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Introduction

Intel (INTC) is the world's largest semiconductor company in terms of revenues. It isn't an exaggeration to say that Intel has been one of the linchpins of the technology industry and has played a pivotal role in getting the technology industry to where it is today. It was an Intel CEO who coined the Moore's Law which has shaped and defined the technology industry. The company has successfully managed to navigate the rapid changes in the industry over the last 2-3 decades. The company now dominates the PC and server processor market, having vanquished its main rival AMD (AMD) through sheer ruthlessness.

AMD is on life support, with Intel outspending AMD both on marketing and R&D. Despite its success in its core market, Intel's stock has underperformed the rest of the industry due to concerns about the decline of the PC industry. Apple (AAPL) has disrupted the established order by creating two new product segments through brilliant product innovation and marketing. As a result, smartphones and tablets are cannibalizing PC and laptop sales. The Wintel companies such as HP and Dell (DELL) have seen their stock prices crash. The company is now making a major push to introduce products for the tablet and smartphone segments. Though Intel has never managed to succeed in the mobility segment, the sheer money and intellectual power makes us think that the company has a great chance of transitioning itself successfully from the PC to the mobility era. Intel's valuation at less than 10 P/E, compelling value and the dividend yield of more than 4%, easily makes it a top pick in a diversified dividend portfolio.

Why we love Intel

1) Technology Advantage - Intel has tremendous intellectual capital both in terms of its employees and its patent portfolio. The company makes the most powerful processor chips on a commercial scale and no other semi company can match it currently. The company spends a stunning amount of money on R&D, as it is looking to get a move on the mobile space. The company increased its R&D spend by 25% in 2012 to $10 billion. While critics can argue that money cannot solely create innovative products, the sheer money power makes us think that Intel has more than an even chance, of competing with ARM (ARMH) based products.

2) Manufacturing Edge and Scale - Most of Intel's competitors like AMD and Qualcomm rely on foundries for their manufacturing. While the "fabless" strategy has its benefits in terms of low capex spend etc., Intel's integrated model has its benefits as well. Intel never has to worry about not getting enough leading edge capacity or fear that its designs/ products can be copied by its foundry partners (Samsung). Intel, through its huge capex spend, built 300 mm fabs with a market leading 22 nm process node. In the semiconductor industry, this is a huge advantage, since you can make more powerful processors at lower costs if you have smaller process node. Its main semi-rivals, Samsung and TSMC, have not yet caught up with Intel in this respect. Intel is also investing heavily to keep up its lead by buying a $3 billion stake in ASML and putting money into transitioning to the 14 nm node and 450 mm wafers. The company is going to spend $2 billion in 2013 to build the world's first 450 mm wafer facility.

3) Partnerships - The technology industry is a story of immense rivalry between the principal players like Microsoft (MSFT), Google (GOOG), Apple, Amazon (AMZN) and Samsung. Intel surprisingly has little to fear from any of the big players in the industry, because it does not directly threaten any of them. While each of these big tech gorillas is trying to outwit each other, Intel is cleverly partnering the major players to improve its competitive positioning.

  • Google - Intel has signed an agreement with Motorola to provide Intel Application Processors. Google is also working with Intel to optimize the Android operating system for Intel's x86 based processors.
  • Nokia (NOK) - Intel and Nokia had jointly developed the Meego operating system for smart phones. While Nokia's strategy on mobile O/S has changed dramatically, it shows that Intel has a good relationship with one of the top global mobile players as well.
  • Lenovo - The fastest growing and second biggest PC company in the world has agreed to use Intel's processors for its smartphones. Note that Lenovo, like Intel, is hurting from the decline in global PC sales and is looking to diversify into smartphones and tablets.
  • Microsoft - Intel shares the closest relationship with Microsoft, forming the Wintel duopoly which has dominated the technology industry all these years.
  • Apple - Intel does not have any major agreement with the world's biggest tech company yet. But Apple uses its main rival Samsung's application processors for its smart phones. If Intel manages to convert Apple to its mobile centric application processors, we could see the potential beginning of an "Apptel" ecosystem.

4) Competition is in a Sorry State - The company's main competitor, AMD, is in a sorry state right now and we don't think the company can challenge Intel's supremacy. AMD, like Intel, will have to concentrate its resources on mobile devices. That will leave Intel to milk the mature PC and server processor industry for a long time. We don't think that ARM based processors for the PC and server segment present a credible challenge to Intel at this point of time.

5) Huge and Growing Dividends - Intel has managed to grow dividends at ~30% in the last decade. From less than 10c/share, Intel's annual dividend is now 90c/share, which implies a dividend yield of a stunning ~4.5% (at less than 40% payout ratio). Large utility stocks offer an average dividend yield of just 4.2%, with payout ratios between 60-70%. No big technology company of Intel's size offers such a sizeable dividend yield along with huge buybacks. While Seagate (STX) and Western Digital (WDC) also give 3 plus dividend yields, their payout ratio is much higher. Intel paid $4 billion in dividends and bought back stock worth $5 billion in 2012.

6) Diversification away from PCs - Intel just announced that they would get into providing TV content through web-based services. The innovative feature about this product is that it will be able to customize the service based on who the viewer is (through a camera). Though we are not completely sure what strengths Intel brings into providing TV content, we are heartened to see that Intel is making an effort into diversifying away from its PC and server centric businesses.

7) Strong balance sheet and huge cash flows - Intel, unlike other technology companies, has not hoarded the massive cash flows that it is generating. The company has "only" $8 billion of net cash, which is more than enough to pay the bills. Intel managed to earn a stunning $20 billion in operating cash flow in 2011. This gives the company enough money not only to spend more than $10 billion on capex, but also enough to return a huge amount of cash to shareholders through dividends and buybacks.

8) Increasing Margins - Intel's technology and manufacturing strength has not only allowed it to increase market share and revenues, but the company's margins have improved as well. The company's gross margin has increased from ~58% in 2004 to ~63% now. The ROE has also increased from ~20% in 2004 to ~25% now.

9) Security Focus - Intel remains essentially a hardware player, but the company is also taking software and security more seriously. The company bought one of the biggest security companies, McAfee and is trying to use that technology to improve the security of its hardware products. Security is becoming a huge issue in the world today, with major organizations reporting security breaches (LinkedIn (LNKD), Wall Street Journal, etc). If Intel can offer a market leading security product, then a huge amount of business will automatically come Intel's way.

Intel Risks

  1. ARM based processors for servers - ARM based processors are now starting to make an entry into Intel's core PC and server market. Intel has made its "Datacenter" segment into a huge money spinner and if these processors get traction, then Intel will have to fight on 2 fronts against the ARM ecosystem.
  2. Product Risk - Intel's products for the tablet and smartphone market won't be introduced till late 2013 and 2014. Also there is no guarantee that Intel will manage to transition successfully to low power chips that are required for mobile devices as compared to PCs and servers. Meanwhile competitors will be coming up with better products. Nvidia (NVDA), which is another chip company trying to make the same transition from PCs to smartphones/tablets, is facing a tough time doing so.
  3. Declining PC market - The PC market is showing declining revenues and volumes, as tablets cannibalize the laptop market. However, the introduction of faster laptops (ultrabooks) and PC-tablet hybrids by leading PC makers such as HP, has the potential to slow the decline if not reverse it entirely. Intel's PC client group declined by 3% y/y in 2012.
  4. Slowing growth - Intel's revenue in 2012 was down 1%, compared to the last year and 2013 revenue forecast is tepid as well. The company also faces growth risks from the global economic slowdown which is affecting both the developed and developing countries.

Stock Performance

Intel's stock has traded in range for most of the last decade like Microsoft. The company has underperformed the broader market returning just 5% in the last 5 years, compared to the ~37% NASDAQ return. However, Intel has outperformed its competitors like AMD (-57%) and Nvidia (-43%) by a huge amount in this period. Other big semi companies such as Texas Instruments (TXN) (+11%), Qualcomm (+55%) and TSMC (TSM) (+92%) have done much better than Intel.

Valuation

Intel trades at a big discount on most valuation metrics, due to concerns about earnings growth. The trailing P/E at 9.3 is less than half of the industry average, while the P/B and P/S both at 2.1x are also at a ~25% discount to the industry.

Summary

We think that Intel is a terrific stock to own at the current price. The company is outspending its rivals both on the R&D and manufacturing front and the fruits of these efforts will be seen in the next couple of years. There are only 2 companies in the world which have the resources to match Intel and both of them are at least one technology node behind. It is also not certain that TSMC has the money and R&D to keep up with others in the semi fab race. Intel manages to earn a huge amount of cash every year from its dominant PC and server processor business. It will take a long time for competitors to make a material difference to Intel in its core business. Meanwhile, Intel is pushing hard to enter the new fast growing tablet and smartphone segments through a new line of tailor-made processors which are more energy efficient. The company's valuation is extremely cheap, with its dividend yield higher than that of traditional power utilities. We can think of few better stocks in the technology industry that has such a good risk reward tradeoff.

Source: Intel - Outspending And Outgunning Rivals