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Intel (INTC) reported an estimate-beating $0.48 per share of earnings yesterday afternoon, on the analyst consensus estimate of $0.45. Revenue came in at -3% year-over-year at $13.48 billion, missing expectations by $50 million. This quarter's results also mean that Intel topped expectations for each quarter in 2012. The earnings "beat" looks great until you consider that 2011's Q4 was $0.64 and that Intel bought back roughly $1 billion of shares in 2012, according to CFO Stacy Smith. In addition to this, Intel guided revenue to the range of $12.2 billion to $13.2 billion for the first quarter of 2013, with the midpoint of those numbers significantly lower than the $12.91 billion consensus estimate compiled by Thomson Reuters.

Gross margin for the quarter was one point higher than estimates, clocking in at 58%, but was down from 64.5% a year earlier. This is ugly, but expected at this point from investors as Intel's PC-related issues have been well documented. Revenue for 2013 was guided to rise "low single-digit percentage," whatever that means, which caused INTC to get whacked in the pre-market this morning, down just over $1 per share to $21.60 at the time of this writing.

The question for investors becomes: What now?

Valuation

Let's turn our attention now to valuing INTC shares, given the expectations laid out following last night's earnings report. First, some assumptions for the DCF analysis must be made: 1) 2012 actual earnings, 2013 and 2014 estimated earnings and the 5-year growth rates are all from Yahoo! Finance analyst compilations 2) discount rate of 9% (my number, reflecting risk and return on capital) 3) perpetual growth rate of 3% (also my number) 4) dividend growth rate of 7% (based on 2012). You can debate the efficacy of some or all of my numbers but remember any DCF type analysis is subject to conjecture.

2012

2013

2014

2015

2016

2017

2018

Earnings Forecast

Reported earnings per share

$2.13

$1.93

$2.06

$2.25

$2.46

$2.69

x(1+Forecasted earnings growth)

-9.39%

6.74%

9.32%

9.32%

9.32%

9.32%

=Forecasted earnings per share

$1.93

$2.06

$2.25

$2.46

$2.69

$2.94

Equity Book Value Forecasts

Equity book value at beginning of year

$9.89

$10.86

$11.89

$13.04

$14.32

$15.75

Earnings per share

$1.93

$2.06

$2.25

$2.46

$2.69

$2.94

-Dividends per share

$0.90

$0.96

$1.03

$1.10

$1.18

$1.26

$1.35

=Equity book value at end of year

$9.89

$10.86

$11.89

$13.04

$14.32

$15.75

$17.34

Abnormal earnings

Equity book value at begin of year

$9.89

$10.86

$11.89

$13.04

$14.32

$15.75

x Equity cost of capital

9.00%

9.00%

9.00%

9.00%

9.00%

9.00%

=Normal earnings

$0.89

$0.98

$1.07

$1.17

$1.29

$1.42

Forecasted EPS

$1.93

$2.06

$2.25

$2.46

$2.69

$2.94

-Normal earnings

$0.89

$0.98

$1.07

$1.17

$1.29

$1.42

=Abnormal earnings

$1.04

$1.08

$1.18

$1.29

$1.40

$1.52

Valuation

Future abnormal earnings

$1.04

$1.08

$1.18

$1.29

$1.40

$1.52

x discount factor (9%)

0.917

0.842

0.772

0.708

0.650

0.596

=Abnormal earnings disc to present

$0.95

$0.91

$0.91

$0.91

$0.91

$0.91

Abnormal earnings in year +6

$1.52

Assumed long-term growth rate

3.00%

Value of terminal year

$25.41

Estimated share price

Sum of discounted AE over horizon

$4.60

+PV of terminal year AE

$15.15

=PV of all AE

$19.75

+Current equity book value

$9.89

=Estimated current share price

$29.65

Looking at the table, we see that Intel's management creates an enormous amount of economic value from the company's assets. Given my assumptions, Intel is worth about $29 per share for long-term holders of the stock. In addition, stockholders receive a dividend of about 4.2%, based on premarket trading this morning. This is 2.3 times the current 10-year Treasury rate, offering tremendous income for those seeking it. Intel's dividend payout ratio is only 37%, offering significant upside in the next few years for dividend raises.

According to Yahoo! Finance analyst estimates, earnings expectations for 2013 have been coming down steadily for the past three months, having decreased from $2.0 to the current $1.93 and for 2014 estimates have decreased from $2.19 to $2.06. This is troubling in that when earnings estimates are being cut consistently, it can be difficult to know where the bottom lies. Of course, estimates could be too pessimistic right now but they could also still be too high, implying significant downside for shareholders. Indeed, Sterne Agee cut its price target to $18 in the wake of last night's report on such pessimism.

Metrics

Intel's operating metrics are quite impressive but the share price does not reflect management's efficiency in creating economic value, due to declining expectations for the future. However, it can be instructive to view Intel's results and expectations in light of historical trends in order to assign a value to the shares. Note: all charts below are from YCharts.

First, Intel generates an enormous amount of cash from operations. As seen below, in recent years, Intel has doubled its cash flow from operations to nearly $20B per year. This allows management free reign to increase the research and development budget to whatever is necessary to support future growth (guided to roughly $13B for 2013) and also to increase that huge dividend.

Speaking of the dividend, the chart below outlines perhaps the best reason at this juncture to buy INTC shares; the ever-increasing dividend.

This chart of the quarterly dividend is exciting for income investors as the growth is astonishing. Ten years ago, Intel was paying virtually nothing, but the dividend per year is now $0.90 per share and expected to continuously increase. This is terrific for income investors and I believe it provides a margin of safety for the shares as the yield should serve to buoy the stock on declines as long as our zero interest rate policy world persists.

Intel recently issued $6B in debt to finance more stock buybacks. This was welcome by many investors and derided by others but as we can see in the chart below, Intel had very little in the way of long-term debt prior to the issuance and outstanding long-term debt now stands at a very manageable $7B.

This ~$7B of long-term debt means Intel has a robust debt-to-equity ratio of only 14.5%. Obviously, this should not worry shareholders as Intel's management has proven they are quite capable of managing cash flow and this small amount of debt can easily be serviced by Intel's operations.

Next, we see in the chart of Intel's book value per share that book value has relentlessly climbed from about $5.50 per share 10 years ago to nearly $10 per share now. This is key to investing in any company as it means that retained earnings is growing each year and thus, shareholders' equity is growing.

While this chart is great, we need to also know how much the market is willing to pay for such book value. The answer isn't as clear cut as one may imagine as the price the market is willing to pay for INTC's book value fluctuates.

For instance, we see that the price per book value for INTC shares declined steadily from roughly 5 times book value in 2004 to just over 2 times book value today. This is telling in that we see that Mr. Market isn't impressed by book value growth at Intel and has been assigning lower and lower multiples over the years. The good news for shareholders is that Intel is currently on the lower bound of the range and this should provide at least some support for the shares. In addition, if shares once again trade at roughly three times book value, a price of roughly $29 per share is implied at current valuations.

One troubling development over the past couple of years is the staggering growth in inventories for Intel. The chart below depicts something that a mature business like Intel never wants to see; unrelenting growth in inventory, reflecting overproduction.

This isn't good for shareholders because it can indicate waning demand for the company's products, which we have seen play out in any number of PC-related stocks in the past 12 months. However, the company said inventory was reduced by roughly $600 million in the fourth quarter, which is a very encouraging development. The inventory number is certainly something to keep an eye on if you own the shares.

Taking a look at gross margin percentage, we see that GM% tanked during the depths of the financial crisis to the mid-40's and has since rebounded to over 60%. However, the fourth quarter's GM% was only 58% and next year's guidance was uncertain at best, coming in at 58%, plus or minus two points. Again, as margins are at the higher end of the historical range, it is important for investors to keep an eye on eroding margins as it indicates a loss of pricing power due to waning demand for the company's products.

Lastly, let's take a look at what the market is willing to pay for Intel's earnings.

We see from the chart above that Intel's trailing P/E ratio has hovered right around 10 since early 2011, down from a range of 20-40 in the years prior. While we can't expect 20 times earnings for a slow grower like Intel, it is telling that the market has settled in a very tight range at 10 times earnings for Intel. This means that we can reliably forecast that the market is probably going to continue to pay 10 times trailing earnings for Intel, making our forecasts a bit more reliable in the process.

Conclusion

So what do we make of this? Using numbers from my DCF calculations, if the market is willing to pay 2.3 times book value for Intel shares and I am forecasting a book value of roughly $15.75 per share in 2018, a price of roughly $36 is implied five years from now. Obviously, since shares can be purchased today for less than $22, a nominal return of 67% over the next five years is quite attractive.

Next, we know that the market is willing to pay right at 10 times trailing twelve month earnings for Intel and I have forecast 2018 earnings at $2.94, implying a value of about $30, based on the P/E ratio. Therefore, if my assumptions for earnings play out, Intel should have a share value of between $30 and $36 in five years, implying 40% to 67% over the next five years. This return is capital appreciation only and does not include the robust dividend of over 4% that is currently offered and is nearly certain to be increased.

There are risks to this rosy forecast, of course. PC demand has been weak for some time now and opinions differ on when this may end. I believe Intel is probably priced for most, if not all, of the PC-related weakness fears of investors. In addition, mobile computing is clearly the wave of the future and shareholders are betting that Intel's management has a strategy to move the company into that space in a big way in the years to come. Intel's enormous R&D budget would suggest something is in the works, but only time will tell.

Intel is a very cheap stock right now and I believe long-term shareholders will benefit from Intel's generous cash flow and innovative R&D department. Intel is a market leader and has been for a very long time. However, shares are priced as though Intel has lost its competitive edge and for the demise of the PC. If you believe, as I do, that PCs aren't going away, Intel could be a great buy at current levels.

Source: Intel's Soft Guidance - Now What?