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Texas Instruments (TXN - Analyst Report), or TI) reported third quarter earnings that were up 27.2% sequentially and down 4.0% year over year. Earnings also exceeded the Zacks Consensus Estimate by 17 cents or 37.8%.

Shares remained depressed however, 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 (MSFT - Analyst Report) launching Windows 8 in the quarter adds another variable and its impact on the computing market in the current quarter is not clear yet.     

Revenue

TI reported revenue of $3.39 billion, which was up 1.6% sequentially and down 2.2% year over year (slightly better than the mid-point of the recently narrowed guidance range of $3.27 billion to $3.41 billion).

With lead times remaining very low (they dropped to 6 weeks at the beginning of the quarter), there is reduced visibility into the 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.

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 drive growth in this market.

TI is currently being impacted by caution at carriers, which are adjusting inventories and buying less. The weakness appears to have hit the important markets of China and the U.S.

The Industrial market was weak in the last quarter, which is particularly negative for TI since it acquired a big industrial business through National and also inherited significant capacity. The weakness in the last quarter impacted the HPA and SVA businesses, particularly in the U.S. and Europe.

Similar to trends noticed by other technology companies with Automotive exposure, TI continued to see some growth. Management attributed this to growth in the U.S. that offset declining trends in China and Europe. Specifically, this led to neutral results for the company’s embedded processing business and modestly positive impact on analog. 

The Computing market remained soft as may be expected, with the weakness broad-based across all of TI’s product lines (except analog battery management products, where TI took share according to management).

Management mentioned some seasonality-driven strength in the Consumer business for gaming and audio applications. Normal seasonal declines may be expected in the fourth quarter.

Segment Revenue

The Analog business, which grew 2.4% sequentially and 18.4% year over year, benefited from the inclusion of a full quarter of SVA results in the last quarter. Performance in the rest of the business, comprising the HVAL, HPA and power management product lines was mixed.

While power management and HVAL increased from last year, HPA declined. Power management and HVAL were also strong a sequential basis, offsetting the weakness in HPA and SVA. The weakness in HPA is not surprising, since the business is closely linked to the computing and consumer markets that are currently in the doldrums.

Despite stronger demand for catalog products - mainly Digital Signal Processors (DSPs) and microcontrollers (MCUs) – and products sold into automotive, weakness in the communications infrastructure business pulled down the overall Embedded Processing results. As a result, segment revenue declined 3.5% the year-ago quarter. Catalog products also drove the2.2% sequential increase, supported by flat sales into auto and weakness in communications infrastructure.

TI’s focus in the wireless segment is on the proprietary OMAP and connectivity products. Segment revenue in the last quarter was down 5.0% sequentially and 44.0% year over year. Baseband products accounted for most of the decline from both the sequential and year-ago quarters, although connectivity was also down from both periods, with OMAP the only offsetting factor.

The Other segment was up 2.6% sequentially and down 11.1% year over year. The decline from last year was on account of lower DLP shipments, expiration of transitional supply agreements associated with acquired factories and decline in calculator revenue, as offset by insurance proceeds. DLP and custom ASIC products were both down on a sequential basis and calculator sales were only up slightly, with insurance proceeds saving the day.

Orders

Net product orders were $3.2 billion in the last quarter, down 5% sequentially. The book-to-bill ratio dropped below unity. Turns sales have been increasing over the last few quarters. 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 49.6% was flat sequentially and down 76 bps from the year-ago quarter. The gross margin was the net result of weak revenue and low utilization rates The gross margin remains well below the long-term target of 55%.

Operating expenses of $916 million were lower than the previous quarter’s $936 million. The operating margin was 22.5%, expanding 110 bps sequentially, while declining 519 bps from the year-ago quarter. All expenses were flattish sequentially as a percent of sales while growing from the year-ago quarter. However R&D and SG&A costs increased the most.

The Analog, Embedded Processing, Wireless and Other segments generated operating margins of 25.0% (up 68 bps sequentially), 12.1% (up 210 bps), -16.3% (down 140 bps) and 52.7% (up 2,917 bps), respectively.

Net Income

The pro forma net income was $713 million, or a 21.0% net income margin compared to $537 million, or 16.1% in the previous quarter and $714 million, or 20.6% in the year-ago quarter. The fully diluted pro forma earnings per share were 62 cents compared to 47 cents in the previous quarter and 62 cents in the September quarter of last year. The pro forma calculations for the last quarter exclude the impact of restructuring and acquisition-related charges, as well as insurance gains on a tax-adjusted basis.

On a fully diluted GAAP basis, the company recorded a net profit of $784 million, or 69 cents a share compared to a net profit of $446 million, or 39 cents per share in the previous quarter and a net profit of $601 million (52 cents per share) in the comparable prior-year quarter.

Balance Sheet

Inventories increased 2.0% to $1.85 billion, which resulted in inventory turns of 3.7X, up from 3.6X in the previous quarter. Days sales outstanding (DSOs) went down slightly from 45 to around 44. TI generated $1.20 billion in cash from operations, spending $149 million on capex, $600 million on share repurchases and $194 million on cash dividends. At quarter-end, TI had $4.2 billion in long-term debt, which was up from $2.7 billion going into the quarter, as TI made the most of low coupon rates. The company also had $1.5 billion in short-term debt.

Guidance

TI provided guidance for the fourth quarter (to be updated on December 10) and provided some limited estimates for fiscal year 2012.

Accordingly, TI expects third quarter revenue to come in between $2.83 billion and $3.07 billion (down 13.0% sequentially at the mid-point), which is well below the consensus estimate of $3.24 billion.

The EPS for the quarter is expected to be 23 to 31 cents (after adjusting for acquisition and restructuring charges of around 6 cents, well below the Zacks Consensus Estimate of 41 cents.

For 2012, TI expects R&D expenses of1.9 billion (unchanged), capex of 0.7 billion (unchanged), depreciation of $1.0 billion (unchanged) and an annual effective tax rate of 22% (down from 26%).

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 Semiconductor strengthened 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.

However, the softening demand in the near term is reason for concern, since TI is now saddled with a lot of capacity for which it is now taking underutilization charges.

Another point to keep in mind is National’s huge debt balance, which has negatively impacted the balance sheet.

The Zacks Rank for TI shares is #3, implying a Hold recommendation in the next 1-3 months.

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