Writing this article has been a special pleasure. Not only is Texas Instruments (TXN) a world-class chip company that has come into a fair valuation range, but its business model is one of the most clearly explained that I have ever encountered.
My first encounter with Texas Instruments was through its famous hand-held calculators – an old-line business that still exists today. TXN invented the calculator in 1967. My first one was similar to the TI-2500 pictured here. At the time, it seemed like a miracle.
But calculators are not TXN’s main business. Its main business is analog chips that translate real-world information (like speed or temperature) into digital signals that can be processed by digital chips and computers.
Texas Instruments emerged in 1951 after a reorganization of Geophysical Service Inc., a company founded in 1930 that manufactured equipment for use in the seismic industry, as well as defense electronics. TI produced the world’s first commercial silicon transistor in 1954, and designed and manufactured the first transistor radio in 1954. Jack Kilby invented the integrated circuit in 1958 while working at TI’s Central Research Labs. TI also invented the hand-held calculator in 1967, and introduced the first single-chip microcontroller (MCU) in 1970, which combined all the elements of computing onto one piece of silicon.
Today, Texas Instruments is the world’s 4th-largest semiconductor company based on revenues.
Let’s see how TXN stacks up as a candidate for a dividend growth stock portfolio. I will use the analytical approach described in DGI Lesson 14: Grading Dividend Growth Stocks to Find the Best Ones for Your Portfolio.
Texas Instruments’ Dividend Record
Here’s a summary of TXN’s dividend resume, with some discussion to follow.
As you see from all the green categories, this is an outstanding dividend record.
Texas Instruments would be classified as a mid-yield, fast-growth stock. That’s an unusual combination, as most mid-yield stocks (2%-4% yields) are medium-speed growers (5-9% per year).
But TXN is different, combining a fast growth rate with a good yield, and that is partly the result of its capital allocation strategy, which is illustrated by this statement from the company:
The design of our business model enables us to commit to a capital management strategy that allows us to make all the required investments in R&D, marketing and manufacturing and then return all of our free cash flow to our owners. [Emphasis added.]
Texas Instruments is committed to its dividend and growth streak. Their stated target is to pay 50-80% of the average free cash flow over the past 4 years as a dividend. Here’s how its dividend has grown since TXN began its streak in 2005:
[Source of all yellow bar charts: Simply Safe Dividends]
With its upcoming increase, in 2018 TXN will have paid total dividends of $2.63 (24% increase over 2017), and in 2019 it will pay a dividend in excess of $3.08/share (17% increase).
TXN gets a high dividend safety score of 95 (out of 100) from Simply Safe Dividends.
That rates as Very Safe, meaning that a cut is extremely unlikely.
(For more insight into dividend safety, see Dividend Growth Investing Lesson 17.)
Texas Instruments considers that it is somewhat unique in its ability to grow and simulataneously return copious amounts of cash to shareholders.
Texas Instruments’ Business Model and Quality
When I research some companies, figuring out their business model can be a challenge. Their investor materials are scattered, and while there are lots of pretty pictures, they often don’t articulate their vision and operations very well.
Texas Instruments is different. They have a clear business vision, and they spell it out explicitly. Much of the following discussion is drawn from two TXN documents: A strategic white paper from March, 2018, and an investor presentation from February.
TXN’s semiconductors are used for processing analog signals (like temperature, speed, and electrical current), converting that data into digital formats, interfacing with digital devices, and improving signal resolution. Analog semiconductors are integral to almost all electronic equipment.
TXN has identified what it believes are the best products in the semiconductor industry for their strategic focus:
• Analog processing
• Embedded processing
Analog processing brings in about 66% of TXN’s revenue. Every electronic product requires analog technology: Analog provides the power to run devices, and it is fundamental to how technology interfaces with human beings, the real world, and other electronic devices.
The market for analog processing is highly fragmented, and TXN holds the leading share at about 19%. While TXN has many products optimized for specific applications, most of its analog business focuses on “catalog” products that can be sold to many customers, who use them in a wide range of applications. Catalog products tend to have long life cycles that are advantageous to TXN.
Embedded processing brings in about 23% of Texas Instruments’ total revenue. Like Analog, this is a fragmented market. TXN holds about 18% market share.
One of the attractive features of the embedded product line is that TXN’s customers often invest to write software that runs on TXN’s chips. Once a customer writes their own software for TXN’s platform, they usually want to re-use that investment from generation to generation of their product. As a result, relationships with these customers tend to be long-lasting and strategic.
Just as it has identified the best products for strategic focus, Texas Instruments has also identified what it considers the best markets:
TXN believes that both markets offer solid growth opportunities, because of increasing semiconductor content as companies strive to make their equipment smarter, safer, more connected, and more efficient. These two markets also tend to be long-lasting, meaning that product life cycles are measured in years and decades, rather than the shorter cycles found in consumer products (like phones).
As a result of its product/market analysis, TXN has made accelerating growth in those areas a corporate priority.
Texas Instruments has about 100,000 customers all over the world. The company is divided into three reporting segments:
• Embedded Processing
Analog and Embedded Processing are TXN’s largest businesses, accounting for about 90% of revenue. Both offer the opportunity for growth, solid profits, stability, and compelling cash generation.
The “Other” segment – which houses the calculator line – adds value despite slower growth rates, because it provides high returns with a relatively low level of investment required to keep the product lines relevant.
TXN also grows through acquisitions. Its most recent major acquisition was to spend $7 billion on its 2011 acquisition of National Semiconductor. As we will see in the financial review later on, the acquisition seemed to slow TXN down for a couple of years, but it has since been fully digested.
The company states its approach to acquisitions clearly:
We look at an acquisition opportunity through two lenses. First, it must be a strategic match, which for us translates into an entity that is analog- and catalog-focused with a high exposure to industrial and automotive. Second, it must meet certain financial performance levels such that it generates a return on invested capital greater than our weighted average cost of capital…in about four years.
Morningstar assigns Texas Instruments a wide moat, its highest ranking, indicating sustainable competitive advantages. Factors include:
• TXN’s strong proprietary analog chip designs created by engineers who are experienced in the intricacies of such designs.
• Manufacturing expertise in producing high-quality chips. Quality often determines buying decisions, as the cost of a chip is small compared to the value of the equipment into which it is built. That, in turn, helps TXN maintain pricing power.
• Switching costs that make it hard for customers to swap out analog chips for competing chips once they are designed into devices. There is a strong tendency for customers to stay with the same chip designs for the life of the devices.
• The size and scale of TXN’s salesforce and field applications engineers, which allow it to reach and support a broad customer base.
Here is a summary of Texas Instruments’ business quality rankings:
All the categories are green. Texas Instruments is a high-quality company.
Texas Instruments’ Financials
Value Line gives TXN its highest Financial Strength Grade of A++. Let’s look at some key financial categories and see if we agree.
Return on Equity (ROE) is a standard measure of financial efficiency. ROE is the ratio of profits to shareholders’ equity (also known as net assets or assets minus liabilities).
The average ROE among Dividend Contenders is 20%, and for S&P 500 companies it is about 13%. The following chart shows Texas Instruments’ ROE since 2008.
TXN’s ROE has been outstanding. It not only has a high value, but it also has been generally rising for several years.
Debt-to-Capital (D/C) ratio measures how much the company depends on borrowed money. Companies finance their operations through a mixture of debt and equity (shares sold on the open market or issued to pay for acquisitions) as well as their own cash flows.
High leverage creates risk. The higher the D/C ratio, the riskier the company is. Debt must be paid back, so debt repayments create a constant draw on the company’s cash flows.
TXN states the following philosophy with respect to debt:
With interest rates at historical lows, we plan to continue to hold debt as long as it makes economic sense.
A typical D/C ratio for large companies is 50%. TXN’s debt is much lower.
At 28%, TXN has a low debt load, and it has been pretty low for the past several years. And as we saw earlier, the company has a very good credit rating of A+ from S&P. That means that it can borrow at lower interest rates than most companies.
Operating margin is one of my favorite financial metrics. It measures profitability: What percentage of revenue is turned into profit after subtracting cost of goods sold and operating expenses.
Per recent research, typical operating margins for S&P 500 companies have been in the 11-12% range. By comparison, TXN’s record here is outstanding.
In its most recent earnings report a few days ago, TXN’s operating margin hit 46% for the preceding 12 months.
Earnings per Share (EPS) is the company’s officially reported profits per share. We want to see if a company has had years when it officially lost money, or if its earnings are steadily increasing, declining, or basically flat.
Again, TXN has an outstanding record. It has delivered positive earnings every year, with increases in 6 of the past 9 years.
The consensus earnings growth estimate reported by analysts is 14% per year over the next 3-5 years, which is decent for a mature company.
Free Cash Flow (FCF) is the money left over after a company pays its operating expenses and capital expenditures. Whereas EPS is subject to GAAP accounting rules, cash flow is a more direct measure of money flowing through the company. It’s the money a company has available for dividends, stock buybacks, and debt repayment.
Excess FCF allows a company to pursue investment opportunities, make acquisitions, repurchase shares, and pay/increase dividends.
Texas Instruments elevates the importance of free cash flow in its business thinking: Indeed, growing FCF is the central financial goal of their entire business.
Long term, we believe the ability to generate cash, specifically free cash flow growth on a per-share basis, is what matters most to any business. We also believe that free cash flow will be valued only if it is productively reinvested in the business or returned to shareholders.
In 2017, TXN converted 31% of revenue into free cash flow, placing it in the top 13% of S&P 500 companies on that metric. As of its most recent quarterly report earlier this week, TXN has converted about 38% of revenue into FCF over the preceding 12 months.
TXN’s FCF record is impressive. FCF has been positive every year since 2004, including the recession years of 2008-2009, rising steadily in most years.
Share Count Trend shows whether the company’s outstanding shares are increasing, decreasing, or remaining flat.
I like declining share counts, because the annual dividend pool is spread across fewer shares each year. That makes it easier for a company to maintain and increase its dividend. By buying back its own shares, the company is essentially investing in itself and expanding each remaining share into a larger piece of the pie.
In the past, I have treated this metric as a “Miscellaneous” factor, but I was impressed by the way that TXN discusses it as part of their overall financial strategy, so I am putting it here in the financial discussion.
I have mentioned in the past that I do not like it when companies state that share repurchases “return money to shareholders,” because shareholders only benefit if the shares are retired. TXN does use that unfortunate terminology, but its record in retiring shares is outstanding.
TXN has stated that “We focus on consistent repurchases when the stock price is below the intrinsic value, using reasonable growth assumptions.” I like when a company factors its stock’s valuation into buyback decisions. Some companies buy back stock when their shares are wildly overvalued, which effectively wastes some of the money.
In 2018, additional share retirements have brought TXN’s outstanding share count down below 1B shares. The company recently announced that they would add another $12B to their buyback authorization program, and it now has about $18B earmarked to buy its own shares.
Overall, TXN has reduced its share count by 43% since 2004.
Here is a summary of the items above:
That is a pretty impressive financial picture. I have no disagreement with Value Line’s ranking of TXN’s financials as A++.
Texas Instruments’ Stock Valuation
My 4-step process for valuing companies is described in Dividend Growth Investing Lesson 11: Valuation.
Step 1: FASTGraphs Basic. The first step is to compare the stock’s current price to FASTGraphs’ basic estimate of its fair value.
The basic valuation estimate uses a price-to-earnings (P/E) ratio of 15, which is the historical long-term P/E of the stock market, to create a baseline “fair value” reference line, shown by the orange line on the following chart. The black line is TXN’s actual price.
Texas Instruments’ actual P/E is 16.6 (circled), which is more than the 15 used to draw the orange reference line. So this valuation method suggests that the stock is overvalued.
To calculate the degree of overvaluation, we make a ratio out of the P/Es: 16.6 / 15 = 1.11. In other words, TXN is overvalued by 11% as estimated by this first method.
The fair price is then calculated by dividing the actual price by the valuation ratio. We get $92 / 1.11 = $83 for a fair price.
Note that I round all dollar amounts to the nearest dollar. That’s to help avoid creating a false sense of precision in making valuation assessments.
Step 2: FASTGraphs Normalized. The second valuation step is to compare Texas Instruments’ current P/E to its own long-term average P/E. This gives us a valuation estimate based on the stock’s own long-term valuation instead of the market’s long-term valuation that was used in Step 1.
This changes the picture, because TXN’s 5-year average P/E valuation of 19.8 (circled) is higher than the market’s historic average of 15 used in the first step.
Using the same calculation methods as above, we get the following results for TXN’s valuation. For the valuation ratio: 16.6 / 19.8 = 0.84, meaning TXN is 16% undervalued. For the fair price: $92 / 0.84 = $110.
Step 3: Morningstar Star Rating. Morningstar approaches valuation differently. They ignore P/E ratios and instead use a discounted cash flow (DCF) model for valuation. Many investors consider DCF to be the best method of assessing stock valuations.
Morningstar’s approach is comprehensive and detailed. They make a detailed projection of all the company’s future profits. The sum of all those profits is discounted back to the present to reflect the time value of money. The resulting net present value of all future earnings is considered to be the fair price for the stock today.
Morningstar gives TXN 4 stars on their 5-star scale, meaning that they consider the stock to be undervalued.
More specifically, Morningstar calculates that Texas Instruments is selling at a 13% discount, and that it has a fair price of $106. Although Morningstar’s fair price of $106 was originally calculated in July, they stated that they are sticking with it after TXN’s 3rd-quarter earnings report a few days ago.
Step 4: Current Yield vs. Historical Yield. My last step is to compare the stock’s current yield to its historical yield.
This way of estimating fair value is based on the idea that if a stock’s yield is higher than usual, it may indicate that its price is undervalued (and vice-versa).
Texas Instruments’ 5-year average yield is 2.5%, while its current yield is 3.3%. Current yield higher than historical average suggests undervaluation.
Again, we use a ratio to compute the degree of undervaluation: 2.5% / 3.3% = 0.76, or 24% undervalued. In this method, I cut off valuation gaps at 20%, because this is an indirect way to measure valuation.
So using a valuation ratio of 0.80, TXN’s fair price computes to $92 / 0.80 = $115.
Now let’s average the 4 valuation methods.
Thus, I conclude that Texas Instruments is priced at a discount, available at a 12% undervaluation to its intrinsic value.
For a couple of other points of comparison:
• CFRA has a 12-month price target of $103.
• Jason Feiber recently made Texas Instruments his Undervalued Dividend Growth Stock of the Week. He calculated a fair price of $118.
Beta measures a stock’s price volatility relative to the S&P 500. I like to own stocks with low volatility for 2 reasons:
• They present fewer occasions to react emotionally to rapid price changes like sudden price drops that can induce a sense of fear.
• There is industry research that suggests that low-volatility stocks outperform the market over long time periods.
Texas Instruments has a higher-than-average 5-year beta of 1.2 compared to the market as a whole (defined as 1.0). That means that its price has been 20% more volatile than the index. This is a negative factor.
Here is what that extra price volatility has looked like over the past 5 years. You can see that TXN’s price has had many more ups and downs than SPY (an ETF that tracks the S&P 500), but the overall outcome has been favorable to TXN.
The steep drop at the end of this chart is somewhat the result of TXN’s recent 3rd-quarter earnings report. The report contained softened guidance for demand going forward, which many investors interpreted as the result of the trade “war” with China. TXN sells a lot of its products into China.
The upside of the drop, of course, is that it improved TXN’s valuation and yield significantly. Morningstar had this to say after TXN’s report:
We see the recent sell-off in [semiconductors] as the start of an attractive margin of safety for long-term investors as moaty companies, such as [TXN], know how to weather the upcoming industry storms.
In their most recent report on Texas Instruments, CFRA shows the recommendations of 32 analysts who cover the company. Their average recommendation is 3.8 on a scale of 5, where 5 means “buy” and 3 means “hold.” The rating of 3.8 translates to “buy/hold.” This is a slight positive factor.
What’s the Bottom Line on Texas Instruments?
Here are Texas Instruments’ positives:
• Very good dividend payout record: Its yield of 3.1% is higher than it’s been in the past 5 years, and that is combined with a fast growth rate, including 24% just announced.
• Strong Dividend Safety grade of 95/100 from Simply Safe Dividends.
• Analog chips are essential to electronic equipment. Company has broad product line and business relationships with a wide range of customers. Clear growth strategy focused on 2 product lines and 2 primary markets. Riding secular trend toward more automation and more smart products (“Internet of Things”).
• Wide Moat rating from Morningstar, best Safety rating from Value Line.
• Attractive financials, including low debt, outstanding profitability, and high cash-conversion ratio. Best A++ Financial rating from Value Line.
• Stock is around 12% undervalued.
• Management has stated a commitment to both the company’s dividend growth and repurchasing shares.
• Long-term declining share count, with more buybacks authorized.
And here are Texas Instruments’ drawbacks:
• It is in a cyclical industry (semiconductors).
• It may be facing softening demand, especially from China.
• High-beta stock, more variable than general market.
Overall, I see Texas Instruments as a very attractive investment opportunity at this time. Its good yield (3.3%) combined with its fast growth rate is an unusual combination.
Assuming that the basic factors stay about where they are, I will strongly consider TXN as a candidate for the next dividend reinvestment in my Dividend Growth Portfolio later in the year.
That said, this is not a recommendation to buy, hold, or sell Texas Instruments. Any investment requires your own due diligence. Think not only about any company’s quality, dividend resume, and business prospects, but also about how and whether it fits your personal financial goals.
— Dave Van Knapp