Texas Instruments (NASDAQ:TXN), a leading semiconductor manufacturer, will report its Q3 2013 earnings on October 21. Backed by a strong order book, the company narrowed its revenue outlook to $3.15 — $3.29 billion compared to its initial estimate of $3.09 — $3.35 billion last month.
TI reported a 6% sequential growth in revenues and marked its second consecutive quarter of growing order rate in Q2 2013, on account of increasing strength in its core business of analog and embedded processors. It witnessed strong order growth in Q3 as well, backed by robust demand from automotive and industrial products, which was partially offset by the decline in the PC market.
TI anticipates a $90 million sequential decline from its legacy wireless business and expects them to phase out by the end of 2013. Though we estimate revenues to be more or less flat this year, we believe that a robust product portfolio, one of the best sales and field application team and strong manufacturing capacity will help spur TI’s top line in the future. Additionally, as the company completely exits the comparatively lower margin wireless business and increases the proportion of profitable analog and embedded products in its portfolio, it can report improving gross margins going forward.
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TI remains confident that its business model is well positioned to generate $0.20 to $0.25 of free cash flow for every dollar of revenue that the company earns in the future.
Strong Growth In Industrial & Automotive Markets To Drive Demand For Analog & Embedded Products
Though TI claims that growth is returning to the handset, game-console and notebook markets, strong demand for automotive and industrial products and ongoing recovery in the communications infrastructure market are the main factors driving its business. TI ships a broad range of analog and embedded products for the industrial, automotive and communications infrastructure markets, which contribute 17%, 11% and 31% to the company’s overall revenues, respectively.
After its planned exit from the smartphone and tablet market, TI has been focusing on transitioning its operations to become a pure analog and embedded processing company, segments that it believes will offer it long term growth and less volatility, compared to the past. It registered a 6% and 10% sequential rise in its analog and embedded processor revenues in Q2 2013, respectively, and we expect the growth momentum to continue in Q3 2013.
TI now derives 78% of its revenue from these segments compared to approximately 72% a year ago. The company remains focused on building a diverse analog and embedded processing business across customers and markets. With an expanding product portfolio combined with an industry leading sales force, TI has managed to consistently gain market share in the analog and embedded divisions in the last few years.
Improving Gross Margins
The declining revenue base combined with additional manufacturing capacity acquired in the last few years increased TI’s under-utilization charges, which in turn put pressure on margins. TI’s gross margins declined from 53.6% in 2010 to 49.7% in 2012. A lower revenue base contributed to a 10% annual decline in gross profits in Q1 2013 as well. However, higher revenues combined with an improving product mix increased TI’s factory utilization which in turn contributed to a significant improvement in gross margins in Q2 2013 (51.5%).
Below are a few reasons that support our belief that gross margins will continue improving over our review period –
- Increasing factory utilization: With an improvement in the macro environment TI can leverage its low-cost manufacturing capacity to cater to higher market demand. Though its excess manufacturing capacity might be detrimental to its short term growth, we feel it will serve as a competitive advantage to the company in the long run. Higher demand for its products will increase TI’s factory utilization, in turn lowering its under-utilization expense. The increasing scale of operation also gives TI a greater control over its operational costs.
- Exiting the wireless business: As TI derives an increasing proportion of its revenue from high-quality analog and embedded processing products, and lower revenue from the less profitable wireless products, we expect its gross margins to increase marginally going forward. The cost saving incurred from exiting the wireless business will further ease pressure off gross margins.
- Saving from the closure of two factories: At the start of 2012, TI announced its decision to close down two old factories in Japan and Texas by the second half of 2013. The move will lower its expenses, easing pressure off margins.
We will update our price estimate of $36.37 for TI after its Q3 2013 earnings release.