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Is Texas Instruments Incorporated Due for a Big Increase In Cash Flow?

Texas Instruments (NASDAQ: TXN  ) has a long history of making semiconductors for all kinds of applications, ranging from calculators to missile-guidance systems. More recently, the company has undergone a restructuring and is focusing on two main segments: analog and embedded processing. 

Of the two segments, analog is currently the bigger, more established business. Thanks to the acquisition of National Semiconductor and its portfolio of 12,000 analog patents in 2011, Texas Instruments is now ranked No. 1 in this $39 billion industry. In 2013, the company's revenue from analog was $7.14 billion, with a healthy operating margin of 25.8%.

The developing embedded segment
Embedded processing is the more interesting case. The market opportunity is already large -- in 2012, Texas Instruments estimated it to be worth $12 billion. More importantly, this is a market that is set to explode in the coming years. 

The reason is the ever-increasing penetration of electronics into every aspect of our world. From automated cars to intelligent cities and smart appliances -- the Internet of Things -- the emerging network of devices will expand to 26 billion units by 2020, according to Gartner.

Texas Instruments has only seen limited profits from this change. In 2013, revenue from embedded was $2.45 billion, but the operating margin was only 7.6%. As a consequence, embedded processing contributed just 6.5% to the company's total operating income, which encompasses a third category that includes revenue from patents, calculators, and legacy products.

However, the operating margin for embedded will improve. Texas Instruments' embedded market share is low and the competitors are fragmented. As revenue increases, so will the operating margin, as the substantial existing investments in facilities and R&D begin to pay off. Management believes that an operating margin of 30% is a reasonable target in its embedded segment.

An opportunity for investors
How much would this be worth to investors? Texas Instruments has a policy of returning all free cash flow -- less debt payments and plus the proceeds of employee stock options -- to investors through dividends and stock repurchases. In the 12 months ending in March 2013, this totaled $4.2 billion, with free cash flow making up 74% of this amount.

A back-of-the-envelope calculation using the same numbers that the company provided for 2013 and a 30% operating margin for embedded gives an operating income of $3.4 billion. Continuing with the same costs and adjustments, the resulting free cash flow would have been $3.5 billion, an 18.5% increase over the actual 2013 results.

How close is this figure to something that Texas Instruments can actually achieve? Costs are likely to grow at a low rate due to the company's recent restructuring, as well due to the already-mentioned investments in facilities and R&D. On the other hand, to get to the 30% operating margin, revenue in the embedded market will clearly need to increase significantly, so the 18.5% growth figure might actually be lower.

Looking forward 
So, what are the prospects for embedded processing revenue growth? Management named automotive as a definite driver of growth for the future. Indeed, this is an attitude shared across the semiconductor industry. Jen-Hsun Huang, CEO at graphics and mobile chipmaker Nvidia, recently said that "the car industry is really going through a renaissance," comparable to the shift from phones to smartphones.

A second growth driver is chips for communications equipment like base stations, which management said was "clearly a lift" for Texas Instruments in the first quarter of 2014. Looking down the line, demand in this sector will also increase. Analysts at Mobile Experts project that semiconductors driving small-cell wireless base-stations will grow 80% in 2015, and will reach $10 billion in revenue by 2018.

In conclusion
Clearly, the growth in embedded processing is a great opportunity, and one that Texas Instruments is well-positioned to capitalize on. The time frame for increased revenue and improved operating margin in Texas Instruments' embedded processing segment is probably at least several years. Nonetheless, with the company's pledge to return all free cash flow to investors, Texas Instruments looks like a good long-term value play.

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