Much has been said and written about the giant chipmaker Intel (INTC), but following a detailed analysis, I think I can add to that mix with my conclusion that Intel is undervalued, with a potential of about 30%.
A Bit Of History
In the late '80s, Intel was not a chip maker leader as we know it today. The market was much more fragmented with many competitors such as NEC Semiconductors, AMD, Zilog... In 1987, Intel was barely #10 among chip makers by size. However, within ten years, Intel was able to reach almost 90% in market share in the PC segment. Intel managed to impose its brand to OEMs, essentially thanks to an impactful BtoBtoC marketing campaign: the famous "Intel Inside."
Intel benefits from competitive advantages over its chip maker rivals, in particular Advanced Micro Devices (AMD). Mainly:
- Intel's brand, particularly for PCs, a bit less for servers (pros want cost effective products). This is not so much the case with mobiles devices (Smartphones, tablets…).
- Intel's size, affording it huge scale effects: Intel's R&D expenses per unit sold are much smaller than those of its long-time rivals (AMD, Cyrix…).
In fact, size gives Intel a double advantage:
- It invests more easily in new technologies. Considering sales volume, it is much more likely that R&D expenses will be amortized.
- Intel's market share allows it to generate very high margins (30% average operating margin over the past 4 years). These margins are higher than its peers on the PC segment. Thus, Intel may still be able to make money while cutting prices. It gives Intel more resilience than others.
Today, Intel's business lines are challenged by the development of mobile devices. Intel is now in competition with the whole ARM ecosystem. For mobile devices, the computing power is not enough. Chips have to be more "energy efficient" than just "efficient." Nevertheless, several OEMs already use Intel's chips for mobile devices (Motorola, Lenovo, Lava, ZTE). Samsung (GM:SSNLF) recently confirmed it will soon launch new Smartphones with its Tizen OS co-developed with Intel.
I used 6 different valuation methods:
- Historical and comparable multiples, DCF using XlsValuation.
- Adjusted Book Value, Earnings Power Value (EPV) and FCF Value using Excel.
I did not estimate total value, since I am not making any growth assumption (conservatively).
Adjusted Book Value
The method is the same as in Greenwald's in Value Investing: From Graham to Buffett and beyond.
For the balance sheet value, I took last quarter's equity: $49bb.
Off-balance sheet, I added:
- The valuation of Intel's know-how (design and development of new chips …), which I estimated by capitalizing 5 years of R&D expenses, amounting to $24bb.
- The valuation of its marketing know-how (Intel Inside). I added 3 years worth of average marketing expenses. It is a part of SG&A expenses. I assumed SG&A expenses represent 17% of sales, and I estimate marketing expenses to be 50% of these SG&A expenses. It amounts to $14bb.
This leads to $87bb in adjusted book value. Intel capitalizes around $110bb. Intel's shares are priced around $22. It represents a 1.25 adjusted Price to Book, historically low. Since 1975, this adjusted P/B has always been above 1, with a historical low around 1.2. An adjusted P/B of 1 would lead to an $18 share price.
Earnings Power Value
EPV provides a valuation devoid of any growth assumption. The difference between EPV and adjusted book value normally corresponds to the moat value, and is hence equivalent to an "earnings power."
There are two ways of estimating EPV:
- The first is fairly quick: using the Weighted Average Cost of Capital (GM:WACC) and operating profit. I am not very fond of this approach, because it does not include corporate taxes. I would adjust it by using Net Operating Profit After Taxes (NOPAT). Nevertheless, it would still remain a trailing or at best current measure of operating profit.
- The second approach is based on almost the same formula, but NOPAT gets normalized since semiconductors are a cyclical business. This method was developed by Greenwald in Value Investing: From Graham to Buffett and beyond.
The adjustment in question, however, does raise some concerns:
- Unusual items. These are the only items that do not affect normalized earnings power. However, they are expenses. I smoothed them using the average unusual items expenses over the past 4 years.
- Operating margin. I also used the average operating margin over the last 4 years: 27%.
- R&D expenses. The adjustment removes R&D expenses linked with growth. But I add back 25% of the R&D expenses. The remaining 75% are still integrated in the normalized operating profit. I believe 25% is quite enough, it implies 75% of R&D expenses are made just to keep up.
- SG&A expenses. The method is the same: I add back 25% of SG&A expenses.
- Corporate taxes: I assumed 27%.
- Depreciation, amortization and replacement investment. The sector evolves very quickly, and as a result provisions for depreciation certainly exceed the cost of replacement investment. Hence, I simply add 25% of the provisions for depreciation and amortization. It implies that 75% of these provisions are enough for replacement investment.
The formula is: Normalized NOPAT / WACC. Greenwald assumed 12% (for the late '80s period).
My calculations result in almost 10%. It seems justified to me because:
- The debt/equity ratio is not the same.
- Interest expenses are historically low.
Finally I took out long-term debt and added excess cash. This leads to a total EPV of around $145bb; $30 per share. Historically, Intel's share price has almost always been over EPV, except in the late '80s. At that time, Intel did not benefit from its strong current market share.
This valuation approach does not assume any kind of growth.
Here I follow my own back-of-the-envelope approach, adding cash and 12 years of trailing FCF. This also leads to a $30 share price.
Distribution To Shareholders
Relative to share prices, dividends are on the high side, around 4.5%. In addition, share repurchases have been significant over time. Intel also recently announced it raised $6bb in bonds for general purchases, including share repurchases. This implies that management believes the shares are undervalued.
Under $20/share, Intel's Earnings Power Value comes almost for free, and any growth potential on top of it is actually for free! Nevertheless I think the market expects Intel's shares to decline. At this price level, I estimate there is a 30% margin of safety on EPV. I am long Intel.