Texas Instruments: Short-Term Headwinds Produce Long-Term Opportunity – Texas Instruments Incorporated (NASDAQ:TXN)
Much of our time recently has been spent focusing on companies poised to thrive throughout the pandemic and the economic disruption that is occurring as a result of isolation actions taken to mitigate the spread of coronavirus. However, we don’t want to ignore companies that may see short-term headwinds, but are still strong companies that will be “ok” in the long run. The short-term headwinds can actually create a buying opportunity that investors can profit from in the years following the eventual passing of coronavirus. We want to update our coverage on Texas Instruments Incorporated (TXN). The pandemic appears poised to disrupt certain end markets that Texas Instruments holds high exposure to. While this will impact its operating results, the company remains fundamentally strong. Potential weakness over the next 12 months would represent strong opportunities to build out long-term holdings.
End Market Exposure Will Disrupt Operating Results
We suspect severe disruption to the company’s operating results as a result of the coronavirus pandemic, and the actions taken to contain it (economic shut-downs). While economic disruption will certainly slow industrial activity, we see that many industrial businesses are at least maintaining operations to some capacity due to being classified as “essential businesses” in many areas.
Our concerns are more centered around the end markets that are driven by discretionary consumer spending, namely automotive and personal electronics. These two categories contribute a total of 43% of total revenues for Texas Instruments.
Source: Texas Instruments Incorporated
There are some projections that the continued lock-down mandates being put in place could drive unemployment in the US to as high as 32%, a staggering figure. With such a strain on consumer spending, we expect demand to severely contract in these higher-dollar, non-essential spend categories. For example, we saw massive declines in automotive sales in China during the height of the outbreak there. This trend will clearly hit the US markets, and many automotive factories have already shut down.
In time we will see the company quantify the impact of COVID-19 on its bottom line, but we expect the contraction to be noteworthy. This will strain earnings for 2020, and have some short-term impacts on how Texas Instruments operates. We don’t anticipate a dividend freeze/cut, but expect its next increase to be minimal (versus a three-year CAGR of 25.1%). We also anticipate a reduction to guidance, and a slow-down in stock buybacks. Anything less drastic would be seen as a “win” in our view.
Safety Via Strong Fundamentals
These measures will be taken to preserve cash flow, but investors should not interpret these actions as a sign of fundamental weakness at Texas Instruments. The company will see a demand shock to its business, but the model itself is very robust.
This stems from Texas Instruments’ ability to generate large streams of cash flow. Technological advancements (300mm technology) have produced margin expansion, and enabled the company to convert revenue to cash flow at an efficient rate of 40.34%. The company is also quite non-capital intensive for a manufacturer, spending 3-6% of revenues on CAPEX in a given year.
The company’s steady top-line growth (10-year revenue CAGR of 3.27%) combined with strong margin expansion has drastically boosted its FCF streams. FCF has grown at a high single-digit rate over the past decade.
A demand shock for most manufacturers typically results in margin compression because profitability/unit always suffers when capacity drops (overheads are not as diluted). Fortunately, the strength of the business model indicates that Texas Instruments can absorb this. This is a different type of business than an automotive manufacturer, for example. An automotive manufacturer generates much lower margins, and is much more capital-intensive than a semiconductor manufacturer.
In the event that things play out worse than anticipated, Texas Instruments has a strong balance sheet to fall back on. The company holds $2.4B in cash, almost 42% of the company’s total long-term debt. Even on a gross basis, the company’s leverage ratio is just 0.8X EBITDA. In the event that the company had to tap into its balance sheet, it would have plenty of room to do so without long-term ramifications.
And while the dividend may not see a huge increase this year, investors should know that the payout itself is very well covered. The dividend consumes just 51% of Texas Instruments’ cash flow. Combined with its total annual payout of $3.60 per share yielding 3.53%, the company’s strong dividend growth rate (21.7% CAGR over 10 years) makes it a strong dividend growth holding. The company’s dividend growth streak is currently at 16 years. This not only means that the payout has become important to management and investors alike, but that Texas Instruments was also able to manage the financial crisis in 2008-2009 without touching its dividend payout. This bodes well for the payout amid this new crisis.
Where Shares Make Sense
Shares of Texas Instruments had established strong upward momentum in early 2020, but were hit particularly hard when the bottom fell out from the market in March. Shares quickly established new 52-week lows at $93 per share, and have slightly rebounded to just under $100 since then.
If we use the company’s 2019 diluted EPS of $5.24, the stock currently trades at an earnings multiple of 19.04X. This is a 9% discount to the stock’s 10-year median P/E ratio of 20.95X. Despite the discount, we feel that the company’s expanded margins as a result of technological advancements are actually an argument for a premium to decade norms. We would build a long-term position with shares as high as 22X because of the company’s robust financials.
If we look at the company’s current yield on free cash flow, the 6.11% yield is near the highest level it has been over the past several years.
The current investing environment is quite volatile. The company’s exposure to cyclical end markets will result in some volatility in the semiconductor industry as a whole. We are just beginning to see the economic impact that coronavirus mitigation efforts are causing, so it’s very possible that things get worse from here. However, it’s also difficult to ignore such a cash-flow-rich business that has still fallen more than 22% YTD – despite a bounce off of lows. We like Texas Instruments at these levels for accumulation (for a long-term holding). However, it’s very important to recognize that we are likely not yet at a cyclical bottom – we just haven’t seen enough trickle-down impact from end markets yet. Calling a bottom, however, is a fool’s errand, which is why averaging in works so well.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.