The lack of enthusiasm for Intel's (INTC) latest announcement to issue $6B in Senior Notes to fund stock repurchases is very surprising from a corporate finance perspective. Keep in mind that this article assumes everything else is equal -- we are only looking at the impact of the financing arrangement, not on mobile speculation, margin speculation, or fiscal cliff concerns. This will be a brief overview of Intel, and to save additional time, I project this move will save over $850M in the next five years in cash flow commitments and over $140M per year in perpetuity. At a 10% discount rate, this deal added close to $1.5B to Intel's valuation in financing terms alone, before considering the 5% addition to EPS.
Intel's Additional Debt Expense
Intel will carry its interest as an operating expense, which is critical because the actual interest post-tax costs will be approximately 30% less. As an investor, post-tax is all that really matters. The debt is split into four tranches ($3B/5y-1.35%, $1.5B/10y-2.7%, $750M/20y-2.7%, and $750M/30y-4.25%). Pretax yearly expense for the first five years will be approximately $133M, and post-tax expense will be close to $93M (effective rate of 1.55% on $6B). This compares to the effective rate of 2.34% on the $5B from 2011.
Benefit 1: More Total Cash Availability Sustainable Dividend Growth
Observing a company with a higher yielding stock than senior debt is a rare phenomenon, unless we are comparing utility companies. In the technology sector, this is unheard of. Intel currently pays out 90c per year (4.5% yield) on 5B shares outstanding. This amounts to a "dividend outflow" of $4.48B. Intel's five-year dividend growth rate is 14.86%; however, I expect future growth in line with the recent 7.1% increase. This amounts to a dividend expense of $6.3B in 2017 assuming all else is equal and no shares are retired. If INTC can retire their shares at my projected (conservative) average of $24, INTC will "save" $225M in the next year, and $267M in 5 years. This saves INTC a net of $132M year 1 through $174M in year 5. With a discount rate of 10%, this alone is worth $570M today and is worth an additional $900M+ if you assume constant dividend growth of 6%, and interest rates of 4% into perpetuity.
Note: This assumes conservative figures of $24/sh, 4% future i/r, and a 7.1/6% dividend growth model. (A change to $20/sh and 3%, changes the gain to over $2.5B in present valuation.)
Benefit 2: Lower Share Count, Larger EPS
This is the more "obvious" benefit of a share repurchase, but is primarily just the other side of a repurchase "coin." As long as INTC's debt expenses are less than the effective reduction of shares, EPS will rise. With an effective rate of 1.55% and a projected share count reduction of 5%-6%, this undoubtedly will occur. Clearly if earnings decline, the EPS will decrease, but the earnings decline will be due to factors unrelated to the new finance structure.
Benefit 3: Increased ROE and FCF/E
This is simple ratio math-earnings and FCF will decrease far less ($93M) than the decrease in shareholders' equity, boosting INTC's ROE and FCF/E. This doesn't really add anything in value beyond benefit No. 1 and benefit No. 2, but the latter ratio has been the subject of investor complaining during the past two years as Intel has ramped up their capital expenditures.
Red Flag 1: Increase Debt/Assets and Debt/Equity
This move will push INTC's debt to approximately $13B, which will bring a D/A of 18% (up from 10%) and a D/E of approximately 30% (up from 14.5%). These higher ratios could hurt their credit rating and will increase Intel's future interest rate exposure, assuming an environment of sky-rocketing interest rates.
Red Flag 2: Decrease Interest Coverage Ratios
Pre-tax, INTC will now have interest expenses of close to $300M (up from $170M). The 76.4% jump will far surpass the percentage increase in earnings or free cash flow. INTC's interest coverage will still be very favorable, but as stated above, the future exposure is the key concern.
This is obviously a great move from Corporate Finance 101, so why are investors and analysts skittish? I believe INTC has been black listed by many investors due to the recent CEO's departure, and the aforementioned margin & fiscal cliff concerns. However, I also believe that these impacts have already been priced into INTC's stock and once a few analysts bust out their corporate finance equations and study the true impact on Intel, we will see some upgrades and positive price movement. Intel is quickly becoming a dividend growth investment stock, and the primarily concern is the sustainability of the dividend increases. This financing move will undoubtedly bolster INTC's dividend sustainability, and should increase demand from this investor segment once the news is digested.
I recommend accumulating INTC for a long-term position. Increasingly, I view INTC similar to a Microsoft-type investment in that sustainable dividend growth is the primary target. In the current interest rate environment, I believe INTC's yield is sustainable and should ideally be around 3% -- giving INTC a price target of $30, or 50% upside.
If you are simply buying INTC for the 4.5% return and do not have faith in a market price revival, consider selling the April 13 $20 call for $1.10, for an effective yearly yield of approximately 18%.