Texas Instruments (TXN - Analyst Report), or TI) reported third-quarter earnings that grew 19.6% sequentially and 29.1% year over year, easily beating the Zacks Consensus Estimate. Guided revenue and earnings were both ahead of expectations, which is why the shares were up 1.3% post announcement, building on the 1.7% increase during the day.

Revenue was slightly ahead of expectations (1.2%). Management said that revenue growth in the quarter was equally attributable to the communications equipment industrial and automotive markets. Enterprise systems also grew, but personal electronics continued to be impacted by the phase out of its legacy wireless products.

Revenue

TI reported revenue of $3.50 billion, which was up 6.3% sequentially and up 7.9% year over year (slightly better than the guidance of $3.45 billion at the mid-point).

Distributor resales jumped 10% from last year, with distributor inventories remaining at the same level. Internal inventories were flattish.

Segment Revenue

The Analog, Embedded Processing and Other Segments generated 62%, 20% and 18% of quarterly revenue, respectively.

The Analog business grew 7.7% sequentially and 11.3% year over year. Power management was the main driver of growth from the year-ago quarter although HPA, HVAL and SVA also grew.

The Embedded Processingsegment, which includes the processor, microcontroller and connectivity product lines, was up 1.1% sequentially and 6.4% from last year. Growth from the year-ago quarter was fairly broad-based across product lines.

The Other segment, which includes DLPs, custom ASICs, calculators, royalties and some legacy wireless products was up 7.9% sequentially but down 0.6% year over year. Legacy wireless products again impacted the year-over-year decline but this was almost totally offset by the growth in DLP products.

Orders

Net product orders were $3.34 billion in the last quarter, flat sequentially and up 6.1% year over year. Backlog declined 17.8% sequentially and remained 23.8% below the year-ago level. Turns sales increased 7.0% sequentially, growing as a percentage of sales from the previous quarter.  

Margins

TI’s gross margin of 58.4% was up 124 bps sequentially and 354 bps from the year-ago quarter. The gross margin benefited from higher volumes in the last quarter  as well as lower underutilization charges and production efficiencies. The mix (analog and embedded processing is now 82% of revenue) was neutral to both sequential and year-on-year comparisons. TI exceeded its long-term gross margin target of 55% in the last quarter and its low-cost manufacturing capacity will continue to expand margins as long as loading remains high.

Operating expenses of $795 million were down 3.2% sequentially. The operating margin was 35.7%, up 348 bps sequentially and 651 bps from the year-ago quarter. All expenses declined as a perentage of sales from both the previous and year-ago quarters.

The Analog, Embedded Processing and Other segments generated operating margins of 37.3%, 16.0% and 40.4%, respectively. The Analog margin expanded 404 bps sequentially, Embedded Processing 124 bps and Other 438 bps. Margin increases from the year-ago quarter were even more significant across all segments.

Net Income

Net income excluding restructuring gains and acquisition charges (that will remain steady over the next five years), was $900 million, or a 25.7% net income margin compared to $761 million, or 23.1% in the previous quarter and $721 million, or 22.2% in the year-ago quarter. Excluding these items, earnings were 84 cents in the last quarter, compared with adjusted earnings of 70 cents in the previous quarter and 65 cents in the year-ago year.

On a GAAP basis, the company recorded a net profit of $826 million, or 76 cents a share compared to a net profit of $683 million, or 63 cents per share in the previous quarter and a net profit of $629 million (57 cents per share) in the comparable prior-year quarter.

Balance Sheet

Inventories increased 0.4% sequentially to around $1.75 billion, with inventory turns remaining more or less steady at around 3.3X. Days sales outstanding (DSOs) went from 42 to around 39. TI generated $1.38 billion in cash from operations, spending $103 million on capex, $670 mllion on share repurchases and $319 million on cash dividends. Durng the quarter, spending on share repurchases and dividends increased 11% and 1%, respectively.

At quarter-end, TI had $3.64 billion in long-term debt and $1.00 billion in short-term debt. During the quarter, the net debt position dropped by $385 million. It also had net underfunded retirement plans of $87 million.

Guidance

TI provided guidance for the fourth quarter.

Accordingly, TI expects revenue of between $3.13 billion and $3.39 billion (down 6.9% sequentially at the mid-point) and roughly in line with the consensus estimate of $3.24 billion.

Restructuring charges will be negligible and non-cash amortization charges related to acquisitions will remain in the range of $85- $89 million for the next five years. The tax rate will remain at around 28%.

The EPS for the quarter is expected to be 64 to 74 cents, well over the Zacks Consensus Estimate of 62 cents.

Recommendation

Texas Instruments is prudently investing its R&D dollars into several high-margin, high-growth areas of the analog and embedded processing markets. This is gradually increasing its exposure to the industrial and automotive markets, while reducing its exposure to the volatile consumer/computing markets.

TI, along with chipmaker Intel (INTC - Analyst Report) remains one of the few semiconductor companies that depend on internal capacity for manufacturing the bulk of its devices. But since it has the policy of building out capacity ahead of demand, it is able to make opportunistic purchases. As a result, it is able to contain capex at up to 4% of sales even while on any expansion plan.

While we remain optimistic about TI’s compelling product line, the differentiation in its business and lower-cost 300mm capacity that should in combination drive earnings, we recognize that the channel is more conservative than it has been before.

TI shares carry a Zacks Rank #3 (Hold). Other technology stocks worth considering include Intel, Micron (MU - Analyst Report) and OmniVision (OVTI -Analyst Report), all of which have a Zacks Rank #2 (Buy).