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Play Hold 'em with Texas Instruments

By Amrit Tewary The tough times remain for many chip stocks, with the S&P Semiconductors index continuing to lag behind the broader equity market. The index fell 8.9% year-to-date through Jan. 21, vs. a 3.8% decline for the S&P 1500 index. The chip index significantly underperformed the broader market in 2004 as well. Following recent share price declines, most chip stocks we follow trade below historical average price-earnings and price-to-sales multiples.

We at S&P Equity Research Services believe these discount valuations are warranted, for the most part, given the moderation in industry growth we forecast for 2005. Also, we think they are appropriate in light of what we see as elevated macroeconomic risks and lingering inventory concerns. That's why we maintain a neutral stance on the subindustry, as well as 3 STARS (hold) recommendations on a number of chipmakers, including a bellwether for the group, Texas Instruments (TXN

; recent price, $22.66).

Here, we'll take a look at TI's current business -- and its prospects for upcoming periods.

CHIPS AND MORE CHIPS. TI has three separate business segments: Semiconductor (87% of 2004 sales), Sensors & Controls (9%), and Educational & Productivity Solutions (4%). The Semiconductor segment averages a higher growth rate than the other two businesses, although the semiconductor market is characterized by wide swings in growth rates from year to year. In terms of revenues, TI is among the five largest chipmakers in the world.

The Semiconductor segment focuses primarily on technologies that make it possible for a variety of consumer and industrial electronic equipment to process both analog and digital signals in real time. These technologies are known as analog semiconductors and digital signal processors (DSPs). Almost all of today's digital electronic equipment requires some form of analog and digital signal processing.

DSP and analog product lines are largely complementary. These chips work together to enable electronic devices to benefit from digitization of electronic signals. Analog technology converts real-world signals, such as sound, light, and pressure, into the zeros and ones of the digital world. DSP chips then process signal information in real time. Analog chips also convert signals back to analog format.

MARKET OPPORTUNITIES. The DSP market has recently been a fast-growing segment of the semiconductor industry, driven by strong demand for devices such as wireless phones, modems, and computer networking gear. We believe that increased use of digital components in embedded systems in automobiles, appliances, and manufacturing equipment should also enhance market opportunities.

DSPs accounted for 35% of TI's semiconductor revenues in 2004, up from 30% in 2002; analog chips provided 40% (40% in 2002); and the remaining 25% (30%) came from other chip products such as standard logic, ASICs, RISC microprocessors, microcontrollers, and digital imaging devices.

The company's focused DSP strategy required a multiyear restructuring. In 1997, TI sold its defense electronics business to Raytheon. In 1998, it sold its struggling dynamic random access memory (DRAM) operations to Micron Technology (MU), taking some payment in stock; after selling some shares in prior years, it sold its remaining 57 million MU shares in the second half of 2003.

ACQUISITIONS. But TI also added a number of businesses under its DSP revamp. In 2000 it acquired Toccata Technology, a developer of digital-audio amplifier technology; Dot Wireless, a specialist in CDMA third-generation wireless technology; Alantro Communications, a developer of wireless local area networking technology; and, most notably, Burr-Brown Corp., a high-end analog chipmaker with expertise in data converters and amplifiers.

In 2001 it acquired Graychip, a developer of digital converters used for high-speed signal-processing applications. TI's most recent DSP acquisition came in 2003: Radia Communications, a semiconductor outfit focused on systems for 802.11 wireless local area networking products.

The Sensors & Controls segment sells electrical and electronic controls, sensors, and radio frequency identification systems to the commercial and industrial markets. The Educational & Productivity Solutions unit is a leading supplier of educational and graphing calculators.

THE LATEST NUMBERS. According to its latest 10-K filing, TI had about 30,000 customers in 2003; Nokia (NOK) accounted for 14% of total revenue during the year. Over 80% of 2003 sales were made outside the U.S., and distributors handled 25% of 2003 sales.

On Jan. 25, TI posted fourth-quarter 2004 earnings per share of $0.28, vs. $0.29 in the year-earlier period, a penny above our estimate. Total sales of $3.15 billion fell 3% from the third quarter, compared with our expectation of a 5% decline.

Revenue in the Semiconductor segment of $2.80 billion was about even with the preceding quarter, as strong growth in products for the wireless market and higher royalty revenue were offset by declines in other businesses, primarily standard products, reflecting continued inventory adjustments by distributors.

SEASONAL DECLINES. Sensors & Controls segment revenue in the fourth quarter of $277 million was about even, sequentially. Educational & Productivity Solutions segment revenue of $80 million was down 58% sequentially due to a seasonal decline in product demand, primarily for graphing calculators, associated with the end of the back-to-school sales season.

Gross margin for the entire company of 42.3% declined 350 basis points from the 2004 third quarter, as TI decreased semiconductor factory loadings to work off inventory. Also, gross margin was hurt by a seasonal sales decline in the Educational & Productivity Solutions segment.

We were impressed with the $100 million reduction in inventory on the company's balance sheet. However, we believe total inventories will likely rise in the 2005 first quarter due to an increase in work-in-process inventory. In addition, although we believe the company's distributor customers have been making steady progress in recent months in reducing their own inventory to desired levels, we expect to see additional channel inventory adjustments in the first quarter.

LOOKING AHEAD. TI provided first-quarter earnings guidance of between $0.22 and $0.26 per share on sales of between $2.90 billion and $3.14 billion. The midpoint of the first-quarter sales guidance implies about a 4% sequential sales decline. We estimate EPS for the quarter at $0.22 on a mid-single-digit sequential decline in sales.

For all of 2005 we estimate that revenues will rise about 2%, reflecting our expectation of a significant moderation in worldwide semiconductor industry growth. We expect a new profit-sharing plan for employees to control bonus costs better than in the past. We project that gross margin will widen to 45.9% in 2005, from 44.7% in 2004, and we forecast operating expenses to increase year over year, primarily due to higher R&D costs. We expect the number of common shares outstanding to decrease in 2005, as buybacks should more than offset dilution from stock options. We see EPS of $1.11, versus the $1.05 reported in 2004.

What's behind our hold opinion on the shares? We believe TI's technology leadership position and scale-based advantages in R&D, manufacturing, and marketing should help it prosper over the long run. Although the shares are down significantly over the past 12 months, we think current valuation multiples are warranted, given our more moderate growth outlook for the chip industry in 2005. Also, we think the stock's valuation adequately reflects what we see as elevated macroeconomic risks and some lingering inventory concerns.

THE RISKS. At 20 to 21 times our 2005 EPS estimate and roughly 3.1 times our 2005 sales per share estimate (using the closing price of $22.66 on Jan. 26), TI is trading below the stock's average p-e and price-to-sales multiples in recent years. However, we think the discount valuation is warranted, given the concerns we've listed above.

The primary risk to our opinion and target price, in our view, is the possibility that future semiconductor demand will be weaker than what we anticipate. Other risks include competition in chip design and price, and the challenges of operating wafer plants.

12 Month Target Price History

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Note: Amrit Tewary has no stock ownership or financial interest in any of the companies in his coverage area. All of the views expressed accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed. Price charts and required disclosures for all STARS-ranked companies can be found at

Required Disclosures

5-STARS (Strong Buy): Total return is expected to outperform the total return of the S&P 500 Index by a wide margin, with shares rising in price on an absolute basis.

4-STARS (Buy): Total return is expected to outperform the total return of the S&P 500 Index, with shares rising in price on an absolute basis.

3-STARS (Hold): Total return is expected to closely approximate the total return of the S&P 500 Index, with shares generally rising in price on an absolute basis.

2-STARS (Sell): Total return is expected to underperform the total return of the S&P 500 Index and share price is not anticipated to show a gain.

1-STARS (Strong Sell): Total return is expected to underperform the total return of the S&P 500 Index by a wide margin, with shares falling in price on an absolute basis.

As of December 31, 2004, SPIAS and their U.S. research analysts have recommended 26.5% of issuers with buy recommendations, 61.3% with hold recommendations and 12.2% with sell recommendations.

All of the views expressed in this research report accurately reflect the research analysts' personal views regarding any and all of the subject securities or issuers. No part of the analysts' compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report.

Additional information is available upon request to Standard & Poor's, 55 Water Street, New York, NY 10041.

Other Disclosures

This research report was prepared by Standard & Poor's Investment Advisory Services LLC ("SPIAS"), and may have been provided to you either by: (i) Standard & Poor's under a license agreement with The McGraw-Hill Companies, Inc., which holds the copyright to this report; or (ii) a Standard & Poor's client who is granted a sub-license by Standard & Poor's. This equity research report and recommendations are performed separately from any other analytic activity of Standard & Poor's. Standard & Poor's equity research analysts have no access to non-public information received by other units of Standard & Poor's. Standard & Poor's does not trade in its own account. SPIAS is affiliated with various entities, which may perform services for companies covered by the recommendations in this report. Each such affiliate is operationally independent from SPIAS.


This material is based upon information that we consider to be reliable, but neither SPIAS nor its affiliates warrant its completeness or accuracy, and it should not be relied upon as such. Assumptions, opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. Past performance is not indicative of future results.

This material is not intended as an offer or solicitation for the purchase or sale so any security or other financial instrument. Securities, financial instruments or strategies mentioned herein may not be suitable for all investors. This material does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation of particular securities, financial instruments or strategies to you. Before acting on any recommendation in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Analyst Tewary follows semiconductor stocks for Standard & Poor's Equity Research Services

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