Factors That Can Lead To A Significant Increase In TI’s Valuation

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Texas Instruments

Texas Instruments (NASDAQ:TXN) is the world’s leading analog chipmaker and a key supplier of embedded chips for a host of applications. Since its exit from the wireless chip business (which weighed on TI’s revenue growth) in 2012, the company has focused on further developing its high margin analog and embedded products portfolio. The operating margin for embedded processing products more than doubled (to 18%) in Q1 2015.

TI’s top line has grown at a CAGR of 7% in the last five years. However, muted growth in the company’s personal electronics business, completely driven by a steep decline in TI’s PC circuits offering, and currency fluctuations, slowed the company’s growth momentum in the last quarter. TI believes that this is a short-term trend and is confident about its long-term outlook. Both its analog and embedded processing business remains strong, and the recent product launches as well as a strong product pipeline is expected to re-accelerate growth in the future.

Our price estimate of $50 for TI is at an approximate 10% discount to the current market price. Below are three key factors that can significantly increase our valuation for the company.

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TI’s Analog Market Share Increases To 25% (~15% Upside)

TI has a wide economic moat because of its proprietary analog designs and the high switching costs of its products. The global analog market is expected to grow at a CAGR of 4.79% between 2013 – 2018 [1] as high-quality analog chipmakers tend to retain design wins for the life of the product, yet maintain healthy pricing and strong profitability on such sales over time. TI has renewed its focus on its analog chip business, highlighted by the large acquisition of National Semiconductor and shrewd purchases of cutting-edge manufacturing equipment for pennies on the dollar. The expansion should allow TI to attract additional high-volume analog chip orders, all while taking on relatively lower fixed costs that should lead to improving gross margins.

TI is converting part of its 13-year-old DMOS6 factory to support $3 billion of 300-millimeter analog revenue from a space that had been used for wireless products the company no longer makes. The plan for DMOS6 fits into TI’s target of its capital spending equaling 4 percent of revenue. Most of the equipment already is in place at the above mentioned factory. [2]. The rest of TI’s chip production is done on smaller 200-millimeter wafers. TI’s goal is not to shift existing production from smaller wafers to the larger wafers, but to support future growth. TI can put 2.3 times more chips on the larger wafer, reducing chip costs by 40 percent and increasing its gross profit margin by 8 percentage points. [2]

TI generates enough revenue to adequately fund the large sales force and field applications engineers team that only a handful of chipmakers can match. Its sales force helps the firm reach more customers and generate additional chip sales that can fund further sales team expansion, creating a virtuous cycle for the company.

We currently forecast TI’s analog market share to increase marginally, from 18.3% in 2014 to 19.2% by the end of our review period. However, there is a possibility that we are underestimating TI growth potential in the analog market. If the company’s market share increases to 25% over our review period, it will lead to a 20% increase in our valuation.

TI’s Gross Profit Increases To 65% (~15% Upside)

Having seen its gross margin decline from 53.6% in 2010 to 49.7% in 2012, on account of lower revenue, increased capacity, under-utilization charges and the acquisition of its large analog competitor, National Semiconductor, TI has marked a continuous improvement in gross margin since 2013.

TI’s overall gross margin increased by 3.8 percentage points, from 58% in Q4 2014 to 57.7% in Q1 2015, reflecting higher revenue, increased factory load-ins, and an improved product portfolio focused on analog and embedded processing that benefits from an efficient manufacturing strategy. 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.

We currently forecast TI’s gross profit to increase marginally, from 56.9% in 2014 to 57.9% by the end of our review period. However, as a result of strong growth gross profit margins coming from the analog and embedded systems, TI could gain operational efficiency at a much faster pace. If TI’s gross profit increases to 65% over our review period, it will lead to a 15% increase in our valuation for the company.

TI Sees Huge Growth In Internet of Things (IoT) Market (~10% Upside)

Microcontrollers (MCUs) dominate the Internet of Things (or IoT) that spans across all computing devices except PCs, tablets, and smartphones. Cloud Times estimates that IoT will grow to reach 26 billion connected devices by 2020, up from just 0.9 billion in 2009. Given this exponential growth, it seems the strong demand for MCUs is likely to continue in the future.

Owing to the growth in connected devices, TI’s core end markets— automotive and connected devices—present huge addressable opportunities for the company. According to the company’s own estimates, 50 billion devices are expected to be connected by 2020.

The above advancement could create a stronger growth for TI’s embedded revenue (MCUs)  in the future. If the company’s embedded business increases, owing to IoT, to 23%  over our review period (as compared to our forecast of 13.6%), it will increase our valuation for TI by almost 10%.

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Notes:
  1. Global Analog IC Market 2014-2018, Research and Markets []
  2. Texas Instruments introduces 32-bit microcontrollers, Reuters, March 24th, 2015 [] []