TI’s Q3 2014 Earnings Preview: Improving Revenue Mix To Benefit Top & Bottom Line

Texas Instruments (NASDAQ:TXN), which designs and manufactures semiconductors, will report its Q3 2014 earnings on October 20. On account of the diminishing revenue base from its legacy wireless business (TI exited this business in September 2012), the company reported a 4.8% decrease in its 2013 revenue. However, as revenue from the wireless business almost phased out in Q1 2014, TI witnessed strong growth in the first half of 2014.

Though TI’s restructuring initiative is almost over, the company states that it will continue to monitor its investments and the market opportunities they address, to focus on those that have the best potential for sustainable growth and returns. It remains focused on the analog and embedded processing markets, which it believes are the best opportunities inside the semiconductor market.

Microchip, a leading provider of microcontrollers with over 80,000 customers, pre-announced a significant revenue miss for its September quarter ($529.3 million versus the prior guidance of $560.0 to $575.9 million). Microchip attributed the miss to an unexpected decrease in demand from China and suggested this was the first indication that the next industry correction has begun. Because the company reports distribution sales on a sell-through basis (i.e, when its distributors sell the products to their customers), it is recognized as a leading indicator of future demand.

TI’s stock price declined by more than 10% after Microchip announced its preliminary reports. TI expects to report revenue in the range of $3.31 billion to $3.59 billion. We look forward to the earnings to understand TI’s view on the future industry demand.

Our price estimate of $42 for TI is at an approximate 10% discount to the current market price. We will update our valuation after the Q3 2014 earnings release.

See our complete analysis of Texas Instruments here

An Expanding Product Portfolio Will Increase TI’s Footprint In Micocontrollers

Since  its exit from the smartphone and tablet market in September 2012, semiconductor manufacturer TI has transitioned its operations to become a pure analog and embedded processing company. With a market share of 17%, TI is one of the leading player in the analog semiconductor market, and derives over 60% of its revenue from this division. On the other hand, TI derives only 21% of its revenue from the embedded division and accounts for 13% of the global embedded market.

TI’s embedded division includes processors, microcontrollers and connectivity products, which account for 50%, 45% and 5% of its embedded revenue, respectively. While it has a leading market share in processors, the company is still relatively under-represented (6% market share) in the microcontroller space. Over the last 3-4 years, TI has increased its focus on microcontrollers. Over the last few years, TI has expended its investment to broaden its microcontroller portfolio and increase its application support for the same, which has helped the company increase its market share. The company now has a wider product portfolio with microcontrollers ranging from $0.25 up to a couple of dollars using all different combinations of its connectivity products.

According to Grand View Research, the global microcontroller market is expected to reach  $27 billion by 2020, driven by growing demand from industries, such as automotive and consumer electronics, and the advent of the Internet of Things (IoT) coupled with declining microcontroller prices.

In Q2 2014 (ended June), TI marked its seventh consecutive quarter of year-on-year growth and a big part of that was driven by growth in microcontrollers. The company intends to continue investing in this area, expanding its product offering of controllers and increasing the number of dedicated field application engineers positions to better serve its customers. Such actions should help it  to grow its market share in the future.

Gross Margin Hit New Record in Q2’14

Lower revenue, increased capacity under-utilization charges and the acquisition of its large analog competitor, National Semiconductor, impaired TI’s gross profitability over the last few years. TI’s gross margins declined from 53.6% in 2010 to 49.7% in 2012. However, higher revenues, combined with an improving product mix and better factory utilization, increased TI’s gross margin to 52.1% in 2013. In Q1 2014, gross margin further improved to 53.9% on account of an improved product portfolio, higher factory utilization and increased efficiency of manufacturing operations. In Q2 2014, gross profit increased 20% annually and gross margin increased to 57.1%, hitting another new record.

The analog and embedded processing products are more profitable and less capital intensive compared to wireless products. Thus, the company benefits by deriving a larger portion of its revenue from these two divisions. In addition to a favorable revenue mix and improved manufacturing efficiency, the gross margin will also benefit from lower depreciation in the future. At present, depreciation is ahead of TI’s capital expenditures. The company expects its capital expenditure to remain at low levels (4% of revenue) for the next few years. As depreciation starts to work itself down over the next couple of years, it will boost gross margins.

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