Why Texas Instruments Is A Buy

Many insurance companies run frequent ads meant to tickle the funny bone. A recent television commercial from the Progressive Corporation (NYSE: PGR) illustrates my point.

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In the ad, actor Radek Lord walks into a kitchen while looking at his cellphone. He immediately commands his computer to order a pizza, and then he has the refrigerator recite the current weather. He tells a trashcan to turn on his television, and the icemaker is instructed to find a dog sitter — and then make ice. And before the commercial ends, the aforementioned pizza is delivered via drone.

#-ad_banner-#Of course, the commercial is a spoof on the Internet of Things (IoT) — the long-awaited hope that everyday objects will communicate with the internet to make our lives more efficient. It’s the trend John Chambers of Cisco (NASDAQ: CSCO) said would grow to $19 trillion in a decade.

While Chambers overstated the size of the trend — that doesn’t mean the trend isn’t real. A report by Market Research Trend suggests IoT will grow at a compound annual growth rate (CAGR) of 19.7% through 2022 — valuing the IoT market at nearly $2.5 trillion. That’s not $19 trillion, but it’s a trend investors can ride to incredible profits.

Analog In A Digital World
Given the scope of the potential market for connected objects, many investors assume that digital chipmakers like Intel (NASDAQ: INTC), Samsung (SSNLF), and Taiwan Semiconductors (NYSE: TSM) stand to benefit the most from this mega trend.

But that’s shortsighted. Digital semiconductors are standardized — meaning there’s no significant difference between the chips of the major players. This forces companies to compete almost exclusively on price — a less than ideal business practice.

On the other hand, analog chipmakers like Texas Instruments (NASDAQ: TXN) have a distinct advantage over their digital competitors. Development of analog and mixed-signal chipsets are harder to perfect and therefore harder for competitors to duplicate. This provides Texas Instruments a wide and relatively deep moat in the analog and embedded chip sector.

So, what is an analog semiconductor?

Analog semiconductors regulate functions like temperature, speed, sound, and electrical current and convert this data into digital signals useable by digital semiconductors. In short, they provide the data that digital chips need for processing information over the internet.

And they’re the reason for Texas Instruments’ success.

TXN dominates the analog industry — holding 69% market share. The company generates about 95% of its revenue from semiconductors and digital signal processors. The other 5% of revenues comes from the company’s ubiquitous calculators.

Texas Instruments’ Fundamentals
As you can see in the chart below, the stock has performed brilliantly over the past five years — outpacing the S&P 500 Index by more than a 2:1 ratio.

Of course, there’s good reason to believe it can continue its forward momentum. Over the past 12 months, the company’s revenues have grown by more than 12% to $15.7 billion. Earnings before interest, taxes, depreciation, and amortization (EBITDA) grew by 16.7% over that same period.

But there’s another metric that should catch every investor’s eye. It’s the company’s free cash flow. Free cash flow is the money left over after a company pays its operating expenses and capital expenditures (CAPEX). In other words, it’s the money a company has available for dividends, stock buybacks, and debt repayment.

In the past 12 months, TXN has gown its free cash flow by 44.2%. Of course, recent tax cuts helped push the cash flow higher, but margin expansion and continued strong sales added to the mix.

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And speaking of margins, gross margins for the company rose from 52% in 2013 to 64% last year. Analysts’ expectations are for the margin to continue expanding — reaching 67% through 2022. Here the company benefits from longer life cycles of the analog chip, giving the company time to amortize their costs over a longer period.

Investor Friendly, Too!
Texas Instruments currently pays a forward dividend of $3.08, which translates to a yield of 3%. Better yet, the company has raised its dividend for 14 consecutive years and maintains a five-year growth rate of 21.5% – and that doesn’t even count the 24.2% dividend increase the company recently authorized. And with a payout ratio of just 54%, there’s plenty of room to continue growing the dividend.

Using a Graham Formula to calculate a fair value, Texas Instruments is valued at roughly $140 — a 36% premium to its current value. While that valuation assumes earnings per share (EPS) growth rate at the high end of expectations, it’s certainly within the realm of possible. Still, a more conservative EPS growth rate of 10% still prices the stock at roughly $120 per share — a 17% premium to its current value. And based on the stock’s current price to earnings ratio and EPS growth rate, the stock could be valued at close to $200 per share by 2022.

Best of all, a healthy TXN dividend makes waiting for weather reports from refrigerators and trashcans capable of finding dog sitters all the more fun. It doesn’t get any better than that!

Risks To Consider: Texas Instruments operates in a cyclical industry. This means TXN could experience much slower growth in the short term should the economy enter a recession. This is partially offset by the bullish long-term trend towards the Internet of Things. Additionally, the Federal Reserve raised interest rates last month, and has hinted that they may do so again in December. If the Fed continues to raise rates beyond December, there is a greater possibility that top and bottom line growth for TXN is impacted.

Action To Take: Buy shares of TXN up to $105 per share. Mitigate risk by using no more than 3% of your portfolio to Texas Instruments. Use a hard stop at $80 to protect your principal. An investment in Texas Instruments is meant to be for investors with time horizons beyond three years to give the trend underlying the thesis sufficient time to develop further.