Texas Instruments: Long-Term Strategy As A Competitive Advantage

Summary

• Texas Instruments is among the semiconductor companies where valuation is still linked to profitability.
• The company's unique positioning results in sustainable competitive advantages and steady value creation.
• Within the light of the recent market melt-up, Texas Instruments still trades at reasonable levels that allow for attractive returns.

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Investment thesis

Texas Instruments (NASDAQ:TXN) is among the high quality and long-term-oriented companies in the semiconductors space, that also have sustainable competitive advantages on its back. However, this is not what is currently rewarded with a high valuation multiple in the space. Instead, high short-term sales growth is all that matters for some semiconductor companies.

While investing in the latter results in a strong momentum trade and exceptionally high short-term returns, valuations of such companies are subject to stronger reversals on the downside than the industry average. That is why Texas Instruments' steady value accumulation is to be preferred over the long run given the company's strong competitive advantages.

It's all about growth, or not

The semiconductors industry has become the linchpin of today's digital economy. Datacenters, mobile devices, automobiles, cryptocurrency mining, and telecommunication equipment are all thirsty for an ever-growing amount of silicone. Naturally, this has led to an industry that is favoring short-term sales growth numbers, over long-term strategy and high-quality business models.

This could easily be illustrated by the cross-sectional relationship between expected revenue growth rate and forward Price-to-Earnings multiples within the sector.

Source: prepared by the author, using data from Seeking Alpha

While the r-squared between those two variables is high, it falls down to 0.05 once we remove NVDA and AMD. As a matter of fact, if we substitute the P/E multiple with P/S and run the regression on both revenue growth and gross margin figures an interesting pattern emerges.

When using all the companies within the set on a revenue growth basis, the relationship is relatively strong with r-squared of 0.35. However, once we exclude AMD and NVDA, it falls down to 0.03. Doing the same analysis, but on a gross margin basis, yields exactly the opposite results.

Source: author's calculations

In other words, when analyzing all major semiconductor companies, profitability does a relatively good job at explaining valuation differences. But once we add NVDA and AMD to the sample, profitability loses its relevance in favor of expected growth. This clearly shows, how different certain segments of the semiconductors industry are and especially the exciting field of graphic processing units.

Given the fact that profitability is still relevant for the large part of the semiconductors industry, TXN appears as one of the best choices out there due to its highly profitable business model - both on gross and operating margin basis.

Source: prepared by the author, using data from Seeking Alpha

Unique positioning and strategy

There are a number of key differentiating factors for TXN that set the company apart from its other peers in the semiconductors space. First of all, TXN is the leader in the analog integrated circuits space (see below).

Source: prepared by the author, using data from IC insights

The field is not as exciting as that of GPUs, however, analog ICs are integral for almost any electronic device that needs to interact with the environment. That is why TXN revenue streams are very diverse and span across many different markets.

Source: TXN Investor overview white paper

This in combination with TXN's relatively larger size and global reach, allows for economies of scale, cross-selling opportunities and last but not least - long-lasting relationships with customers.

Source: Texas Instruments Annual Report 2020

Texas Instruments strategy also differs in one key aspect - most of its production facilities are based in the United States, while sales are predominantly overseas.

Source: prepared by the author, using data from TXN Annual Report

This creates a very different dynamic to most other semiconductor peers that have gone fabless and rely heavily on overseas production partners for their domestic sales.

Strategy and capital allocation

Instead of maximizing short-term profitability by becoming a fabless chipmaker, TXN's strategy is based around long-term sustainability of production and margins.

Source: Texas Instruments

To begin with, analog integrated circuits enjoy a much longer useful life when compared to digital ones and as such allow for a more long-term-oriented strategy. This in turn creates incentives for more production being done in-house, as opposed to relying on foundries based in Asia, and with that less supply chain-related risks.

And just to highlight something for maybe new listeners. Dave mentioned the foundries, only about 20% of our wafers are -- come from foundries. The vast majority, 80% and growing, we've had investments in 300-millimeter are internal wafers, and that just gives us much better control of our destiny.

Source: TXN Q3 2021 Earnings Transcript

While being a capital intensive business has fallen out of favor in recent years, there are signs that deglobalization trends are associated with significant risks for companies that rely less on in-house production.

In the meantime, even though TXN's strategy has been at odds with the short-term focus of recent years, the company has continued to reinvest into the business, while also rewarding shareholders.

Source: Texas Instruments

Moreover, as the company's share price has become increasingly expensive over the recent years, TXN's management has dialed down its share repurchase program in favor of dividend payments. That is why the ratio of dividend payments to share repurchases trails the company's Price-to-Book multiple.

Source: prepared by the author, using data from TXN SEC Filings

As market valuations reached peak levels in 2021, TXN management has reduced its share repurchase program to only $400m in the past 12-month period.

Source: prepared by the author, using data from TXN SEC Filings

Reasonable valuation

Contrary to most of its peers, TXN management targets are based around the key valuation metric - the dollar amount of free cash flow per share.

We believe that growth of free cash flow per share is the primary driver of long-term value.

Source: Texas Instruments

The strategy seems to be working as TXN free cash flow per share has been growing steadily since 2003 at a compounded annual growth rate (CAGR) of 14%.

Source: prepared by the author, using data from TXN SEC Filings

At the same time, using a cost of equity of 7.7% (based on 2.5% risk-free rate, 5.5% equity risk premium and 0.94 beta) and the company's free cash flow per share over the past 12-month period of $7.60, we arrive at a mere 3.5% required growth rate in perpetuity to justify the current share price.

The company's revenue growth rate estimates also appear very conservative at the moment. The consensus estimate for fiscal year 2022 stands at 4.3% as of today.

Source: Seeking Alpha

However, over the long run, the company's revenue growth rates exhibit a strong relationship with the previous year growth (t-1) in shipments of silicon materials (the former is plotted on the y-axis below and the latter on the x-axis).

Source: prepared by the author, using data from TXN SEC Filings and semi.org

Based on that relationship and shipments growth of 14% so far this year, it will be reasonable to expect TXN revenue growth of around 7% in fiscal year 2022.

Taking into account margins, TXN does not appear significantly overvalued on a historical basis.

Source: prepared by the author, using data from TXN SEC Filings and Yahoo! Finance

In addition to the high growth rate and more sustainable in-house operations, TXN's migration to 300-mm wafers provides a further tailwind for margins.

Source: TXN Capital Management Presentation

This will also be the case for the company's Richardson wafer fabrication facility expansion and the recent acquisition of Micron Technology's (MU) fab in Lehi, Utah.

Conclusion

Texas Instruments' profitable business model is based on a number of sustainable competitive advantages. At the same time, management has a long-term-oriented approach and has adapted the company's strategy to achieving long-term results as opposed to maximizing short-term profits. Low reliance on foundries on the other hand, makes TXN's high margins less susceptible to supply chain-related risks. Last but not least, the company's valuation appears conservative relative to fundamentals which creates a significant margin of safety in the highly cyclical industry of semiconductors.

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.