By The Valuentum Team
Texas Instruments' Investment Considerations
• Texas Instruments (NASDAQ:TXN) 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 #1 in analog and #3 in embedded, but it still has room to grow. It was founded in 1930 and is headquartered in Dallas, Texas.
• Texas Instruments expects the personal electronics market to be under pressure in 2016. Aside from this area, the firm expects demand for its products to be relatively stable from late 2015 levels. We love its focus on long-term free cash flow growth, however.
• TI boasts a diverse product portfolio, but it faces intense competition from a long list of rivals: Analog Devices (NASDAQ:ADI), Intersil Corp (NASDAQ:ISIL), and NXP Semi (NASDAQ:NXPI), among others. Pricing pressure will continue across much of its product line-up, but we're confident the company can navigate the landscape effectively, as it has done so effectively for the past 80+ years.
• In the near term, Texas Instruments is expecting significantly weaker demand within the personal electronics market to impact its top line after growth in 2015 was slower than management originally anticipated. Nevertheless, 2015 was a solid year for the firm as it expanded its 300 millimeter analog production, improved gross margin to a new record level, realized operating margin improvement, and advanced free cash flow margin to a new record level.
• Texas Instruments' capital allocation strategy is to grow, generate and return cash to shareholders over the long term. Organic growth remains the priority for use of capital, and automotive and industrial R&D spending has led the way in recent years. Expanding 300mm Analog production will continue to be a focus.
• Texas Instruments' acquisition of National Semiconductor has not changed our view on the firm's dividend strength. The move has met management's objectives thus far, as it has leveraged and strengthened its competitive advantages.
Economic Profit Analysis
In our opinion, 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 33.5%, which is above the estimate of its cost of capital of 9.4%. 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.
Companies that have strong economic profit spreads are often also solid free cash flow generators, which also lends itself to dividend strength. Texas Instruments' Dividend Cushion ratio, a forward-looking measure that takes into account our projections for future free cash flows along with net cash on the balance sheet and dividends expected to be paid, is 1.9 (anything above 1 is considered strong). Click here to learn more about the Dividend Cushion ratio.
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 24.7 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. At Texas Instruments, cash flow from operations increased about 14% from levels registered two years ago, while capital expenditures fell about 22% over the same time period.
In fiscal 2015, Texas Instruments reported cash flow from operations of ~$4.3 billion and capital expenditures of ~$600 million, resulting in free cash flow of ~$3.7 billion. This represents a ~6% increase from fiscal 2014.
This is the most important portion of our analysis. Below we outline our valuation assumptions and derive a fair value estimate for shares.
Our discounted cash flow model indicates that Texas Instruments' shares are worth between $40-$60 each. Shares are currently trading at ~$58, in the upper half of our fair value range. This indicates we feel there is more downside risk than upside potential associated with shares at this time.
The margin of safety around our fair value estimate is derived from the historical volatility of key valuation drivers. The estimated fair value of $50 per share represents a price-to-earnings (P/E) ratio of about 19.1 times last year's earnings and an implied EV/EBITDA multiple of about 10 times last year's EBITDA.
Our model reflects a compound annual revenue growth rate of 2% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of -1.7%. Our model reflects a 5-year projected average operating margin of 34.2%, which is above Texas Instruments' trailing 3-year average.
Beyond year 5, we assume free cash flow will grow at an annual rate of 2.2% for the next 15 years and 3% in perpetuity. For Texas Instruments, we use a 9.4% weighted average cost of capital to discount future free cash flows.
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 $50 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.
In the graph above, we show this probable range of fair values for Texas Instruments. We think the firm is attractive below $40 per share (the green line), but quite expensive above $60 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 $50 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above 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 $61 per share in Year 3 represents our existing fair value per share of $50 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.
Wrapping Things Up
There is plenty to like about Texas Instruments. The firm's dividend has fared extremely well due to its focus on increasing free cash flow. The company's capital allocation strategy is to grow, generate and return cash to shareholders over the long term. Investing in organic growth remains the top priority for use of capital, and automotive and industrial R&D spending has led the way in that category in recent years. The personal electronics market is expected to be under pressure in 2016, but aside from this area, Texas Instruments expects demand for its products to be relatively stable from late 2015 levels. Though we like the company's dividend prospects, shares are too pricey for us at the moment. Texas Instruments currently registers a 3 on the Valuentum Buying Index.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.