Texas Instruments Inc. (TXN) reported third quarter earnings that were up 12.1% sequentially and 69.4% year over year, beating the Zacks Consensus Estimate by 3 cents. The strong earnings growth was driven by healthy revenues, a better mix of business, cost control and good execution.
Despite the positive surprise, Texas Instruments’ shares dropped 1.28% in after-hours trading on continued concerns regarding the slowing of demand, as evident from the first bookings decline in 7 quarters.
Texas Instruments has been reporting very strong revenue growth over the past four quarters, indicative of share gains at the expense of its analog peers, particularly National Semiconductor Corp. (NSM) and also possibly Analog Devices Inc. (ADI). Share gains should continue over the next few quarters as well, as the RFAB and other lower-cost facilities enter production, enabling Texas Instruments to cut prices without sacrificing margins. We expect analysts and investors to have their eyes on the gross margin line, which is currently almost at Texas Instruments’ long term target of 55%.
Revenue
Texas Instruments reported revenue of $3.74 billion, which was up 7.0% sequentially, up 29.9% year over year and over the middle of the revised guidance range of $3.62 billion to $3.78 billion (a sequential increase of 3.5%−8.1%). Revenue also exceeded the Zacks Consensus Estimate of $3.69 billion by 1.5%.
Although revenue growth in the quarter was broad-based across end markets, some markets, such as industrial and communications were stronger, while others, such as PC and consumer, had pockets of weakness. End market trends in the last quarter are expected to carry into the current quarter, with the exception of industrial, which has already grown significantly, so may be expected to slow down. Region-wise commentary was not available.
Both internal and distributor inventories grew during the quarter, although Texas Instruments stated that increases were commensurate with the level of demand in the market.
Segment Revenue
All segments witnessed sequential increases in the last quarter. The Analog segment was up 4.6%, Embedded Processing up 12.2%, Wireless (excluding baseband) up 5.8% and Other up 9.7%. The baseband business was 11.7% of revenue, increasing 5.3% sequentially and declining 2.7% from the year-ago quarter. All segments increased double-digits from the year-ago quarter.
All three major businesses within Analog (roughly 40-30-30 mix)—high volume analog and logic (HVAL), high-performance analog (HPA) and power management—contributed to the increase in analog revenue. HPA was the fastest-growing on a sequential basis, given its exposure to industrial markets, while HVAL and power management products grew slower due to their dependence on computing and consumer markets. However, all three businesses contributed to analog market share gains and were equally responsible for the 35.4% year-over-year increase, according to management.
While catalog products—mainly Digital Signal Processors (DSPs) and microcontrollers (MCUs)—continued their growth trajectory in the last quarter, the Embedded Processing segment also benefited from improvement in the communications infrastructure and industrial markets. Growth of 47.3% from the year-ago quarter was however mainly on account of catalog products. Management stated that Texas Instruments’ embedded products continued to gain share in the last quarter.
Texas Instruments’ focus in the wireless segment is on the proprietary OMAP and connectivity products. This business was up 6% sequentially and 37% from a year ago, driven by strength in the smartphone market. The baseband business, which the company is phasing out, was up sequentially, positively impacting segment performance in the fiscal third quarter. The bulk of the baseband revenue comes from a single customer, Nokia Corp (NOK) and Texas Instruments is committed to meeting Nokia’s requirements until other vendors such as Broadcom Corp (BRCM) are able to take over. However, Texas Instruments remains on track to phase out this lower-margin business by 2012.
The Other segment remained strong in the last quarter, growing 29.5% from the year-ago quarter. Texas Instruments is benefiting from its DLP and custom ASIC products here, which fueled growth from the year-ago quarter. Calculators also contributed to the sequential increase.
Orders
Net product orders were $3.43 billion in the last quarter, down 8.0% sequentially and up 10.3% year over year. We estimate that backlog declined 12.6%, with turns sales flattish (up 0.8% sequentially). The sluggish turns and declining orders (orders were down 8.0% sequentially and up 10.3% from the year-ago quarter) indicate that Texas Instruments’ business is losing momentum. The silver lining here is that Texas Instruments’ lead times continued to decline in the last quarter and are likely to reach normal levels in 2011 (according to management). The additional capacity coming online and declining demand is expected to lead to equilibrium.
Margins
The gross margin was 54.5%, up 34 basis points (bps) sequentially and 310 bps from the year-ago quarter. The reasons for the continued improvement in the gross margin is primarily related to the higher level of revenue and an improving mix of analog and embedded processing business.
Operating expenses of $808 million were higher than the previous quarter’s $770 million. The operating margin was 32.9%, up 76 bps sequentially and 566 bps from the year-ago quarter. The higher gross margin and lower SG&A as a percentage of sales contributed almost equally to the sequential increase, while R&D was flattish as a percentage of sales. The gross margin accounted for more than half of the operating margine expansion from the year-ago quarter, with R&D and SG&A contributing roughly equally for the balance.
The Analog, Embedded Processing, Wireless and Other segments generated operating margins of 33.0% (up 127 bps sequentially), 27.8% (up 494 bps), 23.6% (up 21 bps) and 45.3% (down 291 bps), respectively.
Net Income
The pro forma net income was $863 million, or a 23.1% net income margin compared to $786 million, or 22.5% in the previous quarter and $540 million, or 18.8% in the prior-year quarter. Fully diluted pro forma earnings per share were 72 cents compared to 64 cents in the previous quarter and 43 cents in the September 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 $859 million (72 cents per share) compared to $769 million (63 cents per share) in the previous quarter and a net profit of $538 million (42 cents per share) in the comparable prior-year quarter.
Balance Sheet
Working capital management continued to improve. While inventories increased 5.6% to $1.42 billion, this resulted in inventory turns of 4.8X, unchanged from the previous two quarters. Days sales outstanding (DSOs) wet down from 45 to around 43. Texas Instruments generated $1.32 billion in cash from operations and spent $396 million on capex, $600 million on share repurchases and $143 million on cash dividends. The company did not have any long-term debt, although long-term liabilities totaled $849 million at quarter-end.
Guidance
Management provided guidance for the fourth quarter. Accordingly, revenue is expected to range between $3.36 billion and $3.64 billion (down 2.7% to 10.2% sequentially), a typically broad range. The 5-year average sequential decline in the December quarter is 6.7%. The EPS is expected to be $0.59 to $0.67.
For 2010, Texas Instruments expects R&D expenses of $1.6 billion (up from previous guidance of $1.5 billion), capex of 1.2 billion (unchanged from previous guidance), depreciation of $0.9 billion (unchanged) and an annual effective tax rate of 31% (unchanged).
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 solid order growth in the recent past. However, the company is now up against weak demand in the PC market and certain areas of the consumer market, which typically drive fourth quarter results. Considering these factors, we cannot think of the fourth quarter guidance as disappointing, since the below-average decline expected for the quarter indicates that Texas Instruments has obviously made headway in other markets.
The phasing out of the low-margin baseband business also remains on track and should generate some margin expansion every quarter. This, along with a stronger mix and cost control is resulting in great earnings momentum and solid cash flow.
We are particularly optimistic about the analog share gains over the past few quarters, which we expect will continue through the rest of the year at a minimum. Texas Instruments’ compelling product line, the increased differentiation in its business, lower-cost 300mm capacity and possibly aggressive pricing strategy (in the next few quarters) should continue to drive earnings momentum.
That said, we would like to point out that additional capacity, while bringing down lead times, would also increase costs, so if demand does not pick up soon, there will again be downward pressure on earnings. The Zacks Consensus Estimate for fiscal year 2011 has lost 5 cents over the past 60 days, although it has held relatively steady for 2010.
As such, we believe our long-term Neutral recommendation on Texas Instruments shares is justified. We also do not see any near-term catalysts that could drive the shares higher in the near term. We are therefore comfortable with the short-term Hold recommendation (Zacks #3 Rank) that the company carries.
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