Thesis & Catalyst For Intel Corporation
The market is very pessimistic about Intel's (INTC) ability to compete in the Smartphone and tablet space and is overestimating the decline in the company's legacy markets. If you believe that these fears are unfounded (which we do) then Intel offers patient investors a Gross IRR in the range of 12.5% to 20.4% over the next 5 years.
The market is forecasting zero to negative earnings growth over the next 5 years. We are anticipating average annual earnings per share growth of 6.9% over the next 5 years. Once Intel starts to deliver, investors should expect to receive 6.9% annual average earnings per share growth, a 4.1% current dividend yield and possible multiple expansion.
Valuation / Calculation Of Expected Returns
Earnings Per Share Estimate
There are four building blocks to our earnings per share estimate: Implied Growth In Earnings derived from Invested Capital, Organic Growth, Earnings Per Share Uplift from Share Buybacks and Earnings Per Share Dilution from stock compensation.
1. Implied Growth Earnings Per Share
Firstly, we took a look at Intel's cash flows to see how much cash it is generating and how it has historically deployed that cash (Table 1 below). We use our own proprietary Adjusted Operating Cashflow number that includes proceeds from employee stock options.
Table 2 below breaks down how Adjusted Operating Cashflows are deployed. Over the last 10 years, the company has invested on average 12.6% of its Adjusted Operating Cashflows back into its business either in the form of Acquisitions or Growth Capex, 33.6% of Adjusted Operating Cashflows were required to maintain its assets (otherwise known as Maintenance Capex), 17.1% was paid out in Dividends, and 38.4% went into Share Buybacks. In the last five years, the company has spent 22.6% of Adjusted Operating Cashflows on Growth Capex and Acquisitions, 21.4% was paid out in Dividends and 35.4% was spent on Share Buybacks. Going forward, we estimate that spending 23.2% of Adjusted Operating Cashflows on Share Buybacks is sustainable without changing the capital structure of the company (however, please note that the stock has a net cash pile which could be used to ramp up Share Buybacks in the short term without impacting the company's capital structure).
Implied Growth Earnings Per Share represents the increase in earnings we expect to see from Invested Capital. The stock has a 10-year average Return On Invested Capital of 24.2% as can be seen in Chart 1 below. If we multiply the 10-Year Average Return On Invested Capital of 24.2% by the 22.6% of Adjusted Operating Cashflow spent on Growth Capex and Acquisitions, we get 5.5% which is what we expect to be the Growth Earnings Per Share over the next five years.
2. Organic Earnings Per Share
Intel's segmental reporting is divided into five categories. Table 3 below shows the YoY % change in revenue for each division. We like to calculate the trend growth of the existing business excluding the effect of Invested Capital (Acquisitions and Growth Capex), this is what we refer to as Organic Earnings Per Share. Extrapolating the sales trend forward, we get a compound annual growth rate of -2.0% over the next five years.
3. Earnings Per Share Uplift from Buybacks
In Table 4 below, we have estimated how much we anticipate Earnings Per Share to grow based on the % of Adjusted Operating Cashflow used for Share Buybacks. Based on the current market capitalization, we estimate the company can sustain buying back 4.5% of its stock every year. The company could in theory continue to do more than this by using its net cash pile.
4. Dilution from stock compensation
In Table 5 below, we have estimated the dilutive effect on earnings of the company's stock compensation plans. Over the last 5 years, the average annualized dilution to the basic share count was 1.2%
Table 6 below pulls together the four drivers of our Earnings Per Share estimate. We calculate 6.9% expected Earnings Per Share growth over the next five years. This assumes stable margins throughout that period.
Our next step is to identify the assumptions we will use to calculate the Internal Rate Of Return for the stock. Table 7 below shows the current P/E ratio of the company of 10.37, which is calculated based on a time weighting of the trailing 12-month P/E and the forward P/E. In addition, we identified that over the last 5 years, the company's P/E has traded at 0.88x the S&P 500's P/E which is currently 13.50. The current trailing 12-month P/E of the S&P 500 is 15.36.
In Table 8, below we calculate the 5-year Internal rate Of Return of holding Intel stock based on three scenarios. Scenario 1 assumes that in five years, the stock still trades on its current P/E ratio of 10.37. Scenario 2 assumes that in five years, the stock trades based on its average relative P/E to the S&P 500 of 0.88 which would be 13.50x. Scenario 3 assumes that in five years, the stock trades on a market multiple currently 15.36x (for the S&P 500).
In conclusion, we believe that for patient investors a minimum gross return of 12.5% will be realized. If Intel surprises and starts to build momentum in the Smartphone and Tablet space, then we could see an earlier re-rating of the stock resulting in shorter term gains for the more speculative investor.
Intel could continue to see deterioration in its legacy businesses and fail to launch competitive products in the rapidly growing Smartphone and Tablet space. In addition, the as yet to be announced CEO replacement may or may not have a negative impact on the business going forward.