Texas Instruments: a perpetual compound that rivals our Apple investment (NASDAQ: TXN)
Warren Buffett has repeatedly mentioned the secret of compound selection:
Leaving aside the issue of price, the best business to own is one that, over a long period of time, can employ large amounts of additional capital at very high rates of return.
Indeed, the two most important characteristics of an ideal preparer are high return on capital employed (“ROCE”) and flexibility in capital allocation. These traits reinforce each other. High ROCE leads to strong earnings, which leads to more flexible capital allocation to fuel additional growth, which then leads to more earnings, and so on. More quantitatively, the long-term compound rate of such a company is simply the product of these two characteristics, i.e.:
Long-term growth rate = ROCE * Reinvestment rate
And then you’ll see that Texas Instruments (TXN) is a stock that demonstrates both traits so well that it rivals Apple (AAPL), another exemplary builder. Additionally, the recent market correction has provided a rare entry opportunity.
TXN’s return on capital rivals AAPL
As seen below, TXN has been able to maintain a remarkably high and stable ROCE over the long term (averaging 72% over the past decade). ROCE has been even higher in recent years, averaging 90% since 2018. In this analysis, I considered the following as capital actually employed 1) Working capital, including payables, receivables, inventories, 2) Gross ownership, plant and equipment, and 3) research and development costs are also capitalized.
To put it in perspective, the long-term average of 72% is already a very respectable and competitive profitability even when compared to outperformers like FAAMG Group. The GAAMG group maintains an average ROCE around “only” around 80%.
TXN’s current 90%+ ROCE is actually only a very close second behind AAPL in this group (whose ROCE is around 140% in recent years).
TXN Capital Allocation Flexibility
Having established the superb return on capital, the next important trait to look for is flexibility in capital allocation. The reason is simple and intuitive as mentioned above. An ideal preparer would be a company that makes a high profit on every dollar of capital used AND can reinvest a healthy fraction of its profits to fuel its growth.
The following chart looks at TXN’s capital allocation and reinvestment rate. How much to reinvest is probably the most important capital allocation decision management has to make. And luckily for TXN, its management enjoys enviable flexibility when it comes to capital allocation. The capital allocation picture is very simple here: TXN makes a lot of money organically from its operations, but doesn’t need to spend a lot. Its capital allocation flexibility also rivals that enjoyed by AAPL.
As seen, for starters, TXN is essentially debt-free. Its interest coverage (defined as EBIT earnings divided by interest expense) has averaged over 50x. This means that it only takes around 2% of its EBIT to pay off its debt. Second, it only used on average about 13% of its OPC (operating cash) as CAPEX expenses and an additional 38% to pay its dividends, or about 51% combined. So that’s it – those are the only mandatory expenses for TXN.
All the remaining money, about 50% of its OPC (a whopping $8.5 billion in 2021) can be freely deployed. He can use it for a variety of things: reinvest to fuel his growth, keep it to strengthen the balance sheet, buy back shares, etc. TXN has allocated the remaining profits fairly evenly – averaging 40% in recent years to buy back stock. And because of this, it maintains a reinvestment rate of around 10%.
Now, with the above discussion of its profitability and capital allocation, we can discuss some return scenarios based on company fundamentals. The following table shows its valuation. As can be seen from these following valuation metrics, at its current price level, it is close to fair value. It is overvalued by a few percent based on historical PE multiples and operating cash flow, but about 9% discounted based on historical dividend yield.
Going forward, for the next 3 to 5 years, we can expect an annual growth rate higher than single digits. With the ROCE and reinvestment rate established above, an annual growth rate of 8% or 9% can be comfortably and organically sustained (90% ROCE * 10% reinvestment rate = 9% organic growth rate annual).
And the total return over the next 3-5 years is expected to be in the range of around 21% (the low-end projection) to around 48% (the high-end projection), which translates to a total return solid annual. between 5% and 10%. And I’m very optimistic that the high-end projection is more likely to materialize.
Finally, the company is in very good financial health and enjoys excellent earnings regularity. As mentioned above, it regularly generates a significant amount of cash, maintains a well-managed balance sheet, and has no problem servicing its debt. As such, there’s no need to overlook the 10% annual return – that’s already a solid return in this market and the risk-adjusted return is even higher.
Investing in TXN involves risks, as set out below.
- Macroeconomics. As I can see, the biggest risk is the pace and degree of post-COVID economic recovery. The pandemic is far from over and uncertainties such as delta and omicron variants still exist and may still impact TXN in unexpected ways.
- TXN Specific Risks. TXN is taking some major initiatives. A new wafer fabrication facility is underway in Sherman, Texas. This is a new 300 millimeter semiconductor wafer fabrication facility. In the meantime, this development has the potential to expand to four new factories. Total capital expenditures for all initiatives are budgeted at approximately $30 billion. This is a considerable investment for TXN and creates uncertainty. And the results will only be known a few years later, until these factories are fully operational.
Conclusion and final thoughts
TXN is an attractive perpetual compounder. It is characterized by an optimal combination of excellent financial security, high return on capital employed and enviable flexibility in capital allocation. Specifically,
- Its long-term average of 72% ROCE is already a very respectable and competitive profitability, even when compared to outperformers like FAAMG Group. Its current ROCE of over 90% is actually a very close second only to AAPL in this group.
- And a perpetual growth rate of around 8-9% can be sustained organically given its ROCE and flexible capital allocation.
- Additionally, the recent market correction has provided a rare entry opportunity. An investment here offers very favorable odds for a double-digit annual total return over the next few years. The risk-adjusted return is even more attractive given its financial strength and steady income.
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