Texas Instruments Points To A Spicier Dip For Chips

Summary:

• Texas Instruments posted a soft quarter, with excess capacity having a more noticeable impact on gross and operating margin despite basically in-line revenue and ongoing growth in the auto market.
• Guidance was the real story this quarter; with a steep cut to guidance relative to Street expectations, TI has signaled that they haven’t yet reached the bottom of the cycle.
• TI’s policies will worsen the margin and FCF hits in the short term, but should solidify the company’s position with major customers and leave the company well-placed for the upturn.
• Trading a little below my fair value estimate, something not so common with a well-liked tech company, these shares are getting more interesting.

It’s not entirely true that “as Texas Instruments (NASDAQ:TXN) goes, so goes the chip sector”, but the fact remains that TI is a major player in a range of semiconductor markets and products, and you ignore the performance of this company at your own peril. It’s likewise true that what goes up eventually comes down, and in the context of the recent semiconductor “super-cycle”, it shouldn’t be altogether shocking that TI is seeing a more challenging cyclical correction despite its many positive long-term attributes and drivers.

I still saw too much risk to the TI story back in April and too little return potential relative to the near-term risk of a more painful chip correction cycle. Since then, lead times have shrunk meaningfully across most of the space and TI’s share price has fallen more than 20%, lagging the chip sector by a wide margin and names I’ve highlighted as better options like Broadcom (AVGO) (networking/AI leverage), ON Semiconductor (ON) (SiC/turnaround leverage), and Renesas (OTCPK:RNECY) (MCU/turnaround leverage).

My feelings on TI are more positive from a “strategic” standpoint, as I think the Street is better dialed into the reality of this sharp correction cycle. I do still see some risk to autos and industrial markets in 2024, and I think TI needs to up its game in some product categories (MCUs, particularly). Valuation today is okay, but not exactly compelling – this isn’t a stock I expect to get on the cheap, but it’s still not undervalued enough for me to consider it a top-of-list idea.

A Soft Quarter And Weaker Guidance

This wasn’t the quarter that the Street wanted to see from TI, as the market wanted confirmation that the cycle was indeed bottoming out and that slowing industrial end-markets weren’t as much of a problem as bears feared. Instead, it’s evident that industrial demand is still soft and markets like auto aren’t going to be enough to compensate.

Revenue fell 35% year-over-year and came in flat with the prior quarter, a very slight miss relative to Street expectations, with analog sales down 16% (but up 2% qoq) and embedded up 8% (but down less than 1% qoq).

Gross margin fell nearly seven points yoy (and about two points sequentially) to 62.1%, missing expectations by 80bp. With the company’s inventory position now where it needs to be, management is scaling back on fab utilization, and that’s driving lower margins. Operating income declined 29% yoy and 4% qoq, missing by about 2%, with margin down about 11 pts yoy and down close to two points qoq to 41.7%.

By end-market, auto was up mid-single-digits, industrial was down mid-single-digits, consumer electronics was up 20% (off a low bottom), communications was down high-teens, and enterprise was up high single-digits.

It’s not unusual for TI to offer up conservative guidance for the fourth quarter, but this was definitely a step beyond “conservative”. Management is looking for revenue to decline nearly 10% at the midpoint, some 9% below the prior average sell-side estimate for the quarter.

Historically Speaking, This Isn’t So Unusual

A fifth straight quarter of year-over-year declines in revenue is a little more than typical for a semiconductor down-cycle (two to four is more the norm), but it’s well worth remembering that the last up-cycle was incredibly strong, with lead-times driven to never before seen levels due to a combination of overly conservative capacity adds going into the turn and growing chip content across a range of markets (most famously, but not exclusively, the auto market).

While that part is unusual, the 22% peak-to-trough move in revenue that Q4’23 guidance would represent is more consistent with past cycles, so I wouldn’t say this is a reason to panic.

Now the question is whether this really is the bottom, and here I’m guardedly optimistic. I don’t expect the auto market to be nearly as strong next year in terms of production volumes, but I do still expect it to be up and content growth remains a driver. I also expect communications to find a bottom, along with a gradual improvement in consumer electronics. Enterprise should be relatively healthy. That leaves industrial as a key unknown, and I don’t have much to say here that I haven’t said before – I think there’s ample evidence of softer demand and I don’t expect it to improve until the second half of 2024 (though orders for chips could come in a little ahead of that).

TI Will Manage The Downturn

This isn’t TI’s first time through the cyclical ups and downs of the semiconductor market, and I have no long-term concerns about the company.

Revenue is likely being compromised in the short term by management’s avoidance of stringent no-cancel/no-reduce order policies – while these policies can perhaps preserve revenue in downturns, I agree with TI management that you risk alienating customers and/or only adding to volatility (if customers know you won’t budge, they may under-order … or force you to enforce the agreements in court). Long term, then, I think management gets rewarded for customer-friendly policies.

I feel much the same about inventories and capacity. TI did well in the last cycle in no small part because they didn’t cut back as much as other companies – they wanted to be ready, with inventory on hand, to serve their customers when demand recovered, and they were. Inventory is now back around management’s targeted range (208 days), and the company is moving forward with its capacity expansion plans. This will have a significant near-term negative impact on margins and FCF (and margins do matter in semiconductor valuation), but again it gives TI the opportunity to be ready to serve customer needs in the upturn with more capacity than rivals.

While a bit off-topic, I do want to say that I think management needs to increase its efforts in the microcontroller (or MCU) space. The company has been losing some share here of late, and I think this is an attractive market – not just for applications like auto, but also growing use cases in areas like edge AI/IoT. MCUs aren’t a huge part of TI’s mix (9% to 10%), but it’s an area where I think the company can do better and should devote a little more R&D attention.

The Outlook

With the ongoing share price declines, TI shares look more interesting relative to my fair value estimates. I’ve cut my 2023 and 2024 revenue estimates in response to this guidance, but I’m still looking for 5%-plus long-term revenue growth, as I do expect revenue to rebound strongly (double-digit year-over-year growth) in FY’25. I’m still about 13% below management’s $33.7B target for 2030, but I also don’t know if that’s still a valid target that management would endorse.

Margins are trickier. With the lower utilization and capacity additions, I’m expecting a much sharper decline in gross and operating margin in 2024 (around four points now for operating margin). I do expect a rebound in 2025, though, and I’m using ’25 margins to drive my margin-based valuation, as I don’t believe 2024 is representative of the long-term earnings power. With that, I get a fair value a little above today’s price.

For free cash flow, I’m still expecting several years of below-average FCF margins due to the capacity additions (and now the increased margin pressures as well), but I still expect long-term FCF margins to reach the high-30%’s, driving high single-digit FCF growth and supporting an annualized total potential return in the high single-digits.

The Bottom Line

Predicting cycles is notoriously difficult – the last up-cycle exceeded everybody’s initial expectations, and I don’t dismiss the risk that the bottom of this cycle may not yet be in sight. I do think, though, that it’s a question of quarters and that TI still has a bright future ahead of it. The shares aren’t especially cheap, but that’s not uncommon for a well-liked bellwether. I might hold off a bit longer to see if there’s further pressure on TI’s share price from other semiconductor company reports, but I think we’re nearing a point where more value-oriented investors may want to think about this as a name for the next up-cycle.

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