Highlights From TXN's Q1 Conference Call: Two Incidents Created Noise on Top of Strong Underlying Demand Signals

Last night (after the close), Texas Instruments (NYSE: TXN) reported Q1 EPS of $0.55, $0.03 worse than the analyst estimate of $0.58. Revenue for the quarter came in at $3.39 billion versus the consensus estimate of $3.4 billion. Shares are down $0.14 (-0.46%) today to $34.65.

Highlights From TXN's Q1 Conference Call:

• Sees Q2 sales of $3.41-$3.69 billion, versus the consensus of $3.53 billion. Sees Q2 EPS of $0.52-$0.60, versus the consensus of $0.63.
  
• (Ron Slaymaker) Our mid-quarter update to our outlook is scheduled this quarter for June 8th. We expect to narrow or adjust the revenue and earnings guidance ranges as appropriate with this update.
  
• I'll start with the demand environment. As a reminder, in January, we said we believe the inventory correction that had occurred in the second half of 2010 was largely complete and that we expected demand in the first quarter to be above our seasonal average. There is much evidence that this did happen. Specifically, orders were strong, re-sales were very strong and our core businesses performed well.
  
• That said, we had two incidents that created noise on top of this strong underlying demand signal, the earthquake in Japan and late quarter unexpected weakness in baseband demand by a single customer. In fact, during the months of January and February we were tracking consistent with our expectations for above seasonal demand, which led to us narrow our revenue and earnings guidance ranges at our mid-quarter update around the prior midpoint.
  
• In March, the earthquake in Japan negatively impacted our revenue due to the disruption at many of our customers' Japan factories as well as damage to two of our factories in Japan. This impact, combined with our baseband customer's unexpected weakness resulted in revenue in the lower half of our expected range.
  
• In total, TI revenue of $3.39 billion grew 6% from a year ago and declined 4% sequentially. Revenue from our core businesses increased 14% from year ago and was even sequentially. In total, our core revenue was 71% of total revenue in the quarter.
  
• The breakout of our core revenue results includes analog up 12% from a year ago and up 1% sequentially. Embedded processing grew 21% from year ago and declined 1% sequentially. Wireless, OMAP and connectivity revenue increased 10% from a year ago and declined 3% sequentially.
  
• Non-core revenue declined 10% from a year ago and declined 12% sequentially. This was mostly affected by wireless baseband where revenue fell 21% from a year ago and declined 23% sequentially to $334 million.
  
• Baseband revenue fell to below 10% of TI revenue in the quarter, down from 12% last quarter. Other non-core revenue fell 2% from a year ago and fell 5% sequentially.
  
• Turning to our segments, the most significant driver of analog growth from a year ago was High Performance Analog. Power management and HVAL were both up by similar amounts, although by a lesser amount than HPA. Sequentially, power was up the most with HVAL about even and HPA down a few points.
  
• Wireless revenue will increasingly be driven by our core product areas of connectivity and OMAP application processors. We continue to be encouraged by our design win momentum in both areas.
  
• We have also continued to win a broad swath of smartphones, tablets, e-readers, personal navigation devices and other mobile computing applications with our OMAP 3 and OMAP 4 products setting the stage for strong OMAP growth over the next few quarters as these products ramp into production.
  
• (Kevin P. March)Our operations teams have done a great job responding to the crisis. We will soon be restoring the Aizu to full production status and just last week we started initial production in Miho. We expect that Miho will be able to start full production loadings in mid-July, although it will be several months later before we see the revenue effect due to the manufacturing cycle time.
  
• In the meantime, we identified alternative TI manufacturing sites for 80% of the devices that we manufacture in Miho and we are working with customers on those qualifications. Of course, this transition will take some time to complete.
  
• In addition to the lost output and therefore lost revenue that is associated with this disruption, we are also incurring additional costs.
  
• Gross profit in the quarter declined $141 million sequentially. This included the impact of almost all of the previously mentioned earthquake costs.
  
• The combination of R&D and SG&A increased $36 million from the fourth quarter. We have continued to increase our investment in our core businesses especially targeted programs in analog and microcontrollers. We've also continued to increase our field sales and applications engineering resources in important emerging markets such as China.
  
• We have adjusted our estimate for TI's annual effective tax rate for 2011 to 28%. This is partly the result of lower expected taxable income, which includes considerations such as our earthquake related costs and certain anticipated acquisition related costs.
  
• Net income in the first quarter was $666 million, or $0.55 per share. In the earnings per share calculation, please note that accounting rules require that we allocate a portion of net income to any unvested restricted stock units on which we pay dividend equivalents.
  
• When comparing with our $0.78 of EPS in the fourth quarter, recall that the fourth quarter included $0.14 from the combination of a gain on sale and a tax benefit that was primarily associated with the reinstatement of the federal R&D tax credit that was retroactive to the beginning of 2010.
  
• Cash flow from operations was $516 million. This was down $714 million from the last quarter. Cash flow reflects lower net income and the payment of accrued annual profit sharing and performance bonuses in the first quarter.
  
• Capital expenditures declined to $194 million in the quarter from $301 million in the fourth quarter and included additions to our assembly and test capacity as well as our analog wafer fab capacity.
  
• We used $771 million in the quarter to re-purchase 21.9 million shares of TI common stock and pay dividends of $153 million.
  
• We increased our inventory by $158 million in the quarter. Most of this increase was planned and supports our goal to maintain short lead times and support high customer service levels.
  
• Orders in the quarter increased 14% sequentially to $3.58 billion. TI's book-to-bill ratio increased to 1.06 in the quarter and from 0.89 in the fourth quarter.
  
• Turning to our outlook, we expect TI revenue in the range of $3.41 billion to $3.69 billion in the second quarter, or up 1% to 9% sequentially. We expect earnings per share to be in the range of $0.52 to $0.60.
  
• Our estimates for 2011 R&D capital expenditures and depreciation are unchanged.
  
• In summary, we're encouraged by underlying demand as evidenced by orders and our trends during the first two and a half months of the first quarter. Although we certainly have a near term operational challenge associated with the earthquake and its aftermath, we're confident that its impact will be confined to the near term and we're looking forward to a strong second half of the year.
  
• (Q&A) I guess, Ron, the first question is given the hiccup on the baseband business this quarter, how should we think about that going forward? I know you said don't expect a seasonal recovery, but when you look at the guidance for Q2, how would you have us model that business? (A) John, I would say probably unchanged from what we have told you in the past. Although, certainly, it looks like that guidance has more and more opportunity to come to fruition here, which is basically, we still expect that by the end of 2012, that revenue will be essentially gone and so kind of a linear progression from where we were in first quarter down basically to zero in first quarter '13 would be about the best we could provide you in terms of guidance.
  
• And then, guys, as my follow-up, when you look at the Op profitability on the analog business, on up revenue operating profits were down almost $70 million sequentially. I'm just kind of curious if you can talk a little bit about pricing in that business currently and also when you look at the weakness in the high performance market, is that expected to rebound in the second quarter and why was Q1 so weak for that segment? (A) John, profitability was down - back to the initial comments that I made about our increase in investments in certain projects in analog and embedded processes and a similar story holds in embedded processing as well. We have stepped up our spending on product development in those areas. In addition, as I mentioned, we are increasing our salespeople and field app engineers in support of those areas, so actually similar to what we did a year ago in embedded processing where we stepped up the investment there. We've done it again this year, stepping up the investment in both those segments.
  
• As you describe the outlook for second half of the year, you say that you expect a quite good second half. Where are the areas that you see the greatest grounds for optimism around the second half? And maybe as part of that, it did look like your book to bill, your order numbers were strong in the quarter and maybe you can give us some color as to where you saw the best lift in the order book? (A) Tim, I don't think we believe it's necessarily going to be driven by any particular market segment. In fact, I think that's part of the reason why we're somewhat optimistic because we see it being pretty broad-based underlying strength. That certainly happened, you know, as we said in the prepared remarks there was some noise in first quarter, but if you peel back pretty much the isolated events, one baseband customer and a Japan earthquake, underlying business was really pretty strong. In fact, you know, I think, you know, if you look at the baseband numbers, we gave you them pretty specifically. You see pretty much $100 million decline, of which, about half of that was unexpected. So you know, basically, we had about a $50 million unexpected decline in baseband. We had about the impact of the Japan earthquake on revenue, you know, since it came so late in the quarter was about $20 million, but you need to look at where we were relative to our guidance, you know, we were, you know, below the middle of the range but not very far below, which means areas outside of baseband and outside of the Japan related impact actually ran pretty strong in the quarter. So again, we have to kind of get through second quarter and some of the noise associated with Japan, but we think that broad-based strength will then become increasingly evident once we get into second half. Again, not driven by any particular area but rather broad-based. Okay. Tim, thank you, and let's move to the next caller.

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