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As the Street has come around to the idea of weaker demand in 2023, semiconductor stocks have had a rougher go of it lately, and Texas Instruments (NASDAQ:TXN) (“TI”) is no exception. While TI has held up better than the average chip company (fair, given its quality), falling about 10% since my last update versus the 25% drop in the SOX index, the shares have moved into that $150’s range that I said I would find more interesting.
I do see some risk of a greater slowdown in auto and industrial demand in 2023, but I believe the longer-term outlook for TI is unchanged – while the last couple of years have been unusual in terms of demand and supply trends, I believe the increased electrification seen across numerous end-markets is not some temporary aberration. With that, I expect healthy mid-single-digit long-term revenue growth from TI as well as strong margins. The shares now look attractively-priced, though readers should be aware of the overall risk that a higher, sharper peak in this last semiconductor cycle could well be followed by an unusually sharper trough before a stronger recovery in 2024.
Mixed Markets Will Weigh On Some TI Markets More Than Others
Looking at a wide range of reports from chip companies like Advanced Micro Devices (AMD) and Analog Devices (ADI), as well as consumer electronics companies like HP (HPQ), fabs like TSMC (TSM), and other suppliers, it’s pretty clear that demand in consumer/personal electronics has weakened significantly and is likely to remain soft for the next six to 12 months.
With roughly 25% exposure to those markets, TI will certainly feel some impact from this weakness. In the short term, though, this may not be so bad. TI has the flexibility to shift under-used capacity in the consumer/personal electronics space toward auto and industrial production, and given stronger demand/lead-time trends there, that could work better for TI than simply offsetting weaker electronics demand.
At the same time, though, markets like auto and industrial remain healthy. The auto market is almost certainly going to soften relative to the strong demand seen post-pandemic, but with the IHS expecting around 5% volume growth in auto production in 2023, auto OEMs continuing to shift toward models with more advanced electronics (demanding more semiconductor content), and auto chip inventories still not where OEMs would like them to be, I expect 2023 will still be a solid year for this important end-market.
Assessing industrial end-markets is a little more challenging. Various macro indicators suggest slowing trends across a range of industrial markets, but early indications are that demand for automation, electrification, and other chip-heavy sub-sectors remains rather healthy.
Wired communications and data center demand is likely to slow further in 2023, but these aren’t particularly large markets for TI.
There are some watch items of note to me for this upcoming quarterly report and the next 12 months. One is the company’s microcontroller (or MCU) business.
Microchip (MCHP), NXP (NXPI), and perhaps Renesas (OTCPK:RNECY) and STMicro (STM) could be gaining share here at TI’s expense. Another watch item is pricing; management here has expressed a willingness to use price to gain share, and with excellent margins across much of the business (as well as its own internal wafer manufacturing capabilities), that seems like a worthwhile “pay now, gain later” strategy to consider.
Handicapping Texas Instruments’ Q3 Results And Q4 Guidance
Management guided to a 2% sequential revenue decline for Q3, and given relatively healthy trends in auto and industrial markets, as well as TI’s history of generally conservative guides, I could see some upside here. I’d likewise note that TI has a history of generally conservative guidance for Q4, so in a nervous market looking for excuses to stay away, TI’s customary caution and conservatism could drive an outsized impact to sentiment.
Recent trends and reports likewise seem to support an “okay but not great” reporting set-up for TI this quarter. Lead-times have started to shrink overall, but TI’s seem to be stronger than average and areas like high-voltage auto and auto MCUs remain in shortage. Likewise, auto and industrial inventory positions are healthier than for end-markets like consumer electronics.
TSMC’s recent report was inline with management’s guidance midpoint on revenue, while guidance for the fourth quarter (up <1% qoq) was better than the Street expected. Management here cited weaker demand in areas like consumer and smartphones, but strong ongoing demand in areas like auto and industrial. So too with Analog Devices, where the company did acknowledge emergent cancellations in some markets.
The Outlook
If the semiconductor space follows its past trends this time around, the stocks will likely bottom around six months ahead of a noticeable shift in fundamentals. To me that suggests a bottom somewhere late in 2022 or in the first quarter of 2023. The sector has already seen a meaningful correction in terms of share price performance and forward P/E from the recent peak, but again I’d note that the sharper upswing of this latest cycle could drive a sharper than average correction (suggesting some further downside risk).
I do see near-term risk here if the global economy slows even more than I expect in 2023, but I don’t believe the longer-term trend of increased chip content across a range of end-markets is a mirage or just a temporary dislocation in the market. With that, then, I still see a strong argument for TI generating long-term revenue growth in the mid-single-digits (on the higher end, actually) on increased chip content with auto and industrial customers, as well as potential share gains driven by a differentiated manufacturing and marketing strategy (prioritizing availability for customers and working directly with customers instead of through distributors).
Significant capacity expansions here do introduce some potential volatility into margins (capacity that could be under-absorbed initially), but TI has shown time and time again that it is among the most efficient operators in the business, and I believe the short-term pain of higher capex (and possibly lower margins) will be rewarded longer term with better availability and structural margins than many of its rivals. With that, an adjusted FCF margin in the mid-to-high 30%’s and high single-digit FCF growth seems achievable to me.
The Bottom Line
I value chip companies like TI primarily on discounted adjusted FCF and margin-driven EV/revenue and EV/EBITDA multiples. By these approaches, I believe TI is priced to deliver a relatively attractive high single-digit long-term total return and may be undervalued by 15% or so in the shorter term.
There are chip stocks out there that I believe offer higher prospective returns, but at the cost of higher risk. I do think investors need to be aware of the risk that conditions and sentiment could get worse before they get better, but I think TI is definitely a name to consider in a market of weak sentiment toward chip names.
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