Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

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Overview

We design, make and sell semiconductors to electronics designers and manufacturers all over the world. Our business model is designed around the following four sustainable competitive advantages that we believe, in combination, put us in a unique class of companies:

	•	A strong foundation of manufacturing and technology. We invest in manufacturing technologies and do most of our manufacturing in-house. This strategic decision to directly control our manufacturing helps ensure a consistent supply of products for our customers and also allows us to invest in technology that differentiates the features of our products. We have focused on creating a competitive manufacturing cost advantage by investing in our advanced analog 300-millimeter capacity, which has about a 40 percent cost advantage per unpackaged chip over 200-millimeter. To strengthen this advantage, we are planning our next phase of 300-millimeter capacity expansion as 300-millimeter wafers will continue to support the majority of our Analog growth.

	•	Broad portfolio of differentiated analog and embedded processing semiconductors. Our customers need multiple chips for their systems. The breadth of our portfolio means we can meet more of these needs than our competitors can, which gives us access to more customers and the opportunity to sell more products and generate more revenue per customer system. We invest more than $1 billion each year to develop new products for our portfolio, which includes tens of thousands of products.

	•	Broadest reach of market channels. Customers often begin their initial product selection process and design-in journey on our website, and the breadth of our portfolio attracts more customers to our website than any of our competitors’ websites. Our web presence, combined with our global sales force that is also greater in size than those of our competitors, are advantages that give us unique access to about 100,000 customers designing TI semiconductors into their end products.

	•	Diversity and longevity of our products, markets and customer positions. Together, the attributes above result in diverse and long-lived positions that deliver high terminal value to our shareholders. Because of the breadth of our portfolio, we are not dependent on any single product, customer, technology or market. Some of our products generate revenue for decades, which strengthens the return on our investments.

Our strategic focus, and where we invest the majority of our resources, is on Analog and Embedded Processing, with a particular emphasis on designing and selling those products into the industrial and automotive markets, which we believe represent the best growth opportunities. Analog and embedded processing products sold into industrial and automotive markets provide long product life cycles, intrinsic diversity and less capital-intensive manufacturing, which we believe offer stability, profitability and strong cash generation. This business model is the foundation of our capital management strategy, which is based on our belief that free cash flow growth, especially on a per-share basis, is important for maximizing shareholder value over the long term. We also believe that free cash flow will be valued only if it is productively invested in the business or returned to shareholders.

The combined effect of these sustainable competitive advantages is that over time we have gained market share in Analog and Embedded Processing and have grown free cash flow. Our business model puts us in a unique class of companies with the ability to grow, generate cash and return that cash to shareholders.

Management’s discussion and analysis of financial condition and results of operations (MD&A) should be read in conjunction with the financial statements and the related notes that appear elsewhere in this document. In the following discussion of our results of operations:

	•	Our segments represent groups of similar products that are combined on the basis of similar design and development requirements, product characteristics, manufacturing processes and distribution channels, and how management allocates resources and measures results. See Note 1 to the financial statements for more information regarding our segments.

	•	When we discuss our results:

	o	Unless otherwise noted, changes in our revenue are attributable to changes in customer demand, which are evidenced by fluctuations in shipment volumes.

	o	New products tend not to have a significant impact on our revenue in any given period because we sell such a large number of products.

	o	From time to time, our revenue and gross profit are affected by changes in demand for higher-priced or lower-priced products, which we refer to as changes in the “mix” of products shipped.

	o	Because we own much of our manufacturing capacity, a significant portion of our operating cost is fixed. When factory loadings decrease, our fixed costs are spread over reduced output and, absent other circumstances, our profit margins decrease. Conversely, as factory loadings increase, our fixed costs are spread over increased output and, absent other circumstances, our profit margins increase. Increases and decreases in factory loadings tend to correspond to increases and decreases in demand.

	•	The 2017 enactment of the U.S. Tax Cuts and Jobs Act (the Tax Act) reduces our annual operating tax rate, which does not include discrete tax items, from 31 percent in 2017 to an ongoing rate of about 16 percent starting in 2019. In 2018, our annual operating tax rate was 20 percent, 4 percentage points higher, primarily due to a transitional non-cash expense. For an explanation of the term “annual operating tax rate,” see the Non-GAAP financial information section.

	•	After a sustained period of growth, in late 2018 the semiconductor market entered a downturn. As a result, demand for our products weakened, and we expect this weakness to continue in 2019. During this time, we will continue to be disciplined with our operating plan and expenses, while focusing on long-term investments to strengthen our competitive advantages.

	•	All dollar amounts in the tables are stated in millions of U.S. dollars.

Results of operations

We continued to perform well in 2018, even as the year ended with a semiconductor market slowdown. We focus on Analog and Embedded Processing, with an emphasis on the industrial and automotive markets, because these products serve highly diverse markets with thousands of applications and have long-term growth opportunities. Gross margin of 65.1 percent reflected the quality of our product portfolio, as well as the efficiency of our manufacturing strategy, including the benefit of 300-millimeter Analog production.

Our focus on Analog and Embedded Processing allows us to generate strong cash flow from operations. Our cash flow from operations of $7.19 billion underscored the strength of our business model. Free cash flow was $6.06 billion and represented 38.4 percent of revenue, up from 31.2 percent a year ago. During 2018, we returned $7.66 billion to shareholders through a combination of stock repurchases and dividends. Our strategy is to return all free cash flow to shareholders. Our dividends represented 42 percent of free cash flow, underscoring their sustainability. Free cash flow is a non-GAAP financial measure. See the Non-GAAP financial information section.

Details of financial results – 2018 compared with 2017

Revenue of $15.78 billion increased $823 million, or 6 percent, primarily due to higher revenue from Analog. Embedded Processing also grew.

Gross profit of $10.28 billion was up $663 million, or 7 percent, due to higher revenue and lower manufacturing costs. As a percentage of revenue, gross profit increased to 65.1 percent from 64.3 percent.

Operating expenses (R&D and SG&A) were $3.24 billion compared with $3.20 billion.

Acquisition charges of $318 million were non-cash. See Note 8 to the financial statements.

Operating profit was $6.71 billion, or 42.5 percent of revenue, compared with $6.08 billion, or 40.7 percent of revenue.

Other income and expense (OI&E) was $98 million of income compared with $75 million of income. See Note 13 to the financial statements.

Interest and debt expense of $125 million increased $47 million due to the issuance of additional long-term debt.

Our provision for income taxes was $1.11 billion compared with $2.40 billion, which includes a discrete tax benefit of $198 million in 2018 and a discrete tax expense of $540 million in 2017. The decrease in our tax provision was due to the enactment of the Tax Act in 2017, which included a reduction in the statutory tax rate in 2018 and the tax on indefinitely reinvested earnings recorded in 2017. The benefits of the Tax Act in 2018 were partially offset by higher income before income taxes. Our effective tax rate, which includes discrete tax items, was 17 percent in 2018 compared with 39 percent in 2017. See Note 5 to the financial statements for a reconciliation of the U.S. statutory income tax rate to our effective tax rate.

Net income was $5.58 billion compared with $3.68 billion. EPS was $5.59 compared with $3.61.

Segment results – 2018 compared with 2017

Analog (includes Power, Signal Chain and High Volume product lines)

		2018					2017					Change
Revenue		$		10,801			$		9,900					9	%
Operating profit				5,109					4,468					14	%
Operating profit % of revenue				47.3	%				45.1	%

Analog revenue increased due to Power and, to a lesser extent, Signal Chain, partially offset by a decline in High Volume. Operating profit increased due to higher revenue and associated gross profit.

Embedded Processing (includes Connected Microcontrollers and Processors product lines)

		2018					2017					Change
Revenue		$		3,554			$		3,498					2	%
Operating profit				1,205					1,143					5	%
Operating profit % of revenue				33.9	%				32.7	%

Embedded Processing revenue increased due to Connected Microcontrollers. Processors revenue was about even. Operating profit increased primarily due to higher gross profit.

Other (includes DLP® products, calculators and custom ASIC products)

		2018					2017					Change
Revenue		$		1,429			$		1,563					(9	)%
Operating profit *				399					472					(15	)%
Operating profit % of revenue				27.9	%				30.2	%
* Includes acquisition charges and restructuring charges/other

Other revenue decreased by $134 million, and operating profit decreased by $73 million.

Details of financial results – 2017 compared with 2016

Revenue of $14.96 billion was up $1.59 billion, or 12 percent, from 2016 due to higher revenue from Analog and Embedded Processing.

Gross profit of $9.61 billion was up $1.36 billion, or 16 percent, primarily due to higher revenue. As a percentage of revenue, gross profit increased to 64.3 percent from 61.8 percent.

Operating expenses were $3.20 billion compared with $3.10 billion, as we allocated resources from manufacturing support and SG&A into R&D activities.

Acquisition charges of $318 million were non-cash.

Restructuring charges/other was a charge of $11 million compared with a credit of $15 million in 2016. These amounts are included in Other for segment reporting purposes. See Note 12 to the financial statements.

Operating profit was $6.08 billion, or 40.7 percent of revenue, compared with $4.86 billion, or 36.3 percent of revenue.

OI&E was $75 million of income compared with $155 million of income in 2016.

Our provision for income taxes was $2.40 billion compared with $1.34 billion. The increase was due to the enactment of the Tax Act and, to a lesser extent, higher income before income taxes. Our effective tax rate, which includes discrete tax items, was 39 percent in 2017 compared with 27 percent in 2016.

Net income was $3.68 billion compared with $3.60 billion. EPS was $3.61 compared with $3.48.

Segment results – 2017 compared with 2016

Analog

		2017					2016					Change
Revenue		$		9,900			$		8,536					16	%
Operating profit				4,468					3,416					31	%
Operating profit % of revenue				45.1	%				40.0	%

Analog revenue increased due to Power and Signal Chain. High Volume also grew, but to a lesser extent. Operating profit increased primarily due to higher revenue and associated gross profit.

Embedded Processing

		2017					2016					Change
Revenue		$		3,498			$		3,023					16	%
Operating profit				1,143					817					40	%
Operating profit % of revenue				32.7	%				27.0	%

Embedded Processing revenue increased due to growth in both product lines, led by Processors. Operating profit increased primarily due to higher revenue and associated gross profit.

Other

		2017					2016					Change
Revenue		$		1,563			$		1,811					(14	)%
Operating profit *				472					622					(24	)%
Operating profit % of revenue				30.2	%				34.3	%
* Includes acquisition charges and restructuring charges/other

Other revenue decreased by $248 million primarily due to custom ASIC products and the recognition of royalties in OI&E instead of revenue, which began in the first quarter of 2017. Operating profit decreased by $150 million.

Financial condition

At the end of 2018, total cash (cash and cash equivalents plus short-term investments) was $4.23 billion, a decrease of $236 million from the end of 2017.

Accounts receivable were $1.21 billion, a decrease of $71 million compared with the end of 2017. Days sales outstanding at the end of 2018 were 29 compared with 31 at the end of 2017.

Inventory was $2.22 billion, an increase of $260 million from the end of 2017. Days of inventory at the end of 2018 were 152 compared with 134 at the end of 2017.

Liquidity and capital resources

Our primary source of liquidity is cash flow from operations. Additional sources of liquidity are cash and cash equivalents, short-term investments and a variable rate, revolving credit facility. Cash flows from operating activities for 2018 were $7.19 billion, an increase of $1.83 billion from 2017. This increase was due to higher net income, which benefited from a lower effective tax rate.

Our revolving credit facility is with a consortium of investment-grade banks and allows us to borrow up to $2 billion until March 2023. This credit facility also serves as support for the issuance of commercial paper. As of December 31, 2018, our credit facility was undrawn, and we had no commercial paper outstanding.

Investing activities for 2018 used $78 million compared with $1.13 billion in 2017. Capital expenditures were $1.13 billion compared with $695 million in 2017 and were primarily for semiconductor manufacturing equipment in both periods. We had sales of short-term investments, net of purchases, that provided cash proceeds of $1.07 billion compared with purchases of short-term investments, net of sales, that used cash of $460 million in 2017. We received $9 million from asset sales compared with $40 million in 2017.

Financing activities for 2018 used $6.33 billion compared with $3.73 billion in 2017. In 2018, we received net proceeds of $1.50 billion from the issuance of fixed-rate, long-term debt and retired maturing debt of $500 million. In 2017, we received net proceeds of $1.10 billion from the issuance of fixed-rate, long-term debt and retired maturing debt of $625 million. Dividends paid in 2018 were $2.56 billion compared with $2.10 billion in 2017, reflecting an increase in the dividend rate, partially offset by fewer shares outstanding. We used $5.10 billion to repurchase 49.5 million shares of our common stock compared with $2.56 billion used in 2017 to repurchase 30.6 million shares. Employee exercises of stock options provided cash proceeds of $373 million compared with $483 million in 2017.

We had $2.44 billion of cash and cash equivalents and $1.80 billion of short-term investments as of December 31, 2018. We believe we have the necessary financial resources and operating plans to fund our working capital needs, capital expenditures, dividend and debt-related payments, and other business requirements for at least the next 12 months.

Non-GAAP financial information

This MD&A includes references to free cash flow and ratios based on that measure. These are financial measures that were not prepared in accordance with generally accepted accounting principles in the United States (GAAP). Free cash flow was calculated by subtracting capital expenditures from the most directly comparable GAAP measure, cash flows from operating activities (also referred to as cash flow from operations).

We believe that free cash flow and the associated ratios provide insight into our liquidity, our cash-generating capability and the amount of cash potentially available to return to shareholders, as well as insight into our financial performance. These non-GAAP measures are supplemental to the comparable GAAP measures.

Reconciliation to the most directly comparable GAAP-based measures is provided in the table below.

	For Years Ended December 31,
	2018					2017					2016
Cash flow from operations (GAAP)	$		7,189			$		5,363			$		4,614
Capital expenditures			(1,131	)				(695	)				(531	)
Free cash flow (non-GAAP)	$		6,058			$		4,668			$		4,083
Revenue	$		15,784			$		14,961			$		13,370
Cash flow from operations as a percent of revenue (GAAP)			45.5	%				35.8	%				34.5	%
Free cash flow as a percent of revenue (non-GAAP)			38.4	%				31.2	%				30.5	%

This MD&A also includes references to an annual operating tax rate, a non-GAAP term we use to describe the estimated annual effective tax rate, a GAAP measure that by definition does not include discrete tax items. We believe the term annual operating tax rate helps differentiate from the effective tax rate, which includes discrete tax items.

Long-term contractual obligations

		Payments Due by Period
Contractual Obligations		2019					2020/2021					2022/2023					Thereafter					Total
Long-term debt (a)		$		886			$		1,281			$		1,188			$		3,876			$		7,231
Purchase commitments (b)				389					469					37					15					910
Tax on indefinitely reinvested earnings (c)				—					46					156					304					506
Operating leases (d)				56					82					47					39					224
Deferred compensation plans (e)				17					46					48					111					222
Total (f)		$		1,348			$		1,924			$		1,476			$		4,345			$		9,093

(a)	Principal and related interest payments for our long-term debt obligations, including amounts classified as the current portion of long-term debt.

(b)	Includes payments for software licenses and contractual arrangements with suppliers when there is a fixed, non-cancellable payment schedule or when minimum payments are due with a reduced delivery schedule. Excludes cancellable arrangements.

(c)	Future payments for the one-time transition tax on our indefinitely reinvested earnings related to the enactment of the Tax Act. See Note 5 to the financial statements for more details.

(d)	Includes minimum payments for leased facilities and equipment and purchases of industrial gases under contracts accounted for as operating leases.

(e)	Estimated payments for certain liabilities that existed as of December 31, 2018.

(f)

Excludes $286 million of uncertain tax liabilities under ASC 740, as well as any planned future funding contributions to retirement benefit plans. Amounts associated with uncertain tax liabilities have been excluded because of the difficulty in making reasonably reliable estimates of the timing of cash settlements with the respective taxing authorities. Regarding future funding of retirement benefit plans, we plan to contribute about $50 million in 2019, but funding projections beyond 2019 are not practical to estimate due to the rules affecting tax-deductible contributions and the impact from the plans’ asset performance, interest rates and potential U.S. and non-U.S. legislation.

Critical accounting policies

Our accounting policies are more fully described in Note 2 of the consolidated financial statements. As disclosed in Note 2, the preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions about future events that affect the amounts reported in the financial statements and accompanying notes. However, based on facts and circumstances inherent in developing estimates and assumptions, management believes it is unlikely that applying other estimates and assumptions would have a material impact on the financial statements. We consider the following accounting policies to be those that are most important to the portrayal of our financial condition and that require a higher degree of judgment.

Revenue recognition

Based on management’s assessment of the revenue recognition criteria, we usually recognize revenue from sales of our products to distributors upon shipment or delivery to the distributors. For our consignment arrangements with distributors, delivery occurs when the distributor pulls product from consignment inventory that we store at designated locations. Recognition is not contingent upon resale of the products to the distributors’ customers in either scenario.

Revenue is recognized net of allowances, which are management’s estimates of future credits to be granted to distributors under programs common in the semiconductor industry. These allowances are not material and generally include special pricing arrangements, product returns due to quality issues, and incentives designed to maximize growth opportunities.

Allowances are based on analysis of historical data and contractual terms and are recorded when revenue is recognized. We believe we can reasonably and reliably estimate allowances for credits to distributors in a timely manner.

Income taxes

In determining net income for financial statement purposes, we must make certain estimates and judgments in the calculation of tax provisions and the resultant tax liabilities, and in the recoverability of deferred tax assets that arise from temporary differences between the tax and financial statement recognition of revenue and expense.

In the ordinary course of global business, there may be many transactions and calculations where the ultimate tax outcome is uncertain. The calculation of tax liabilities involves dealing with uncertainties in the application of complex tax laws. We recognize potential liabilities for anticipated tax audit issues in the United States and other tax jurisdictions based on an estimate of the ultimate resolution of whether, and the extent to which, additional taxes will be due. Although we believe the estimates are reasonable, no assurance can be given that the final outcome of these matters will not be different than what is reflected in the historical income tax provisions and accruals.

As part of our financial process, we must assess the likelihood that our deferred tax assets can be recovered. If recovery is not likely, the provision for taxes must be increased by recording a reserve in the form of a valuation allowance for the deferred tax assets that are estimated not to be ultimately recoverable. In this process, certain relevant criteria are evaluated including the existence of deferred tax liabilities that can be used to absorb deferred tax assets, the taxable income in prior years that can be used to absorb net operating losses and credit carrybacks, and taxable income in future years. Our judgment regarding future recoverability of our deferred tax assets based on these criteria may change due to various factors, including changes in U.S. or international tax laws and changes in market conditions and their impact on our assessment of taxable income in future periods. These changes, if any, may require material adjustments to the deferred tax assets and an accompanying reduction or increase in net income in the period when such determinations are made. Also, our plans for the permanent reinvestment or eventual repatriation of the accumulated earnings of certain non-U.S. operations could change. Such changes could have a material effect on tax expense in future years.

Inventory valuation allowances

Inventory is valued net of allowances for unsalable or obsolete raw materials, work-in-process and finished goods. Statistical allowances are determined quarterly for raw materials and work-in-process based on historical disposals of inventory for salability and obsolescence reasons. For finished goods, quarterly statistical allowances are determined by comparing inventory levels of individual parts to historical shipments, current backlog and estimated future sales in order to identify inventory judged unlikely to be sold. A specific allowance for each material type will be carried if there is a significant event not captured by the statistical allowance. Examples are an end-of-life part or demand with imminent risk of cancellation. Allowances are also calculated quarterly for instances where inventoried costs for individual products are in excess of the net realizable value for those products. Actual future write-offs of inventory for salability and obsolescence reasons may differ from estimates and calculations used to determine valuation allowances due to changes in customer demand, customer negotiations, technology shifts and other factors.

Changes in accounting standards

See Note 2 to the financial statements for information on new accounting standards.

Off-balance sheet arrangements

As of December 31, 2018, we had no significant off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of SEC Regulation S-K.

Commitments and contingencies

See Note 11 to the financial statements for a discussion of our commitments and contingencies.