Chit Chat Stocks - Texas Instruments (TXN) with John Rotonti

Episode Date: April 7, 2022

Texas Instruments designs and manufactures semiconductors and other integrated circuits. The company sells that technology to electronic designers around the world. Listen as Brett and Ryan ask Jon questions about the company, its business model, and valuation. Enjoy the show! This episode is sponsored by Quartr, the new way of doing company research. Access conference calls, presentations, transcripts, and more for FREE on your mobile device. Download Quartr on the App Store here: https://apps.apple.com/us/app/quartr-investor-relations/id1552412128  Download Quartr on the Google Play Store here: https://play.google.com/store/apps/details?id=se.quartr.android Subscribe to 7investing with the code "CCM" and get $10 off: https://7investing.com/subscribe/aff/4/ Want updates on future shows and projects? Follow us on Twitter: https://twitter.com/chitchatmoney Interested in more of Leandro's work? Follow him on Twitter here: https://twitter.com/Invesquotes?s=20&t=0NSDbs0svMweFlA1XoT0Yg Contact us: [e-mail]  Timestamps Texas Instruments | (3:37) What TXN Looks Like Today? | (14:06) Electric Vehicles & Robots? | (29:02) Disclosure: Chit Chat Money hosts and guests are not financial advisors, and nothing they say on this show is formal advice or a recommendation. Brett Schafer and Ryan Henderson are general partners and portfolio managers at Arch Capital. Arch Capital and its partners may hold securities discussed on this show. Learn more about your ad choices. Visit megaphone.fm/adchoices Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Chit Chat Money. This is our Thursday deep dive episode where we invite on one guest to discuss a single stock in a deep dive format. And today we are joined by John Rotonti and we're talking Texas Instruments, which is a company that admittedly Brett and I are not experts on in any way, but John definitely is. And he goes through the company thoroughly. Did you have any highlights from the interview? Yeah, just to be clear, it's not just the calculators. That's a tiny part of their business. We mentioned that during the episode, so don't get thrown off by that. But I just like talking about how management has their capital allocation strategy, and it's in line with the industry that they're in, and it's in line with how shareholders and all the stakeholders are hopefully going to benefit in the long run. And also they're one of these businesses, at least from the way he was pitching it, that have these broad tailwinds that are just going to make demand come to them, which is

one of those, that's a rare situation where they don't have to force demand to come to them. It already will come to them and that's why their margins are so high. So I think that kind of hopefully teases it a bit of why he thinks it's a pretty compelling long-term investment. Yeah. And at one point, he also gives an illustration of a customer use case, which I thought was really helpful as someone who isn't super familiar with the business. And he kind of just details where the chips fit in on a car. And I would say that's my highlight from the interview. So look out for that. But before we get to the interview, we got to talk about our friends, Quarter. They are the investor relations app for your phone. It's 100% free. You can listen

to conference calls, read conference call transcripts. There's presentations as well, all from your dashboard. I have to say, I've been reading a majority of my call transcripts on Quarter lately. They are one of the only ones that do it well. Yeah. It's, it's, it's usually, uh, transcripted properly and it's up pretty in a pretty timely fashion. So consistently good product. Yeah. Uh, I really actually recommend, uh, going and downloading it. It's really helpful if you're an investor. Um, they, they have companies from all over, like I said, a hundred percent free it's on Android and iOS and it's quarter Q U A R T R. There's no E at the end. Uh, so you go ahead, check them out. You can also follow them at

quarter underscore app on Twitter. Without further ado, let's get to the interview. Welcome to Chit Chat Money. On this show, hosts Ryan Henderson and Brett Schaefer interview industry experts and riff on the world of investing. As a quick reminder, Chit Chat Money is a CCM Media Group podcast. Ryan and Brett are also general partners at Arch Capital, and Arch Capital may have positions in the securities discussed in this podcast. Anything discussed on Chit Chat Money by Ryan or Brett or any other podcast guest is not formal advice or recommendation. Now, please enjoy this episode.

Welcome in. We are joined by John Rotonti. I'm going to say recurring guest at this point. I think you've been on. I want to say this might be the third time. But today we're talking Texas Instruments, and John is a lead analyst at, or senior analyst at The Motley Fool. He also is a manager of a real money portfolio for The Fool.

And Texas Instruments, to be clear, we just discussed this, is not in the portfolio yet. So maybe we'll get into why that is. But to kick things off, how did you come across Texas Instruments to begin with? Awesome. So I like the sound of that. recurring guest. I love this podcast. Definitely one of my favorites. And thank you for having me. So how did I come across Texas Instruments? In early 2016, I commenced a deep dive into the semiconductor industry and Texas Instruments. And I was new to the industry,

semiconductor industry, pretty much. And so I basically started by looking at the largest companies by sales or market cap or whatever in the semiconductor industry, and Texas Instruments was one of those. It pretty quickly stood out to me as one of the highest-quality companies in the semiconductor industry. I saw that it was highly unique and taking a completely different approach to value creation than many of the other high-profile companies in the semi industry. Importantly, though, TI also stood out to me as one of the highest-quality companies I had ever come across in any industry in roughly 15 years of researching businesses at the time. Excuse me. So at some point in 2016, I pitched Texas Instruments to Inside Value,

which was a value investing service we had at The Motley Fool at the time. And I was an analyst on that service. I think we decided to pass on recommending the stock at the time because our team was not yet fully comfortable with semis just given the cyclical nature of the industry back then. We were still in that learning phase. And then in November, 2017, a subscriber to Inside Value, that service that I worked on, posted a question to our message boards, which are like online chat rooms for The Motley Fool, asking if Texas Instruments is on our radar. And our team leader, Rich Griefner, immediately sent that board post to me because Rich had remember that I pitched TI back in 2016. And because honestly, I was probably constantly

talking about it in all of our weekly stock chat meetings. But rather than respond to that question on the message boards, I took that question and I put it into a watch list article that I published on Texas Instruments in November of 2017. So that was the first time that I publicly commented on the company. In that article, I explained that TI was not only on our radar, but that we had been researching it for more than a year. In that article, I also told a story of how at the time I told our chief investment officer, Andy Cross, that Texas Instruments is one of the highest quality companies not already in the Foolish universe. And I noted to Andy that I had not gotten that excited about researching a new business in a very long time. And so I told

Andy that about five and a half years ago, and I've been following TI closely since then. And I guess the moral of this walk down memory lane is that I don't get excited by too many businesses. I mainly get excited by what I believe to be the highest quality, most resilient growing businesses in the world. And there are probably about 100 or a couple of hundred of those that are somewhere on my radar, somewhere. I haven't done deep dives on all of those 100 or 150, but they're somewhere on my radar.

um ti excited me back then and it excites me just as much today maybe to wrap up this i'll just say that i believe texas instruments to be one of maybe a dozen of the very highest quality resilient growth businesses in the world today um i really do want to highlight that i think ti is one of the best of the very best okay that that's high praise before we go a little further i'm curious I guess I'm sure we have a lot of listeners that are kind of in the same spot as Brett and I, where they aren't experts by any means in the semi space. And it sounds like you were kind of in that position, what was it, five years ago. So how did you get familiar with the industry? Was it just like digging through 10Ks of each company or was there maybe, is there a place to start for the rookies of the semi industry?

So that's what I did back then. Like I said, I looked at the 10 or 12 largest companies in the industry, reading their 10Ks, reading their annual letters. At the time, I had this thing where I insisted on reading eight quarters of earnings transcripts for whatever company I was covering. So basically, two years of earnings transcripts. If they had a slide deck, went through that. If they had a proxy, I read that. That's how I started. That helped me understand what I believe were the good businesses and the lesser quality businesses. It did not really help me understand the science, the material science behind semiconductors. That I didn't get until more recently, let's say three-ish years ago, when I started reading industry research from

Gartner, for example. I started speaking to PhDs at Gartner, for example, and I started speaking to industry investing experts that cover the semiconductor industry. I learned just immense amounts from speaking to these PhDs and these investors that specialize in the semiconductor industry. That's where I really started to understand the science behind it all and the physics behind it all. It was a journey. it's a five or six year, five or six year journey. And that's how I did it.

And now, you know, you can go on YouTube, you can watch all these videos about the science and there's all these tours taking you behind the scenes and the, in the fabrication facilities and all of that stuff. And so, yeah, I, I've done it all. All right. Yeah. It's a big mountain to climb. Can you give a brief history of Texas Instruments? I know we could go an hour on that because of how old the company is.

So just to get us to the context of where we are. It's not just a calculator company anymore. is what I'm saying. Right. You know, it's funny. It was never just a calculator company. It's just that's the consumer-facing product that they sell, right? And so, that's what people associate with Texas Instruments. So, the predecessor company to Texas Instruments was Geophysical Services Incorporated. That was founded in 1930. The company sold equipment and electronics to the seismic industry and the defense industry. That company was eventually reorganized into Texas Instruments in 1951. The name Texas Instruments dates back to 1951. I think the early history

really shows how many technologies TI invested behind, how many they invented, and how it has this very long history of roughly 70 years of being an innovator. The history also shows that in the early days, TI was involved with a bunch of different stuff. Its business probably wasn't very focused, definitely not as focused as it is today, which we'll get into, and its business definitely wasn't as profitable as it is today, which we'll get into. But just a couple of the big inflection points, if you look at the history in 1954, completely separately, Bell Labs and Texas Instruments both created the first silicon transistor. In 1954, TI also made the first transistor radio. Then there's maybe some debate over which company invented the first

integrated circuit or IC. Back in 1958, Jack Kilby of Texas Instruments patented integration and created the first prototype IC, and then Texas Instruments commercialized and sold that IC. Kilby was eventually awarded the 2000 Nobel Prize in Physics for inventing the integrated circuit. So, TI does get the credit there. Now, Robert Noyce at Fairchild developed a different type of integrated circuit, a monolithic circuit, I think about a year later, a year after Kilby at Texas Instruments. And that is really the type of integrated circuit that has become the basis of modern semiconductors. Let's see. TI also invented the first handheld calculator, as we discussed, and the first digital light processing device. That's the technology behind digital

projectors like digital cinema, rear projection televisions, and that type of thing. TI eventually sold off its defense business to Raytheon, but where I think its modern history starts is when Rich Templeton became CEO in 2004, so 18 years ago. He is the remarkable architect of TI's business model shift, which began in 2005, 2006. He focused the company on analog and embedded chips and moved the company towards faster-growing products with higher margins, lower capital expenditure needs, and longer life cycles. He also leaned in towards creating a massive manufacturing competitive advantage. He got out of the company's lower growth, lower margin, highly cyclical wireless business.

He bought manufacturing assets out of bankruptcy for pennies on the dollar during the global financial crisis. And he acquired National Semiconductor all the way back in 2011, when prices for assets still had not fully recovered coming out of the GFC. National Semi, that company he acquired, supercharged Texas Instruments' growth into autos and industrial end markets. And right now, currently, he is architecting the next major growth investment cycle in TI's long history, which should enable organic revenue growth of around 7%, possibly higher, over the next 10 to 15 years. So that's a brief history of where Texas Instruments has been. I hope it shows a history of its innovation and adaptability.

And if you want, we can talk more about what Texas Instruments looks like today. Cox Panoramic Wi-Fi includes advanced security to help protect all your connected devices. You'll get real-time alerts. Oh, like this one. So you don't have to worry about malware. Or when your kid downloads a song from a shady link. And now all your computer can play is... Red, color, where are you?

All blocked. Thanks to Advanced Security. Included with Cox Panoramic Wi-Fi. Advanced Security must be enabled in the Panoramic Wi-Fi app. Restrictions apply. Yeah, let's do it. So what is, you kind of alluded to it there at the end of the history, but what are they selling primarily today?

And then how do they, who are their typical customers? And maybe add in financials today too. Okay, awesome. Awesome. So today, Texas Instruments is one of the 10 largest semiconductor companies in the world measured by either sales or market cap. I also think it is the largest as measured by the number of products sold, which is about 80,000 different products.

In 2021, Texas Instruments generated about $18.3 billion in sales, $7.8 billion in gap net income and gap earnings per share of $8.26. It does not report non-gap earnings like nearly every other company on earth that I can think of. TI pays a quarterly dividend of $1.15. So that's an annual dividend of $4.60. And at a stock price of $180, that's a 2.6% dividend yield. And that dividend is growing rapidly, which is something I hope we discuss later on when we talk about capital allocation. Texas Instruments designs and manufactures analog and embedded semiconductors mainly for the industrial, automotive, and personal electronics industries. At year-end 2021, analog was 77% of revenue. Embedded processors made up 17% of revenue.

41% of revenue is sold into the industrial sector, 24% into personal electronics, and 21% into automotive. It's two primary markets that it's leaning into most heavily are industrial and automotive. So 62% of revenue comes from industrial and automotive end markets. That's up from 42% in 2013. So 62% up from 42% in 2013. Once again, you can see the clear shift in strategy towards automotive and industrial. The rest of the revenue comes from communications equipment, enterprise systems for things like data centers, and then, of course, a tiny single-digit percentage from calculators. They are vertically integrated. They manufacture about 80% of their chips in-house, and I think they manufacture 90% of their analog chips in-house. This provides them with an ultra

low-cost manufacturing advantage and gives them more control over their supply chain and customer service. TI manufactures on 300-millimeter wafer technology, and manufacturing on a 300 millimeter wafer costs 40% less than manufacturing on a 20 millimeter wafer size. And manufacturing on 300 millimeter has 70 to 75% incremental gross margins for TI. They are currently entering a much more aggressive CapEx investment cycle to drive growth for the next 10 to 15 years. And they have targeted a 10 to 15 year organic revenue CAGR of around 7%. When painting a picture of TI, we need to highlight that it really is in this major investment cycle right now, with a goal to manufacture 90% of all of its chips internally by

2030, up from 80% today. How major? Well, in 2021, TI… So, let me step back. In the five years from 2016 to 2020, TI spent an average of $771 million per year in CapEx. That was about roughly 5% to 6% of sales. That was from 2016 to 2020. Then in 2020… I'm sorry. Then in 2021, TI's CapEx jumped to $2.5 billion, which was 13% of sales. And from 2022 through 2025, it is expecting CapEx to average $3.5 billion per year. Remember, just a few years ago, it was averaging $771 million per year. In other words, TI's CapEx in 2021 was about 220% higher than its average over the prior five years. It will be 350% higher than the prior five-year average from 2022 through 2025. Then starting in 2026, TI is guiding for CapEx to average about 10% of sales per year.

Even after it exits this current heavy investment portion of the cycle, TI still expects its CapEx to sales ratio to be 10% over the long term versus historically 5%. It is investing this CapEx to grow its wafer fab capacity and to grow its capacity to assemble and test the final product internally as it continues to vertically integrate further. And like I said, the goal is to support 7% average annual revenue growth. So before I get to the numbers, what makes TI unique? When an investor thinks about TI, they should focus on a few key business model and value drivers. First, its revenue is extremely diverse by end market and geography.

We already discussed the end market breakdown. Also, I'll say it sells 80,000 different products to about 100,000 different customers, and only about 10% of its revenue is generated in the US. So if you're looking to diversify a portfolio geographically, TI could be an excellent choice. It's diamond-solid in the US with headquarters in Dallas, Texas, but 90% of its revenue comes from outside of the US with 55% coming from China, 12% coming from the rest of Asia, and 15% coming from EMEA. Two, TI sells long-lived, long-lived analog and embedded chips primarily to the industrial and automotive end markets. Its auto chips have an average life

of about seven years. Its industrial chips have an average life of about 10 years. Because of this, and this is important, TI is less tied to Moore's law and rapid technological change than many other semiconductor companies. TI is still selling some chips, Ryan and Brett, that it designed 30 years ago at an average, at a gross margin of 80% to 90%. Chips are designed 30 years ago. So if they don't sell a chip this quarter or even this year or even next year, it doesn't matter. They'll sell it eventually. The technology and the demand are not going anywhere over the long-term. The question I get most often with Texas Instruments is, why are they selling these boring, old-school analog chips when everything else in the world is going digital and digital

is exciting and digital is fun. The reason is because TI is this amazing business. It's run by an amazing leader. They realize that there's this analog paradox at work, meaning that as the world shifts to digital, the demand for analog grows in tandem. One easy way to see this is that digital chips only work on two voltages, high and low, but analog chips can work on an infinite number of voltages. So analog chips are always going to be needed to manage the power in digital chips that require different voltages. Another way to think about this is battery life. Analog circuits charge the battery, maintain that charge in the battery, estimate the power left in the battery, discharge energy from the battery, and then convert that energy from the battery to what

the other chips and electronics need to do in the device, whether it's something for the screen or something to engage the buttons or whatever. All those components need different voltages to operate, and power analog chips are the only way to do that. So I have 99% conviction that the world is going to need a ton, like literally a ton more of these inexpensive, boring, quote-unquote, lagging-edge chips as we continue to see the electronification of everything as we shift to an IoT world.

But three, TI is vertically integrated and probably has a roughly five to 10-year manufacturing advantage over its competitors. It is still the only pure play analog company manufacturing on 300-millimeter wafers, as far as I can tell, which, as we said before, reduces costs by 40% and has 70% to 75% incremental gross margins. The reason is because a 300-millimeter wafer is larger in size. than a 200-millimeter wafer. A 300-millimeter wafer has about 2.3 times more surface area, which means you can cut about 2.3 times more chips from the wafer.

TI owns and operates 15 manufacturing facilities today. The reason I think this is a strong and durable competitive advantage is because of the time and the scale or the volume that will be required for its competitors to move all of their analog revenue onto in-house 300-millimeter assets. In fact, some of its competitors are currently moving in the opposite direction by going more fabless and manufacturing that capacity out to third parties. Four, in 2019, about one-third of Texas Instruments' business was direct-to-consumer, or DTC. So that's 2019. I'm sorry. In 2019, about one-third was DTC. By the end of 2021, this grew to 70% as the company continued to build out TI.com, as it built out its direct

sales force and support, and as it built out additional supply chain and logistics. So with their DTC business, customers can literally now go online and have the product show up within two days almost anywhere in the world. And in major hubs like in China, they do multiple deliveries each day. I really cannot stress how unique this is. the industry is used to operating with backlog and normal lead times of like 12 to 16 weeks. Like literally, I don't think anyone else is doing two-day delivery. In China, they're doing multiple deliveries per day. So just once again, this shows their heavy emphasis on selling catalog of products across 80,000 products and their heavy emphasis on fully integrated vertical

integration. Five, Rich Templeton, CEO, and Raphael Lazzardi, CFO, are one of the very best one-two combos I've come across in 20 years of doing this. This is just an excellent management team. They understand the few key drivers of intrinsic business value. They understand the importance of building and investing in multiple competitive advantages that overlap. They understand the importance of taking a stakeholder-first approach to value creation. They understand the importance of innovating and adapting, but in a controlled, methodical, deliberate, intentional way. They understand when to strike and push the gas pedal to the floor, and then when to throttle back on growth. They understand accounting and value creation.

They truly excel at both operations and capital allocation. They understand the importance of investing in assets with high terminal values, these long-life assets, and they are trying to invest to maximize long-term growth. They're trying to extend that growth out over multiple decades rather than just maximizing growth today with the risk of flaming out. And then six, and lastly, the numbers, Brett. So there are few companies as profitable and financially healthy as Texas Instruments, in my opinion. So quick look at the balance sheet first. This is a solid, massive rock of granite. It has $1.5 billion in net cash. The debt that it does have has a weighted average interest rate of only 2.6%.

percent. Debt to capital, 38 percent. Total debt to EBITDA is less than one times. Its interest coverage, EBIT to interest expense, is a whopping 49 times. It has an A-plus credit rating from S&P Global and a very attractive credit rating from New Constructs, and that is their highest rating category, very attractive. Its credit facility is undrawn, and it has zero commercial paper outstanding. It has zero bank debt. So all of its debt is corporate debt and it has zero variable rate debt and its pension is 100% fully funded. So if someone asks me, what does a strong balance sheet look like? Honestly, Texas Instruments is going to be one of the case studies and then profitability. And then I'll throw it back to you. It's profitability is just really a thing of

beauty. So its gross margin was 50% in 2011, and it increased to 64% in 2020. So gross margin then increased again to 67.5% in 2021. But 2020 was a strange year because we had this massive supply-demand imbalance. So I'm just going to use 2020 numbers. So from 2011 to 2020, gross margins increased 14 percentage points or 1,400 basis points. EBIT margin was 25% in 2011. That increased to 41% in 2020. And then once again, EBIT margin increased to 49% in 2021, but that was a strange year. So from 2011 to 2020, EBIT margins increased 16 percentage points or 1,600 basis points. So you've got this very consistent and very substantial increase in gross and EBIT margins. Then you've got this very, and we talked about historically, they had this very

steady CapEx, which was historically about 5% of sales, and they don't really make acquisitions except for 2011. So it's 2011 to 2021, average free cash flow margin was 30%, but it's 2016 to 2021 average free cash flow margin jumped to 35%. So to repeat, it's 10-year average free cash flow margin, 30%, but it's five-year average free cash flow margin, 35%. And you see that same improvement with its return metrics. So for returns on capital, I'm using new constructs numbers. 2011 to 2021, its average ROIC was 20%, but that jumped in 2016 to 2021, its average ROIC was 27%. So once again, it's five-year average ROIC, much higher than its 10-year average ROIC. And so you've got this company with incredible fundamentals that have only gotten more

incredible over time. All right. That's a great overview. One thing on the end markets, I think a lot of people, when they hear industrial or automotive, they kind of say like, all right, what specifically within that is Texas Instruments doing? Is it really electric vehicles and like full self-drive or not full self-driving autonomous vehicles with an automotive and then in industrial is it really just digitization and robotics coming into factories is that the tailwind that texas instruments is going after or is it something different yeah so um that's a great question so so let's let's so so they sell 80 000 different products right and so their chips do a lot of different things but maybe we'll focus on on auto as a simple example since you asked

about auto. And then we'll get to industrial next. So first I'll say cars today, even cars today, internal combustion engine cars, ICE cars are just computers on wheels. They're run with chips. Now EVs and autonomous vehicles eventually are going to run on even more chips. I think it's anywhere from three to five times more chips in an EV than in an ICE engine car. But still, even ICE engine cars run on just tons of chips. So yes, they will benefit as there's more chip content as we shift more to EVs. But even in an ICE engine, so every piece of electronics in the car needs the right voltage and current. If it's a fan in the car, if it's a seat motor, if it's a dashboard display, if it's an infotainment system display, if it's a headlight,

turn signal, the engine, you mentioned autonomous driving assist systems, everything. And so TI sells power chips into nearly every electronic application across the car, okay? That's one thing. That's power. Then there's also signal chain. So, signal chain chips sense real-world signals like temperature, gas, light, sound, vibration, movement, these real-life signals. they convert it into an analog signal so that it can be moved across a wire before it's converted back into a digital a digital reading in the car so like when you're um like low tire pressure right uh shows up on your dashboard the pressure is a real world signal that the chip needs to read and then needs to convert it from analog to digital so that can show up on your dashboard

TIs behind that or analog and embedded chips are behind that. So in an industrial, it's the same thing. It's chips used for automating the factory. Yes. And the same things, sensing things across the factory, converting it from analog to digital, and then doing everything with the batteries and the voltage and the current that we talked about in the car. It's all the same uses for a factory. And then in personal electronics, I'll just say quickly, so like button controllers, for example. So just to sense when a button has been pushed, you need a chip for that. And then think of all of the buttons, and TI does that. It has chips to sense when a button has been pushed.

And then think about all of the buttons across all of the electronic devices in the world. And then think about all the additional electronics we're going to have over the coming decades as we shift more to an IoT world. So that's just an example of how Texas Instruments really sells chips across automotive, across industrial, across personal electronics and what those chips do. So first of all, and I think you may have mentioned this earlier, do they have any true competitors? And then if the answer is no, what's prohibiting someone from doing exactly what TI is doing? Is it just like the manufacturing expertise or is there more to it? So they do. They have competitors for sure. I think that TI is the market share. Oh, not think. I know that TI is the market share leader in analog. I think they're top three in embedded. So I think analog, Semiconductor Manufacturing Association came out with numbers for 2021. I think analog is a $74, $75 billion industry right now globally, and I think TI has a high

teens market share of that in analog. And so, yeah, I mean, it definitely has competitors. It competes with a lot of good companies. So STM, Microelectronics, Microchip, NXP, Semiconductor, Renaissance. But its largest competitor is definitely analog devices. That's ticker ADI, especially because analog devices has made so many large acquisitions in the analog space. So analog, I think they made three fairly sizable acquisitions going back to 2014. So they acquired Hittite in 2014, they analog acquired linear technologies in 2017, and they acquired Maxim in 2021. And so again, analog is sort of rolling up a lot of the market share in the analog industry. And I'm sorry, analog devices is rolling up a lot of the market share in the analog industry, and is a real competitive threat. analog devices is also a real good business as well. I'll highlight maybe a few differences. So let's see. So TI is much larger and has achieved greater scale. And it's done so organically,

not through acquisitions, as we've discussed. So TI's annual run rate sales is $18.3 billion. And ADI's annual sales are $8.4 billion. And then their profit margins and returns are in different categories right now. Once again, ADI is a good business. I'm about to read you some margins. It's a good business. ADI has EBIT margins in the 25% to 30% range, but Texas Instruments has EBIT margins in the 40% range. ADI's return on assets and its return on invested capital are in the single-digit range, both for ROA and ROIC. TI's return on assets and its returns on invested capital are both above 20% plus. So it's got ROA and ROIC over 20%. So that's the first thing. Second thing is TI is more vertically integrated than ADI. TI manufactures 80% of its

chips in-house, as we discussed, and they have plans to manufacture 90% of its chips in-house by 2030. That compares today with ADI, which manufactures about 50% of its chips in-house, And that's as per ADI's most recent 10K. Three, ADI has, sorry, go ahead, go ahead. Well, I was just going to say, and I might be kind of demonstrating my naivete here, but like if I'm a customer and I need analog chips, why would I go to,

why would I select one of either ADI or Texas Instruments? Are they different products? is there like why should a customer prefer one over the other it's some are different products yes they both have large catalogs ti's is larger um we talked earlier about ti can get you get it to you in two days a lot of other people can't do it for weeks um ti's customer service is the third reason but probably the most important reason is these chips cost less than a dollar okay and once you work a chip once you design a chip into a device like into a car that chip is in that car for the life of the car right and if something for the life of the car i mean that's

that's actually based on like regulations i think even and so if if if that chip goes bad or something it's got to be replaced by the same chip and let's say ti sells a chip for 35 cents and its competitor sells a chip for 20 cents, are you going to try to save 15 pennies when you've already designed your entire product around a specific chip? And the answer is no. And so there's not a lot of shifting market share in this industry. And so, yeah, I mean, there's lots of reasons. They don't talk about it, but it's just kind of known. Texas Instruments' largest customer is Apple. And it's because of the iPhone. I mean, I don't think Apple is a 10% customer, but it's close. And so, you've got the biggest company,

most important company, most profitable company selling the most coveted product in the world relying on Texas Instruments. And so, I mean, these chips get built into a product. And like I said, they have long life cycles, 7 to 10 years or more. And so, once they're designed in, they just kind of stay and they're not going to switch out for this to save a couple of pennies. Right. With the iPhone, it's only, it's barely any of Apple's costs. That's kind of anything. Yeah. Nothing, nothing. Yeah. The third big difference is ADI incorporates much more acquisitions into its

strategy. In fact, ADI discusses its acquisition strategy on page one of its 10 K on page one of its 10 K TI has an acquired a business since 2011 when it acquired national semiconductor. Now, it's acquired some assets since then, like a factory or two, but it has not acquired a business. Four, TI manufactures significantly more of its chips on 300-millimeter wafer fab, which, as we said, reduces the cost by 40% and carries very, very high incremental gross margins. I think ADI is using some 300-millimeter fabrication on the fringes, as far as I can tell, but I don't think it's a core part of their manufacturing strategy right

now. And I do think TI has this five to 10 year lead in ultra, ultra low cost, 300 millimeter manufacturing excellence. Five, TI is more, TI focuses more on selling catalog parts. So, and what I mean by that is like, think about a catalog. You can like just scroll through hundreds or thousands of parts. Well, they have 80,000 parts that you scroll through. And these parts, they fit multiple purposes and multiple customers, multiple applications. It's my understanding that ADI is shifting to more custom chips, so not something that you buy out of a catalog, right? I think this is sometimes referred to as differentiated analog or integrated analog. TI's catalog approach, though, makes it less dependent on any one customer, any one application,

or any one technology, and it ensures that really diverse revenue stream that we talked about. six. This one's interesting. ADI spends about 12% of revenue on SG&A per year. Okay. About 12% of revenue SG&A, which is very similar to TI, which spends about 11% on SG&A every year. But ADI spends 18% to 19% of revenue on R&D, and TI only spends about 11% of revenue on R&D. Uh, so even though, but even though TI is spending so much less on R and D as a percent, as a percentage of revenue, it's spending more than ADI every year based on an absolute dollar amount because it has greater scale. So TI spends about 1.5 billion per year on R and D. And I think the reason that ADI spends so much on R and D as a percentage of revenue is because

the three companies that it acquired were spending such high amounts of R and D. But honestly, I don't think those companies were growing very fast. So I'm not sure how much that higher percentage of R&D to sales is contributing to growth. I'll just say this. Spending more on R&D does not guarantee higher revenue growth. It only guarantees higher spending on R&D. right? There's this sort of love affair with companies spending on R&D right now. I love innovation and invention as much as anyone, but you want to be able to measure the effectiveness on that R&D. You want to be able to measure the return on that R&D in some way. We talked about it. TI is putting out hundreds of new products every year. That's one way to measure the effectiveness of their R&D. TI's gross margins have exploded up. That's another way to measure the effectiveness of their R&D. ADI's gross margins have actually fallen a little, if I'm

being honest. TI's returns on invested capital have exploited up. ADI's returns on invested capital have actually fallen a little bit, if I'm being honest, according to new constructs numbers. And so spending double almost what TI is in R&D to revenue, I don't see the payoff yet. I just don't see it. So TI is a much more methodical, deliberate spender. And then just the last, the seventh difference I'll mention is very quickly, ADI's share count is going up and TI's share count is going down, way down actually. Yeah, that leads right into capital allocation. You mentioned they're very strong at that.

Really great track record. Templeton, the CEO on the website, has that great free cash flow per share quote. And we had a nice little question from Twitter from Stonk Metal, which is a great name. Stonk Metal, yeah. uh he they wanted to ask you know with capex going up what do you think about the tug tug of war between capex dividends buybacks do you really care too much or do you put too much do you put any thoughts on that thank you for the question um so you mentioned the quote by by templeton by rich templeton their ceo that they have up on their investor relations page uh so a focus on

long-term growth of free cash flow per share was really implemented by rich templeton when he took over in 2004, and has become ingrained in the culture and the soul of the company. I think Rich Templeton and TI should be seen as modern-day exemplars of focusing on what matters, which is ultimately the long-term growth of free cash flow per share. And so here are just a few other quotes to show you what I mean. So here is one that Rich Templeton gave at a Morgan Stanley conference just last month, March 2022, quote, the religion that we believe greatly is to be successful and grow free cash flow per share over the long-term, end quote. Here's a quote from Rafael Lozardi, their CFO,

at their 2022 Capital Management Day. So just once again, a month or two ago, quote, we fervently believe that the driver of value for the long-term owners of the company is the free cash flow per share growth over the long term. And then just one last quote, because I can't help myself. Also from Rich Templeton at the Morgan Stanley Conference a month ago, quote, and the way we talk about these competitive advantages is that they've got to give you a tangible benefit. It's got to be something that's difficult to replicate. And in the long term, the real test of whether it exists or not, is can you grow your free cash flow per share faster than your best competitors, end quote. So, Brett and Ryan, to use phrasing like religion and fervently believe,

you really get a sense very quickly that this is not marketing or like PR bullshit, right? To talk about how a competitive advantage must be difficult to replicate and must result in a tangible, measurable benefit the way they do. And then you compare that to some non-earning, cash-burning companies operating in low barriers to entry. It's just they take a completely different approach. So anyway, this is the leadership of Texas Instruments exposing the soul of this company. When you talk about religion, when you talk about getting down to the core of their existence, and for TI, that core of their existence is to treat all their stakeholders well in their long-term quest to grow free cash flow per share.

I challenge someone to do a word search for free cash flow per share in their capital markets calls or in their earnings calls or in conference transcripts. You will lose count. I literally cannot count the amount of times they say it. So that's their soul, right? That's their religion. That's their focus, long-term growth of free cash flow per share. And then how do you do that? That's through capital allocation. Now we'll talk about capital allocation. Depending on how you calculate free cash flow, Ryan and Brett, there are only four or five uses of free cash flow. That's it. If you are not an acquisitive company and you are not subtracting acquisitions to get free cash flow, which Texas Instruments doesn't because they don't make

acquisitions, then there are five uses and only five uses for free unencumbered cash. a company can, one, make acquisitions, two, pay down debt, three, pay a dividend, four, buy back stock, and then five, let it build up on the balance sheet. Texas Instruments, their philosophy, their capital allocation philosophy, they have committed to returning 100% of their free cash flow to investors through dividends and buybacks. It does not hit that goal every year, but that is the long-term objective and that is how they prioritize cash allocation, right? And the formula is simple. It aims to use 40% to 80% of its annual free cash flow to pay a growing dividend and to use the remainder

to buy back stock only when it believes the stock is trading at a discount to its intrinsic value. And Rafael, the CEO, he has a DCF and he lives and dies with that DCF. It's an intrinsic value calculation on when and how much stock they buy back. So 40% to 80% of annual free cash flow goes to the dividend, and the remainder goes to stock buybacks. The current dividend yield is 2.6%, and it has increased the dividend for 18 consecutive years. Since 2004, which is the year Rich Templeton took over as CEO, its dividend per share has compounded at a 25% CAGR. And more recently, it's five and it's 10-year dividend per share CAGRs are both over 20%. So if you're looking for a solid dividend growth company, in my opinion, this is one of the very best.

Regarding buybacks. Oh, yeah. Sorry. That's exactly what I was about to ask. How much are they buying back? A lot. Yeah. So regarding buybacks, it has reduced its shares outstanding by 46% since 2004, when Rich Templeton became CEO. So to repeat, since Rich Templeton became CEO in 2004, TI has increased the dividend for 18 consecutive years at a CAGR of over 20% and has bought in nearly 50% of the shares outstanding. So that's dividend and buybacks. The company has not acquired a company since 2011. And then the rest of the cash flow is used to pay down debt when it comes due, or it just builds up on the balance sheet. And so it's a very simple, yet very, very effective capital allocation

philosophy. And yeah, this team is one of the best at it. Oh, Brett, you asked me about could free cash flow decrease in the next couple of years as CapEx increases? For sure. for sure. But this is a company giving a 10 to 15-year target. And that's how they think. They think in decades. And so their goal is to grow revenue organically by at least 7% per year over the next 10 to 15 years. Now, over the next one to two years, they may not hit that 7% mark. And over the next one to two years, free cash flow may fall a bit, but they have a lot of margin to give. I mean, this is a company, I just told you, they generated five-year average free cash

flow margins of 35%, right? And so they have a lot of margin to give. They have a lot of free cash flow. Could it decrease in the short term? For sure. But this is the type of company and the type of leader that has the capacity to suffer. They're willing to take that short-term pain for the long-term gain. And I'm, as an owner, I'm going to be along for that ride.

Okay. And let's talk valuation because I'm wondering, listening to this conversation, I'm convinced of the quality. And so in my head, I'm thinking, what's the holdup? Why isn't it a part of the real money portfolio? I think maybe we'll be getting to that. But the enterprise value right now, I think, is around $161 billion, maybe a little higher. And they generated, correct me if I'm wrong, $6.3 billion in free cash flow last year.

So what expectations do you think are embedded in the stock right now? And do you think Texas Instruments can exceed those? So thanks for the question, Ryan. You know me, so I try to come at valuation from a lot of different angles. I try to triangulate what I think is a reasonable range of expectations. And so you mentioned the enterprise value and the free cash flow. Yeah, those numbers are spot on. So that's a 4% free cash flow.

So the first method, right? Here's my first method. That's a 4% free cash flow yield. And at a 4% free cash flow yield, Texas Instruments only has to grow free cash flow at 6% annually to generate a roughly 10% annualized return over the next 5 to 10 years. So that's just 4% free cash flow yield plus 6% growth gets you to 10%. I think that can hit that. So that's sort of like my bottom range of my estimate right there is, you know, I think

at a minimum, I think at a minimum, you've got a 10% annualized return using that sort of free cash flow total return formula, which is free cash flow yield plus expected growth of free cash flow. So that's 10% right there, expected annualized return. Another way I think about valuation and return expectations for a company that pays such a beautiful and growing dividend is I think about total shareholder return is equal to earnings per share growth plus dividend yield plus or minus the change in the P-E ratio. And that's just math. That gets you literally exactly your total shareholder return, earnings per share growth, plus the dividend yield, plus or minus the change in the PE ratio.

Right now, Texas Instruments is trading at 20 times forward earnings, which is perfectly in line with its 10-year average forward PE, according to S&P Global. By the way, the S&P 500 is also trading at 20 times forward, according to FaxUp. So let's assume no change in PE ratio, since this is perfectly in line with this 10-year average. TI currently has a 2.6% dividend yield. Let's round that up to 3% just to make the math quick and easy. That means Texas Instruments only has to grow its earnings per share by 7% annually to generate a 10% annualized return. Do I think it could do that? Yes. So to be clear, I think these assumptions are conservative once again. For one, why do I think they're

conservative? For one, I think it can grow earnings per share or really free cash flow per share by at least 10% over the next 10 years, which when added to the dividend yield of roughly 3% would provide investors with roughly 13% annualized returns. But also TI is trading at 20 times forward, which is in line with its 10-year average, as we said, but it's also a market multiple, a market multiple for one of the best businesses in the world, in my opinion. Its 10-year average is 20 on a forward basis, but its six-year average is 22. Its six-year average forward PE is 22, and its five-year average forward PE is 23. So multiples have been trending higher in recent years, right? And so there's reason to believe that it's 20

times multiple could expand from here. So I think TI deserves to trade at a higher than a market multiple. I don't think it deserves to trade at just a market multiple because of its extremely high incremental returns on invested capital, plus its low risk profile, in my opinion, plus the high probability that it will experience accelerating organic revenue growth because of this massive investment cycle that we just talked about. So if you assume even modest multiple expansion and EPS growing at 10% per year, and then plus that 3% dividend yield, you can easily see 15% annualized returns in that scenario. So I think a reasonable range of expected returns is somewhere in the 10% to 15% range over the next five to 10 years.

And then the third method is, if we use the new constructs reverse DCF, you can see that at Texas instrument stock price of about 180 per share, free cash flow only has to grow 6% at a 6% CAGR over the next 10 years. So to justify today's stock price of about 180, free cash flow has to grow at a 6% CAGR over the next 10 years. In that reverse DCF, I'm assuming net operating profit before tax margins, I'm assuming they drop because as we talked about 2021, everything was elevated. So 2021, it's net operating profit margins before tax were 50%. I dropped those down to 46% in year 10 of the model. Remember, TI has just set a long-term goal to grow organic revenue by 7% per year. So I think they can grow free cash flow by at least 7% per year. But the stock price today only demands that they grow 6% free cash flow annualized over

the next 10 years. And so basically, that's saying that the reverse DCF from new constructs is suggesting that the stock is moderately undervalued, but I'm comfortable saying it's trading somewhere around fair value, somewhere around fair value. So the reason it's not in the portfolio that I lead for The Motley Fool yet, I'm not suggesting that it's going to be in soon. I'm just suggesting that it's on our short list, on our watch list. The reason is because the goal of the portfolio is to 3X in five years, which is 25% annualized returns. And so I have to take some big swings in that portfolio. I am going to layer in a lot of these resilient, more moderate growth businesses.

I am, and I have, and I do think I'll find a place for Texas Instruments in that portfolio at some time before the end of this year. I just haven't done it yet. But yeah, it's at the very top of the watch list, Ryan. Okay. And one follow-up I have here, well, I guess I have two. I don't know if they're two related. I might just separate them out. So you mentioned China's a big portion of revenue. I kind of think that could be a risk if there's a decoupling from China, that there's talk of all that and stuff. And maybe you can correct me if or wrong if there isn't, but also if we, if the United States and Europe decide to, you know, they've talked a lot about it, they're making those big announcements of reshoring all the

stuff back into North America, South America, and Europe, the, you know, manufacturing and all that stuff, would that benefit Texas Instruments, you think? Or would that be a net negative? How do you think about those maybe tug and pull there? Yeah, I think it's, you know, I think there's some offsets there for sure. So if you were to ask me, what do I think is the biggest risk of investing in Texas instruments today? It is China. 50% of its revenue, more than 50% of its revenue comes from China. And China is currently investing hundreds of billions of to build their own homegrown semiconductor industry. And as you said, relations with China aren't great. Going back to the previous administration, the White House, there was a

full-blown trade war going on with China. It was an actual trade war. I don't know if we're in a trade war today or not. But relations with China are not as strong as we would probably like them to be. And so, yeah, that is a risk. China is investing hundreds of billions to build their own homegrown semiconductor industry. But I do not think Texas Instruments can be easily replicated given its 80,000 product catalog and its 70 years of innovation and patents. And then just what we talked about, choosing to switch out a chip that your products rely on and that other software is written into and that a chip that only costs 30 cents or something like that. Those chips are not switched out of that frequently. The other thing is China seems to

be focusing its semiconductor investments on leading-edge digital chips for things like HPC, high-performance computing, AI, cloud, and all of those things. So I'm not overly concerned. As the world is tripping over themselves and China, tripping over themselves to get into digital chips, TI is generating 40% free cash flow margins, supplying analog chips, which are needed to run digital devices. And then, you know, you said it. There is this massive push right now for sovereignty when it comes to semiconductor development. And so the US, Europe, and South America, Japan, another place in Asia, all trying to build homegrown, reliant semiconductor industries. It's not going to happen overnight. It's going to take time. But yes, that could offset some of the risk, potential risk of losing business from China. So did I answer the question?

I think so. What about the semiconductor down cycle? I know people have been talking about gluts. There's been worries about the glut coming. I know there's people predicting that. I know it's very hard to predict. How could that impact them? Would margins go down most likely? I know there's been semiconductor cycles in the past, so maybe we have examples. Yes, we do. And we have recent examples. The margins will most definitely go down. So the semiconductor industry peaked, I think, around Q3 or Q4 in 2018. So 2018 was a very strong year for Texas Instruments and for the semiconductor industry. And then we entered a down cycle in 2019. And so in 2019, TI's revenue declined 9% from 2018. Gross margins declined from 65% in 2018 to 63.7% in 2019. So still at a high level. They declined, but still high. And EBIT margins declined from 42.3% in 2018 to 39.5% in 2019. Still very high, but they did decline. This resulted in operating income declining 15% in 2019. So you did have negative operating leverage. Revenue declined 9%. Operating income declined 15%. That may sound like a severe decline, but it's really not that bad because

one, these down cycles don't last that long. And two, Texas Instruments is taking share during these downturns. It has taken share during past down cycles. And I think it's the type of company that will take share in future down cycles. In 2019, like any exceptional manufacturer, its free cash flow, Texas Instruments' free cash flow in 2019 remained very strong because it got very aggressive managing working capital and because it pulled back on CapEx a bit. And so in 2019, which was this industry downturn, this industry down cycle, it generated a 40% free cash flow margin, 4-0, 40% free cash flow margin. And its free cash flow conversion, which was free cash flow divided by net income, was 116%. Its return on invested

capital only dropped from 28% in 2018 to 25% in 2019. So there you go. At the bottom of the cycle, it generated 25% ROIC and 40% free cash flow margins. The industry was ready for a recovery in 2020, I think. But Texas Instruments' revenue was flat in 2020 because COVID hit and the world went into economic lockdown mode. And so, the final thing I'll say is, Brett, down cycles are honestly not a risk for Texas Instruments. In fact, down cycles are probably the best thing that could possibly happen to Texas Instruments, because that is when they have the opportunity to buy assets at distressed prices, take market share, and plant the seeds for faster growth coming out the other side. They've done this throughout history time and time again.

They bought manufacturing assets out of bankruptcy during the global financial crisis. They bought National Semi in 2011, so right coming out of the financial crisis. They bought a 300-millimeter fabrication in Iowa, I think, or something in 2020 or last year, basically during COVID, when prices for those assets were distressed. And so Rich Templeton has said in the past, never let a recession go to waste. Next, recessions are when TI turns up the speed dial. That's when they really get to work. And so recessions, either broad economic recessions or industry-specific semiconductor downturns

are not something to fear for long-term investors. Okay. I think this is our last question. You may have already answered it a bit when you said China is the biggest risk, but is there anything else, if you were writing a pre-mortem, is there anything else that would cause this to be a poor investment? I love the pre-mortem. I think China, I think China, 55% of your revenue is a lot. And so if China decides to get into lagging edge, analog chips in a heavy way, and they're successful, investing doesn't guarantee success.

It's, you know, the barriers to entry are high and the barriers to success in this industry are high as well. So if they are successful and or if trade relations between China sour even more, then yes, that's a risk. So that could be one thing. The other thing I would say is if Rich Templeton, the CEO, steps down sooner than expected. He's a one-of-a-kind CEO, in my opinion. I do think that TI has the culture and the bench to do it, to replace him and to continue to grow and create value over a long period of time. But there's probably only one Rich Templeton. And so that's probably the other thing. Like I said, I think it could be done. It's just the company will have a slightly different flavor probably because I think Rich Templeton is one

of a kind. Right. There's always risk absorbing new management. There's always uncertainty with that. I think, yeah. And so those would be the two premortem risks that I would call out. Okay. I think that's all the questions we have. And I'm sure our listeners are already familiar with you, but anyways, where can they get a hold of you or where can they follow you? Do you have your Twitter handle? Yeah. So thanks for having me again. Honestly, this is my favorite podcast. I love coming on. I hope we can do it again. I'm on Twitter. It's the only social media I'm on, at J-R-O-G-R-O. So, at J-R-O-G-R-O-W. And then, I occasionally write articles for fool.com too. Most of the writing I do is behind the paywall, but I do

do some writing on fool.com. Perfect. All right. That's going to do it. We want to remind our listeners that Brett and I are not financial advisors. Anything we say or discuss here on Chit Chat Money is not formal advice or recommendation. We are, however, general partners at Arch Capital so clients may have positions in the securities discussed in this podcast. Thank you all for listening. We'll see you next time.