Texas Instruments Still Beyond Criticism On Quality, But Not So Bulletproof On Valuation And Expectations

Summary

• Texas Instruments posted another strong quarter during this semiconductor upswing, with revenue and operating profits both beating analyst estimates by comfortable margins.
• Management guided for sequentially flat revenue in the third quarter, and it is well worth asking if capacity constraints, plateauing demand, and limited incremental operating leverage are near-term risks.
• Long term, it's hard to argue with owning TI shares, as it is one of the best-run chip companies, but the long-term prospective returns today aren't so attractive.

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My “love the company, don’t love the stock” position on Texas Instruments (NASDAQ:TXN) hasn’t changed all that much, and with the shares up about 8% since my last update (slightly better than the SOX index, slightly worse than the S&P 500), I don’t feel like I’ve missed out on much by not owning the shares. To be clear, TI was, is, and likely will remain one of the best-run semiconductor companies, but expectations have gotten high and it seems as though the Street may be getting a little more nervous about how much juice is left to squeeze in the sector.

While I can still see a path to $200-plus in the short term, I think TI’s priced more for mid-single-digit annualized long-term returns today, and that’s not enough for me, though I’d certainly rather own TI than a bond with similar return potential.

A Beat With Q2 Results, But No Raise … Though TI Is Often Conservative On Guidance

It typically takes beat-and-raise quarters to maintain sector and stock momentum, and while TI’s second quarter results were once again better than expected, management didn’t offer the “and raise” part of the equation. Although expectations are certainly higher now than they were before the pandemic and management has a track record of conservative guides, I do think maintaining the sort of momentum the business has seen is going to be very difficult.

Revenue rose 41% year over year and 7% quarter over quarter, beating expectations by over 5% with strong growth in the industrial end-market (up 40% yoy and “mid-teens” qoq), autos (more than doubling yoy), and personal electronics (up 25% yoy and flat). Growth was pretty balanced between analog and embedded, and not only did TI beat the overall industry in Q2’21 (as derived/implied from SIA numbers suggesting 29% growth), it looks as though the company outperformed in the analog and MCU segments.

Gross margin rose almost three points from the year-ago level and another two points sequentially, beating expectations by almost two points. Operating income rose 74% yoy and 14% qoq, beating by about 13%, with over nine points of yoy operating margin expansion (beating by 340bp).

While guidance from companies outside the chip sector indicates strong momentum in industrial end-markets and improvements in areas like data center, TI’s guidance was for just flat quarter over quarter revenue growth in the third quarter – below seasonality and underwhelming versus Street expectations. Management didn’t cite any specific problems, and it’s well worth noting that the company is typically conservative with guidance. On the other hand, auto sector volumes are looking less certain in the second half and it’s plausible that TI’s growth may be limited by its capacity situation in 300mm.

Strategic Decisions Have Led To Outperformance … Can They Continue To Do So?

TI management hasn’t been afraid to go its own way when it comes to significant strategic decisions, and more often than not, those decisions end up looking like the right ones over the long term.

When the pandemic led to sharp drops in end-market demand (and semiconductor company share prices), management was happy to build inventory and buy back stock. Management has also chosen long-term strategic differentiation like significant internal manufacturing capacity (including 80% of its wafers) and a shift away from distributor-based selling, deciding instead to forge stronger direct relationships with large customers.

In pursuit of more capacity, TI recently (June 30) announced that it would acquire Micron’s (MU) 300mm fab in Lehi, Utah for $900M in cash. This brings a fourth 300mm fab to TI, adding about 70K wpm additional capacity and around $4B to $5B in annual revenue potential. Given the strength in analog sales TI has seen, and comments about “hot spots” in lead-times for certain products, I believe this was an opportunistic buy to ensure the company’s ability to meet the needs of its top customers.

I’d also note that inventory days have declined to 111 days, below the company’s long-term target range of 130 days to 190 days. Given lower inventory levels and some potential near-term capacity limits, that may be capping TI’s beat-and-raise potential in the short run, as the company doesn’t have that same leeway to ship out of inventory or offset supply chain constraints in areas like test and assembly as it did in recent quarters.

The Outlook

I have few concerns about TI from an operating standpoint. Based on management commentary, it sounds like they’ve avoided some of the more serious lead-time blow-outs that their peers/rivals have encountered. Still, I would keep an eye on the MCU business in the near term, as this business has looked a little soft in market share terms.

One item worth mentioning again is that management has ratcheted down their share repurchases in recent quarters – spending just $146M this quarter after $882M a year ago and $100M in the prior quarter. It’s possible that TI is socking away cash to facilitate a large M&A transaction, but given how active TI was with buybacks in the downturn, I think it’s plausible that management just doesn’t see the stock as all that cheap now and views buybacks as a suboptimal use of capital. Even if a large deal were in the works, TI could likely raise debt on good terms to fund it.

I’ve raised my 2021 and 2022 revenue numbers, but that more represents a pulling forward of demand, as my longer-term estimates don’t change as much. I’d note, though, that my 2023 revenue estimate is a bit higher than the sell-side average and my ’24 estimate is more than 2% above the average, so I wouldn’t exactly say I’m negative on TI’s growth prospects. Long-term, I still expect annualized revenue growth of around 6%.

I do believe TI is going to have a harder time delivering materially higher operating leverage in the near term, though I do think FCF margins can and will migrate to over 40% over the long term, helping drive mid-to-high single-digit FCF growth.

Semiconductor stocks don’t often trade on discounted cash flow in the short term, so I’m not surprised that TI shares look expensive by this metric. Shorter-term approaches like margin-driven EV/revenue and EV/EBITDA are more mixed, though there’s a path to $200+ in the short term.

The Bottom Line

As I’ve said in past articles, I’m not interested in driving long-term holders out of TI – I do see current prospective returns as sub-optimal, but TI is one of the best companies in the space and I will almost always prioritize company quality over short-term valuation. Still, in the short-term, I think you need to believe that demand will accelerate even further, TI will find some way to meet it, and margins can head even higher to buy now. My preference is to wait for an inevitable pullback, though, as I do think this is a good one to own if you can get a good prospective return on entry.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.