Financialization is profit margin growth without labor productivity growth. Financialization is the zero-sum game aspect of capitalism, where profit margin growth is both pulled forward from future real growth and pulled away from current economic risk-taking. Financialization is the story of using share buybacks to mortgage the future of public companies over and over and over again for the primary benefit of today’s management shareholders. Texas Instruments
recently caught my eye. And while I decided to dig into its story, what happened isn’t unique to this company. Texas Instruments is, in fact, a poster child for financialization. And there’s nothing illegal or incompetent about it. I’m going to focus on a five-year stretch of the company’s financials, from 2014 through 2018. This is where the truly meteoric stock-price appreciation took place over the past 10 years, even with the stock market’s swoon in the fourth quarter of 2018, and comparing full-year financials makes for a more apples-to-apples comparison.
But before I get into the numbers, let me tell you the story. The Texas Instruments story is free cash flow and earnings growth that management “returns to shareholders”. Earnings per share on a fully diluted weighted basis has more than doubled from 2014 through 2018, net income available to shareholders on a GAAP basis has doubled, and cash from operations has almost doubled. What makes this a story of financialization is the why of the very real free cash flows and earnings growth and the how of the allocation of those cash flows and earnings. The why is pretty simple. Management has cut its cost structure to the everlovin’ bone. At the end of 2013, the company’s cost of goods sold (COGS) was 48% of revenues. By the end of 2018, COGS was 35%. Gross margins went from 52% to 65%. At the end of 2013, sales, general and administrative costs (SG&A) was 15.2% of revenues. By the end of 2018, SG&A was 10.7%. At the end of 2013, research and development expenses (R&D) was 12.5% of revenues. By the end of 2018, R&D was 9.9%. And while it’s not part of the fixed cost structure, Texas Instruments was a keen beneficiary of the Tax Cuts and Jobs Act of 2017, seeing its 2017 tax rate of 16% cut to 7% in 2018 and reducing its tax bill by $1.2 billion. See, there was zero revenue growth at the company from 2014 to 2015 (flat in both years), and tiny growth from 2015 to 2016 (less than 3%). But there was healthy revenue growth from 2016 to 2017 (11% or so) and so-so growth from 2017 to 2018 (6% or so). And when you’re cutting costs like Texas Instruments was doing over a multiyear period, even mediocre top-line increases can lead to dramatic profit increases. How dramatic? Cash from operations was $3.9 billion in 2014, but by 2018 was $7.2 billion. Nice! Over this five-year period, Texas Instruments generated $25.5 billion in cash from operations and $32.5 billion in earnings before interest, taxes, depreciation and amortization (Ebitda). From a cash perspective, of course you’ve got to pay taxes out of all that, which comes to about $7 billion over the five years, but you can defer some of this to minimize the cash hit. And you’ve got to pay interest on the $5.1 billion in debt you’ve taken out, which comes to … oh yeah, basically nothing … thank you, Fed! And you’ve got to account for depreciation and amortization, which comes to $5.2 billion over the five years … but this is a non-cash expense, so it’s not going to dig into that cash hoard. And you’ve got some cash puts and takes from working capital and inventory and what not, but nothing dramatic. And you’ve got $1.3 billion in stock-based comp, but again that’s a non-cash expense … whew! And — oh, here’s an interesting cash windfall — Texas Instruments raised about $2.5 billion by selling stock over these five years. Wait, what? Selling stock, not buying stock? Selling stock to whom? Hold that thought … Put it all together and I figure the company generated about $25 billion in truly free cash flow over this 5-year span. What is management going to spend this treasure chest on? Well, surely you’re going to spend a healthy amount on capital expenditures, right? I mean, you took a $5.2 billion depreciation and amortization charge over this time span, and we all know that semiconductor manufacturers need to stay on that bleeding edge of technological innovation to keep earnings growing in the future, right? Nope. Texas Instruments spent $3.3 billion on fixed assets from 2014 through 2018, one-third of that total in 2018. Some significant proportion of that was maintenance capex as opposed to growth capex. Well, if you didn’t spend your money on property, plant and equipment, then surely you spent a healthy sum in M&A, right? Nope. $1.6 billion over five years. Tuck-in stuff. I guess you were paying down debt, then. Deleveraging up a storm, right? Nope. Paid down debt by $500 million a year in 2014, 2015 and 2016, but increased debt by $500 million in 2017 and $1 billion in 2018. So it’s dividends, right? This is where all the cash went? Now we’re getting there: $9.1 billion in dividends over five years. A healthy direct return of capital to shareholders. But it’s just a warm-up to the main event: $15.4 billion in buying back stock from 2014 through 2018. Between stock buybacks and dividends, that’s $24.5 billion in cash “returned to shareholders”, essentially 100% of the free cash flow generated by the company over the past five years. Now here’s the kicker. What sort of share-count reduction would you think that this $15.4 billion in buybacks gets you? I mean, that is the logic here, that investing $15.4 billion in the company’s own stock is the best possible capital allocation that the company can make. I would have guessed that surely $15.4 billion would retire anywhere from 20% to 25% of the shares outstanding over this time frame, with the stock price ranging from $40 to $100. In truth, Texas Instruments retired only 10% of its outstanding diluted shares with its $15.4 billion investment, going from 1.1 billion shares to 990 million shares. But wait, there’s more. From 2014 through 2018, Texas Instruments bought back 228.6 million shares for $15.4 billion. That works out to an average purchase price of $67.37. Over that same span, Texas Instruments sold 90.8 million shares to management and board members as they exercised options and restricted stock grants, for a total of $2.5 billion. That works out to an average sale price of $27.51. The difference in average purchase price and average sale price, multiplied by the number of shares so affected, is $3.6 billion. In other words, 40% of Texas Instrument’s stock buybacks over this five-year period were used to sterilize stock issuance to senior management and the board of directors, who received $3.6 billion in direct value from these buybacks. But wait, there’s more … As of Dec. 31, 2018 there were still 40 million shares outstanding in the form of options and restricted stock grants to management and directors, at an average weighted exercise price of $55. At today’s stock price, that means an additional $2.6 billion in stock-based compensation has already been awarded. Well golly, these surely must have been amazing managers and directors to warrant that sort of stock-based compensation in addition to their cash compensation. This is the performance of Texas Instruments (in white) and the iShares PHLX Semiconductor ETF
(in gold) over the same five years. Texas Instruments is the fifth-largest position in that ETF and that underlying index, with a 7.1% weight.
For the past five years, Texas Instruments has been nothing more than a tracking stock for a passive semiconductor index. And for this privilege, shareholders have rewarded management and directors with $6.2 billion in stock, plus a couple of billion in cash compensation. That’s why it’s never been a better time in the history of the world to be a senior manager of a publicly traded company. It’s a crying shame, because here’s the thing … the total return on owning Texas Instruments is, in fact, 15% higher than the ETF over this five-year span. Because of the dividend. Do you want to run your company for cash generation? Do you want to return that cash to shareholders? Great! Use a special dividend, not buybacks. There, fixed it for you. Ben Hunt is co-founder and chief investment officer at Second Foundation Partners. This is an abridged version of “Yeah It’s Still Water,” which ran on his Epsilon Theory website. Follow him on Twitter @EpsilonTheory. Also from Ben Hunt: This perversion of capitalism is causing the zombieficiation of our economy