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Texas Instruments (TXN or TI), reported second quarter earnings that were up 35.3% sequentially but down 19.6% year over year. Earnings also exceeded the Zacks Consensus Estimate by 7 cents or 19.1%.

Shares remained depressed however, dropping 0.2% after-hours, despite the 1.6% decline during the day, as guidance disappointed. Management mentioned caution at distributors, which confirmed the PC market weakness described by Intel (INTC - Analyst Report) and Advanced Micro Devices (AMD - Analyst Report). Microsoft Corp (MSFT - Analyst Report) should do better, but only because of the expected launch of its Windows 8 OS during the quarter.  

Revenue

TI reported revenue of $3.34 billion, which was up 6.9% sequentially and down 3.6% year over year (toward the middle of the recently narrowed guidance range of$3.22 billion to $3.48 billion).

With lead times dropping to a new low of below 6 weeks, there is reduced visibility into the quarter. However, current order trends indicate that the first two months of the quarter will be normal. Therefore, if demand picks up during the quarter, TI could ultimately have a normal quarter.

TI stated that distributor inventory levels remain lean and distributor shipments similar to the company’s own growth rates. Overall, distributors remain cautious, especially given TI’s capacity to ship products sooner.

Management had stated in the first quarter earnings call that the first quarter should be regarded as the bottom and the business appears to be playing out as expected.

End Market Backdrop

The secular drivers of the wireless infrastructure market are data capacity expansion in North America and Europe and infrastructure build-outs in Asian countries such as China and India. Additionally, broader market trends, such as increasing data traffic and capacity expansions all over the world, as well as an increased share of BOM at customers through its integrated offerings should continue to drive growth in this market.

The industrial market appears to be recovering faster than expected and the addition of National’s solid product lineup should drive strong overall results for TI this year.

Similar to trends noticed by other technology companies with automotive exposure, TI continued to see some growth. The business is related to the broader economy and consumer spending, as well as issues in Japan and China, where a significant percentage of automotive semiconductors and automobile manufacturing is done.   

Computing and consumer markets remain soft and may be expected to remain soft in the next quarter as well.

Segment Revenue

The core Analog business, comprising the HVAL, HPA and power management product lines was mixed. While HVAL and HPA declined from the year-ago quarter, power management was about flat. The inclusion of revenue from the newly acquired business (SVA) was therefore the main reason for the 13.4% year-over-year increase in analog revenue.

Sequentially, the segment was up 6.8%, driven primarily by growth in power management products, helped by HVAL and HPA. SVA contribution was minimal.

With catalog products - mainly Digital Signal Processors (DSPs) and microcontrollers (MCUs) – and communications infrastructure remaining weak and the growth in automotive failing to offset the impact, the Embedded Processing segment declined 14.6% from the year-ago quarter. However, segment revenue was up 7.6% from the previous quarter, as both catalog and communications infrastructure increased with automotive declining.

TI’s focus in the wireless segment is on the proprietary OMAP and connectivity products. Segment revenue in the last quarter was down 8.3% sequentially and 38.7% year over year. Baseband products accounted for most of the decline from the year-ago quarter, although they were up very slightly on a sequential basis to $90 million.

TI’s OMAP products (roughly 60% of non-baseband revenue) grew from the year-ago quarter, while declining sequentially. Connectivity products (the balance) were the weakest, declining from both the previous and year-ago.

The Other segment was up 16.1% sequentially and down 4.5% year over year. The decline from last year was on account of expiration of transitional supply agreements associated with acquired factories and decline in calculator revenue, as offset by increases in DLP and custom ASIC. The sequential increase was due to increase in DLP revenue and a seasonally stronger calculator business.

Orders

Net product orders were $3.41 billion in the last quarter, up 5.2% sequentially and down 5.3% year over year. We estimate that backlog grew 6% sequentially, even as turns sales imrpoved by around 5%. The higher level of turns business is the result of the historic low lead times that TI is now able to maintain. 

Margins

TI’s gross margin of 49.5% shrunk 22 bps sequentially and 199 bps from the year-ago quarter. Lower revenue and lower utilization rates were responsible for the decline from last year, while insurance proceeds in the first quarter offset by higher revenue was responsible for the decline from the first quarter. The gross margin remains well below the long-term target of 55%.

Operating expenses of $936 million were lower than the previous quarter’s $971 million. The operating margin was 21.4%, up 282 bps sequentially and down 511 bps from the year-ago quarter. All expenses declined sequentially as a percent of sales while growing significantly from the year-ago quarter.

The Analog, Embedded Processing, Wireless and Other segments generated operating margins of 24.3% (up 322 bps sequentially), 10.0% (up 241 bps), -14.9% (down 821 bps) and 23.5% (up 1,488 bps), respectively.

Net Income

The pro forma net income was $536 million, or a 16.1% net income margin compared to $400 million, or 12.8% in the previous quarter and $682 million, or 19.7% in the year-ago quarter.

The fully diluted pro forma earnings per share were 46 cents compared to 34 cents in the previous quarter and 58 cents in the June quarter of last year. The pro forma calculations for the last quarter exclude the impact of restructuring and acquisition-related charges on a tax-adjusted basis.

On a fully diluted GAAP basis, the company recorded a net profit of $446 million, or 38 cents a share compared to a net profit of $265 million, or 23 cents per share in the previous quarter and a net profit of $672 million (57 cents per share) in the comparable prior-year quarter.

Balance Sheet

Inventories increased 1.7% to $1.89 billion, this resulted in inventory turns of 3.6X, up from 3.4X in the previous quarter. Days sales outstanding (DSOs) went up from 43 to around 45. TI generated $675 million in cash from operations, spending $146 million on capex, $575 million for repayment of commercial paper borrowings, $300 million on share repurchases and $195 million on cash dividends.

At quarter-end, TI had $2.7 billion in long-term debt, $2.0 billion in short-term debt and net under-funded retirement plans of $652 million.

Guidance

TI provided guidance for the third quarter (to be updated on September 11) and provided some limited estimates for fiscal year 2012.

Accordingly, TI expects third quarter revenue to come in between $3.21 billion and $3.47 billion (flat sequentially at the mid-point), which is below the consensus estimate of $3.54 billion.

The EPS for the quarter is expected to be 34 to 42 cents, well below the Zacks Consensus Estimate of 48 cents.

For 2012, TI expects R&D expenses of1.9 billion (down from $2.0 billion), capex of 0.7 billion (maintained), depreciation of $1.0 billion (maintained) and an annual effective tax rate of 26% (down from 28%).

In Summary

Texas Instruments is prudently investing its R&D dollars into several high-margin, high-growth areas of the analog, embedded processing and wireless markets, which has led to important design wins. The addition of National Semiconductorstrengthened its product lineup and brought on board additional capacity. Therefore, the company is much better positioned today to deal with any spike in demand.

The phasing out of the low-margin baseband business also remains on track and is expected to be totally wiped out by the end of 2012.

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 in the longer term.

Moreover, in 2011, TI has announced the closure of a couple of 6-inch facilities in Hiji, Japan and Houston, Texas, transitioning the remaining products to more advanced facilities. Of the $215 million in charges, $112 million were taken in the fourth quarter of 2011, with the remainder being spread out over the next seven quarters. The restructuring is expected to generate annual savings of $100 million a year.

However, the softening demand is reason for concern, since TI is now saddled with a lot of capacity for which it has to take underutilization charges when demand falls short.

Another point to keep in mind is National’s huge debt balance, which has negatively impacted the balance sheet. A significant portion of this debt is short-term, so there could be a near-term impact on cash (TI could choose to cut share repurchases).

The shares therefore have a short-term Sell recommendation, as denoted by the Zacks Rank of #4.

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