texas Instruments (NYSE:TXN) as a calculator maker. Many probable still have their TI-version from high school. But Texas Instruments is much more than that. Let's take a look at the company and run shares through the Valuentum style of investing.

For those that may not be familiar with our boutique research firm, we think a comprehensive analysis of a firm's discounted cash flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. We think stocks that are cheap (undervalued) and just starting to go up (momentum) are some of the best ones to evaluate for addition to the portfolios. These stocks have both strong valuation and pricing support. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best.

Most stocks that are cheap and just starting to go up are also adored by value, growth, GARP, and momentum investors, all the same and across the board. Though we are purely fundamentally-based investors, we find that the stocks we like (underpriced stocks with strong momentum) are the ones that are soon to be liked by a large variety of money managers. We think this characteristic is partly responsible for the outperformance of our ideas -- as they are soon to experience heavy buying interest. Regardless of a money manager's focus, the Valuentum process covers the bases.

We liken stock selection to a modern-day beauty contest. In order to pick the winner of a beauty contest, one must know the preferences of the judges of a beauty contest. The contestant that is liked by the most judges will win, and in a similar respect, the stock that is liked by the most money managers will win. We may have our own views on which companies we like or which contestant we like, but it doesn't matter much if the money managers or judges disagree. That's why we focus on the DCF -- that's why we focus on relative value -- and that's why we use technical and momentum indicators. We think a comprehensive and systematic analysis applied across a coverage universe is the key to outperformance. We are tuned into what drives stocks higher and lower. Some investors know no other way to invest than the Valuentum process. They call this way of thinking common sense.

At the methodology's core, if a company is undervalued both on a discounted cash flow basis and on a relative valuation basis, and is showing improvement in technical and momentum indicators, it scores high on our scale. Texas Instruments posts a Valuentum Buying Index score of 3, reflecting our "fairly valued" DCF assessment of the firm, its neutral relative valuation versus peers, and very bearish technicals. A score of 3 is not fantastic, but it probably should be no surprise to investors that bargains are few and far between in today's equity markets (i.e. the Dow Jones Industrial Average just crossed 17,000 to the upside). Still, let's take a good look at Texas Instruments' fundamental drivers.

Texas Instruments' Investment Considerations

Investment Highlights

  • Texas Instruments' business quality (an evaluation of our ValueCreation™ and ValueRisk™ ratings) ranks among the best of the firms in our coverage universe. The firm has been generating economic value for shareholders, with relatively stable operating results for the past few years, a combination we view very positively.
  • Texas Instruments designs and makes semiconductors, and sells them to electronics designers and manufacturers all over the world. It has four segments: Analog, Embedded Processing, Wireless, and Other. The firm is the #1 in analog and embedded combined, but it still has room to grow.
  • Texas Instruments has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 22.9% in coming years. Total debt-to-EBITDA was 1.2 last year, while debt-to-book capitalization stood at 32.3%. The firm has reduced its share count by ~40% in the past decade. Texas Instruments is slowly going private.
  • TI boasts a diverse product portfolio, but it faces intense competition from a long list of rivals: Analog Devices (NYSE:ADI), Freescale Semiconductor (NYSE:FSL), Intersil Corp. (NASDAQ:ISIL), and NXP Semiconductors (NASDAQ:NXPI), among others. Pricing pressure will continue across much of its product lineup, but we're confident the company can navigate the landscape effectively, as it has done so effectively for the past 80+ years.
  • Texas Instruments' acquisition of National Semiconductor does not change our view on the firm's dividend strength. Management is committed to returning cash to shareholders, and the firm's Valuentum Dividend Cushion score remains solid. It boasts a ~2.5% annual yield.

Business Quality

Economic Profit Analysis

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Texas Instruments' 3-year historical return on invested capital (without goodwill) is 36.5%, which is above the estimate of its cost of capital of 10.2%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead, based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Texas Instruments' free cash flow margin has averaged about 27.1% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures, and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Texas Instruments, cash flow from operations decreased about 38% from levels registered two years ago, while capital expenditures fell about 50% over the same time period.

Valuation Analysis

Our discounted cash flow model indicates that Texas Instruments' shares are worth between $32-$48 each. Shares are trading at just above the high end of the range. If nothing changes, the next update of Texas Instruments may indicate shares are overvalued. The margin of safety around our fair value estimate is driven by the firm's LOW ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers.

The estimated fair value of $40 per share represents a price-to-earnings (P/E) ratio of about 20.6 times last year's earnings and an implied EV/EBITDA multiple of about 10.7 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 5.3% during the next five years. Our model reflects a 5-year projected average operating margin of 28.1%, which is above Texas Instruments' trailing 3-year average. We're building in some strong performance in coming years, and shares are starting to get expensive.

Beyond year 5, we assume free cash flow will grow at an annual rate of 2.8% for the next 15 years, and 3% in perpetuity. For Texas Instruments, we use a 10.2% weighted average cost of capital to discount future free cash flows. We think the long-term growth rates and discount rate are consistent with Texas Instruments' size and risk profile.

We understand the critical importance of assessing firms on a relative value basis, versus both their industry and peers. Many institutional money managers -- those that drive stock prices -- pay attention to a company's price-to-earnings ratio and price-earnings-to-growth ratio in making buy/sell decisions. With this in mind, we have included a forward-looking relative value assessment in our process, to further augment our rigorous discounted cash flow process. If a company is undervalued on both a price-to-earnings ratio and a price-earnings-to-growth ratio versus industry peers, we would consider the firm to be attractive from a relative value standpoint. For relative valuation purposes, we compare Texas Instruments to peers Advanced Micro Devices (NYSE:AMD) and Intel (NASDAQ:INTC), among other firms.

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Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $40 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets, as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety, or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Texas Instruments. We think the firm is attractive below $32 per share (the green line), but quite expensive above $48 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

We estimate Texas Instruments' fair value at this point in time to be about $40 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Texas Instruments' expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential
outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $51 per share in Year 3 represents our existing fair value per share of $40 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

Pro Forma Financial Statements

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In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score as it relates to firms in the Best Ideas portfolio. Past results are not a guarantee of future performance.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: INTC is included in Valuentum's newsletter portfolios.