With a 6% sequential growth in revenues ($3.05 billion), leading semiconductor manufacturer Texas Instruments (NASDAQ:TXN) reported an encouraging Q2 2013. While revenues from its legacy wireless business continued to decline (fell by $62 million q-o-q to $148 million), the company saw increasing strength in its core business of analog and embedded processors. In addition to rising demand, TI’s strong operational execution and its improving product mix increased its gross margins to 51.5% in Q2 2013, compared to 41.6% in Q1 2013 and 49.7% in Q2 2012.

Witnessing a higher order rate for the second consecutive quarter (6% q-o-q rise), TI claims that its overall backlog continues to improve. We believe that a robust product portfolio, one of the best sales and field application team and strong manufacturing capacity will be the key factors driving TI’s future growth. 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.

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.

See our complete analysis of Texas Instruments here

A Strong Analog and Embedded Portfolio Will Help Drive Future Demand

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. 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.

In Q2 2013, TI registered a 6% and 10% sequential rise in its analog and embedded processor revenues, respectively. While the high-volume analog and logic, and high-performance analog categories saw strong growth, the silicon valley analog segment was the leading driver in Q2, outgrowing the overall analog market for the third consecutive quarter. In the embedded portfolio, TI saw strong demand for processors, microcontrollers as well as connectivity, as a range of customers embraced its low-power products.

While the PC and game console markets remain weak, TI benefited from strong demand from the industrial, automotive and communication markets. TI now derives more than 35% of its product revenue from the industrial and automotive markets, whereas the contribution of the PC and handset markets continue to decline. The company believes that an increased diversity of markets and customers will provide steadier growth and financial returns.

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. It accounts for over 15% of the analog market and we think that it has the potential to gain additional market share in the future.

TI has been focusing on expanding the OMAP footprint in embedded applications such as automotive, industrial equipment, enterprise communications, etc. The company feels that the embedded markets currently valued at $19 billion offers greater potential for sustainable growth compared to mobile devices. In the last year, TI has expanded its product portfolio by almost 20%.

Higher Gross Margins In The Future

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.

Here are few reasons tha 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.

Q3 2013 Outlook

– Revenue in the range of $3.09 – $3.35 billion.

– Revenue from legacy wireless business will decline by approx. $90 million. Wireless revenue will be less than 2% of TI’s total revenues.

– Operating expenses to decline by a few percentage points sequentially.

– EPS in the range of $0.49 to $0.57.

We are in the process of updating our price estimate of $36.31 for TI.

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