Investors are always looking for stocks that can produce solid gains year in and year out. Texas Instruments (TXN +0.90%) has recently become such a stock, as its shares have been moving higher with virtually no interruption for about two years, giving investors more than double the gains they would have enjoyed from an S&P 500-tracking index fund:
TXN Total Return Price data by YCharts
We recently examined several reasons why these gains might continue, but there are two sides to every investing story, and it's important to consider the risks looming in TI's future before adding its shares to your portfolio -- or keeping them around if you've already bought in. Let's dig deeper today to find three reasons why TI's days of growth might be over. They may not ultimately outweigh TI's positives, but we should still take a closer look nonetheless.
TI is at the high end of its valuation range
TI's fundamentals, as we explored earlier, are strong -- but that doesn't mean it's still a good value buy. Its P/E ratio is 50% higher than it was at the start of 2012, 23% higher than its five-year average P/E of 18.8, and 26% higher than its 10-year average P/E of 18.4. Over the past decade, TI's P/E has tended to oscillate around 18, with lows typically coinciding with surges in earnings:
TXN EPS Diluted (TTM) data by YCharts
TI's free cash flow, which is stronger than its earnings, results in a more reasonable price-to-free-cash-flow ratio of 16.6, but this ratio is also at the high end of its five-year range after storming back from lows near the single digits just two years ago:
TXN Free Cash Flow (TTM) data by YCharts
Large, well-established companies with well-known market opportunities tend to revert to their valuation means over time, and if their valuations endure a prolonged slide, they can easily slip below ratio averages before recovering again. TI is hardly in the nosebleed-valuation territory occupied by some more recent Silicon Valley market entrants, but that doesn't mean it's not susceptible to slipping back to lower valuations if the market's sentiment shifts.
The analog chip market is barely growing
We've already covered TI's leadership in analog chips, and this segment has become very important to TI's overall growth prospects, as it's responsible for 61% of the company's revenue and about 70% of its operating profit so far this year. But unlike other segments of the semiconductor world, the analog chip market has barely grown at all in recent years.
From 2010 through 2013, TI used analyst reports to estimate that the global analog chip market shrank by $2 billion in nominal terms. This market will return to growth in 2014, according to technology research firm IC Insights, but not by much -- this summer, the firm predicted that worldwide analog chip revenues would reach $43.2 billion this year. IC Insights' models also projected that the analog market reached $42 billion in global sales last year, which runs slightly ahead of TI's estimates. By 2017, IC Insights believes that total analog revenue may hit $49.5 billion, which works out to 2.4% in annualized growth from 2010 through 2017. After accounting for inflation, analog chip sales may not even grow at all.
TI believes that it can continue to gain market share in analog, and the company has already expanded its share from 13% in 2009 to 18% last year. Continued outperformance relative to other analog players will make this concern more or less irrelevant, but TI will have to gain significant share year after year in what's expected to be a flattish market in order to maintain its top- and bottom-line growth rates. TI's share of the analog market stayed the same from 2012 through 2013, so investors will need to watch closely for any news of growth to overcome stagnation concerns.
TI has been spending less and less on R&D
Dominance in a stagnant sector might not be so bad if TI were pushing itself hard in new directions, and it has touted its Internet of Things offerings as its next big area of growth. But over the past decade, TI's commitment to discovering these new opportunities through R&D has been trending in the wrong direction:
TXN Research and Development Expense (TTM) data by YCharts
Today, the company's R&D spending is more than 25% lower than it was 10 years ago, both in nominal terms and as a percentage of revenue. As a result, TI now sports one of the lowest R&D ratios of any major chip-maker on the market:
Source: Morningstar.
In fact, the only large-scale chip-maker that seems to boast a lower R&D ratio than TI is Taiwan Semiconductor (TSM 0.84%), and that's probably because it's a foundry and doesn't develop its own chip designs. A few rare tech companies can get away with lower-than-average R&D if they're highly focused companies with huge revenue streams -- Apple (AAPL +2.08%) famously spends only about 3% of its revenue on R&D, but Apple also happens to make more money than any other American tech company, and you can tick off its major products on the fingers of one hand.
TI, on the other hand, boasted "more than 100,000 orderable parts" on its latest 10-K, and many of these are largely undifferentiated commodities in competitive markets. In other words, every edge matters. While TI may be able to sustain that edge with a lower R&D spend than many of its peers, the long-term decline in that spending should be of at least some concern to investors.
Three good reasons?
TI has been a solid choice for value investors looking for good dividend payouts over the past few years. However, the gap between value and value trap may not be as wide as you think, and TI's focus on a segment that's barely grown could easily come back to haunt it if its low R&D spending causes it to fall behind on innovation. Investors aren't worried about that today, but they may need to pay closer attention to these challenges in the future. The health of their portfolio might come to depend on it.
