Texas Instruments Inc. (TXN) reported first quarter earnings that were down 21% sequentially and up 3.7% year over year, missing the Zacks Consensus estimate by 2 cents, or 3.4%. The earthquake in Japan, which impacted both TI’s own operations and that of its customers and a weaker-than-expected baseband revenue from a key customer — possibly Nokia Corp (NOK) — contributed to the weakness.
Estimates have been moving downward since the Japan quake, but this did not affect the Zacks Consensus for the March quarter and only lowered the second quarter, fiscal 2011 and fiscal 2012 estimates by a penny each.
This pulled down the TI share prices by 1.55% in after-hours trading yesterday.
Revenue
TI reported revenue of $3.39 billion, which was down 3.8% sequentially, up 5.8% year over year and at the lower end of the originally guided range of$3.27 billion to $3.55 billion (down 3.3% sequentially at the mid-point). Revenue was more or less in line with the Zacks Consensus Estimate of $3.41 billion.
TI stated that the first two months were going on track to deliver above-seasonal results in the quarter, but the disaster in Japan changed the course of business flow. Overall inventory concerns related to the computing and consumer markets that impacted results in the back half of 2011 did not persist in the first quarter.
End Market Update
TI was positive about growth prospects in the communications infrastructure market. While the last quarter saw some negative seasonality, mostly in the Americas, sales of legacy products into China were steady. Going forward, TI expects to see continued strength, driven by broader market trends, such as increasing data traffic and capacity expansions all over the world, as well as through an increased share of the bill of materials (BOM) at customers through its integrated offerings.
The industrial market was robust in the last quarter, with growth trends accelerating across not only the developed markets of the Americas and Europe, but also a growing contribution from developing countries, such as China.
The automotive market, while strong in the last quarter due to steady demand and increasing electronic content, is expected to turn sluggish going forward. This is because many of the automotive semiconductors are manufactured at Japanese fabs and a significant percentage of automobile manufacturing is also carried out in the region. Although it is as yet hard to tell, the Japan crisis may be expected to impact this side of the business.
Although internal inventories grew during the quarter, distributor inventory dropped a couple of days due to the extremely strong sell through during the quarter. Around 2/3 of the internal build was attributable to strategic product buildups, while the remaining 1/3 was on account of baseband inventory accumulated as a result of weak sales.
Segment Revenue
All except the analog segment declined sequentially, although both analog and embedded processing segments were up strong double-digits from last year.
The Analog segment was up 1.2% sequentially, Embedded Processing down 0.9%, Wireless down 14.2% and Other down 5.3%. The baseband business dropped to around 10% of revenue, declining 23.0% sequentially and 21.2% from the year-ago quarter. Excluding the baseband business, the wireless segment revenue would have been down 2.7%, in line with normal seasonal trends.
All three major product lines within TI’s Analog business (roughly 40-30-30 mix) – high volume analog and logic (HVAL), high-performance analog (HPA) and power management – grew from last year. The increase in HPA (used in computing and consumer devices) was the most significant, while HVAL (industrial markets) and power management saw similar growth rates. However, power management products were the strongest in the sequential comparison, with HVAL coming in flat and HPA actually seeing a small decline.
While catalog products — mainly Digital Signal Processors (DSPs) and microcontrollers (MCUs) — declined sequentially, the Embedded Processing segment was also impacted by slowdown in the communications infrastructure market. The automotive market was particularly strong in the last quarter. Growth of 21.1% from the year-ago quarter was however due to a higher level of business from catalog products, with both the communications infrastructure and automotive markets helping.
TI’s focus in the wireless segment is on the proprietary OMAP and connectivity products. However, while OMAP grew year over year, it saw a sequential decline, which along with the decline in baseband offset the growth in connectivity products.
The decline in the baseband business, which TI is phasing out hurt both sequential and year-over-year comparisons. The bulk of the baseband revenue comes from a single customer, Nokia and TI is committed to meeting Nokia’s requirements until other vendors, such as Broadcom Corp (BRCM) are able to take over. However, TI remains on track to phase out this lower-margin business by 2012.
The Other segment was down 2.3% from last year, impacted by lower royalties, partially offset by transitional supply agreements. TI benefited from its DLP and calculator business in the last quarter, which increased sequentially, although offset by weakness in royalties and custom ASIC products.
Orders
Net product orders were $3.58 billion in the last quarter, up 14.4% sequentially and down 1.6% year over year. We estimate that backlog declined 14.9% sequentially, despite the 19.1% increase in turns. First quarter pickup in orders is in line with seasonal trends. Of course the higher turns are encouraging and seem to validate what TI said about improving demand. In this context, the additional capacity should be most welcome.
Margins
TI’s gross margin was 50.9%, down 208 basis points (bps) sequentially and 176 bps from the year-ago quarter. The sharp decline from both the previous and year-ago quarters was on account of the lower volumes, inclusion of earthquake-related costs (underutilization of facilities, inventories scrapped, recovery teams employed and other one-time costs) increased holiday time during the quarter and annual pay and benefit increases.
TI stated that the gross margin was likely to remain lower than the mid-fifties percentage range, until revenues went back to the levels they were at last year. Also, some of the new designs (analog and embedded processing products) getting into volume production should help the gross margin move up toward the long-term target of 55%.
Operating expenses of $818 million were higher than the previous quarter’s $782 million. The operating margin was 26.8%, down 401 bps sequentially and 313 bps from the year-ago quarter. The weaker gross margin was the primary reason for the sequential and year-over-year declines, although slightly higher R&D and SG&A expenses as a percentage of sales also helped.
The Analog, Embedded Processing, Wireless and Other segments generated operating margins of 27.2% (down 487 bps sequentially), 19.1% (down 744 bps), 21.4% (down 204 bps) and 37.1% (down 2,283 bps), respectively.
Net Income
The pro forma net income was $668 million, or a 19.7% net income margin compared to $845 million, or 24.0% in the previous quarter and $668 million, or 20.8% in the prior-year quarter. The fully diluted pro forma earnings per share were 56 cents compared to 71 cents in the previous quarter and 54 cents in the March quarter of last year. The pro forma calculations for the last quarter exclude the impact of restructuring charges.
On a fully diluted GAAP basis, the company recorded a net profit of $666 million, or 56 cents a share compared to a net profit of $942 million, or 79 cents per share (78 cents after deducting $14 million of profits for unvested RSUs to which dividend equivalents were paid) and a net profit of $658 million (53 cents per share) in the comparable prior-year quarter.
Balance Sheet
Working capital management continued to improve n the last quarter. While inventories increased 10.4% to $1.68 billion, this resulted in inventory turns of 4.0x, down from 4.4X in the previous quarter. Days sales outstanding (DSOs) went up from 39 to around 42. TI generated $516 million in cash from operations, spending $194 million on capex, $771 million on share repurchases and $153 million on cash dividends. The company did not have any long-term debt, although long-term liabilities totaled $943 million at quarter-end.
Guidance
TI provided guidance for the first quarter and some limited expectations for fiscal year 2011.
Accordingly, TI expects second quarter revenue to range between $3.41 billion and $3.69 billion (up 4.7% sequentially at the mid-point). The 5-year average sequential increase in the June quarter is 9.1%. The below-seasonal performance is likely on account of the Japan crisis.
The EPS for the quarter is expected to be $0.52 to $0.60, below the Zacks Consensus Estimate of $0.63. However, Japan-related costs included in these expectations are expected to be 5 cents, excluding which the EPS would have exceeded.
For 2011, TI expects R&D expenses of $1.7 billion (unchanged), capex of 0.9 billion (unchanged), depreciation of $0.9 billion (unchanged) and an annual effective tax rate of 28% (down from previous estimate of 30%).
In Summary
Texas Instruments is prudently investing its R&D dollars into several high-margin, high-growth areas of the analog, embedded processing and wireless markets, which has led to important design wins.
TI will also benefit from its proposed acquisition of National Semiconductor (NSM), if regulatory approval for the transaction is received. You can see our detailed analysis here – TI Snaps Up National Semiconductor.
Inventory concerns related to the computing and consumer markets are no more. Communications infrastructure and industrial markets should continue to trend up, although automotive will soften given concerns related to Japan.
TI stated that it was able to transfer 80% of production to unaffected facilities; however, some inventory needed to be scrapped. The concerns in Japan are supply-related more than demand related and TI’s customers are seeing problems in the supply chain. This is the primary reason for the below seasonal guidance.
The phasing out of the low-margin baseband business also remains on track and should generate some margin expansion every quarter. However, Japan will more than offset this benefit. Additionally, TI will have to work down/write off the inventory it accumulated as a result of the baseband sales falling below expectations in the last quarter.
We remain optimistic about TI’s compelling product line, the increased differentiation in its business, lower-cost 300mm capacity and possibly aggressive pricing strategy (in the next few quarters) that should in combination drive earnings ex-Japan.
That said, we would like to point out that additional capacity, while bringing down lead times, would also increase costs, so if facilities remain underutilized, there will be downward pressure on earnings.
As such, we believe our long-term Neutral recommendation on the shares is justified.
We also do not see any near-term catalysts that could drive shares higher and are therefore comfortable with our short term Hold recommendation (Zacks Rank #3) on TI shares. We note that other analog players, such as Linear Technology Corp (LLTC) and Maxim Integrated Products (MXIM) and Analog Devices (ADI) also carry a Zacks #3 Rank, reflecting a peaking of the semiconductor cycle.
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