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Texas Instruments: Proceed With Caution

Stocks in this article: TXN QCOM

By Chris Bulkey of Technology Research Group

Texas Instruments (TXN) revised first-quarter earnings guidance this week to a range of 48 to 52 cents from 44 to 52 cents and disclosed that it still sees supply constraints, which could impact inventories and margins.

What this really means is that the company is having difficulty gauging utilization following a downturn in sales and orders last year.

We view the revision to guidance as inconsequential. Cautious comments are the real story. Shares closed Thursday at $24.07, down 52 cents, or 2.1%.

Working capital metrics contradict any notion of improving visibility. For full-year 2009, inventory turns failed to show improvement and actually deteriorated slightly (4.52 vs. 4.55 in 2008). Less stringent credit policies bode poorly for revenue recognition. Receivables jumped 40% for the year, while revenue declined by about 17% (contra account was lowered by a fairly substantial amount as a percentage of A/R balance; decision should raise an eyebrow).

Managing Results

Earnings quality suggests business conditions remain far from optimal (i.e., companies generally do not manage results unless there is a need to do so). Over the past four quarters, income was positively affected by several nonoperational sources.

Contributions from the following cannot be relied upon over the long term: utilization of restructuring reserves (accruals less payments and adjustments), R&D expense decline (as a percentage of revenue including amounts capitalized), lowering doubtful accounts (as a percentage of asset balance), tax credits (related to product development), and pension-expense reduction (normalizing service cost and curtailment credits).

Collectively, the above-mentioned items lifted net income by about 17 cents per share in 2009. This puts earnings closer to 98 cents per share in sustainable operating terms; an unhealthy 15% below reported levels. Going forward, we look for earnings management to become increasingly nonconservative.

Valuation and Recommendation

Shares are up 70% over the past 12 months and valued at 21 times trailing earnings. Comparable communications-chip provider Qualcomm (QCOM)) trades at roughly 31 times. Both are profitable, but using cost-containment measures to stabilize expense levels. Qualcomm has a healthier operating margin (trailing 12 months period).

TI has a better return on equity (trailing 12 months period). Valuation would seem to have more downside risk than upside potential in each case. We reiterate a sell rating and $22 price objective (target multiple lowered to 11 times forward earnings from 14 times).

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