Texas Instruments Well Placed For Long Haul, But Not Especially Cheap Today (NASDAQ:TXN)

Texas Instruments’ (NASDAQ:TXN) (“TI”) track records of exceptional margins and market share are no accident, and management has not been afraid to break from the pack to chart its own course (including decisions to build inventory when others cut production, using price to gain share, and eschewing distributors for more direct relationships). Over the long term, this has served investors well, with above-sector performance and a reputation as more of a safe haven in the semiconductor space. I liked Texas Instruments back in October near the end of a slide that took the shares from the $180s to the $150s, and the shares have done reasonably well since then as the broader semiconductor space also has picked up off its lows. I do see elevated ongoing risk to the sector for at least another three to six months, though, and I don’t expect TI to be as much of an outperformer when the markets go back to a “risk-on” positioning with chip stocks. An OK hold at these levels, I’m more neutral on the stock as a near-term buy, but I would keep an eye out for the upcoming fourth quarter earnings/guidance cycle as a potential opportunity to pick up shares on a pullback.

It’s Getting Worse … But That Was Expected

The semiconductor sector has continued to cool as end-customers see weaker demand heading into 2023 and less need to over-order to avoid critical component shortages. With that, lead-times are shrinking, inventories are rising, and chip companies have been guiding to more meaningful sequential declines in revenue. None of this is unusual for the semiconductor cycle. Despite the projections of same analysts back in early 2022 that it would be different this time (famous last words for cyclical stocks/industries), the cycle is in fact playing out as it as in the past (albeit from a higher starting point).

Specific to TI, when I last wrote about the stock ahead of third quarter earnings, I said I expected a modest beat for Q3’22 revenue (the company beat by about 2%), but saw a risk for more conservative guidance given both the company’s historical conservatism around Q4 guides and growing weakness in multiple end-markets (including consumer electronics). That too played out, with the company guiding to a 12% qoq revenue decline that was about $300M worse than the Street expected, with management noting weaker trends everywhere outside of auto (including growing weakness in industrial end-markets).

Subsequent reports from companies like Analog Devices (ADI), Broadcom (AVGO), Marvell (MRVL), and NXP Semiconductors (NXPI) have further confirmed those trends I had discussed – while high-end datacenter spending remains strong (including routing/switching and custom ASIC) and auto demand is still healthy, industrial demand is starting to crack in many sub-markets, while consumer electronics, enterprise, IoT, and other markets continue to weaken.

Looking ahead at this upcoming earnings report, I see some cushion from TI’s customary conservatism, but also risk that industrial and enterprise demand weakened further in the quarter. With that, I think we could see a repeat of the prior quarter’s modest beat and weaker forward guidance, particularly with respect to the industrial end-markets.

2023 – How Low (Or Slow) Will It Go?

There’s still ample debate as to whether or not the U.S. will see a true recession begin in 2023. Most industrial company CEOs have become increasingly conservative/concerned about the outlook for demand in 2023, and we’ve already seen some significant high-profile layoff announcements (including Amazon (AMZN) and Salesforce.com (CRM)). Banks, too, have been offering more conservatism in their outlooks, with managements starting to increase their provisioning and pull back on lending in response to an anticipated turn in the economy.

The market has certainly already factored at least some of this downturn into semiconductor stock prices. The SOX declined over 30% last year, the worst decline in well over a decade and only the second decline at all in the last 10 years. With that, it’s also worth noting that in past cycles, the moves in semiconductor stock prices have usually come around six to nine months ahead of the underlying fundamentals.

I expect 2023 will be a relatively healthy year for auto semiconductor demand (around a quarter of TI’s business mix). While weaker end-user demand in response to higher rates and a weaker economy (including consumer confidence) is a risk, dealer inventories are still low and auto OEMs have signaled their desire and intention to catch up on the production of models that were deprioritized during the component shortages of 2022. To that end, I’d note that lead-times for auto MCUs have remained healthier than for most other sub-segments of the chip space.

TI generates around 30% of its revenue from a broad swath of industrial end-markets, and I’m definitely more cautious here. When the CEOs of well-regarded companies like Dover (DOV), Eaton (ETN), and Illinois Tool Works (ITW) express some caution in their outlooks, it’s usually worth listening, and I do see a risk of weaker overall industrial production in 2023. That said, there are markets within industrial with brighter outlooks, including aero/defense and healthcare, and I believe this downturn is likely to be relatively mild (though I’m not yet sure if we’ll see a sharper, shorter downturn, or a softer, somewhat longer slowdown).

Consumer electronics is another significant part of TI’s mix (over 20%), and the weakness in areas like phones, wearables, PCs, appliances, and so on has been widely echoed by many companies. I don’t see particularly bright prospects here in the near term, though I also don’t see much downside risk from current expectations at this point.

Communications and enterprise make up around 10% to 15% of TI’s revenue base, and the outlook here is more interesting and nuanced. I believe core wireless spending could be a little stronger than expected in 2023, not so much because orders will be strong (they likely won’t), but because customers couldn’t get the components they needed in 2022 and have had to wait on their deployments. With enterprise, TI lacks high-end exposure to high-speed networking and custom ASICs, and I don’t expect much excitement here in 2023.

The Outlook

While TI isn’t immune to short-term cyclical movements in its end-markets (not to mention the cyclicality of sentiment on semiconductor companies), this is a chip company built to last. I do expect fairly sharp year-over-year corrections in gross and operating margins on weaker volumes and operating leverage, but gross margins in the mid-to-high 60%’s and operating margins (non-GAAP) in the high-40%’s are still exceptional relative to most peers.

Likewise, I applaud the company’s decision to continue investing in capacity – while this will depress free cash flow in the short term, and likely add to margin pressures (start-up costs and underutilized capacity), it will position TI with ample state-of-the-art capacity to serve the eventual recovery in demand, as well as years of demand growth driven by increased demand from autos, automation, electrification, IoT, and so on.

Given what I saw in the third quarter reporting cycle (not just TI or semiconductors, but a wide swath of companies in a range of industries), I’ve reduced my expectations for 2023, but my long-term expectations haven’t changed much – I’m still looking for long-term (2021-2031+) revenue growth of over 6%, with adjusted free cash flow margins approaching the mid-30%’s over the next five-to-six years and the high-30%’s over a longer time period, driving high single-digit FCF growth.

The Bottom Line

With the performance of the stock since my last update, the prospective returns aren’t as compelling as they once were, and the share price is pretty close to the high end of my 12-month fair value range, while the long-term cash flow-based annualized potential return has slipped back toward the mid-single digits.

Were the stock fall back into the $150’s (or below) on a weak Q4 report/guide and/or weaker overall market sentiment in response to other company reports, this is definitely a name I’d revisit. That said, while I do think that TI is a good “all-weather” holding for investors who would prefer not to trade as much and want long-term exposure to underlying chip demand growth, I don’t expect TI to lead the pack in a recovery (something I expect later in 2023) and this is more of a “hold / buy on a dip” name for me now than a straight-up buy candidate.