Texas Instruments Inc. (TXN) reported second quarter earnings that were up 3.8% sequentially and down 9.8% year over year, exceeding the Zacks Consensus estimate by 5 cents, or 9.4%.
Estimates have been moving downward since TI lowered its guidance, but actual results were within the original guidance range.
Investor response was lukewarm, as the guidance disappointed.
Revenue
TI reported revenue of $3.46 billion, which was up 1.9% sequentially, down 1.1% year over year and at the lower end of the originally guided range of$3.41 billion and $3.69 billion (up 4.7% sequentially at the mid-point). On June 8, TI lowered guidance to between $3.36 billion and $3.50 billion (up 1.1% sequentially at the mid-point), in response to weaker demand from a single wireless customer, possibly Nokia Corp (NOK).
As expected, revenue from Japan was weak. The net result was a top line that was more or less in line with the Zacks Consensus Estimate of $3.43 billion.
TI stated that distributor inventory levels remained steady, with the double-digit decline in Japanese resales offset by double-digit increase in resales in other parts of Asia and the Americas, while remaining flat in Europe.
End Market Summary
The wireless infrastructure market is currently being driven by data capacity expansion in North America, as well as some moderate growth in Europe. TI expects China and India to pick up in the second half of the year, driven by 3G rollouts in both regions.
Additionally, broader market trends, such as increasing data traffic and capacity expansions all over the world, as well as an increased share of the bill of materials (“BOM”) at customers through its integrated offerings will drive growth in this market. The smartphone market on the other hand remains particularly strong, with TI’s OMAP and connectivity products driving growth for the company.
The industrial market was steady in the last quarter, with analog, particularly catalog products and embedded processing leading the way.
The automotive market, while growing slightly, showed signs of softness, related to the broader economy, consumer buying power as well as a shortage in supply related to supply chain issues in Japan. Many of the automotive semiconductors are manufactured at Japanese fabs and a significant percentage of automobile manufacturing is also carried out in the region. The Japan impact may continue in the near term.
Computing and consumer markets, particularly in Asia, look softer than usual, according to TI.
Segment Revenue
TI took share in the analog and embedded business segments, both of which grew from the previous and year-ago quarters.
Wireless was impacted by lower baseband sales, which dropped to 7% of revenue in the last quarter compared to 10% and 12%, respectively in the previous and year-ago quarters.
The Analog segment was up 3.4% sequentially, Embedded Processing up 11.8%, Wireless down 15.2% and Other up 7.7%. The baseband business declined 31.7% sequentially and 45.2% from the year-ago quarter.
The three major product lines within TI’s Analog business (roughly 40-30-30 mix) are high volume analog and logic (HVAL), high-performance analog (HPA) and power management. The increase in HPA (used in computing and consumer devices) and power management was driven by catalog products in the last quarter.
Second half comparisons will benefit from the inclusion of National Semiconductor, which will further boost TI’s catalog offerings. The HVAL product line (industrial markets) on the other hand took a slight hit, coming in flat on both sequential and year-over-year bases, as HVAL was impacted by the earthquake damage at TI’s Miho facility in Japan.
With catalog products – mainly Digital Signal Processors (DSPs) and microcontrollers (MCUs) – strengthening sequentially due to share gains, the Embedded Processing segment also benefited from the wireless infrastructure buildouts in North America. Data demand in North America continues to accelerate due to the proliferation of tablets and smartphones in the region.
TI’s focus in the wireless segment is on the proprietary OMAP and connectivity products. Management stated that OMAP and connectivity together grew 2% sequentially and 6% from last year. However, the decline in the baseband business, which TI is phasing out hurt both sequential and year-over-year comparisons.
The bulk of the baseband revenue comes from a single customer, Nokia and TI is committed to meeting Nokia’s requirements until other vendors, such as Broadcom Corp (BRCM) are able to take over. However, TI remains on track to phase out this lower-margin business by 2012.
The Other segment was down 3.4% from last year, impacted by softness in DLP (affected by the Japan crisis), lower royalties and the sale of a cable modem product line in the fourth quarter of 2007. The sequential comparison was positively impacted by seasonal strength in calculators.
Orders
Net product orders were $3.60 billion in the last quarter, flat sequentially and down 3.5% year over year. We estimate that backlog was up 7.3% sequentially, even as turns sales declined 7.5%. Second quarter orders were softer than satisfactory, considering the usual sales pickup in the second half. Additionally, turns sales were down quite a bit, despite the linearity of orders. Therefore demand looks sluggish.
Margins
TI’s gross margin was 50.7%, down 25 basis points (bps) sequentially and 348 bps from the year-ago quarter. The sharp decline from both the previous and year-ago quarters was on account of lower utilization rates and higher earthquake-related costs (underutilization of facilities, inventories scrapped, recovery teams employed and other one-time costs).
The gross margin is likely to remain lower than the mid-fifties percentage range, until revenues went back to the levels they were at last year. Some of the new designs (analog and embedded processing products) getting into volume production should also help the gross margin move up toward the long term target of 55%.
Operating expenses of $835 million were higher than the previous quarter’s $818 million. The operating margin was 26.5%, down 28 bps sequentially and 560 bps from the year-ago quarter. The sequential decline was due to higher R&D as a percentage of sales, offset by decline in other expenses. The significant decline from the year-ago quarter was mostly on account of the weaker gross margin, with the balance coming evenly from higher R&D and SG&A expenses as a percentage of sales.
The Analog, Embedded Processing, Wireless and Other segments generated operating margins of 28.1% (up 87 bps sequentially), 23.7% (up 452 bps), 14.7% (down 673 bps) and 33.0% (down 418 bps), respectively.
Net Income
The pro forma net income was $685 million, or a 19.8% net income margin compared to $668 million, or 19.7% in the previous quarter and $786 million, or 22.5% in the prior-year quarter. The fully diluted pro forma earnings per share were 58 cents compared to 56 cents in the previous quarter and 64 cents in the June quarter of last year. The pro forma calculations for the last quarter exclude the impact of acquisition-related charges.
On a fully diluted GAAP basis, the company recorded a net profit of $672 million, or 57 cents a share compared to a net profit of $666 million, or 56 cents per share in the previous quarter and a net profit of $769 million (63 cents per share) in the comparable prior-year quarter.
Balance Sheet
Working capital management continued to improve in the last quarter. While inventories increased 5.0% to $1.76 billion, this resulted in inventory turns of 3.9X, down from 4.0X in the previous quarter. Days sales outstanding (DSOs) went up from 42 to around 44.
TI generated $631 million in cash from operations, spending $276 million on capex, $452 million on share repurchases and $150 million on cash dividends. The company had $3.5 billion in long-term debt and net under-funded retirement plans of $507 million.
Guidance
TI provided guidance for the third quarter and some limited expectations for fiscal year 2011.
Accordingly, TI expects second quarter revenue to range between $3.4 billion and $3.7 billion (up 1.7% sequentially at the mid-point). The 5-year average sequential increase in the June quarter is 8.1%.
The below-seasonal performance is likely on account of continued impact of the Japan crisis that impacts the industrial and automotive businesses, soft consumer consumer and computing markets this year, as well as the continued planned phase out of the wireless baseband business. The EPS for the quarter is expected to be $0.55 to $0.65, the mid-point below the Zacks Consensus Estimate of $0.64.
For 2011, TI expects R&D expenses of $1.7 billion (unchanged), capex of 0.9 billion (unchanged), depreciation of $0.9 billion (unchanged) and an annual effective tax rate of 27% (down from previous estimate of 28%).
Our Take
Texas Instruments is prudently investing its R&D dollars into several high-margin, high-growth areas of the analog, embedded processing and wireless markets, which has led to important design wins.
We remain optimistic about TI’s compelling product line, the increased differentiation in its business and lower-cost 300mm capacity that should in combination drive earnings ex-Japan.
TI will also benefit from its proposed acquisition of National Semiconductor (NSM), if regulatory approval for the transaction is received.
The communications infrastructure market is likely to remain strong, as the strength in North America is supplemented by the second half pickup in China and India. Auto and industrial will both remain challenging at least through 2011, given concerns related to Japan.
TI stated that it was able to transfer 80% of production to unaffected facilities; however, some inventory needed to be scrapped. The concerns in Japan are supply-related more than demand related and TI’s customers are seeing problems in the supply chain.
The phasing out of the low-margin baseband business also remains on track and should generate some margin expansion every quarter. However, Japan will more than offset this benefit. Additionally, TI may have to work down/write off the inventory it accumulated as a result of the baseband sales falling below expectations in the last quarter.
We are also concerned that the additional capacity would also increase fixed costs. TI already saw lower utilization rates in the last quarter and if the facilities remain underutilized, there will be downward pressure on earnings.
We anticipate downward revision to estimates following the results, which could drive down share prices. We therefore have a short term Strong Sell recommendation (Zacks #5 Rank) on TI shares. We note that other analog players, such as Linear Technology Corp (LLTC) and Maxim Integrated Products (MXIM) and Analog Devices (ADI) carry a Zacks #3 Rank (short-term Hold recommendation) because they have lower exposure to the Japanese crisis.
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