Texas Instruments' Transformation in Full Swing

We were pleased to get a better understanding of the firm's transition to 300-millimeter wafer manufacturing capacity. By shifting to 300mm wafer production (and especially by doing so with used manufacturing equipment), TI expects a 40% reduction in chip manufacturing costs. After factoring in all other assembly and test costs associated with analog production, TI demonstrated that a $1 chip that earned 60% gross margins on a 200mm wafer can now be built at a 68% gross margin on a 300mm wafer. We've anticipated gross margin expansion for quite some time as the firm focuses on 300mm analog production, but the disclosure that TI can fulfill another $8 billion of orders with its factories today shows that its margin expansion could have a long runway and our margin assumptions could be conservative. More important, TI doesn't plan on using this cost advantage to wage a price war, which is usually a losing strategy in analog as chip performance matters more than price, but will instead let these savings fall to the bottom line. Furthermore, TI provided a clear goal that it can expand free cash flow margin to 30% of revenue on a sustainable basis during "good" market conditions, versus 27% earned in 2014, an improvement from its prior target of 20%-30% free cash flow margins, depending on industry cycles.

Given the significant unused manufacturing capacity today, TI reiterated its view that it should not only see both solid revenue growth at 2 times GDP, but also consistent gross margin expansion as its factories take on many new orders in the years ahead. Given our assumption of a low ongoing target of capital expenditures at only 4% of sales going forward, as well as steady share repurchases over time, we expect healthy incremental free cash flow generation in the years ahead. Just as important, TI still expects to distribute 100% of free cash flow to shareholders (including proceeds from stock exercises and excluding debt repayments) over time. We again view each of these targets as reasonable and within the range of our prior expectations, and although we do expect volatility from time to time, we appreciate that management laid out this roadmap. When we look out over the next five years, we don't think the bar is set too high.

Focus on Analog Is Paying Off Texas Instruments is the world's largest analog chipmaker and a key supplier of embedded chips into a host of applications. Although TI has walked away from the wireless chip business, which weighed on revenue growth in recent years, we're much more encouraged by its transformation into a higher-margin company.

TI has a leading share of the fragmented yet lucrative analog chip market. Analog chips are used to convert real-world signals, such as sound and temperature, into digital signals that can be processed. We give TI a wide Morningstar Economic Moat Rating for its proprietary analog designs; since analog chips are neither particularly expensive, nor do they require cutting-edge manufacturing techniques, high-quality analog chipmakers tend to be able to maintain healthy pricing yet generate strong profitability over time. Additionally, TI's size allows the firm to compete across a broader spectrum of industries, without its fortunes tied to a single customer or end market.

TI has renewed its focus on its analog chip business, highlighted by the large acquisition of National Semiconductor and shrewd purchases of cutting-edge manufacturing equipment from bankrupt chipmakers for pennies on the dollar. The expansion should allow TI to attract additional high-volume analog chip orders, all while taking on relatively lower fixed costs that should lead to improving gross margins. TI's embedded chip business may also see healthy growth over the next few years, especially if the nascent Internet of Things trend takes off, as TI's microcontrollers, Wi-Fi, and Bluetooth chips could be key components in a massive array of new electronics devices with improved connectivity and processing power. Finally, we like that TI exited the mobile processor marketplace, given the need for hefty ongoing research and development costs in order to keep pace with industry leaders like Qualcomm.

Exiting Wireless Widens Moat The exit from wireless chips has made the company a more stable and more profitable chipmaker. As TI focuses on analog and embedded products while significantly diversifying its customer base, we have greater confidence that the firm is more likely than not to generate excess returns on capital over the next 20 years.

Moats for analog chipmakers tend to come from the strength of proprietary chip designs, as well as switching costs that make it difficult to swap out analog chips for competing offerings once they are designed into a given electronic device. We believe analog engineering talent is difficult to come by, as greater emphasis is placed on digital chip improvements, and it often takes years to train up-and-coming analog engineers in the intricacies of chip designs. Thus, it is extremely difficult for startups to replicate the many years of analog expertise held by incumbents. Leading analog chipmakers also face stringent quality requirements in some end markets, such as the automotive industry, for example, where defects can only be tolerated as low as one part per million. Although the analog chip market is quite fragmented, it would be difficult for any startup to achieve this level of quality while still being to satisfy high-volume production. Furthermore, analog chips tend to make up only a small portion of a product's bill of materials, so purchasing decisions tend to be based on performance rather than price, helping TI retain pricing power. Automotive, industrial, and communications infrastructure customers in particular are unlikely to choose an inferior chip in order to save $0.50 on the cost of a piece of equipment worth tens of thousands of dollars.

We see other characteristics of the analog chip market that give us greater confidence that TI is more likely than not to generate excess returns on capital for the next 20 years. Once electronics manufacturers select an analog chip, they tend to stick with the chip for the life of the device because it is costly to redesign a device in order to swap in a competing chip that might not necessarily be compatible with the rest of the product. In turn, analog chipmakers like TI tend to benefit from these switching costs by having lower ongoing R&D and capital expenditure investments, which helps to contribute to healthy returns on capital for shareholders.

Shorter-Life-Cycle Products, but Broader Customer Base Some of TI's peers like Analog Devices ADI and Linear Technology LLTC take this benefit one step further by concentrating on end markets where product lives are measured in decades, as opposed to the increasingly short life cycles associated with consumer devices like PCs or handsets. While TI serves these high-performance segments, it also has a high-volume analog chip segment that makes up 35% of analog revenue and focuses on end markets like smartphones, tablets, and PCs. All else equal, we are less confident in outsize economic profits from chipmakers that serve the handset and PC industries, given the shorter product life cycles, intense competition, and customer concentration as a handful of tech titans exert tremendous buying power. In turn, TI has earned relatively lower gross margins than an analog peer like Linear.

On the plus side, the size and scale of TI's salesforce and field applications engineers allow the firm to reach a broader customer base than peers, which has translated into a share lead for TI in the analog chip market. TI generates enough revenue to adequately fund this large sales team that only a handful of chipmakers can match, yet its salesforce helps the firm reach more customers and generate additional chip sales that can fund further sales team expansion, creating a virtuous cycle for the company. We doubt that any other analog chipmakers will be able to assemble such a massive sales team in the near future.

Given TI's presence in high-volume analog, as well as other relatively lower-margin businesses like digital signal processors, wireless processors, and wireless connectivity chips, we were previously hesitant to assign a wide moat rating to the firm. However, TI's presence in the automotive and industrial end markets has risen to 44% of revenue in 2014, and the long product life cycles and high profitability associated with these design wins give us greater confidence that TI will continue to generate robust profitability over the next 20 years and, in turn, merit a wide moat rating.

Biggest Risk Is Cyclical Industry While we like TI's moves to buy manufacturing equipment at pennies on the dollar a few years ago, the firm paid a hefty premium to acquire National Semiconductor and expand its manufacturing capacity even further. Despite a relatively low cost for this capacity, TI will still need to generate healthy analog chip growth to fill these plants, and cyclical downturns in the industry may provide headwinds from time to time. Meanwhile, the analog chip market is fragmented and based on proprietary designs, so market share shifts tend to be quite gradual, and it remains to be seen whether hearty growth can come to fruition.

Shareholder-Friendly Management We view Texas Instruments as a well-run organization whose managers are exemplary stewards of shareholder capital. Richard Templeton has been with TI for more than 30 years; he has been CEO since 2004 and chairman since 2008. Although we would prefer to see a separation of the chairman and CEO roles, we are pleased that TI has 10 independent directors on the board. TI has some shareholder-friendly initiatives, such as providing investors with a capital-allocation strategy update each of the past two years. The management team has done an excellent job in focusing on redistributing excess cash to shareholders, as the firm has raised its dividend to $0.34 per quarter and has several billion remaining on a stock-repurchase program in place. We're also encouraged by management's comments that it believes it can convert 20%-30% of its revenue into free cash flow and intends to distribute 100% of that free cash flow (less debt repayment, plus proceeds from stock exercises) to shareholders. TI may tap the debt markets to boost these programs even further, as long as interest rates are below either the rate of inflation or the company's dividend yield. The only questionable move may have been the hefty 78% premium that TI paid for National Semi, but TI appears to be generating adequate growth from the acquired product lines and the deal has been accretive to earnings. All in all, we applaud TI's capital-allocation moves in recent years.