Dividend investing may seem easy from the outside, but it's not. Looking for a large payout? You'll likely find it in a mature company that won't grow much. How about a really high dividend yield? That could be a sign of trouble, foreshadowing a potential cut. Meanwhile, compelling growth companies in great long-term industries often trade at nosebleed valuations with low dividend payments, limiting your upside.

However, Texas Instruments (TXN 0.96%) appears to be the rare stock that has it all: a solid 2.65% yield, good growth prospects, and a long runway for dividend increases well into the future. Here's how this 90-year-old blue chip works its magic.

A person with their eyes closed and a thought cloud containing cash emerging from their head.

There's no better dividend growth stock than Texas Instruments. Image source: Getty Images.

What Texas Instruments does

You might know Texas Instruments from its calculators, but those aren't its main products by a long shot. Analog chips constituted 71% of TI's 2019 revenue. These small circuits process real-world inputs and convert them into digital signals. Another 20% of TI's revenue last year came from embedded processors, which are essentially tiny computers that do specific tasks inside of many types of devices, from household appliances and automobiles to industrial equipment. The remaining 9% came from digital light processing products and calculators.

Analog chips and embedded processors are basic building blocks in just about every electronic device. While hot new semiconductor designs in AI or 5G get a lot of press, analog and embedded chips are safe bets to grow well into the future as the world becomes more digitized and automated.

Products alone aren't why Texas Instruments is a perfect dividend stock. Rather, TI's dividend nirvana results from two main factors: The deep competitive advantages it has built over time and management's terrific record on capital allocation.

Texas Instruments' four competitive advantages

TI's management actually describes its competitive advantages in a white paper on its investor relations website. They are:

  1. Leading manufacturing capabilities on 300mm wafers, giving TI a cost advantage over rivals that mostly manufacture 200mm wafers.
  2. Industry-leading scale and breadth across 80,000 (and counting) products, making TI a primary go-to for many different industries.
  3. A large and deep sales channel with intimate knowledge of customers' design plans.
  4. Diverse products with long product life cycles, in which every design win lasts for years or even decades.

All of these advantages add up to a formidable economic moat based on scale advantages and a lower cost base, allowing Texas Instruments to produce affordable chips while also making hefty margins.

And best-in-class capital allocation to boot

Adding to these competitive advantages is a culture of disciplined capital allocation that would make Warren Buffett proud. In fact, every year, the company holds an investor presentation during which management grades itself on its capital allocation goal checklist for the year, with the central aim of growing free cash flow per share. That should be music to dividend investors' ears, as sustainable dividends per share can only come from a company's free cash flow.

Capital allocation includes not only continued investments in 300mm manufacturing, but also shifting research and development investments to growth opportunities with the highest returns. For instance, over the past decade, TI has redirected investments from wireless chips and personal electronics to the steadily growing analog and embedded segments. Within these segments, the company has concentrated on the industrial and automotive end markets, where semiconductor content per vehicle or per factory is set to grow robustly over time.

Over the past decade, TI's portfolio has changed significantly. Embedded and analog chips have gone from about 50% of the portfolio in 2008 to 90% of the portfolio today. Meanwhile, automotive and industrial chips have climbed from about 42% of revenue in 2013 to 57% of revenue today, resulting in a much more profitable business relative to a decade ago. 

Important numbers don't lie

That portfolio transformation has allowed Texas Instruments to post some truly eye-popping financial results. Last year, Texas Instruments earned a 40% free cash flow margin -- good for the 92nd percentile of companies in the S&P 500 -- and a 25% return on invested capital, which was in the 95th percentile.

Those profits have allowed TI to return vast amounts of cash to shareholders in the form of share repurchases and dividends. Since 2004, TI has bought back 46% of its stock and has raised its annual dividend per share from $0.09 to $3.60. That's an incredible 40x increase in dividends per share.  Just last month, TI raised its dividend again by 13% to $4.08 annualized, representing 45x its 2004 payout.

While I wouldn't expect TI's dividend to go up another 45x in the next 10 years, Texas Instruments still has a bright future in a world of "connected everything" and increasing automation. Even after the recent hike, TI's dividend is still just 65% of trailing net income and an even lower percentage of free cash flow, even in a terrible year that included an industrial recession and COVID-19.

Dividend investors would be hard-pressed to find a better combination of yield, safety, and growth anywhere else in the market.