Texas Instruments' Long Run

It's been interesting following the performance of semiconductor companies this year; their results have been all over the map. If you listen to the conference call of a contract manufacturer like Celestica (NYSE:CLS) or a semiconductor equipment maker like NovellusSystems (NASDAQ:NVLS), you can almost sense the frustration with the state of the business. Then there are companies like SanDisk (NASDAQ:SNDK) that happen to be in the right place at the right time and are knocking it out of the park.

The third-quarter earnings report of Texas Instruments (NYSE:TXN) comes much closer to SanDisk than to the chip equipment makers. TI reported the strongest quarter-to-quarter growth in sales (13%) of its semiconductor products in 15 years. Sales totaled $3.59 billion for the quarter, with $631 million falling down to the net income line ($0.38 per share). Helping its results were DSP products, which are used in cell phones and the DLP products that form the guts of rear-projection TVs. DSP revenues were up 16% from the previous quarter, while DLP revenues grew by a robust 41% from depressed levels in Q2 (but were flat compared with last year's third quarter).

Despite these strong performance numbers, the stock fell more than 7.5% the day after the announcement. Among other issues, Texas Instruments is having trouble managing its inventory, which is abnormally low for this time of year. The company says it may not be able to meet demand if business remains strong approaching the holiday season. In other words, its sales may not be as high as expected. Hmm . could that be why the stock price fell?

A glance at the balance sheet shows that the finished-goods component of inventory did fall by $61 million during the quarter to $325 million, but strangely enough, the work-in-process line only rose by $19 million to $719 million. For some curious reason, the company is managing its inventory differently than last year, when finished goods stayed about flat, but work in process rose by more than 10%. If Texas Instruments is concerned about meeting demand, shouldn't it be filling the factory? Management said that manufacturing capacity was sufficient, so presumably it could have started more wafers. Strange.

Another concern of mine is the possibility of margin erosion. Texas Instruments' annual gross margins peaked in 1999 and 2000 at 48%. The gross margin was 47% for the first nine months of this year and was above 49% for the third quarter. Will business always continue to be so good that these margins never fall? Compounding my concern is the fact that many of the company's customers have deteriorating margins. For example, Nokia (NYSE:NOK), a big customer, has margins that have been declining for several years. The margin pressures are likely to extend beyond cell phones. Texas Instruments' DLP products are doing well, but new high-tech displays and projectors are facing brutal price competition; suffice to say, if you bought a new TV a year ago, you could buy a much bigger one now for the same price. Many customers have to be eyeing Texas Instruments' strong margins the way a 3-year-old eyes Halloween candy.

Despite these reservations, I think that Texas Instruments is well-positioned for the future; it should be commended for its strong performance. Nevertheless, I am going to hold off on buying these shares until either the price drops further or I can convince myself that this company is not closer to a cyclical peak than a trough.

For related high-tech Foolishness:

• No Surprise at SanDisk
• Novellus Swings and Misses
• UMC for You and Me?

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Dan Bloom doesn't own shares of any stock mentioned in this article. He welcomes your feedback at [email protected].