|  | | | | Texas Instruments (TXN): Quiet exceptionalism |
| Every child in America knows (or at least used to know) who Thomas Edison and Alexander Graham Bell were, and what they did. But how many kids, or adults for that matter, have heard of Jack Kilby, the man who invented the microchip?
Jack Kilby was born in Jefferson City, Missouri in 1923, but grew up in Great Bend, Kansas. His father was an executive at a rural utility company. Kilby once witnessed his father communicate with customers via ham radio during a dangerous ice storm, which left a strong impression on him. He took away from the experience that electronics can help make lives better and safer.
When Kilby graduated from high school, he applied to M.I.T. but failed the entrance exam. So he attended the University of Illinois at Urbana-Champaign, where his parents went. Shortly thereafter, the Japanese invaded Pearl Harbor.
After completing his sophomore year, Kilby joined the U. S. Army Signal Corps. He was assigned to Detachment 101 of the Office of Strategic Services, which was deployed to East Asia to carry out guerilla operations that were coordinated with portable radios. Upon his discharge in December 1945, his rank was T-4 Radio Operator, the equivalent of an army sergeant. |
|  | Sgt. Kilby, U.S. Army Signal Corps |
| After the war, Kilby returned to Illinois to study electrical engineering. He worked on vacuum tubes—a technology he would ultimately render obsolete.
He later worked in Milwaukee and took night classes at the University of Wisconsin. After earning his Masters in Electrical Engineering, he attended a symposium on transistors hosted by Bell Laboratories. This sparked his interest in “microminiaturization”—using transistors to make electronics smaller.
In 1954, a Dallas-based instrumentation company, which got its start selling technical equipment to the oil industry, developed the world’s first transistor radio. Texas Instruments called it the Regency TR-1. |
|  | Advertisement for the Regency TR-1 |
| This little radio put Texas Instruments at the forefront of the miniaturization wave. Kilby (who ironically stood six foot six) wanted to be part of it. In 1958, he moved to Dallas with his wife Barbara and his daughters.
Immediately upon joining TI, Kilby found himself almost completely alone in the office. Most of the staff was heading out for company-mandated vacation. Since he had just started, he wasn’t eligible.
Many brand new employees, left unsupervised in an unfamiliar environment, would not be particularly productive. Maybe they would get their desk organized or figure out where the water cooler is. Instead, the 35-year old Kilby took advantage of the isolation to brainstorm an idea. This idea would completely change the world.
The integrated circuit
When his new boss got back from vacation, Kilby pitched the idea of placing numerous circuit components on a very tiny chip, thereby avoiding the need for wires or external connectors. The chip could be made of silicon, which the company was already using to make transistors.
In August 1958, Kilby demonstrated that a circuit with all silicon elements was possible. In September, using germanium instead of silicon, Kilby presented the world’s first integrated circuit. About the size of a postage stamp, it was patented a few months later.
Now more commonly known as chips, microchips or semiconductors, integrated circuits are the basic building blocks of modern electronics and the computer age. |
| | What we didn’t realize then was that the integrated circuit would reduce the cost of electronic functions by a factor of a million to one. - Jack Kilby |
| | Kilby would stay at Texas Instruments until his retirement in 1983. Chips he developed would be used in the Apollo space mission as well as Minuteman Missiles. He also helped lead the development of the first handheld calculator, which debuted in 1965.
With more than 60 patents to his name, the M.I.T. reject from Kansas received the Nobel Prize in Physics in 2000. Jack Kilby passed away from non-Hodgkins lymphoma at his home in Texas five years later. |
|  | | Behind the scenes innovation |
| From its roots selling seismographic equipment, Texas Instruments (TXN) has evolved significantly since the original predecessor company Geophysical Service Incorporated was founded in 1930. TXN still sells the calculators that we all might remember from high school, but this has become a relatively meaningless portion of the overall business.
Like Jack Kilby, its little known yet most important engineer, TXN is arguably underappreciated amongst the great household names that define the technology landscape. But the products in which TXN specializes are crucial to our modern standard of living. |
| Today, TXN is the global leader in two specific niches within semiconductors: analog chips and embedded processors. |
| Analog chips
The world is becoming more digital, with some form of computing technology getting integrated into more and more devices. Ironically, this trend towards digitalization is driving adoption of analog chip sets. Analog chips are the bridge between the physical world and the computing world.
TXN is the market leader in analog semiconductors. With a catalog of more than 80,000 analog products, TXN sells chip sets that perform a wide range of functions, including power management, sensing and motor control. Analog semiconductors condition and regulate “real world” functions such as temperature, speed, sound and electrical current, whereas digital semiconductors only process binary information.
Analog is TXN’s largest segment, with 2023 revenue of approximately $13 billion, which represented 74% of total revenue. TXN estimates the overall analog market at $81 billion as of 2023. A relatively fragmented industry, TXN is the market leader with just over 15% global share.
Embedded processors
Embedded processors are microprocessors that are used within an embedded system, which refers to a self-contained system that is designed to perform a specific task within a device. Embedded processors work with analog chip sets by receiving and responding to the real world information that comes from the analog chip.
Embedded processors are essentially the digital “brains” of various types of electronic equipment. They handle specific tasks and can be optimized around various objectives, such as performance, power and cost.
TXN is a market leader in embedded processing and generated approximately $3.4 billion in revenue in 2023 from this segment. |
|  | Source: Texas Instruments |
| | Checking all the boxes
Our search process at 76research is relatively straightforward and extends to all of our Model Portfolios. We are looking for competitively advantaged businesses in attractive markets that are run by properly motivated and exceptional managers. These are the types of business that historically deliver the best results for investors over time.
A sailing analogy is potentially called for here. If you want to get to a destination, safely and in good time, you want to sail on the best boat, in the most favorable conditions, with the most skillful skipper.
TXN stands out in all three respects. |
| | Why TXN is competitively advantaged
Many semiconductor companies strive to be on the leading edge of the most advanced and intensive computing applications. This can be enormously profitable when it is pulled off, as NVIDIA (NVDA) has demonstrated, but it’s also risky in that competition is fierce.
TXN, by contrast, seeks to entrench itself in a very broad set of basic computing functions.
A single TXN analog chip may only cost customers a few dollars. By contrast, NVDA charges $30,000+ for its most advanced artificial intelligence chips. TXN customers turn to them for breadth, quality, service and reliability and to access a vast array of relatively simple and inexpensive, but necessary, computing components that are designed into mass-produced items.
The analog business, as a result, can be very sticky. Electronic products are designed around the specs of TXN chips. Product cycles can be ten to fifteen years or longer.
Analog chips are typically a small portion of overall production costs. Customers are usually not extremely price sensitive; they prioritize service as well as the ability to rely on the chip provider long into the future.
While analog chips are comparatively simple, they are extremely diverse and perform a wide range of differentiated functions. This presents a major obstacle to competitors who might seek to replicate TXN’s massive product portfolio, which encompasses tens of thousands of different units.
The competitive moat provided by the breadth and complexity of products is reinforced by scale advantages, in both manufacturing and service. As the market leader in analog chips, TXN has enormous economies of scale, which get reinforced though sustained investment in research and development ($1.9 billion in 2023).
Thanks to its scale, market position and accumulated technological edge within all aspects of the analog business (resulting in part from years of outspending competitors on R&D), TXN unsurprisingly benefits from cost and quality advantages on the manufacturing side. TXN manufactures tens of billions of chips and processors annually and delivers them to more than 100,000 customers worldwide.
A key manufacturing advantage of TXN is its investment in multiple 300mm “wafer production” facilities. TXN has two 300mm facilities in operation, with two more under development. While TXN’s competitors generally operate with 200mm facilities, TXN estimates that 300mm “fabs” provide a 40% cost advantage. |
|  | Rendering of Sherman, TX new 300mm fabrication plant |
| When it comes to analog chips, TXN is the 800 pound gorilla in the global marketplace. No one can do it better or cheaper. |
| | Why TXN plays in attractive markets
TXN is the clear leader in analog chips, a niche of the semiconductor industry that is inherently sticky. As the market leader, TXN’s patent portfolio, manufacturing capability and R&D engine only reinforce its dominance.
The next logical question is, what is the long-term outlook for analog chips and embedded processors? It’s great to have the nicest house in the neighborhood, but it’s just as important, if not more so, to live in a neighborhood that is improving.
We have discussed electrification as a theme, in the context of copper, for example. But electrification is arguably a sub-theme of a broader phenomenon, which is digitalization. Computing technology is getting integrated into more and more places, which necessitates more electrical connections.
The Internet of Things (IoT) has been dreamt about and discussed since the dawn of the internet. The Internet of Things refers to the network of physical objects—“things”—that are embedded with sensors, software, and other technologies for the purpose of connecting and exchanging data with other devices and systems. These devices range from ordinary household objects to sophisticated industrial tools. According to Oracle (ORCL), there are more than 7 billion connected IoT devices today, with the potential to grow to 22 billion by 2025.
Artificial intelligence (AI) has the potential to unlock the real promise of IoT. AI enables networks and devices to learn from past decisions, make predictions about future activity, and constantly improve performance and decision-making.
As more devices become “smart,” and existing smart devices become even smarter, there is growing demand for analog chip technology along with embedded microprocessors. These simple chips essentially function as the eyes and ears of all these connected devices. Artificial intelligence is useless without information, and these chips are how information is obtained.
TXN’s end markets are evolving in the direction of these technological trends. TXN is moving away from the more commoditized and volatile personal electronics and communications equipment categories (which includes mobile phones) and towards industrial and automotive applications. |
|  | Source: Texas Instruments |
| The industrial market applies to a wide range of equipment and is the area where adoption of smart devices is arguably most impactful. Examples of industrial applications include smart thermostats, door locks, and other appliances that sense motion, humidity or temperature and then communicate diagnostic information wirelessly.
More complex industrial applications include smart motors that regulate energy consumption and robotic assembly lines that use sensors to operate autonomously. Industrial also applies to huge investments now going into smart grids, as utilities seek to take advantage of AI technologies that will reduce energy consumption. Analog systems are needed for the precision sensing, control and communication that is behind grid automation and protection.
The automotive market is also undergoing rapid technological changes that translate into demand for significantly more analog chip content. Electric vehicles are a major driver of these changes. EVs requires three to four times as many analog chips versus internal combustion vehicles.
But smart technology is increasingly being applied to all vehicles. TXN’s automotive business includes infotainment systems; advanced driver assistance systems (ADAS); hybrid, electric and powertrain systems; passive safety; and body electronics and lighting.
High tech safety systems that were once cutting edge features on luxury cars are gradually becoming standard features on all vehicles. These systems rely on a vast array of sensors throughout the vehicle that are built around analog chips. |
|  | TXN reports that its revenue from the industrial and automotive segments compounded at 10% annually between 2013 and 2023. We view this rate of growth as sustainable, given technological trends and TXN’s potential to gain market share. |
| | Why TXN has exceptional managers |
| TXN not only enjoys technology and cost leadership within a structurally attractive niche, but truly stands out among public companies in terms of its commitment to shareholder value creation through appropriate management incentives and disciplined capital management. |
| | After accretive investments in the business to grow free cash flow for the long term, the remaining cash will be returned over time via dividends and share repurchases. - Presentation by TXN CFO Rafael Lizard (2/1/2024) |
| | The persistent emphasis on free cash flow reflects a corporate culture that understands the financial mechanics of shareholder value creation, which unfortunately eludes many other companies. TXN gets it. The secret to maximizing shareholder returns is to focus on what actually drives shareholder returns—true cash profitability and effective capital allocation.
TXN is differentiated, especially among technology companies, by its explicit commitment to shareholders to return all free cash flow through dividends and share repurchases. |
|  |  | Source: Texas Instruments |
| TXN’s dual commitment to capital returns through both dividends and buybacks translates into a compelling dividend growth story, which is one of the reasons we include it in our Income Builder Model Portfolio, along with the American Resilience Model Portfolio. |
| Consistent free cash flow generation, dividend growth and a continuously shrinking share count have produced an excellent long-term return profile. TXN has delivered an annualized total return for shareholders of approximately 19% over the past 10 years (13% for the S&P 500); 13% over the past 20 years (10% for the S&P 500); and 15% over the past 30 years (11% for the S&P 500).
Over the past 10 years, TXN has even managed to outperform the Nasdaq 100 (QQQ), with notably less volatility. |
|  | | Why now?
TXN’s recently reported first quarter earnings results have breathed new life into the shares, which significantly lagged semiconductor peers in 2023 and into 2024. Since the April 23 earnings results, TXN shares have advanced approximately 20%. Since we launched our American Resilience and Income Builder Model Portfolios on March 1 with TXN as a top weighted holding, TXN has delivered a total return of approximately 16%, versus 3% for the S&P 500.
Prior to the recent strength, TXN shares had been weighed down by a number of factors. While TXN’s industrial and automotive end markets will require growing expenditure on analog chips, they remain cyclical. Post-pandemic fears of chip shortages created excess inventories, which are being worked off. Largely as a result of inventory de-stocking, 2023 and 2024 have been below trend years for TXN.
By contrast, semiconductor stocks that are geared towards AI applications, like NVDA, have soared over the past couple years. The performance difference since year-end 2022 versus a prominent semiconductor ETF, the VanEck Semiconductor ETF (SMH), has been stark. TXN has been left in the dust. |
|  | The recent strength in the shares potentially marks a turning point, as investors become less focused on short-term cyclical headwinds and more focused on the long-term structural opportunity. We highlight three areas of opportunity as we evaluate TXN’s prospects over the next several years and beyond.
(1) Cyclical bottom
First quarter 2024 results were above analyst consensus, while the outlook for second quarter also appeared to above expectations. This led to a +6% move in the shares the day following the earnings release (which came out post-close) and continued strength since.
Investors have likely been avoiding TXN until evidence surfaced that the cyclical bottom was in sight. Recent momentum suggests building comfort that the inventory issues are dissipating, and the growth trajectory can resume.
An interesting wrinkle—and a favorable one—in the cyclical turnaround is that unit prices for TXN chips have advanced considerably over the past few years, simply because of inflation. It is estimated that average selling prices for TXN products are up about 20% over the past 4 years, in line with broader inflation trends.
As unit sales recover towards long-term trends, revenue may appear to be above trend simply because of higher pricing. In other words, volumes are recovering in what is now a much more favorable pricing environment.
(2) Restoration of free cash flow
The cyclical downturn of 2023-2024 happened to coincide with longer term capacity expansion plans that required elevated levels of capital expenditure, specifically to build out the cost-saving 300mm fabs referenced above. The result was a significant reduction in free cash flow, which has weighed on the shares for a number of reasons.
As noted, TXN prides itself on free cash flow generation and has naturally attracted an investor base that focuses on that metric. The free cash flow squeeze of recent years has likely lessened the appeal of the stock for many investors.
TXN also uses free cash flow beyond the dividend to repurchase shares, which can help support the share price. Repurchase activity has been reduced in recent periods.
The good news is that TXN is poised to turn the corner on free cash flow, as both operating profits recover and the planned investments in new fabs winds down over the next several years. With revenue likely inflecting positively over the remainder of 2024, we are looking at operating profit improvement in 2025, which should be sustained at high rates for the next several years.
Capital spending is expected to stay elevated through 2026 as the major projects are completed (approximately $5 billion per year), but then revert to lower levels (approximately 10 to 15% of revenue). As the cap ex wave passes, the company will not only benefit from greater cash flow availability but also the cost savings that the projects are intended to deliver as the new fabs come online. |
|  | Source: Texas Instruments |
| From 2004 to 2022, before the free cash flow squeeze set in, TXN grew free cash flow per share at approximately 11% per year. The company intends to return to that trajectory and looks set to deliver record free cash flow per share, perhaps as early as 2026. |
| (3) Onshoring
Investor focus is mainly on the cycle and free cash flow trends, but an important transformation taking place at the company is growing domestic production. TXN currently manufactures~80% of its wafers internally and expects to grow this to 90% by 2030.
Tensions with China over Taiwan, home to semiconductor manufacturing titan Taiwan Semiconductor (TSM), have changed the way customers think about sourcing chips. TXN stands to benefit from the growing preference for dependable capacity that is not tainted by geopolitical risk. TXN has a unique ability to offer this.
Along these lines, TXN will also be a direct beneficiary of the CHIPS and Science Act and anticipates a $4 billion benefit on investments made through 2026.
A related trend within the chip industry is sourcing direct from the supplier rather than going through intermediaries. Despite recent headwinds, TXN has been steadily growing its direct distribution, which along with its domestic manufacturing capacity enhances TXN’s appeal as a business partner. |
|  | Source: Texas Instruments |
| During the pandemic, American auto companies and industrial manufacturers were hobbled by critical shortages in semiconductors. There is a sea change underway in terms of customer attitudes to supply chain risk.
Put yourself into the shoes of a customer, American or foreign, sourcing analog chips that you will embed into a product that you intend to manufacture for the next ten years. Which scenario sounds more appealing? Do you want your chips manufactured in a state-of-the-art facility in the middle of Texas? Or do you prefer they are made in China or elsewhere in Asia? |
| | Steadily growing its cash flow and producing the billions of low-priced analog microchips that make modern life possible, Texas Instruments has rather quietly delivered for investors for many decades. Cyclical headwinds over the past couple of years have led to underperformance, especially as flashier peers directly connected to the AI space have produced extraordinary returns.
But the value creation formula that TXN has steadfastly followed with exceptional long-term results should continue to work. Analog chip technology is more relevant than ever. As we learned from Jack Kilby, it’s not always the flashiest people or companies that have the biggest impact.
Historical information about Jack Kilby and Texas Instruments was largely drawn from Engineering the World: Stories from the First 75 Years of Texas Instruments. |
| | Update on TXN: May 28, 2024 |
| Elliott Investment Management sent a letter to the board of directors at TXN today. Elliott communicated its opinion that TXN should rethink and moderate its capital expenditure plans in an effort to improve free cash flow over the next few years.
Founded by Paul Singer, Elliott is one of the largest and most successful activist hedge funds in the world (approximately $65 billion in assets under management as of year end 2023).
Key points from the letter, which is available here. Elliott has a $2.5 billion stake in TXN, which makes it one of their largest holdings. Elliott has “deep conviction in the value-creation opportunity at TI.” They believe TXN is “well positioned with formidable competitive advantages as the analog semiconductor market returns to growth” and that the company “has made a sound long-term strategic decision to focus on the most attractive end markets within analog and to invest in the most efficient, geopolitically secure manufacturing capacity.” Their main, if not only, criticism is that TXN is currently spending a bit too aggressively on capacity expansion. Elliott wants the opportunity to address their board (in a friendly way) on this subject.
|
| | Today, we are proposing that TI adopt a dynamic capacity-management strategy and introduce a free cashflow per share target of $9.00+ in 2026, representing a level that is ~40% above current investor expectations. - Jesse Cohn and Jason Genrich, Elliott Investment Management |
| | Our reaction
Elliott’s analysis of the long-term business prospects of TXN aligns closely with our own. We also share their interpretation that investors are focused on free cash flow generation and that improvement in that metric in the years ahead will likely be a catalyst for upside in the shares.
With $2.5 billion on the line, Elliott is clearly eager to see the free cash flow recovery commence. We tend to agree that if TXN brought down its cap ex spending guidance over the next few years, the market would likely respond positively. As we write, TXN shares are up very slightly, a touch ahead of the broader market.
That being said, it is important to put the capital spending plans in perspective. Elliott’s suggestions here actually appear to be fairly modest. Deferring a few billion of capital expenditures can help near term free cash flow, but we are talking about a company with a ~$180 billion market cap. Shifting the timing on capital investments that represent only 1-2 % of total market cap will not tremendously impact the overall valuation math.
We suspect one of Elliott’s primary motivations may in fact just be to spell out their expectations for a robust free cash flow recovery in the next few years, whether or not their proposed adjustments are accepted. The letter presents an opportunity to lay out a compelling investment case for one of their core holdings, paired with a little bit of gentle criticism and pressure to maintain capital discipline. Elliott wants other investors to understand how attractive TXN is at the moment.
Conclusion
Given management’s long-term track record, we tend to trust their judgment in terms of the pace and strategy behind their expansion plans. To be fair, perhaps there is some room to slow it down without adversely affecting the business long-term. A dialogue between Elliott and the board on this point may be fruitful.
We welcome Elliott’s effort to draw attention to the core strengths of the TXN business model and the prospects for a strong free cash flow recovery over the next few years. We encourage subscribers considering an investment in TXN to review Elliott’s well-written letter. |
| | Texas Instruments (TXN): Company Snapshot |
|  |  | | FOR SUBSCRIBER USE ONLY. DO NOT FORWARD OR SHARE. |
| | | | |  | | |
|
|
|
|
|
