Stock Idea: Free cash flow zealot dominating unsexy sub-sector of semiconductor industry

My latest stock idea may not be as sexy of some of the other big name semiconductor chip manufacturers, but make no mistake Texas Instruments (NASDAQ: TXN) is a free cash flow monster well on its way to achieving dividend aristocrat status (a public company which has increased the size of its annual dividend for 25 years or more).

Texas Instruments (TI) is a global semiconductor company that designs, manufactures, and sells analog and embedded processing chips mainly to industrial, automotive and personal electronics customers. With a 70+ year history of innovation, TI were pioneers in the transition of the electronics industry from vacuum tubes to transistors and now to integrated circuits.

Featured in my recently published fourth annual Top 10 Dividend Stocks report - 2023 edition, Texas Instrument has done an excellent job building a dominant position in the fragmented analog chip market that other semiconductor behemoths have ignored. In 2005 TI began a major business model shift that has the company focused on higher margin analog and embedded chips.

Despite the ubiquitous digital chip stealing all the headlines because of their processing power and use in everything from fridges to phones to airplanes, analog chips are a growing opportunity. Given analog chips represent 77% of TI’s total revenue, this is a good thing. In addition to signal processing use cases, every electronic product requires analog chips to provide the power to run. Every time a new phone gets built or a new “thing” gets electrified so it can connect to the Internet, you better believe it contains analog chips.

TI has built their enviable market position thru vertical integration, ultra low cost 300 mm silicon wafter manufacturing, scale, direct to consumer (DTC) muscle (in 2019 one-third of TI business was DTC, in 2021 this rose to 70%), and diversification of products (TI has over 80,000 SKUs available for 100,000+ customers). TI, and its shareholders, enjoy the benefits of a very attractive market. The analog industry features low risk of inventory obsolescence due to long product lifecycles, lower capital requirements as the manufacturing equipment lasts for decades, high switching costs for customers who have designed chips into their devices, pricing power retained by suppliers, and lower R&D costs than digital chip manufacturers. The result is expanding gross margins that reached 67.5% in 2021 from 52% in 2013, and 12% annual growth of free cash flow per share from 2004-2021.

It is their religious focus on growing free cash flow for shareholders that led them to being one of the top dividend stock selections in my 2023 dividend report. TI is in the 89th percentile of the S&P 500 for free cash as a % of revenue. This is excellent news for shareholders as TI is committed to maximizing the return of cash to shareholders. Their annual goal is to return 100% of cash flow generated to shareholder with a target of 40-80% towards the dividend and the remainder to stock buy backs.

TI has a 19-year streak of consecutive dividend increases, growing at a 25% CAGR over this period. The stock currently sports a 2.7% dividend yield and appears to be quite safe with a 48% payout ratio.

TI has increased its near-term capital expenditure plans considerably from their norm, introducing some risk to cash available for dividend increases. I'm not concerned given their track record of excellent stewardship over the business and cashflow. As a long term shareholder I'm pleased to see TI investing to support their growth over the next 10-15 years. With strong demand for semiconductor chips expected over the next six years (12.2% CAGR from 2022 to 2029 - Fortune Business Insights), TI is smart to invest in extending their cost advantages and to gain greater control of their supply chain.

Valuation

TI is trading at a forward P/E ratio of 20.8, on par with its 5-year average and 2 pts above its peer's average. TI appears to be trading at fair value.

Risks

Despite its strong market position, TI remains susceptible to the volatility of the semiconductor industry.

Trade tensions between the US and China could result in China based customers moving their business to more neutral rivals based in non-US geographies.

Some analysts forecast a downturn in semiconductor demand in 2023 and 2024.

The Bottom Line

As the leader of the attractive analog chip industry and its religious focus on growing free cash flow for shareholders, Texas Instruments (TI) is a dependable dividend payer. TI appears to be in a great position to continue to deliver for shareholders, just like it has in the past. TI has an annualized total return of 13.5% for shareholders.

I have a position in Texas Instrument and as of this posts publish date (January 8th, 2023) its stock price is $175.16.

As with any investment decision you make it’s important to complete your own due diligence and assess if the investment matches your risk profile. Like any individual stock there is risk. You are entirely responsible for your own investment decisions.

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