The fact that Intel (INTC) outperformed the general market by 1.5% after its earnings report on Wednesday along with the announcement of a new CEO may have investors coming out bullish in the coming weeks and drive the shares higher. This higher price could be short-lived as revenue growth from new projects may take longer than investors realize and near-term margins could come under pressure. Long-term investors can take solace in the stable dividend but may not want to take too big a position until later in the year.
The May Head Fake
Intel reported first quarter numbers that were basically in-line with the previous guidance and Wall Street estimates. Revenue was down 6.7% to $12.6 billion on the previous quarter with GAAP earnings at $0.40 per share, just a penny shy of expectations. Gross margin was down 1.8% for the quarter to 56.2% on inventory write-offs and excess capacity charges. Management guided revenue for the June quarter to between $12.4 billion and $13.4 billion, a midpoint about 2.6% above the current quarter.
Shares have done relatively well against the broader index, most notably outperforming the S&P 500 by 1.5% on the day after the announcement. Management reduced its estimate for capital expenditures by $1 billion to $12 billion in 2013 and I think this provided a positive surprise on margin expectations. The company also said that it was close to announcing a new CEO and that the decision would be made before Paul Otellini steps down next month.
The announcement of a new chief and the lead-up to the company's annual meeting on May 16, should provide an upside for the shares relative to the general market. I think there is a good chance that it will break with tradition and select an external candidate with strong credentials in mobile. Doing this could see a more significant pop in the shares on the perception that the company can transition into mobile more quickly.
Unfortunately, that's where the good news ends. After an initial pop in the shares following the announcement of a new CEO, we are likely to see some senior-level management leave as the disaffected realize they won't be steering the boat. The exodus could be more pronounced if the board selects an external candidate.
Beyond the loss of senior talent, I think investor expectations for revenue growth may be premature. Haswell has just recently launched and investors are looking at the $12 billion in capital expenditures as a sign that the new product cycle is coming soon.
The mix of spending for 2013 is shifting to equipment, which has a longer development cycle and will probably not see a payoff until 2014-2015. Management noted that much of the equipment spend would be for the 14nm chip which will not be available on the market until sometime in 2014. Further, another big chunk of the spend is being used for the 10nm chip, which will not be available until 2015.
The company announced in February that it would begin production of field-programmable gate arrays for Altera (ALTR). The project marks a significant departure from Intel's business model as a designer of proprietary chips to a high-end chip foundry for customers. It also carries significant scale in production, something Intel is very able to do, but lower margins on pricing. Investors have been positive on the deal, not because it will add much to near-term income, but because it could lead to a foundry deal with Apple (AAPL) or other big customers. As with other Intel projects, the foundry deal with Altera has a fairly long development cycle and will probably not show much progress for at least a few quarters. This means that a "payoff" announcement in the form of an agreement with Apple could be more than a year away, probably considerably longer than investors are willing to wait.
While management maintained its full-year guidance for a 60% gross margin, I think the odds are for a downside surprise given higher spending as the company reaches peak production on Haswell and the 14nm chips. I also found it interesting that management lowered guidance for capital spending by $1 billion but did not increase earnings or margin expectations. Could it have met previous guidance with the previously announced level of spending? I doubt it and I think that factored into the decision to moderate capex.
I doubt that the shares will test new 52-week lows but a lackluster second or third-quarter report could see a return to $21 per share after the May pop.
Shorts to run for the exits by fourth quarter
After the third quarter, I think the outlook gets considerably better. Production costs will start declining for the 14nm chips and the foundry agreement with Altera could start to show real progress. Intel is still well ahead of peers in terms of technology and it should be only a matter of time before they can grab a significant share of the faster growing mobile market.
Short interest has surged to almost 239 million shares from just 88 million shares in April of last year. This represents almost 5% of the shares outstanding, not a high percentage but still more than six days of trading and a considerable amount of capital at $5.2 billion. This could act as support later in the year as the shorts realize that better days are ahead for the company.
Long-term investors can feel comfortable in the shares with the 4.2% yield and wait for a turnaround. Short-term investors may want to wait a few months or plan for an N-shaped recovery, an initial pop through May, then down and finally back up over the rest of the year.
Preparing for an N-Shaped Year
There are several ways to prepare for the possibility of a pop in the shares followed by weakness and then higher prices. Investors first need to understand their own return requirements and tolerance for risk. Long-term investors can probably ignore the volatility in the shares and be confident in stronger prospects in the years to come.
Those investors with greater liquidity needs or that want to hedge exposure to a possible mid-year drop may want to use the options market. Buying short-dated puts, possibly the July expiration with a $22 strike price, will allow you to put a floor on your shares and will only cost you a $1.00 premium. That means you are completely protected under $21 per share. You could also sell the short-dated call options against your holdings, collecting the premium but putting an upside limit on return.
I own a bull spread on the shares in my own portfolio but for the longer-dated January 2014 expiration. I bought the $22 call options while selling the $25 calls, which help to reduce the cost of the overall position. If the shares close above $25 on expiration, I earn $3.00 per contract while my downside risk is limited to the $0.65 I paid for the position in February. I may sell out of the position in May if the shares do see a pop up to around $24 collecting my profit and waiting for a better re-entry point. The strategy is more speculative than most investors will want to get into but a good bet on end-of-year strength.