Undervalued Dividend Growth Stock of the Week: Texas Instruments Inc. (TXN)

They say death and taxes are the only guarantees in life.

Maybe.

But I can offer you one more guarantee.

Nobody will care more about your money than you. 

This is 100% for sure.

And that’s why it’s so important that you make intelligent financial choices and put your money to work in the best way possible, as soon as possible.

It took me a little while to realize this for myself.

I didn’t start taking care of my money until I was already in my late 20s.

But once I started taking good care of my money, my money started taking good care of me.

Even though I didn’t get started until relatively late in life, I made up for lost time by living well below my means and investing my savings into high-quality dividend growth stocks.

How much time did I make up for? 

Well, I went from below broke at 27 years old to financially free at 33 by following the formula I just laid out.

And you can see how that happened by checking out my Early Retirement Blueprint.

Indeed, it’s the strategy of dividend growth investing that I choose to lead me to financial salvation.

That’s because, in my opinion and experience, it’s the best investment strategy available to become financially independent, which is a fairly common goal among investors.

Dividend growth investing practically limits oneself to just the best stocks out there, for only wonderful businesses can actually manage to pay growing dividends to shareholders for years and years on end.

You can’t run a terrible business that loses money while simultaneously pay out ever-larger checks to your shareholders; they’re pretty much mutually exclusive concepts.

That’s why so many blue-chip stocks can be found on the Dividend Champions, Contenders, and Challengers list, which is a document that tracks almost 900 US-listed stocks that have raised their dividends each year for at least the last five consecutive years.

Jason Fieber's Dividend Growth PortfolioFollowing this strategy has revolutionized my life, allowing me to live off of the five-figure and growing passive dividend income my six-figure FIRE Fund generates on my behalf.

Of course, there’s more to dividend growth investing than saving a few bucks and buying a stock off of the CCC list.

You have to develop a system that allows you to systematically analyze and value dividend growth stocks, which can help you pick out the better dividend growth stock choices at any given time.

What I mean is, not every dividend growth stock is a good investment at every moment.

Some stocks are not fundamentally up to par for whatever reason. And some stocks are overvalued.

But that’s what today’s article is all about.

We’re here to highlight a high-quality dividend growth stock that appears to be a compelling long-term investment at its current price, based on both a comprehensive quantitative/qualitative analysis and the valuation.

Obviously, you want to invest in the highest-quality companies.

But you also want to make sure you’re buying a stock when the valuation is appealing (i.e., when it looks undervalued).

An undervalued dividend growth stock should offer a higher yield, greater long-term total return prospects, and less risk. 

This is all relative to what the same stock might otherwise offer if it were fairly valued or overvalued.

The higher yield comes about due to the inverse relationship between price and yield; all else equal, a lower price will result in a higher yield.

A higher yield certainly means more dividend income on the same invested dollar, which thus positively impacts total return since total return is simply comprised of two components: investment income and capital gain.

The former is given a boost by the higher yield, but the latter is also given a possible leg up by virtue of the “upside” that exists between a lower price paid and higher intrinsic value.

If the stock market temporarily misprices a stock to where it’s undervalued, the favorable closing of that gap over time can lead to capital gain. And that’s on top of whatever capital gain would organically occur as a company becomes worth more (as it increases its profit).

This should all go a long way toward reducing risk for the investor.

You introduce a margin of safety when you pay much less than what a stock appears to be worth, which protects your downside (and capital) against unforeseen events (because we can’t predict the future).

These dynamics are incredibly advantageous to the long-term investor.

That’s why fellow contributor Dave Van Knapp put together Lesson 11: Valuation.

That’s a valuation guide that is part of an overarching series of articles designed to help anyone become a better dividend growth investor.

With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…

Texas Instruments Inc. (TXN)

Texas Instruments Inc. (TXN) is a global technology company that is currently one of the largest semiconductor manufacturers. They’re the biggest analog chipmaker in the world.

Revenue is broadly sourced. Texas Instruments sells its products to ~100,000 customers, with more than one-third of revenue derived from customers outside the largest 100.

The company operates across two segments: Analog (66% of FY 2017 revenue) and Embedded Processing (24%).

Analog includes their analog semiconductors, which change real-world signals into digital data.

Embedded Processing includes their processors that are used as the “brains” of many types of electronic equipment, handling specific tasks.

Technology stocks used to be a bit “taboo” for dividend investors, as the massive meltdown that occurred in the tech bubble back in 2000 led many more conservative investors to shy away from the space. Many tech companies were bid up to massive valuations (speaking on my earlier points), even though they weren’t profitable.

However, it’s no longer 2000. Many tech companies aren’t only profitable, they’re massively successful and operating globally.

In fact, many companies, like Texas Instruments, are absolutely vital to our everyday lives due to the way life and technology have become intertwined.

Meanwhile, some of these companies are sporting valuations that are nowhere near bubble territory – they actually look downright attractive, which is what we’re talking about today.

Getting back to my point on financial success, Texas Instruments is a poster child for this.

And that’s what creates the fertile ground necessary for paying increasing dividends.

Texas Instruments has been increasing its dividend for 15 consecutive years.

That time period stretches right through the financial crisis, which speaks to the company’s financial and dividend health through periods of economic trouble.

And the dividend growth itself has been astounding: the 10-year dividend growth rate is 21.6%.

We’d usually expect to see a pretty marked deceleration when you’ve got a dividend growth rate that high over a longer stretch of time (due to the elevating of a payout ratio and underlying growth that can’t keep up), but the company just very recently announced a 24.2% dividend increase. And that’s on top of lat year’s 24% increase.

So there’s just no slowdown here, although I do think that’s going to change a bit moving forward.

I say that because the payout ratio, while certainly not indicative of any kind of dividend issue, is about as high as it’s ever been for this company.

Now, that’s not a surprise. Texas Instruments has a stated goal of returning all of its FCF to shareholders via dividends and share repurchases. That’s always wonderful to hear, especially when a company is a FCF machine (as this one is).

It’s just that dividend growth will likely come closer to matching EPS growth moving forward. Based on recent EPS growth, however, that’s still a lot of growth to look forward to.

All that said, the payout ratio is now sitting at 60.3% (using TTM EPS that factors out a $0.75 one-time tax-related expense in Q4 2017).

And these dividend metrics look even better when you consider the stock is currently offering a 3.05% yield, which is approximately 70 basis points higher than the stock’s own five-year average yield.

It appears to me that the stock’s valuation hasn’t yet caught up to the recent dividend growth, which could offer a nice opportunity for long-term investors.

Of course, we invest in where a company is going, not where it’s been.

So it’s imperative that we come to some kind of reasonable conclusion about business growth moving forward, which will help us estimate dividend growth. And that data helps us later value the business and its stock.

We’ll first look at what Texas Instruments has done over the last decade in terms of top-line and bottom-line growth, before comparing that to a professional near-term forecast for EPS growth.

The company has increased its revenue from $12.501 billion in FY 2008 to $14.961 billion in FY 2017. That’s a compound annual growth rate of 2.02%.

Not fantastic, but we do have to consider that this period includes a bottoming-out in FY 2009 (due to the Great Recession). The company accelerated off of the low nicely, and they continued to pump out those increasing dividends.

The good news is that bottom-line growth was even stronger over this period, and the company remained a very profitable enterprise right through one of the most notable economic calamities the world has ever seen.

Earnings per share advanced from $1.44 to $4.36 (once again factoring out the aforementioned Q4 2017 $0.75 tax hit) over this same time period, which is a CAGR of 13.10%.

What happened here is, the company greatly expanded margins while simultaneously buying back a ton of stock.

I noted earlier that the company’s stated goal is to return all of its FCF to shareholders via dividends and buybacks.

Well, we see what’s happened with dividend growth.

But the buybacks are just as impressive.

The outstanding share count was reduced by just under 24% over the last decade.

And the company recently added another $12 billion to its repurchase program, which comes on top of the $7+ billion that’s remaining from the last program.

Looking forward, CFRA believes Texas Instruments will compound its EPS at an annual rate of 13% over the next three years, which would be right in line with what’s transpired over the last decade.

That’s status quo. It’s a view solidified by the company’s position as a leader in the analog market, along with widening margins, tax reform, and the huge buybacks.

And as the move moves closer to IoT, many components of our lives will increasingly need the chips that Texas Instruments manufacturers. The idea of autonomous vehicles, for instance, is a huge area of growth for the company, as self-driving vehicles are basically a poster child for needing to convert real-world signals into digital data.

Moving over to the balance sheet, the company’s strong position looks even stronger when you look at these numbers.

The long-term debt/equity ratio is 0.35, while the interest coverage ratio is almost 80. And there’s plenty of cash on hand.

Said another way, the balance sheet is spectacular.

Profitability is also spectacular.

Over the last five years, the company has averaged annual net margin of 22.45% and annual return on equity of 28.90%.

Both metrics are improving almost by the quarter, while ROE isn’t even being juiced by a poor balance sheet.

There’s almost nothing to like about this business.

There’s competition to consider, as always. The semiconductor industry is cyclical (although it held up well during the financial crisis). And while revenue is diversified, the top 100 customers are still vital to the business.

But when you look at a high-quality company like this, the issue usually comes down to valuation.

Strong businesses usually have strong valuations, but this might just be a rare chance to get a wonderful business at a wonderful price…

The stock is trading hands for a P/E ratio of 19.78 (using the same TTM EPS methodology I used for the payout ratio).

That compares favorably to the broader market and industry average. Plus, it’s well below the stock’s own five-year average P/E ratio of 22.2.

This is, in my view, a better-than-average stock trading for a worse-than-average multiple.

Its cash flow (which is robust) is also trading hands for a multiple below its three-year average.

And the yield, as noted earlier, is substantially higher than its recent historical average (as well as much higher than the broader market).

So the stock does look compelling here, but what would a reasonable look at intrinsic value look like? How undervalued might it be? 

I valued shares using a dividend discount model analysis.

I factored in a 10% discount rate and a long-term dividend growth rate of 7.5%

While that’s on the higher end of what I normally allow for in terms of future DGR, it’s honestly quite conservative when you look at the demonstrated long-term DGR, payout ratio, stable business model, balance sheet, robust FCF, massive profitability, recent EPS growth, and forecast for near-term EPS growth.

There’s just nothing indicating that shareholders should expect anything less than double-digit dividend growth for the foreseeable future (or at least high-single-digit dividend growth).

However, the payout ratio being elevated off of the long-term norm, which means we might need to scale back expectations just a tad.

The DDM analysis gives me a fair value of $132.44.

The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.

The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.

It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.

I find it to be a fairly accurate way to value dividend growth stocks.

From my standpoint, this is a high-quality stock that’s very undervalued. That’s why I actually recently bought shares for my personal portfolio, initiating a new position in this fantastic business.

But we’ll now compare that valuation with where two professional stock analysis firms have come out at, which adds balance, depth, and perspective to our conclusion and final valuation.

Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.

1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.

Morningstar rates TXN as a 3-star stock, with a fair value estimate of $106.00.

CFRA is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.

They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.

CFRA rates TXN as a 3-star “HOLD”, with a 12-month target price of $117.00.

I’m surprised I came out high here. I don’t believe I was being aggressive with my valuation. Nonetheless, averaging these three numbers out gives us a final valuation of $118.48, which would indicate the stock is potentially 17% undervalued right now.

Bottom line: Texas Instruments Inc. (TXN) is a dominant firm in tech, which is incredibly important in a world where our lives and technology are becoming increasingly intertwined. Phenomenal fundamentals, a market leading position its core products, 15 consecutive years of dividend increases, a recent 24% dividend raise, a 3%+ yield, and the possibility that shares are 17% undervalued all adds up to one of the more compelling opportunities in the market for dividend growth investors.

-Jason Fieber

Note from DTA: How safe is TXN’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 95. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, TXN’s dividend appears very safe with an extremely unlikely risk of being cut. Learn more about Dividend Safety Scores here.