- Texas Instruments (TI) has been underperforming the industry after delivering soft guidance for the third quarter.
- Analysis of profitability reveals that the company has higher gross and operational margins.
- This is made possible through production of analog chips and better ownership of its supply chain.
- As a result, the company should further improve profitability metrics.
- With a history of providing soft guidances and subsequently exceeding them, there is a possibility for TI to beat the topline as well, in a persistently strong demand environment.
Texas Instruments' (NASDAQ: NASDAQ:TXN) stock continues on its pullback as analysts question the soft guidance for the third quarter of 2021. It is now underperforming the iShares Semiconductor ETF (SOXX) after having outperformed for the most part of the last six months.
Also, with a market cap of over $175 billion, TI is one of the largest producers of chips and concerns voiced about the inline sequential guidance also has implications for the wider semiconductor cycle.
However, as analysts focus on topline, it is important to go deeper into the bottom-line for an understanding of what makes possible TI's high margins as well as obtain insights on its manufacturing model and supply chain.
Gross margins for a semiconductor play is an important metric as it provides a measure of production efficiency.
Exploring further, while outsourcing of semiconductor manufacturing to the external supply chain reduces working capital requirements, other costs and associated overheads related to product engineering and supply chain management remain in place. Also, as fabless plays migrate to lower nodes, there is an increase in design complexity with development projects employing hundreds of people using advanced computing tools to program circuit boards.
In this respect, chip development has never been cheap and leading-edge ones can cost from $30 million to $100 million.
One of the ways to amortize the impact of the huge investments required is to manufacture chips for the right market, or those allowing for higher margins. This is the case for TI, whose products are used in vehicles as micro-controllers and power management chips, as well as in personal computers and other consumer devices. As such, it is one of the world's largest makers of analog and embedded processors.
Source: Seeking Alpha
Now, these semiconductors incorporate both analog and digital functions, providing the ability for digital electronics to interface with the outside world in order to measure functions such as temperature, speed, sound and electrical current. They are used by thousands of customers in industries ranging from communications, computer, instrumentation, military, aerospace, while not forgetting automobiles.
These chips are relatively less complex to design than System on Chip (SoC) processors like Qualcomm's (NASDAQ: QCOM) Snapdragon utilizing billions of transistors each. These are used in smartphones, and judging from Qualcomm's much lower gross margins despite upbeat annual revenues, the company incurs much higher cost of goods (COGs or cost of revenues).
Now, the Dallas chip-maker's products does include hardware for assisting cameras and batteries in Apple's (AAPL) iPhone, but there is yet another reason for its high margins.
As per the acquisition of Micron Technology's (NASDAQ: MU) 300-millimeter semiconductor factory in Utah for $900 million, while being on track to close its last two 150 mm wafers producing factories, shows that the company continues to rationalize production facilities. At the same time, by outsourcing some manufacturing to third-party foundries like United Microelectronics (UMC), TI is also a partial fabless play.
This ability to use its own manufacturing capacity while outsourcing to third parties means more flexibility, which in turn means more efficiency when dealing with the supply chain.
Now, the fact that higher gross margins is obtained from the particular chips TI designs is confirmed when comparing with Analog Devices (NASDAQ: ADI), which as it very names suggests produces analog semiconductors. Still, when comparing EBIT margins (operational margins), TI scores much better.
Source: Charts built using data from Seeking Alpha
This is explained by the fact that over the past few years, TI has evolved its distribution network to further align with its strategy of building closer and more direct relationships with its customers. With a closer and direct relationships with customers, TI has been able to provide better service and ensure enhanced supply of goods. More direct relationships with customers has in turn reduced the volume of transactions going through the distribution channel as the Texan manufacturer needs fewer distributors. These can be viewed as an exclusive group of franchised distributors. The change in distribution process is being done gradually, thus ensuring a smooth transition for customers.
The decreasing SG&A expenses as a percentage of revenues as from the end of 2019 shows that the direct sales strategy has been working nicely, especially during the COVID-induced supply chain disruptions period. Here, some investors would have noticed the R&D expenses expressed as a percentage of revenues declining as well. This signifies that despite seeing a rise in sales, the fabless play is not incurring high R&D costs.
Valuations and key takeaways
A key metric to consider is the inventory. This is very important in an industry notorious for being cyclical. The surge in investment to expand production capacity can potentially impact chip makers' profits when global demand subsides. This was the case in 2011/2012. At that time, there was an unprecedented surge in production resulting in the semiconductor industry overshooting, adding so much capacity that as demand subsided, there was a fall not only in revenues, but also in profits as companies tried to liquidate unsustainable inventory levels.
As for TI, it is running about 111 days of inventory, with the target being 130 to 190 days. That's part of the reason the management cautioned about the third quarter revenues as selling more inventory items makes it possible to generate more sales. For this matter, sales for the period ending in September is forecasted to be in the $4.4 billion to $4.76 billion range, falling short of some analysts' estimates of $4.59 billion.
This forecast was in sharp contrast with the 41 per cent surge in the second-quarter revenue.
However, while inventory numbers are on a downtrend, the "inventory as a percentage of total assets/liabilities" metric, at 9% remains higher than peer Analog Devices' 2.97% and others like NXP Semiconductors (NASDAQ: NXPI) and Infineon (OTCQX: IFNNY) too.
Source: Chart prepared through data from Seeking Alpha
Also, caution expressed by the management that it could not anticipate whether demand is peaking or whether growth at the current levels is sustainable, is understandable. The reason is that TI's chips are mostly embedded in the circuits of customers, giving it more of an indirect visibility on the updates in the supply-demand imbalance. Still, judging by the last few quarters, reported sales have been significantly above the guided range, by as much as 5%-13% above TI's original outlook.
Also, the third quarter is supposed to be a seasonally stronger one.
Consequently, still equipped with more inventory (as a portion of assets) than peers and a flexi-type manufacturing model incorporating both in-house and outsourced production, the company remains in a great position to take advantage of any situation, and should do significantly better than competitors. For this purpose, it should also be helped by strong demand in the industrial, automotive and personal electronics markets.
Thus, with an undervalued trailing Price to Earnings multiple with respect to the Information Technology Sector by as much as 20%, an estimate for the share price is $228-230 based on the current share price of $190-191. Here investors will note that I have based valuations on the bottom-line as this is where TI's competitive advantage predominantly lies. The company is bent in owning and controlling its supply chains and should continue to benefit from related efficiencies.
Finally, there are different ways to interpret TI's management relatively pessimistic posture, two of them being that this could possibly be one of the first signs of a slowdown, or customers, wary of the supply crunch, simply placing some extra orders. Still, with expectations that the global chip shortage will continue for another year or two, conditions for strong demand to persist are still there.
This article was written by
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This is an investment thesis and is intended for informational purposes. Investors are kindly requested to do additional research before investing.This article was edited with the help of Bhoshan Woodun.
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