Texas Instruments Should Ride Even Higher

 | Mar 14, 2017 | 10:00 AM EDT
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Back in November I thought shares of Texas Instruments (TXN) could go higher, but with the stock up 16% since then, now what? Can investors ride this stock even higher?

Texas Instruments is on a roll. I thought the shares could move higher because Texas Instruments is high quality holding that is well-diversified in the industrial, automotive, communications and enterprise communications markets.

In the last year, the stock is up 45%. It looks like the third-quarter report really lit a fire under the shares. Earnings per share were up 24% and revenue rose 7% to $3.67 billion. Then in January, the company said fourth-quarter sales rose 7% to $3.4 billion, $100 million ahead of the consensus estimate, with earnings per share climbing 28% to $1.02.

At the time, management guided first-quarter sales up to a range of $3.17 billion to $3.43 billion from the $3 billion posted in the first quarter of 2016, and put expected earnings per share in a range of 78 cents to 88 cents from the 70 cents reported a year earlier. For the year, analysts are expecting $14 billion in revenue and earnings of $3.67 per share; revenue and earnings were $13.37 billion and $3.48 a share, respectively, in 2016. Next year, the forecast is for earnings of $3.94.

Texas Instruments is scheduled to report first-quarter fiscal 2017 earnings on April 26.

Last month the company held a "Capital Management Strategy" session with the analyst community. Investors have been concerned that Texas Instruments doesn't allocate its capital as effectively as other competitors and the company might be under-investing in new growth areas. Wall Street wants management to make big acquisitions and do giant share buybacks.

On the call, the management team put those concerns to rest. From 2007 through 2016, Texas Instruments said, it allocated $73 billion in capital. The company funneled about $32 billion into the business in terms of research and development, sales, marketing and capital spending. It spent $25 billion on share repurchases and $9 billion on dividends. However, Texas Instruments spent only $7 billion on acquisitions during the period.

The money Texas Instruments invested in R&D is really paying off. For example, the company heavily invested in the industrial and automotive markets. By the end of 2016, the industrial and automotive markets were 33% and 18% of total revenue, respectively. Over the past three years, those markets have been the two best markets and are driving the company's growth. Meanwhile, the company is moving away from slow-growing markets such as enterprise systems and personal electronics.

Texas Instruments is focused on the best markets within the semiconductor industry: analog and embedded. The analog market is estimated to be $48 billion in size and the embedded market is about $18 billion. TI has a leading share in both markets. It has an 18% share and the No. 1 position in analog and a 17% share and the No. 3 position in the embedded marketplace.

Surprisingly, Texas Instruments has 80% of its cash onshore and an estimated annual effective tax rate of 30% in 2017. Management believes it is important to have that cash close by in order to pay down debt, pay dividends and repurchase shares. The company's pension fund is 99% funded, so TI has an exceptionally strong balance sheet.

Capital expenditures are just 4% of total revenue, which is considerably lower than other semiconductor makers. In 2004, for example, TI spent nearly 12% of revenue on capex.

By transitioning from analog to embedded parts, the company can keep its spending down. Right now, TI is undergoing a big manufacturing transition from 200-millimeter wafers to 300-millimeter wafers. The larger wafers drop the cost of a semiconductor by 40%, which means gross margins go from 60% to 68%.

Texas Instruments has the opportunity to expand margins 100 basis points through at least 2018 as it shifts production to 300 mm. Right now, only 30% of the company's capacity is at 300 mm. With such a strong balance sheet, low debt, expanding margins and growing revenues, Texas Instruments can expand free cash flow at an annualized rate of 10% to 12% over the next few years.

And that's why I think Texas Instruments is an attractive play in the semiconductor space. TI shares easily should be able to sail up to the low- to mid-$90s just on margin expansion alone. I think investors can ride this stock higher.

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