Updated from 11:02 a.m. EST

Texas Instruments

(TXN) - Get Report

sharesslipped early Tuesday as analysts gripedabout constraints on the chipmaker's gross profit margins. Shares closed lower by $1.49, or 4.66%, to $30.50 on Tuesday.

Lifted by robust chip sales, Texas Instruments surpassedWall Street estimates for fourth-quarter sales andearnings, and guided for better-than-expected sales inthe quarter now under way. But it wasn't enough tosatisfy market participants jittery about its valuation,particularly since TI failed to offer upside on itsearnings outlook.

Tuesday morning, analysts honed in on TI'sannouncement that it's started to pay some of itsgains into an employee profit-sharing program for thefirst time since 2000. The general view: While it maybe gravy for TI employees, it's bad news forinvestors.

Perhaps the most skeptical was Deutsche Bank's BenLynch, who cut his rating on the stock to a sell froma hold. TI has "shown signs that it may disappoint onthe 'leverage story' which underpins the current loftyvaluation," he explained in a note. Deutsche Bank hasdone investment banking for TI.

The cost of TI's profit sharing, which will run to $60 million a quarter throughout the year, will force analysts to cut EPS forecasts -- currently 91 cents and $1.25 for 2004 and 2005, respectively -- Lynch suggested. "Based on our calendar 2005estimates

of $1.08, TXN is now trading on a richpeak-of-cycle 29 times P/E, ample reason we believe totake profits," he wrote. "We consider

Intel

(INTC) - Get Report

, at 24 times ourcalendar 2005 EPS estimate, considerably moreattractive."

To be sure, TI forecast continued upsideon operating margins as the industry recoverycontinues. But Lynch sounded doubtful in a phoneinterview. "I think it will be hard for them to getthere," he said. Though he estimates TI's revenues in2005 will surpass the 2000 level by about $1.2 billion,the company's cost of goods and operating expensesshould also be higher by about $900 million and $250million, respectively, in part because of profitsharing.

The bottom line, he says, is that TI "would needto have very, very strong growth next year" to notchits operating margin target, and he expects thatrevenues will start to slow down by 2005 afterexpected sales growth of 26% this year in TI's chip business.

For that matter, fourth-quarter margins proved tobe somewhat weak even before profit sharing payoutshad gone into effect, noted Lynch and others.

Oppenheimer's Quinn Bolton said that while fourth-quarter sales and the first-quarter outlook areimpressive, "lower than-expected

fourth-quarter gross marginand the commencement of profit sharing in

the first quarterprevent us from raising our EPS estimates at thistime." Bolton is sticking with his buy ratingon TI, which now trades at 32.5 times his 2004 EPSestimate, but said further margin disappointments maycause him to reevaluate that rating.

After taking out restructuring charges, grossmargin came in at only 43.5%, he pointed out -- 190basis points below his estimate of 45.4%. Meanwhile,despite strong sales growth in the chip business,incremental gross margin was only 56%, below the 70%incremental margin that might be expected.

"While we attribute some of the lower-than-expected incremental margin to higher depreciationcharges and increased use of outsourcing, we willcontinue to watch incremental gross margin closely," Bolton said."Were the company to miss its target of 70% incrementalgross margin for an extended period of time, thatcould cause us to reconsider our investment rating onthe shares."

More positive was Legg Mason's Cody Acree, whocontended in a note (echoing management's commentary) that operating margins in the currentupturn should actually surpass those of the priorpeak. "While the improving momentum of both TexasInstruments and the overall economy could stall forany number of reasons, we believe the firm is finallybeginning to benefit solidly from the investments madethroughout the downturn, which should make the companysubstantially more profitable during the current cyclethan its previous peak," he wrote. Acree has a buy onthe shares; Legg Mason hasn't done investment bankingfor TI.

For the fourth quarter, Texas Instruments said sales rose 29% over the prior year's levels to $2.77 billion. Revenue came in both above analyst expectations for $2.72 billion and ahead of the company's own guidance as of last month.

Back in December, TI upped its sales projections to a range of $2.64 billion to $2.765 billion.

On the postclose conference call, Chief Financial Officer Kevin March said he expects TI's peak operating margin to surpass the prior peak of 22% by a few percentage points sometime in the current upturn, though he declined to guess exactly when that might happen. "We're anticipating that the opportunity for profit expansion should outpace the opportunity for revenue expansion as we move forward," he said.

Gross profit margin stood at 43.1% at the end of December, up 2.4 percentage points from the prior quarter due to lower restructuring charges. Gross margin rose 7.3 points from the same quarter last year because as chip demand has surged, TI has been able to use its factories more efficiently.

Further helping the trend toward margin expansion, March noted that pricing in commodity chips, which account for about 10% of TI's semiconductor revenue, is "just now coming off its floor." Commodity chip prices still stand at less than half their 2000 levels. Another important factor in TI's favor will be relatively flat trends in depreciation expenses on a growing revenue base.

Finally, TI continues to benefit from rising utilization rates in its fabs, as increased production of silicon lets the company spread its costs over a broader base.

Fourth-quarter net income stood at $512 million, compared to a loss of $589 million a year ago. On a per-share basis, earnings amounted to 29 cents, including a 7-cent contribution from the sale of

Micron Technology

(MU) - Get Report

common stock, and a 2-penny contribution from a reduction in TI's estimated taxes for 2003. TI had guided for EPS of 25 cents to 27 cents.

Excluding those items, pro forma EPS would have been 20 cents, or a penny above the 19-cent consensus estimate.

Fourth-quarter chip revenue was up 34% from last year and 16% from the prior quarter, mostly due to strong demand for TI's digital signal processors and analog chips. Wireless-chip revenue was up 41% year on year due to higher demand for 2.5G modems and for OMAP, or open-multimedia-applications platform, application processors.

CEO Tom Engibous said the fourth quarter marked the second in a row in which TI saw double-digit sequential sales growth in its flagship chip division, the first time that kind of back-to-back growth has happened in over ten years.

Though TI offered upside on March quarter sales guidance, its earnings outlook is merely in line with expectations, constrained by a rising tax rate and expected payouts of $60 million into an employee profit-sharing program in the period. (TI hasn't been profitable enough to pay into the program since 2000).

For the first quarter of 2004, the chipmaker expects sales of $2.72 billion to $2.95 billion, with earnings in the range of 16 cents to 20 cents.

Wall Street was expecting sales of $2.69 billion and EPS of 18 cents.

In 2004, TI said today it expects to lift its capex budget to about $1.1 billion, a sizeable increase from 2003 spending of $800 million.

"We believe what we're seeing is pretty broad-based. We saw fourth-quarter growth across almost all semi product lines," said Ron Slaymaker, head of investor relations, on the postclose earnings conference call. "The general strength we're seeing across the business we believe carries forward to the first quarter as well, or has the potential to carry forward. Partly it's market-driven. At the same time we do believe we're gaining share in

digital signal processors as well as analog."