Texas Instruments may increase free cash flow with the help of activist Elliott, potentially leading to a friendly resolution.

Company: Texas Instruments (TXN)

Texas Instruments is a global semiconductor company that designs, manufactures, tests, and sells analog and embedded processing chips for various markets, including industrial, automotive, and personal electronics. Its segments include Analog and Embedded Processing. The Analog segment includes Power and Signal Chain product lines, while the Embedded Processing segment includes microcontrollers, digital signal processors, and applications processors. Additionally, Texas Instruments offers DLP products for projecting high-definition images, calculators, and custom semiconductors known as application-specific integrated circuits.

Stock Market Value: $177.55B ($195.01 per share)

Activist: Elliott Investment Management

Percentage Ownership:  1.4%

Average Cost: n/a

Elliott is a highly skilled and successful activist investor who leads a team of experts from top tech private equity firms, engineers, and former technology CEOs and COOs. When evaluating an investment, the firm employs a range of consultants, including specialty and general management consultants, expert cost analysts, and industry specialists. Elliott typically watches companies for years before investing and has a strong pool of impressive board candidates. Historically, the firm has focused on strategic activism in the technology sector and has achieved great success with this approach. Recently, the firm's activism group has grown, and it has been doing more governance-oriented activism, creating value at a broader range of companies.

What's happening

Elliott has announced a $2.5 billion investment in Texas Instruments and is urging the company to adopt a dynamic capacity-management strategy and set a free cash flow per share target of $9.00+ in 2026.

Behind the scenes

Texas Instruments is a renowned semiconductor company with a century-long history. Known for its pioneering spirit, the company has made significant contributions to modern technology, including the invention of the integrated circuit, handheld electronic calculator, and digital signal processor. Today, Texas Instruments offers over 80,000 unique products to more than 100,000 customers, with a portfolio of analog and embedded semiconductor offerings. The company has positioned itself as a strategic and operational leader by focusing on high-performance analog, a lucrative and challenging market in the semiconductor industry.

Over the years, Texas Instruments has distinguished itself by prioritizing manufacturing as a key competitive advantage. The company was the first to invest in 300-mm wafer production technology more than 15 years ago, which granted them a 40% cost-per-chip advantage compared to legacy 200-mm production. Currently, Texas Instruments sources 80% of wafers internally, with 40% being cost-advantaged 300-mm wafers. This investment in 300-mm technology led to an expansion of gross margin from 54% in 2010 to 63% in 2023. Furthermore, the company boasts the world's largest footprint of geopolitically reliable 300-mm analog manufacturing capacity, with 47% of global capacity outside of China and Taiwan and 85% of capacity in the U.S.

Despite Texas Instruments' dominant position in analog semiconductors, high exposure to attractive end markets, software-like margins, geopolitical security, and company-owned manufacturing capacity, it has lagged behind peers in recent years.

Texas Instruments has long emphasized free cash flow per share as the most reliable measure of value and management performance, according to Elliott.

The company's history demonstrates its commitment to the core principle, as it achieved an annual growth rate of 17% in free cash flow per share from 2006 to 2019, while generating a total return of approximately 440% on the stock, outperforming the S&P 500 by about 200% and analog semiconductor peers by around 135% during the period.

Prior to 2021, Texas Instruments spent an average of $650 million per year in capex, which was 5% of revenue. However, in 2021 and 2022, the company spent $2.5+ billion per year. In 2022, Texas Instruments announced a plan to expand its manufacturing capacity by building six new 300-mm fabrication facilities in the U.S. This plan will require spending $5 billion per year through 2026, which is 23% of revenue, and will nearly triple the company's internal manufacturing capacity by 2030. Despite this expansion, Texas Instruments' free cash flow per share last year was only $1.47, which was 77% lower than the prior year and 76% lower than five years ago. This is also below the free cash flow per share generated at the depths of the 2008-2009 financial crisis, when Texas Instruments' revenue was 40% below what it is today.

Elliott believes that Texas Instruments should adjust its capital expenditure (capex) spending based on demand, rather than increasing it to accommodate future growth. The company's 2022 plan was not necessarily wrong, but consensus expectations for 2026 revenue have declined by 24%, leading Texas Instruments to spend billions of dollars to build to a 50% excess capacity. Elliott is asking the company to follow its own history and what economic logic dictates, by modulating capex spend based on demand. The firm is not taking credit for this plan, as it uses Texas Instruments' own history as a blueprint. In 2003, Texas Instruments built the world's first 300-mm analog fab, RFAB 1, in the midst of a semiconductor industry downturn. The company initially built the facility's shell and then gradually outfitted it with equipment in accordance with customer demand, as the equipment is 80% of the cost of the plant and a shell building could be fully equipped within six months to meet demand. RFAB 1 largely sat dormant for the next roughly five years and shipped its first

Elliott proposes that Texas Instruments adopt a dynamic capacity-management strategy and set a free cash flow per share target of $9.00+ in 2026, which is 40% above current investor expectations. The company believes that a commitment to prudent capital discipline will restore investor confidence, allowing Texas Instruments to achieve this target through a combination of strong organic growth, market share gains, and sensible capacity management. Elliott does not ask the company to cut 2024 or 2025 capex. Instead, the firm recommends that the company decrease 2026 capex to $2.75 billion if there is no increase in consensus revenue projections or keep it at $5.0 billion if Texas Instruments can increase its market share by 250 basis points. In either case, Elliott believes the company can achieve $9.01 of free cash flow per share.

The company's capital expenditure plan has resulted in a significant decrease in free cash flow per share and is building to a 50% excess capacity. However, Elliott's plan restores the growth of free cash flow per share while still achieving a 30% or 39% excess capacity. Despite this, the company may argue that Elliott is being a "short-term minded activist." However, Elliott's plan creates short-term value without sacrificing any long-term opportunities or value. In fact, it may create more long-term value than the company's plan. Texas Instruments' performance and capex plan are exacerbated by poor market communication. Specifically, free cash flow has decreased by 77% due to an aggressive capex plan, and the company has not publicly laid out a detailed plan or made a case as to why they need 50% excess capacity.

Elliott has not worked out with management before sending a public letter, despite the firm supporting the company's strategy, management, and capex for 2024 and 2025. The process is as important as the content, and Elliott would have a better chance of persuading management if it approached the company privately.

An activist like Elliott would face a Herculean task in conducting a proxy fight at a company like this, but if there is any activist with the resources and conviction to do it, it is Elliott. Given the firm's reasonable ask and its support for management outside of this one inexplicable capex decision, we would expect this to settle amicably. However, we do not see Elliott getting one of their people on this board, but it could use some independent industry executives. Elliott does not go into a situation like this without a Rolodex of industry professionals with whom it consults and who would be available for board duty. If the company thinks it can ignore Elliott, it would be mistaken. But if Texas Instruments needs any additional evidence of Elliott's conviction outside of the firm's history, Elliott has built a $2.5 billion position here, which is big by even the firm's standards.

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