Thursday, April 24, 2008

Analyzing TI's current quarter

This is the first of a three part series.

This post discusses Texas Instruments Incorporated (NYSE:TXN) just concluded F1Q08 quarterly results. A later follow up post will discuss TI’s product offerings and a SWOT analysis of their competitive strengths based on their technology and market strategy. Finally, I’ll discuss TI as a stock investment thesis.

In the current quarter just concluded, TI reported revenues of $3.27 billion and an EPS of $0.49. The highlight was the growth in their high-performance analog segment, with revenues up 20% year-over-year (YOY). Overall, revenues declined 8 percent sequentially primarily due to weaker sales into cell phones, especially in the high-end segment.

Expenses: R&D expenses were down 6.8% YOY, primarily due to sourcing of the digital process technologies from foundry partners.
-SG&A was up 7.4% as they have been investing in Field Applications Engineers and customer support to accelerate analog sales growth, especially in the application specific area.

Margins: Gross margins were up due to higher sales of high margin analog products.
- Management has set a long term goal of achieving gross margins of 55% and operating margins of 30%.

DSP revenues: Declined due to lower sales into cell phone applications (75% of the DSP revenue is through handsets).
- DSP security and surveillance market sales were up 63% YOY.
- Their ultra low power microcontroller product line MSP 430 should potentially deliver higher revenue growth going forward due to its prevalent use in an increasing number of new applications. (They didn’t break out the revenue component)

Analog: Their analog revenues were up 6% YOY, driven by stronger demand for high-performance analog products. 45% of their analog revenues were from the high performance analog segment, which grew 20%. This was across all major product categories: amplifiers, power management, data converters and interface. There were gains in hard disk drives, automotive as well as battery management products.

New product introductions included medical ultrasound diagnostic equipments, Class-D audio amplifiers, and a prototype cell phone based on Google’s Android using TI’s OMAP processor. TI entering the application specific space in a big way is definitely not good news for smaller players in niche analog markets.

Raw material costs: I see a risk here of high raw material costs impacting their gross margins.

Cashflow: Business is throwing off nice cash flow and rewarding patient shareholders with buybacks and dividends.

Share count: Diluted share count down 8.3% YOY (Nice!)

Auction rate securities alert! Time for the “Oops! I know what you did last summer” moment!

TI had invested approximately $1 billion in auction-rate securities, essentially student-loan pools. They could offload only $473 million, and are left with $551 million. To avoid taking a mark-to-market hit on their quarterly profit reports, they reclassified these securities from short-term to long-term investments. These will be held to maturity at their cost value, which will be checked periodically for an impairment charge. Their net income could have taken a $20 million hit had they not done this. (They’ve already recognized a $20 million impairment on their balance sheet). Assuming a worst-case situation of a 20% hair cut on the ARS securities and TI's inability to offload the remainder of the ARS, you're looking at a $100 million loss which investors should watch out for in the shareholder equity on the balance sheet. Definitely not chump change!

- Herb Greenberg had an article about this discussing a Merill Lynch report in February, which was categorically denied by TI's investor relations department as 'superficial'. I thought TI gave a very reassuring reply to this situation.

-Auction rate securities information was mentioned in the press release for the quarter, but no mention of any impairment charges. In the conference call remarks, they did disclose the impairment charge to the shareholder equity.

- I did not see a separate line item on the balance sheet for breaking this out. If you look at Palm's 10Q, they have a line item for this impairment in both the income statement and the balance sheet. (TI didn't release their 10Q yet though, so this might change.)

-While reclassification to long term debt is ok, just want to point out that Palm and MetroPCS took an income statement hit from the ARS impairment. On the other hand, TI's ARS are mostly student loans and so they really should be fine. My 2 cents: the due diligence at TI was more rigorous.

High inventory risk alert! TI reported inventories of $1.58 billion. A third of the inventory build up was related to the wireless business, due to unexpected build to plan changes (not good). Translation: A customer just backed out/delayed their order. We hope they’ll be back and not go to the second source for their supplies! In their defense, this sounds like a softness-in-the-market issue.

“As we explained in our mid-quarter update that product was already being manufactured when we received the changes so we carried more inventory of this product than we had initially expected at the end of the quarter.”

That’s about $526 million. Even a 20% inventory writedown would imply a $100 million charge: something investors should keep an eye out for. While too early to speculate, it’s important to factor in a possibility of that in your valuation models, and hence demand the appropriate risk premium for it in your DCF valuation.

(Note that two thirds of their inventory (the analog inventories) should be fine, as analog products tend to be stable with long life cycles. )

Outlook: Hold recommendation on TXN. With Nokia Corporation (NYSE:NOK) and Ericsson(ERIC) looking at second source suppliers for their chips, it’ll be difficult to model TI’s wireless revenue stream. That, coupled with the difficult macroeconomic environment, colors me cautious on their near term to intermediate term prospects. Caveat: Since analog revenues tend to be more resistant to fluctuations in the economic cycle, TI's revenue stream might be less volatile than some of the other chip vendors.

Ticker symbols mentioned : TXN, NOK, ERIC

Full Disclosure: No positions in any of the securities mentioned above. Opinions expressed are my own.