There has been a lot of concern about the chip manufacturers due to the consistent decline in global PC sales. Intel (NASDAQ:INTC), being the world's largest chip manufacturer has also suffered due to the negativity that is persisting in the sector. Sometimes, however, investors tend to ignore the long-term prospects of the business by putting too much emphasis on the short-term performance - that's exactly what has happened with Intel. While there are concerns about the global PC sales going forward; I see a lot of positives for the company. In order to determine the long-term valuation of the company, I decided to develop a free cash flows model for Intel. I have been working on the model for some days; however, slight changes were made after the last night's earnings announcement by the company. However, the key assumptions for the model were not impacted by the earnings announcement, and are in line with the company's future outlook.
Key assumptions for the model are listed below. These assumptions include, revenue growth, cost of sales, gross margin, operating costs including R&D expenses and amortization.
- First of all, we have revenue growth. Intel expects full-year revenue to increase by low-single digits. For my model, I have assumed full-year revenue growth of 1.5%. For the following year, my revenue growth estimate is 3%, which will grow to 4.5% by the end of 2017 and remain at that rate for the next four years. Finally, my terminal growth rate is 3%.
- Moving onto the costs - the first component is cost of sales. For the current year, I have assumed cost of sales to be at 41% of net revenue, giving the company a gross margin of 59%. Cost of sales will come down in subsequent periods, and finally it will settle at 38%. Intel has a massive advantage over its peers when it comes to manufacturing. As a result, I believe the company will be able to improve its gross margin over the next three to four years. My fellow SA author, Ashraf Eassa, wrote a brilliant piece about the manufacturing advantage of company, where he explains where its competitors stand compared to Intel.
- Total operating costs including R&D expenses were 35% of net revenue during the last year. However, for the current year, guidance figures will take Intel's total operating expenses to 36% of the estimated net revenue. In the subsequent periods, I have assumed a declining trend in operating expenses, and finally these will settle at 30% of net revenue. Intel has been increasing R&D expenses recently; however, I expect the expense to come down in the future.
- Finally, I have assumed a flat tax rate of 27% for the whole of the valuation period.
The following table shows the estimated earnings of the company.
Earnings will gradually improve for Intel, and the company will have impressive margins. If Intel is able to successfully implement its strategy to capture the mobile market, then earnings and margins will be extremely attractive. Intel has an incredible R&D team that can provide innovative products to the company. If the pipeline of the company keeps on delivering the products, then my assumptions might become conservative and earnings will be substantially higher.
Intel's stock price has been under some pressure recently due to the concerns about the short-term prospects of the business. For my valuation purposes, I have used a discount rate of 10% -- taking into account the strong position of the company; I believe a discount rate of 10% is appropriate. The table below shows free cash flows, adjustments for different items and valuation.
For the free cash flow calculation, I have taken net income as the starting point. All of these net income figures represent projected net income based on above mentioned assumptions. To reach free cash flows, I have made adjustments regarding, depreciation, amortization and other non-cash items such as gains/losses on equipment sales and taxes. Furthermore, investment in fixed and working capital has also been taken into account. Non-cash items include depreciations and amortization along with stock-based compensation - these items are added back to net income.
However, investment in fixed capital and working capital has been deducted from the net income to reach the free cash flows. At the moment, investment in fixed capital is about 22.65% of net revenue, which I have kept constant for the next two years. Intel has been spending heavily on capital expenditures and the guideline for the current year is $12 billion. However, in the following years, investment in capital has been decreased and finally it settles at 15% of net revenues. In addition, investment in working capital is assumed to be at 7% of incremental sales, and it remains constant for the whole of the valuation period.
Free cash flows beyond 2022 have been projected at a constant growth rate of 3% and discounted at the discount rate of 10% (adjusted for growth rate) to calculate terminal-year free cash flows. After calculating free cash flows for each year, I have discounted those free cash flows at 10% to reach the present value, and added them to achieve about $192 billion in discounted free cash flows. According to my free cash flow model, Intel should be trading at around $37 per share. At the moment, the stock is trading at around $22 per share.
Companies spend cash to maintain/boost growth in the future. As a result, sometimes investors have to be patient to enjoy benefits of the short-term sacrifice. Intel is investing substantially in its future, which I believe will pay handsomely. In the meantime, investors can enjoy its healthy dividend yield of over 4%. In my opinion, Intel is an investment for the long term, and investors should be patient with the company and give it time to implement its strategies.
My valuation model shows that there is about 70% upside potential - Intel might take some time to reach that valuation; however, I remain confident that the company can reach $37 per share.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.