Among semiconductor stocks, Texas Instruments (TXN +0.09%) has typically been seen as a safe-haven blue chip stock.
After all, TI s has the largest scale and lowest-cost manufacturing in analog and embedded chips, the small electrical components that go into just about every machine across just about every industry. TI's massive scale, low-cost 300mm manufacturing, and smart capital allocation had allowed the company to grow free cash flow at an 11% annualized rate since 2004, making for a stunning 25% annualized dividend growth. For context, that means TI's dividend has grown 55.7 times over during the past 18 years.
That's why it was shocking to see the semiconductor giant's free cash flow dip into negative territory in the second quarter, breaking an impressive 19-year streak of positive cash flow quarters.
While TI's stock dipped after the earnings release, it still trades around 20 times earnings, which is not super-cheap. But if investors get nervous and dump the stock in the quarters ahead, it would be a huge opportunity. Here's why.
NASDAQ: TXN
Key Data Points
From raining dollars to plunging cash flows
In the second quarter, TI beat analyst expectations for both revenue and earnings per share, but revenue still fell 13.1% year over year, and earnings per share were down nearly 24%.
Even though TI has been a great dividend growth stock, it does endure the ups and downs of the chip industry along the way. So it wasn't necessarily shocking to see revenue fall year over year. Almost every semiconductor end market is currently in a downturn coming off the pandemic, with the exception of automotive chips and artificial-intelligence accelerators.
Still, what was surprising was to see free cash flow nosedive to a $47 million deficit. That's the first negative cash flow quarter since TI had an $8 million negative free cash flow quarter in the first quarter of 2004.
TXN Free Cash Flow (Quarterly) data by YCharts
So what's going on? A deterioration in TI's fundamentals? Or just an anomaly?
A multiyear strategic shift is under way
Although there is a soft market today, analog and embedded chips were in a severe shortage immediately after the pandemic. That's when demand soared as supply was constrained, especially when having to ship chips from overseas.
TI was one of the bottlenecks there, even though it has a lot of capacity in the United States. But taking a long-term view, management is now embarking on two strategic shifts at once.
First, TI is selling more of its chips directly to customers, rather than through distributors. In 2019, just 35% of TI's revenue came from direct sales to customers. But by 2022, that percentage had gone to 70%, and it continues to climb. While a long-term positive for customer relationships and margins, it's actually a double negative today for financials. For one thing, TI is no longer filling distributor inventory, which would result in revenue today. Second, it's negative for cash flow, since that extra inventory is going to its own balance sheet.
TI is also investing massively in more capacity in the U.S., a multiyear project that management says will support demand for the next 10 to 15 years. Management now projects $5 billion in average capital expenditures per year through 2026, during which time it will finish equipment installation at two fabrication plants in Richardson, Texas, and Lehi, Utah, while constructing two more fabs in Sherman, Texas. And two more fabs, for a total of four, will eventually be built in Sherman by 2030. These investments will increase the percentage of TI's chips that come from internal fabs, more than double the percentage of chips on low-cost 300mm wafers, and increase the percentage of chips internally assembled and tested.
The result of those investments would be lower costs, closer customer relationships, and ultimately higher margins. But in the near term, these huge investments are eating up cash flow. For reference, in 2019 and 2020, TI spent less than $1 billion per year in capital expenditures. Since these investments are just kicking in while revenue is going through a soft patch, cash flow has evaporated:
|
Metric |
Q2 2022 |
Q2 2023 |
|---|---|---|
|
Cash flows from inventories |
($139) |
($441) |
|
Capital expenditures |
($597) |
($1,446) |
|
Free cash flow |
$1,171 |
($47) |
Data source: Texas Instruments Q2 earnings release. Amounts in millions.
If Texas Instruments sells off, it could be a long-term opportunity
It's quite possible that in the near term, TI stock won't perform well, as the evaporation of free cash flow could lead impatient investors to sell. After all, TI probably won't be able to buy back as much stock or raise its dividend as aggressively as it has in recent years.
However, if that happens, it could be a great opportunity. TI's management remains convinced of strong demand for analog and embedded chips through the end of the decade, despite near-term headwinds. If that does happen, then after 2026, TI would theoretically see higher margins on more revenue, just as its capital expenditures on the fab buildout would be moderating. That could lead to a huge jump in cash flow -- that is, if demand grows according to plan.
Therefore, while TI may not be a great stock to own in the near term, if the shares fall or lag the sector over the next year or two, it could be a terrific opportunity for long-term investors.
In other words, put TI on your watchlist, and get ready to pounce.
