Intel & Texas Instruments: Demand For Digital & Analog Chips (NASDAQ:INTC)

Electronic circuit board production and computer chip fly test by robotic automated machine

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Thesis

When we talk about investment opportunities in the chip space, companies like Intel Corporation (NASDAQ:INTC) and Advanced Micro Devices, Inc. (AMD) attracted most of the attention. And Texas Instruments Incorporated (NASDAQ:TXN) is probably overlooked on the radar of many investors. You will see from this article that both TXN and INTC are equally excellent investment ideas to tap into the world’s unstoppable shift to EV, AI, and automation technologies. They are both well-positioned to cater to the insatiable appetite for chips, both digital and analog, created by these future technologies. Both feature similar return potential in the double-digit (about 13% annual returns) thanks to strong demand, sustainable R&D, and consistent return on capital.

The composition of their total return is different. The majority of INTC’s return will come from its current earning yield, while future growth contributes to a lesser degree. In TXN’s case, the roles of current earning yields and future growth are reversed. Therefore, relatively speaking, INTC is more of a value player while TXN is more of a growth play.

INTC and TXN: what are they investing in?

Firstly, a general background of our approach to technologies firms. As detailed in our earlier articles,

We do not invest in a given tech stock because we have high confidence in a certain product that they are developing in the pipeline. Instead, we feel more comfortable betting on A) the recurring resources available to fund new R&D efforts sustainably, and B) the overall efficiency of the R&D PROCESS.

So, let’s first see how well and sustainably INTC and TXN can fund their new R&D efforts and what they are investing in. The next chart shows the R&D expenses of INTC and TXN over the past decade. As seen, both have been consistently investing heavily in R&D.

INTC on average has been spending about 20.4% of its total revenue on R&D efforts. The spending increased by a sizable 5% from about 15% in the earlier part of the decade. In contrast, TXN has been spending on average about 9.65% of its sales in recent years on R&D. Their levels of R&D spending are typical and within the normal range of mature tech firms.

INTC vs TXN - R&D expenses as % of sales

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INTC has been consistently focusing on new chip and architecture designs. It aims at delivering 5 nodes in 4 years as it announced recently in its 2022 Q1 earnings reports. Also, since its new CEO Pat Gelsinger took office, it has also been focusing sharply on reestablishing its manufacturing capabilities. Besides organic growth and R&D, it is also active in the acquisition to jump-start its fab initiatives. It just announced a new R&D and fab investment in Europe in its 2022 Q1 earnings reports. And back in Feb 2022, it also announced a definitive agreement to acquire chip foundry Tower Semiconductor for about $6 billion (or $53 per share in cash).

I am optimistic about its future directions. I view the Tower acquisition as a key step towards vertical integration because it would give INTC direct access to a wafer foundry. Also, its initiatives are supported by the government, as the U.S. now views chips at the level of national security. As an example, the U.S. Senate recently approved the CHIPS act, pledging $52 billion in subsidies for semiconductor manufacturers such as INTC.

Intel Strategy

INTC 2022 Q1 Earnings Report

TXN focuses on the analog segment of the chip market. The company generates about $14 billion of revenue in 2021 from its analog segment (more than ¾ of its total revenues). For readers who are less familiar with analog chips, these are devices that can read and/or process an analog signal (such as your body temperature). They are used ubiquitously in modern technologies such as our existing cars, and especially in future technologies such as EVs and industrial robots.

Indeed, industrial and automotive currently represent the markets with the best opportunities for TXN; they made up 62% of its 2021 revenues and are experiencing rapid growth, as TXN Vice President Dave Pahl commented below in its 2022 Q1 earnings report (abridged and emphases added by me). Also note that TXN, just like INTC, is also in the process of breaking ground on new fab facilities to keep pace with demand and up its capacity.

Revenue in the quarter was $4.9 billion, an increase of 2% sequentially and 14% year-over-year, driven by growth in industrial and automotive, as well as enterprise systems. Analog revenue grew 16%, Embedded Processing grew 2%, and our Other segment grew 27% from the year ago quarter. Moving on, I’ll provide some insight into our first quarter revenue by end market from the year ago quarter. First, the industrial and automotive markets were each up about 20% and both were driven by broad-based growth across sectors.

TXn revenue in 2021

Source: TXN investor overview

INTC and TXN: both feature high R&D yield

Then the next question is, how effective is their R&D’s process? The short answer is extremely effective. Here we will use a variation of Buffett’s $1 test on R&D expenses as detailed in our earlier articles:

The purpose of any corporate R&D is obviously to generate profit. Therefore, it is intuitive to quantify the yield by taking the ratio between profit and R&D expenditures. This way we can quantify how many dollars of profit has been generated per dollar of R&D expenses, as shown in the next chart. In this chart, I used the operating cash flow as the measure for profit. Also, most R&D investments do not produce any result in the same year. They typically have a lifetime of a few years. Therefore, this analysis assumes a 3-year average investment cycle for R&D. And as a result, we use the 3-year moving average of operating cash flow to represent this 3-year cycle.

As you can see, the R&D yield for both INTC and TXN has been remarkable. INTC features a long-term average of $1.8 with remarkable consistency, only with a narrow fluctuation between $1.5 to about $2.2. TXN enjoys an expanding yield as you can see, increasing from about $2.6 in 2013 to more than $4.5 now. Its long-term average is at a superb level of $3.85. Despite the contrast between the two of them, their levels of R&D yield are very competitive even among the overachieving FAAMG group, which generates an average R&D yield of about $1.9.

And as we will see next, both INTC and TXN enjoy superb profitability to fuel their R&D efforts sustainably, which will lead to sustainable growth in turn.

INTX vs TXN - R%D yield

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INTC and TXN: Both enjoy superb profitability

As detailed in our earlier articles:

When we think of long-term growth (like in 10 years or more), the growth rate is “simply” the product of ROCE and reinvestment rate, i.e.,

Long-Term Growth Rate = ROCE * Reinvestment Rate

ROCE stands for the return on capital employed and is the most important metric for measuring profitability because it considers the return of capital ACTUALLY employed. In this analysis, I consider the following items capital actually employed A) Working capital (including payables, receivables, inventory), B) Gross Property, Plant, and Equipment, and C) Research and development expenses are also capitalized.

Based on the above considerations, the ROCE of INTC and TXN over the past decade is shown below. As seen, INTC was able to maintain a remarkably high and again consistent ROCE over the past decade. Its average ROCE has been about 41% in recent years, with narrow fluctuations between 35% and 42%. And TXN’s ROCE is even higher and again enjoyed an expansion over the past decade. Its ROCE started at around 40% in 2011 and expanded to the current level of around 100%. On average, its ROCE has been about 78% in recent years.

Against, despite the relative differences, both of their ROCE are very competitive even among overachievers like the FAANG stocks whose average ROCE is somewhere between 45% to 55% in recent years.

INTC vs TXN - profitability measured by ROCE

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The final verdict

With the above business fundamentals, the following table summarizes the return potentials of both businesses. As aforementioned, as long-term business owners, our long-term return on investment (“ROI”) is determined by two things. First, is the owner’s earning yield (“OEY,” the 4th row in the table). And second, the long-term growth rates (the 7th row).

And as you can see,

  • Both offer good OEY thanks to the recent corrections that brought down their valuation. INTC currently provides a higher OEY of 6.9% compared to the 5.4% provided by TXN due to INTC’s lower valuation.
  • The lower valuation is certainly well justifiable given TXN’s better R&D yield ($3.85 vs $1.8, more than 2x higher) and profitability (78% ROCE vs 41% ROCE, almost 2x higher).
  • Although INTC currently is investing more heavily than TXN (a 15% reinvestment rate vs 10% from TXN). As a result, both features similar long-term growth rates. INTC’s long-term growth rate is estimated to be 6.2% (41% ROCE * 15% reinvestment rate = 6.2%), and TXN is estimated to be 7.8% (78% ROCE * 10% reinvestment rate = 7.8%).
  • Finally, both actually end up with about the same total return in the long term: 13.1% projected for INTC and 13.2% projected for TXN.

Table Description automatically generated

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Final thoughts and risks

Recent corrections provided attractive opportunities for INTC and TXN, leaders in the digital and analog chip market. We see no bad choice here. Both are well poised to cater to the insatiable chip needs created by future technologies like EVs and industrial automation. Both also feature similar return potential in the longer term (13.1% vs 13.2% annual returns).

Although, the composition of the total return is different. In INTC’s case, its 13.1% total return consists of 6.9% from current OEY (the major component) and 6.2% from future growth (the minor part). In TXN’s case, the roles are reversed. Its 13.2% total return consists of 5.4% from the current OEY (the minor component) while future growth is the major part (7.8%). In this sense, INTC is more of a value player while TXN is more of a growth play (relatively speaking).

Finally, both stocks face some risks, too. The silicon shortage and supply-chain bottlenecks have been a challenge for both INTC and TXN (and the whole industry sector, too). Though, in relative terms, TXN has a more substantial footprint of domestic wafer fabrication plants, which can help to alleviate some of the issues better. There is a nonnegligible chance of a recession in the near future. Leading firms like Tesla (TSLA), Netflix (NFLX), and Meta Platforms (FB) have all reported hiring freezes or even layoffs recently, which could soften the demand for chips in both EVs and servers.

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