Technology stocks have produced good gains in 2013 but lagged the overall market through the first half of the year. We believe this underperformance will reverse itself in the back half of the year, and we foresee attractive valuations and an improving U.S. economy to be the catalysts for tech's resurgence.
One stock that should be a part of that resurgence is Texas Instruments (TXN), a solid performer year to date that should have significantly more upside potential. Much of the opportunity with Texas Instruments lies in its ongoing transformation from a cell-phone chip company into a larger and more diversified analog and embedded chip processor.
This is exemplified by the de-emphasis of the old Nokia (NOK) alliance, which once accounted for 25% of company revenue but now represents less than 5% of revenue. Replacing it has been a diversified base of high-end analog chips and processors.
Texas Instruments is still a cyclical chip company. However, revenue and particularly earnings should make new highs in the next technology up-cycle. Besides acquiring key competitors such as National Semiconductor during the slow periods, the company also bought key industry chip-making plants at replacement costs of less than 10 cents on the dollar.
This has given Texas Instruments extra-low-cost plant capacity to significantly improve earnings this cycle, and these deals will make the company a larger and more profitable competitor as the industry enters its next cyclical upturn.
Sales have been relatively flat over the past five years, in the range of $12 billion to $14 billion. The weakness has been due to Texas Instruments' shrinking cell-phone chip operations in addition to weak overall industry prospects. However, the company is poised to grow from here. Over the next three years, earnings per share are projected to rise 50% from current levels of $1.72 per share to $2.80 per share as a better product mix, rising plant utilization, lower costs and 15% fewer shares outstanding boost the bottom line.
The core business is projected to show unit volume growth of a solid 3% to 4% as businesses and consumers use more technology-based products. Volumes have been particularly strong from the various emerging markets of Asia, Latin America, Eastern Europe and Africa.
The company has had a consistently high level of profitability with 30%-plus gross margins, 15% net margins and double-digit returns on capital and equity. Furthermore, the company consistently repurchases shares with its free cash flow, on the order of 3% to 5% per year. This repurchase strategy has enabled Texas Instruments to shrink its share base by 35% in the past decade, materially adding to shareholder value.
Besides improving operating fundamentals, the company's management has been a strong proponent of increasing dividends. The current $1.12 dividend yields a strong 3.14% current yield. Dividends are projected to grow 10% to 12% per year over the next five years.
At a recent price of $35.70, Texas Instruments' stock trades at 19.9x its 2013 EPS estimate of $1.79. On the basis of an EPS estimate of $2.20 for 2014, the company is trading at 16.2x earnings. Texas Instruments' shares have historically traded at 15x to 20x earnings, because of the company's industry-leading analog and embedded-chip franchise. Improving fundamentals should continue into 2014 and 2015, and that, combined with the current attractive valuation, should propel share prices higher.
We believe that Texas Instruments will be a strong beneficiary of the next technology up-cycle. It's a strong and well-positioned franchise, valuations are attractive, and the stock is timely while also offering a healthy and growing dividend.