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Texas Instruments Incorporated (TXN)

Texas Instruments (TXN) is one of the oldest tech businesses in the world, having been founded in 1930. Over the course of nearly 90 years, the company has proven itself to not only be remarkably adaptive but also a leading pioneer in the semiconductor industry. 

In 1958, for example, Texas Instruments employee (and future Nobel Prize winner) Jack Kilby actually invented the first integrated circuit, which literally went on to transform the world. 

Texas Instruments is now the world's largest producer of analog and embedded chips with 18% and 15% global market share, respectively.

Analog chips are used in nearly all electronic equipment to convert physical data about the real world, such as sound, pressure, temperature, humidity and light, into digital information that computers can read. 

Embedded chips (microcontrollers, processors, and connectivity products) serve as the brains behind a wide variety of modern electronics, ranging from electronic toothbrushes to automotive infotainment systems. 

The company's 15 chip manufacturing facilities produce more than 40,00 products that are sold around the world to over 100,000 customers operating in many different industries, including:

  • Industrial (33% of revenue)
  • Consumer electronics (26%)
  • Automotive (18%)
  • Communication equipment (13%)
  • Enterprise systems (6%)

Analog chips are by far the company's largest and most profitable business segment, bringing in 66% of revenue and 74% of operating profit in 2017. However, embedded chips (23% of sales and 19% of operating profit) are the fastest growing category, with 2017 sales and operating profit rising 16% and 40%, respectively. 

Texas Instruments also has numerous legacy businesses which it lumps into its "Other" segment (11% of sales and 8% of operating profit). These are primarily non-core businesses selling products such as movie projectors and calculators that were revolutionized by the company's innovations throughout the decades. However, this segment is gradually becoming less important as its products are largely in secular decline.

Business Analysis

Semiconductors are not traditionally thought of as a great arena for income investors due to the highly competitive, capital intensive, and cyclical nature of industry.

However, Texas Instruments is one of the few industry leaders that has managed to prove itself over nearly a century of being able to turn these negative characteristics into sustainable advantages.

For example, in 2009 the company decided to sharply refocus its business by selling off its wireless division, which represented 20% of company-wide revenue and supplied chips used to connect cell phones to cellular networks.

Management's decision to divest was driven by several reasons, including a fast product development cycle, growing competition (which was reducing margins), and concerns that growth would drastically slow in the future, resulting in further commoditization.

The company was then able to focus primarily on its greatest strengths, analog and embedded chips. These faster-growing areas of the company have expanded from just 44% of total revenue in 2006 to around 90% today.

Equally importantly, management decided to optimize the company's long-term profitability by directing most of its R&D spending into two industries in particular, automotive and industrial, which now represent more than 50% of company-wide sales.

A key reason for this strategic shift is the high cost required to design and build new chip manufacturing facilities. For example, Texas Instruments completed a 300-millimeter wafer fab for analog manufacturing in 2010. This was the industry's first and only such facility and reduced the company's wafer cost by 40% compared to the process used by most of its competitors. However, it cost a whopping $8 billion to construct.

The key to good profitability in the semiconductor industry is being able to amortize these large construction and R&D costs over a long time period. However, wireless devices and consumer electronics (smartphones, tablets, PCs) have a short development cycle.

In other words, manufacturers of these products are constantly demanding new and improved chips, usually every year. Therefore, chip makers in these industries have to spend a lot to improve their offerings and don't have much time to recoup these costs, resulting in lower margins.

However, in the automotive and industrial industries, development cycles are much longer because the overall pace of technological advancement is slower and the end products are expected to last for many years.

In addition, many automotive and industrial chips are mission critical. This means that the reliability of these chips is paramount to the effective and safe operations of vehicles and industrial equipment. For example, in the automotive sector the acceptable defect rate can be as low as one flaw per 1 million parts.

As a result, large chip makers like Texas Instruments can take their time designing the best possible chips to meet their customers' needs and not worry so much about the price sensitivity or loyalty of their clients.

This is because auto and industrial clients usually are designing expensive and highly complex machines, such as a $30,000 car. For these customers, the cost of an individual chip (Texas Instrument's average analog chip costs $1 and has a margin north of 60%) is far less important than whether or not it works well and reliably over time.

Or to put it another way, Texas Instruments has been increasingly focusing on the slower moving but critical parts of the global economy, where it has been able to carve out a highly profitable niche for itself.

Going forward, the automotive and industrial market segments are likely to provide excellent long-term growth, thanks to several major future economic trends.

This includes the internet of things, or IoT, in which an increasing number of devices, especially industrial equipment, cars, and infrastructure, will be connected to the internet to allow for real-time data gathering and analysis. This will allow companies and governments to know exactly when and where critical hardware is deteriorating, becoming unsafe or inefficient, and in need of maintenance or replacing.

Texas Instruments' dominance in analog and embedded chips positions it well to take advantage of this fast-growing industry of the future. For example, analyst firm IDC estimates that IoT hardware sales will reach $239 billion in 2018 alone. To put that in perspective, traditional analog and embedded chips together generate about $66 billion a year in global sales.

Another big opportunity for Texas Instruments is in autonomous vehicles. This doesn't just mean driverless cars, but also drones and robots, all of which require massive amounts of data gathering capabilities about the physical world to operate safely.

The company also intends to differentiate itself in power management and the efficiency of its chips. This is a critical feature of the IoT and automated future, which will require highly energy efficient chips that make it possible to connect so many products to the internet and each other.

Of course, to fully take advantage of this long potential growth runway, Texas Instruments will need to ensure it offers the best products to fit its client's needs. Fortunately, this company is famous for its strong dedication to R&D (typically close to 10% of revenue) and has usually been at the cutting edge of pioneering new chip technology.

For example, today Texas Instruments' Kilby Labs is creating about 500 new chip products per year and generated 1,000 patents in 2016. That just adds to the company's over 40,000 existing patents which give it some of the strongest intellectual property in its industry.

When combined with its very long-term customer relationships, as well as the sticky nature of its sales (high switching costs), this allows Texas Instruments to command very strong pricing power. In fact, in 2017 Texas Instruments enjoyed an operating margin near 40% and a free cash flow margin above 30%.

Not only are those numbers impressive in their own right, but they are about two to three times greater than its peers. In fact, Texas Instruments' free cash flow margin is currently among the highest of any company in the S&P 500.
Source: Texas Instruments Capital Allocation Presentation

Such margins are further made possible by one of the company's largest competitive advantages, scale. For example, Texas Instruments commands the largest global sales force in its industry, one that most peers can't afford to recreate. The company's sales team is not just very good at winning new clients, but also maintaining strong contacts with existing ones that allow it to cross-sell products to existing customers. 

There are many products to choose from since Texas Instruments maintains the broadest portfolio of analog chips and embedded processors in the industry. The breadth of the company’s portfolio helps it solve more needs than its competitors, giving it access to more customers and the ability to generate more sales per system.

The company also has the scale needed to efficiently manufacture most of its products in-house. By owning its own factories rather than outsourcing, Texas Instruments has more control over its supply chain to support its customers and can manufacture its products more cost-effectively than its smaller peers.

Finally, the last component of Texas Instruments' durable business is its highly disciplined management team. Specifically, its leadership team has proven to have an uncanny ability to minimize costs without sacrificing product quality or reliability.

For example, the company is famous for acquiring a lot of its new manufacturing capacity from bankrupt chipmakers, often for pennies on the dollar. This, in conjunction with its increasing focus on only the highest margin business segments, has allowed Texas Instruments reduce its capital spending (as a percentage of revenue) by two-thirds since 2004.

Focusing more on long-lived analog and embedded chips has also improved the company's capital efficiency since these areas of the industry don't require substantial investments to maintain cutting-edge manufacturing processes and technologies (some of Texas Instruments' products generate revenue for decades).
Not surprisingly, management's stated policy is to focus first and foremost on free cash flow per share growth over time. This is a huge benefit since free cash flow is what's left over after running a business and reinvesting into future growth. In other words, it's the true bottom line and what ultimately pays for capital returns, such as dividends.

Texas Instruments has shown a remarkable long-term ability to grow its free cash flow per share over time, at an average of just over 12% per year for more than a decade.
Source: Texas Instruments Investor Presentation

As importantly to long-term income investors is the fact that Texas Instruments' management team has one of the most disciplined (and shareholder-friendly) capital allocation track records in corporate America.
Source: Texas Instruments Capital Allocation Presentation

Management is first and foremost focused on organic growth, rather than high priced and risky acquisitions. This is a great thing because the tech industry is notorious for overpriced mergers that end up destroying shareholder value. 

Texas Instruments is very selective with its acquisition targets to ensure that any purchase is accretive to earnings and cash flow within four years or less. In fact, the company's last notable acquisition was its $6.5 billion purchase of National Semiconductor back in 2011. 

However, ultimately a company's strong free cash flow growth capabilities don't mean much if management isn't willing to return that cash to shareholders. Fortunately, Texas Instruments is one of the most-shareholder friendly companies in America with a stated policy to return 100% of net free cash flow (after debt repayment and pension obligations) each year via buybacks and dividends.

The company has been very conservative with its balance sheet (A+ S&P credit rating), and its pension plan is 99% funded, too. In other words, there should continue to be plenty of excess free cash flow to return each year. 

The combination of a healthy balance sheet, disciplined capital allocation, and strong long-term free cash flow growth is what has allowed Texas instruments to pay an uninterrupted dividend since 1962. 

Overall, Texas Instruments appears to have a fundamentally solid business. It benefits from operating in slow-changing markets and uses its manufacturing, technology, and distribution advantages to protect its leading market share positions. When combined with its disciplined and shareholder-friendly culture, Texas Instruments is arguably one of the best dividend growth stocks in tech. 

Key Risks

There are several risks to keep in mind about Texas Instruments. 

First, the semiconductor industry is highly cyclical, meaning that sales and earnings are volatile over time, even for time tested blue chips like Texas Instruments. Sales of vehicles and industrial equipment tend to be very sensitive to the broader economy, for example, so the company's short-term fortunes can remain largely out of management's control at times. 

In addition, while the company's capital intensivity is less than most rivals, the company still has a substantial amount of fixed costs associated with its manufacturing facilities. As a result, its profitability is also cyclical, ebbing and flowing along with volume growth. 

While the stock can be impacted by unexpected shifts in demand, this really isn’t a risk that threatens the company’s long-term earnings power.

And while Texas Instruments is the world's leader in analog and embedded chips, the company still faces numerous large rivals in these highly fragmented and competitive industries, including:

  • Maxim Integrated Products (MXIM) - analog chips
  • Microchip Tech Inc. (MCHP) - microcontrollers
  • Broadcom (AVGO) - connectivity chips
  • Analog Devices (ADI) - analog chips

Texas Instruments will always face a large amount of pressure from competitors to continue to innovate and upgrade its product offerings. That competition ultimately means that there is a cap on how high the company's profitability and margins can rise. 

Investors need to realize that Texas Instruments' strong margins could be near a short-term top and set for a downturn in the coming years. That's especially true given that a lot of its recent margin expansion has been a result of past investments such as its 300-millimeter analog chip factory, as well as past opportunistic acquisitions of cheap manufacturing plants from bankrupt chipmakers. 

Going forward, these facilities will eventually achieve maximum utilization rates, and the company won't be able to increase profits or cash flow as fast as it has in recent years. In addition, as these older investments age, maintenance costs and retooling needs could increase capital requirements, resulting in decreased profitability and cash flow margin in the future, at least temporarily. 

More importantly, the semiconductor industry constantly faces technological change and intense pricing competition. It is also very mature, potentially making longer-term growth more difficult.

While Texas Instruments focuses on products and markets characterized by a much slower pace of change and longer product cycles, the very nature of technological innovation is unpredictable. The company’s financial strength and diversification by customer, end market, and product help combat this risk, but it’s worth remaining aware of.

A final long-term risk to consider is Texas Instruments’ decision to do most of its manufacturing in-house. Rather than outsource the production of its chips like many of its peers do, Texas Instruments maintains multi-billion dollar manufacturing facilities to gain cost advantages.

If the market were to experience a technological shift that makes in-house production less attractive, Texas Instruments could be stuck with a number of costly and inefficient assets.

Overall, aside from the industry’s expected cyclicality, there don’t appear to be many fundamental risks to the company’s long-term future because of its conservatism and diversification.

Closing Thoughts on Texas Instruments

The semiconductor industry is not one that's generally known for great dividend stocks. After all, it is very capital intensive and highly competitive, and many chipmakers suffer from cyclical sales, profits, and cash flow. 

However, Texas Instruments has proven itself to be a standout. The company dominates its slower-changing markets, maintains significant manufacturing advantages, focuses on generating consistent free cash flow, possesses strong intellectual property, and presumably has plenty of room to continue moderately growing thanks to the internet of things and its large, fragmented markets.

With more than 50 years of uninterrupted dividends and a fundamentally sound business model, Texas Instruments seems poised to continue rewarding shareholders with strong dividend growth for the foreseeable future. 

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