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Texas Instruments , or TI) reported third-quarter earnings that were up both sequentially and year over year, beating the Zacks Consensus Estimate of 57 cents by 8 cents or 13.9%. Results were helped by an improving mix of business, good cost control and a lower tax rate. Investors reacted to the significantly weak guidance, sending shares down 3.15% following the announcement.   

Revenue

TI reported revenue of $3.24 billion, which was up 6.5% sequentially and down 4.3% year over year (at the high end of the recently narrowed guidance range of $3.15 billion to $3.25 billion).

TI saw stronger demand in the computing, game console and handset markets that had been very weak in the last quarter. Automotive and industrial revenue continued to grow strongly and even communications infrastructure wasn’t too bad according to management.

Distributor resales increased 9% sequentially, further depleting already-lean distributor inventories. Internal inventories were flattish sequentially. Management stated that the core business (excluding legacy wireless) grew 10% sequentially, so considering that distributor resales were 9%, it appears that TI is shipping largely to consumption.

Segment Revenue

TI changed the segment reporting structure in the fourth quarter of 2012, 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 10.7% sequentially and 4.8% year over year. All product lines contributed to the sequential increase in analog revenue although power management products saw the strongest increase. TI attributed the year-over-year increase to very strong SVA sales, supported by somewhat higher HPA and power management and flattish HVAL.

The Embedded Processing segment, which now includes the processor, microcontroller and connectivity product lines grew 8.1% sequentially and 13.0% from last year. Processors were again 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 down 5.7% sequentially and 32.5% year over year. While calculators continued to grow on positive seasonality, other products, such as DLP and custom ASIC did moderately well sequentially, remaining below year-ago levels. The legacy wireless business remained a major drag in both the sequential and year-over-year comparisons.

Orders

Net product orders were $3.15 billion in the last quarter, flat sequentially and down 1.7% year over year. Backlog declined sequentially, as order growth was slower than revenues, with turns sales increasing by over 5%.  

Margins

TI’s gross margin of 54.8% was up 331 bps sequentially and 528 bps from the year-ago quarter. Management attributed the gross margin expansion to improving product mix, as analog and embedded processing is now 80% of revenue, higher than ever before.

The positive effect of the mix shift even offset the impact of a year-over-year decline in revenue. TI is now very close to its long-term gross margin target of 55%. The low-cost manufacturing capacity will continue to expand margins as utilization rates continue to increase.

Operating expenses of $833 million were down 3.1% sequentially. The operating margin was 29.2%, up 586 bps sequentially and 662 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. SG&A increased from last year.

The Analog, Embedded Processing and Other segments generated operating margins of 30.2%, 12.4% and 27.6%, respectively. Analog and Embedded Processing margins increased 635 bps and 369 bps on a sequential basis. Other declined due to declined in the legacy wireless business.

Net Income

The pro forma net income was $721 million, or a 22.2% net income margin compared to $513 million, or 16.8% in the previous quarter and $713 million, or 21.0% in the year-ago quarter. The fully diluted pro forma earnings per share were 65 cents compared to 46 cents in the previous quarter and 62 cents in the Sep 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 $629 million, or 57 cents a share compared to a net profit of $660 million, or 59 cents per share in the previous quarter and a net profit of $784 million (68 cents per share) in the comparable prior-year quarter.

Balance Sheet

Inventories were flattish sequentially at around $1.73 billion, keeping inventory turns at around 3.4X. Days sales outstanding (DSOs) went down from 45 to around 43. TI generated $1.15 billion in cash from operations, spending $124 million on capex, $734 million on share repurchases and $308 million on cash dividends.

At quarter-end, TI had $4.16 billion in long-term debt and $1.00 billion in short-term debt. During the quarter, the net debt position declined $353 million. It also had net underfunded retirement plans of $134 million.

Guidance

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

Accordingly, TI expects fourth quarter revenue to come in between $2.86 billion and $3.10 billion (down 8.1% at the mid-point), well below the consensus estimate of $3.12 billion. The decline in the legacy wireless business accounted for about half of the decline, the rest was attributable to the seasonal decline in calculator sales, as well as slightly softer builds in the semiconductor business (again a seasonal factor).

The EPS for the quarter is expected to be 42 to 50 cents, the mid-point being 10 cents 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% (unchanged).

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, indicating that the strategy is continues to pay off.

The last few years have also seen other analog companies, such as Linear Technology and Maxim Interated Products 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 will likely help increase the company’s profitability. 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.

Therefore, TI shares carry a Zacks Rank #2 (Buy), similar to analog peer Intersil Corp .

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