Activist Elliott wants Texas Instruments to boost free cash flow

work: Texas Instruments is a global semiconductor company. The company designs, manufactures, tests, and sells analog and embedded processing chips for markets such as industrial, automotive, and personal electronics. Texas Instruments’ segments include Analog and Embedded Processing. Analog’s product lines include Power and Signal Chain. Power includes products that help manage power in electronic systems. Signal Chain includes products that sense, condition, and measure real-world signals so that information can be transferred or converted for further processing and control. The Embedded Processing segment includes microcontrollers, digital signal processors, and application processors. Texas Instruments offers DLP products, which are primarily used to project high-resolution images, as well as certain custom semiconductors called calculators and application-specific integrated circuits.

Stock market value: $177.55 billion ($195.01 per share)

Ownership percentage: 1.4%

Average cost: None

Activist Comments: Elliott is a highly successful and astute activist investor. The firm’s team includes analysts, engineers, and operating partners (including a former technology CEO and COO) from major technology private equity firms. When evaluating investments, the firm also hires specialty and general management consultants, expert cost analysts, and industry specialists. Elliott often observes companies for years before investing, resulting in a long list of high-caliber director candidates. The firm has historically focused on strategic activism in the technology sector and has been very successful with that tactic. Over the past few years, the firm’s activism group has grown. The firm is conducting much more governance-focused activism, creating value from the board level across a wider range of companies.

Elliott announced on May 28 that it has invested $2.5 billion in Texas Instruments. The company is calling for the company to adopt a dynamic capacity management strategy and set a free cash flow per share target of at least $9.00 in 2026.

Texas Instruments is one of the world’s best-known semiconductor companies, with a history that stretches back nearly a century. The company was a pioneer inventing many of the pillars of modern technology, including the integrated circuit in 1958, the handheld electronic calculator in 1967, and the digital signal processor in 1978. Today, Texas Instruments offers approximately 80,000 unique products in its analog and embedded semiconductor product portfolio that support more than 100,000 customers. The company has established itself as a strategic and operational leader through decades of thoughtful strategic decisions and a focus on high-performance analog, one of the semiconductor market’s most tenacious and profitable segments.

Texas Instruments has long positioned manufacturing as a core competitive advantage and differentiated itself. More than 15 years ago, the company was the first analog semiconductor company to invest in 300 mm wafer manufacturing technology, which has enabled a 40% cost advantage per chip over traditional 200 mm manufacturing. Today, Texas Instruments sources 80% of its wafers internally, of which 40% are cost-advantaged 300 mm wafers. This investment in 300 mm technology has expanded gross margins from 54% in 2010 to 63% by 2023. Additionally, the company has the world’s largest geopolitically reliable 300 mm analog manufacturing capacity, with 47% of global capacity outside China and Taiwan and 85% in the United States.

Texas Instruments has significantly underperformed its peers in recent years, despite its #1 position in analog semiconductors, 74% exposure to the most attractive end markets (automotive and industrial), software-like margins (gross margins ~60%; operating margins ~40%), geopolitical security, and company-owned manufacturing capabilities.

Elliott points to a metric that Texas Instruments has long looked to as its best indicator of value and operating performance: free cash flow per share.

Elliott points out that the company’s history supports this fundamental principle: From 2006 to 2019, the company grew free cash flow per share at an annualized rate of 17%, while its stock price generated a total return of roughly 440%, outperforming the S&P 500 index by roughly 200% and analog semiconductor peers by roughly 135% during that period.

During this time, prior to 2021, Texas Instruments had averaged about $650 million per year on capital expenditures over the past decade, which represents 5% of revenue. The company then spent more than $2.5 billion per year in 2021 and 2022. In 2022, the company announced plans to expand its manufacturing capacity and eventually build six new 300mm manufacturing facilities in the United States. The plan calls for spending $5 billion per year through 2026 and several billion per year thereafter, representing 23% of revenue, nearly tripling Texas Instruments’ in-house manufacturing capacity by 2030. How did this impact free cash flow per share? Last year, the company generated free cash flow of just $1.47 per share, down 77% year over year and 76% from five years ago. That’s less free cash flow per share than Texas Instruments generated during the height of the 2008-2009 financial crisis, when earnings were 40% below what they are today.

Elliott said the company has no problem increasing capital spending to accommodate future growth, and the announced 2022 plan was not necessarily wrong. But in 2022, the consensus forecast for 2026 revenue was $26 billion. Today, the forecast has fallen 24% to $20 billion, and Texas Instruments is now spending billions to build 50% excess capacity. Elliott is calling for what the company has been doing for years, what the industry is doing, and what economic logic dictates: aligning capital expenditure spending based on demand. Elliott doesn’t even take credit for this plan, using the company’s own history as a blueprint. In 2003, Texas Instruments chose the Richardson, Texas, site to build RFAB 1, the world’s first 300mm analog fab, during a semiconductor industry downturn. The company said it would build the exterior of the facility first, then gradually equip it according to customer demand. This is because equipment accounts for 80% of the cost of a fab, and the exterior building can be fully equipped within six months to meet demand. The RFAB 1 remained largely dormant for about five years, shipping its first revenue products in 2010, although Texas Instruments executives frequently stated that the RFAB would “grow as demand dictates.”

Elliott recommends the company adopt a dynamic capacity management strategy and set a free cash flow per share target of $9.00 or more in 2026, about 40% above current investor expectations. The firm believes a prudent approach to capital discipline will restore investor confidence while giving the company the flexibility to achieve this target through a combination of strong organic growth, market share growth, and prudent capacity management. Elliott is not calling for the company to cut capital expenditures in 2024 or 2025. The firm simply recommends reducing 2026 capital expenditures to $2.75 billion if there is no increase in consensus revenue forecasts, or maintaining them at $5 billion if Texas Instruments can expand market share by 250 basis points. In either case, Elliott believes the company can achieve free cash flow of $9.01 per share.

The company’s capital expenditure plan significantly reduces free cash flow per share and builds 50% excess capacity. Elliott’s plan restores free cash flow per share growth and builds 30% or 39% excess capacity. The company may argue that Elliott is a “short-term oriented activist,” but Elliott’s plan creates short-term value without sacrificing long-term opportunities or value. It is arguable that Elliott’s plan creates more long-term value than the company’s plan. Texas Instruments’ performance and capital expenditure plan have been marred by poor communication to the market. The aggressive capital expenditure plan has reduced free cash flow by 77%, and the company has not published a detailed plan or explained why it needs 50% excess capacity.

This is such a simple request that one wonders why Elliott did not discuss this with management before resorting to the open letter. The company supports the company’s strategy, supports management, and supports capital expenditures for 2024 and 2025, but there is no evidence that Elliott requested a meeting with management before sending this letter. Sometimes the process is as important as the content, and Elliott would have had a much better chance of persuading management if it had personally approached the company.

A proxy fight in a company like this would be a tall order for any activist, but if there is one with the resources and conviction to pull it off, it’s Elliott. Given that the company’s demands are reasonable and there is support for management outside of this puzzling capital expenditure decision, I expect this to be resolved amicably. I don’t think Elliott will bring anyone from their own company onto this board, but they may want some independent industry executives. Elliott wouldn’t go into this situation without a roster of industry experts who could consult with them and serve on the board. If the company thinks it can ignore Elliott, they’d be mistaken. But if Texas Instruments needs further evidence of Elliott’s conviction outside of the company’s history, Elliott has built a $2.5 billion position here, which is large even by the company’s standards.

Ken Squire is founder and president of 13D Monitor, an institutional research service on shareholder activism, and founder and portfolio manager of 13D Activist Fund, a mutual fund that invests in the activist 13D investment portfolio.