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Texas Instruments (TXN - Analyst Report), or TI) reported second-quarter earnings that were up sequentially but down year over year. Earnings fell short of the Zacks Consensus Estimate of 46 cents by 4 cents or 9.7%. Investors clearly reacted to the GAAP numbers, which included one-time gains of 16 cents. As a result, shares appreciated 1.95% following the announcement.   

Revenue

TI reported revenue of $3.05 billion, which was up 5.6% sequentially and down 8.6% year over year (in the middle of the recently narrowed guidance range of $2.99 billion to $3.11 billion).

With lead times remaining very low (mostly at 6 weeks), visibility remains low. However, distributor inventories remain lean, so TI is largely shipping to consumption. Internal inventories increased only slightly, which is not a concern given the growing backlog.

Segment Revenue

TI changed the segment reporting structure in the fourth quarter, with the wireless segment being dissolved and relevant portions being included in the remaining segments. TI provided pro forma numbers for historical periods to enable suitable comparison.

Accordingly, the Analog business grew 5.9% sequentially while declining 3.1% year over year. TI attributed the sequential increase to a resurgent SVA (both industrial and automotive), which the company stated was already taking market share, ahead of plan. Both HVAL and HPA also contributed to the sequential increase. Power management was a dampener, as timing-related weakness at certain handset and gaming customers offset strength in other areas.

The Embedded Processing segment, which now includes the processor, microcontroller and connectivity product lines grew 10.2% sequentially and 6.6% from last year. Processors were the strongest product line in the last quarter, although microcontrollers and connectivity products also grew.

The Other segment, which now includes DLPs, custom ASICs, calculators, royalties and some legacy wireless products was up 1.2% sequentially and down 28.4% year over year. The legacy wireless business was a drag, offsetting the growth in all other segments.

Orders

Net product orders were $3.14 billion in the last quarter, up 6.0% sequentially and down 8.0% year over year. Backlog increased nicely for the second straight quarter, with turns sales increasing by over 4%. TI currently generates around 50% of its revenue from the consignment model, which is having a positive impact on turns sales.

Margins

TI’s gross margin of 51.5% was up 390 bps sequentially and 202 bps from the year-ago quarter. Two factors are contributing to the improving gross margins at TI. The first is the improving leverage from its low-cost manufacturing capacity, as production is increased.

The second is the improving mix, as low-margin wireless becomes a smaller percentage of TI’s total revenue. These factors are driving the gross margin toward the long-term target of 55%.

Operating expenses of $860 million were down 2.1% sequentially. The operating margin was 23.3%, up 611 bps sequentially and 186 bps from the year-ago quarter. All expenses declined sequentially as a perentage of sales although cost of sales declined the most, followed by R&D and then SG&A. Cost of sales was also the main reason for the increase from last year, since lower R&D was more than offset by higher SG&A.

The Analog, Embedded Processing and Other segments generated operating margins of 23.8% (up 564 bps sequentially), 8.7% (up 749 bps) and 63.7% (up more than 50 percentage points), respectively.

Net Income

The pro forma net income was $513 million, or a 16.8% net income margin compared to $398 million, or 13.8% in the previous quarter and $536 million, or 16.1% in the year-ago quarter. The fully diluted pro forma earnings per share were 42 cents compared to 35 cents in the previous quarter and 46 cents in the Jun quarter of last year. The pro forma calculations for the last quarter exclude the impact of restructuring gains and acquisition-related charges, as well as tax adjustments.

On a GAAP basis, the company recorded a net profit of $660 million, or 59 cents a share compared to a net profit of $362 million, or 32 cents per share in the previous quarter and a net profit of $446 million (39 cents per share) in the comparable prior-year quarter.

Balance Sheet

Inventories were up 1.2% to $1.72 billion, which resulted in inventory turns of 3.4X, down slightly from 3.6X in the previous quarter. Days sales outstanding (DSOs) went up from 42 to around 45. TI generated $674 million in cash from operations, spending $97 million on capex, $721 million on share repurchases and $309 million on cash dividends.

At quarter-end, TI had $4.17 billion in long-term debt and $1.00 billion in short-term debt. During the quarter, the net debt position moved up slightly. It also had underfunded retirement plans of $134 million.

Guidance

TI provided guidance for the third quarter and updated its limited estimates for fiscal year 2013.

Accordingly, TI expects third quarter revenue to come in between $3.09 billion and $3.35 billion (up 5.7% sequentially at the mid-point), which is a shade better than the consensus estimate of $3.20 billion. Legacy wireless products are expected to decline by around $90 million sequentially. The rest of the business is expected to be up 9%.

The EPS for the quarter is expected to be 49 to 57 cents, the mid-point being slightly lower than the Zacks Consensus Estimate of 56 cents.

For 2013, TI expects R&D expenses of 1.5 billion (unchanged), capex of 0.5 billion (unchanged), depreciation of $0.9 billion (unchanged) and an annual effective tax rate of 24% (up from previous guidance of 22%).

In Summary

Texas Instruments is prudently investing its R&D dollars into several high-margin, high-growth areas of the analog and embedded processing markets. This is gradually increasing its exposure to the industrial and automotive markets, while reducing its exposure to the volatile consumer/computing markets. In the last quarter, TI’s SVA business saw notable strength, so the strategy is likely paying off.

The last few years have also seen other analog companies, such as Linear Technology (LLTC - Analyst Report) and Maxim Interated Products (MXIM - Analyst Report) increasing focus on industrial and automotive markets. These markets have better secular drivers (energy efficiency in industrial and increasing electronic content in automotive). They also generate higher margins.

Therefore, this strategy along with higher utilization rates may enable the company to move closer to its long-term margin targets. For TI, the turnaround in the communications infrastructure market is an added positive that should contribute to its top and bottom lines this year.

We therefore remain optimistic about TI’s compelling product line, the increased differentiation in its business and lower-cost 300mm capacity that should in combination drive earnings.

However, unlike analog peers such as Microchip Technology, Intersil and Analog Devices (ADI - Analyst Report), its declining wireless business is likely to be a drag on TI. Therefore, TI shares carry a Zacks Rank #3 (Hold), while most of its analog peers have a more favorable rank.

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