Texas Instruments: At The Peak

| About: Texas Instruments (TXN)

Summary

We initiated with a buy last year; the stock is up more than 25% since then.

Revisiting valuation indicate that the stock is priced for perfection.

We are downgrading to hold.

We had initiated coverage for Texas Instruments (NYSE:TXN), back in 2015, with a price target of around $64. As the stock is trading around our price target, we are revisiting the valuation of the company with revised estimates. But, first, some highlights from our initiation report.

Texas Instruments is basically involved in the design and manufacturing of analog ICs and embedded processors. The company generates most of its revenue from Analog ICs. Geographically, the company generates most of its revenue from Asian electronic companies. Moreover, Analog IC market ICs is expected to grow in mid-single digits going forward. For details, see the initiation report. This update is from a valuation perspective.


Image credit: Texas Instruments

Accounting For Value
We have employed three different valuation models including EVA model, adjusted dividend model and FCF model to gauge the value of Texas instruments. Note that, according to consensus estimates, earnings are set to grow at 10% per annum for the next five years. The company has growing and sustainable dividends yielding around 2.34%. Moreover, TI tends to maintain FCF at 25% of the revenue, and the long-term CAPEX target is around 4% of the revenue.

Valuation - EVA
According to the economic value added approach, the stock is price for perfection.

Assumptions include:

  1. 8% growth in earnings as compared to the 10% consensus because analog IC market is set to witness mid-single digit growth going forward. Previously, according to ICinsights, Analog market was expected to grow at 8.9% during 2013-2018. So, 10% earnings growth was plausible given the top-line growth combined with the cost savings related to the use of 300mm fabrication facilities. However, the growth is slowing down as TechNavio expects Analog IC market to grow at 6% during 2016 to 2020. Therefore, we assumed 8% earnings growth as compared to the consensus estimates.
  2. Cost of equity is calculated based on the CAPM but market beta is used instead of Texas Instruments' beta value to reflect the return foregone by investor due to investment in the company. Cost of equity is set to grow due to the earnings retained on the balance sheet.

Click to enlarge Click to enlargeFocus Equity Estimates

The EVA based valuation reveals a price target of $61.4, which is slightly below the current. This is also below our previous price target because the 5 year growth is assumed to be 8% rather than 10%.

Valuation - Dividend-Based
Texas Instruments has increased the dividends at a CAGR of ~19% since 2007. However, as the analog growth is slowing down, the dividend growth will also slow down.

Image credit: TI investor relations

Revenue is expected to grow at 5%-7% as the Analog IC market is set to grow at 6% going forward. The company is targeting to maintain FCF at 25% of the revenue; the dividends will also grow in-line with the FCF growth. Dividends will be in-line with FCF as cash-flows reflect the true ability of a company to pay dividends. Therefore, we're assuming 5% dividend growth during the next ten years and 2% growth is assumed in perpetuity. Note that dividends are assumed to grow at 5% in contrast to the 8% earnings growth in the EVA valuation model because the dividend forecast is done over a period of ten years while, in EVA model, earnings are projected over 5 years and then perpetual growth is applied.

Focus Equity Estimates

This valuation approach reveals a price target of $54.6. In this approach, dividends and residual earnings are valued separately and discounted based of CAPM required rate of return. Dividends are valued using dividend valuation model. For residual earnings, a concept similar to EVA is adopted to reflect the return foregone by investor in order to invest in the company.

Valuation - FCF
For our free cash flow based, we used assumptions from company's guidance including FCF i.e. 25% of the cash-flow. Other assumptions include:

Cost of equity based of CAPM. S&P 500 return is assumed to be the market return. Excess working capital is added back to get the true value of the company. 1% perpetual growth is assumed.

Click to enlarge

Click to enlarge Focus Equity estimates

FCF based valuation reveals a price target of $65.3 indicating strong cash generating ability of Texas Instruments. Due to the strength of free cash flows, Texas Instruments will be able to sustain and grow its dividends going forward. Cash flow based dividend cover stood at 2.57 as of December 31, 2015. All in all, dividends of Texas Instruments seem sustainable.

Valuation - PE
Forward PE of the company stands at around 19, which is a bit expensive as earnings are expected to grow at 10% p.a. The growth is priced expensively. But, investors are paying a premium because of the attractive dividend profile of the company. Also, the PE for broad-line semiconductors stands at 22. Overall, the forward PE is high from our perspective.

Final thoughts
All the valuation methodologies reveal a price target around the current price ranging from $55-$65. At current growth rate, the chances for capital appreciation are remote. The company is already trading around the high-end of our valuation. Therefore, buying at current prices for capital appreciation purpose should be avoided. Dividends investors should hold the stock given the strong cash profile of the company. Based on our valuation findings, we are downgrading TXN to hold.

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.

Additional disclosure: This publication is for informational purpose only and reflects the opinion of Focus Equity’s analysts. This opinion doesn’t constitute a professional investment advice. Our senior technology analyst compiled this research piece. Focus Equity is a team of analysts that strives to provide investment ideas to the U.S. equity investors."