Intel: How Safe Is The Dividend?

May.10.13 | About: Intel Corporation (INTC)

Intel's (NASDAQ:INTC) robust dividend is a hallmark of the company and a big reason why most investors hold the shares. At present, the stock yields a cool 3.75% even after a very large run off of its lows below $20. With our zero interest rate policy environment offering little for income investors, Intel shares are attractive as a bond replacement due to their yield. The question inexorably becomes, how safe is that dividend? This article will take a look at how safe Intel's payout to shareholders is.

To do this, we'll take a look at Intel's cash-generating abilities in relation to its promised cash payouts each year. We can then determine how much of the company's cash generated each year is being spent on paying shareholders.

First, we'll take a look at the headline payout ratio. For dividend stocks, this is the holy grail of metrics as it is simply the amount of dividends paid divided by net income. While I believe this metric to be completely worthless, millions of investors still rely upon it so it is worth mentioning.

Click to enlarge

With this graph, we can see that Intel's payout ratio was in danger of approaching the 100% mark during the financial crisis but once earnings picked up again, the payout ratio was more than cut in half in 2010 to just over 30%. Since then, the payout ratio has ticked up to 40%. All is well, right? Not quite. The payout ratio is a totally worthless metric as it is comparing a cash payment to an accounting metric that has absolutely nothing to do with cash at all. Net income is simply an accounting metric that is used to sum up the complete financial performance of a company for a particular period of time. Since it is an accounting metric, nothing can be paid with "earnings". Rather, dividends and other payments must be made with actual cash. This is why the payout ratio is pointless and should be ignored.

In order to get a picture of just how much of the company's cash is used for dividends each year, we should take a look at free cash flow. I've defined FCF for this analysis as operating cash flows minus capital expenditures. Capital expenditures are defined as investing activities excluding cash impacts of equity, short term and other "paper" investments that have nothing to do with running the business. Below, we can see what these figures look like for Intel over the past six years (in $ millions).

Click to enlarge

We can see several things from this graph but most importantly, we can see that Intel produces far more cash from operations than it spends on the investments that allow it to purchase and maintain the assets that produce that cash. This is obviously a positive as it means the business is more than viable over the long term as long as this relationship holds.

Now, we can take a look at Intel's operating cash flows versus its reported net income to give us some perspective on the numbers.

Click to enlarge

We can see that Intel reports far more cash from operations, usually close to twice as much, than it reports in net income. This is a great sign that the business is actually more profitable than net income would lead you to believe. This is true because since net income is a metric, it can be distorted by the actions of management. However, it is very difficult to manipulate cash flows and as such, it is a much truer measure of profitability. Intel has proven the ability to generate cash from its assets and we can see that here.

However, Intel's business requires a lot of capital expenditures in order to acquire and develop the assets it generates its cash from. If we remove those CapEx approximations from our operating cash flows and then compare it to net income, we get the results below.

Click to enlarge

This paints a far less rosy picture than before after accounting for the fact that Intel must spend billions upon billions of dollars each year in order to continue to develop its business. While FCF, as I've defined it here, has been less than net income each of the past three years, all three years are still very strong showings with FCF of $11B, $11B and $7B, respectively. However, it is usually a warning sign to me that a company doesn't produce as much FCF as net income as that means earnings are being inflated by some other means than actually operating profitably.

Finally, from this data we can extrapolate Intel's "FCF Payout" versus its payout ratio. I've defined the FCF Payout as the dividend the company pays divided by the amount of FCF the company produces. This is the same equation as the ubiquitous payout ratio except I've substituted my definition of FCF for net income.

Click to enlarge

The results here aren't pretty. We can see that, for the past three years, Intel has sported a higher FCF payout ratio than the traditional payout ratio. Again, this is typically a red flag for me as I don't care how much the company "earns", I care how much cash the business is producing to service the dividend payments. Indeed, Intel's traditional payout ratio was about 40% last year while its FCF payout ratio was nearly 60%. While 60% isn't necessarily alarmingly high, it should make investors pause and take a harder look at Intel's dividend safety.

I'm not suggesting that Intel is in immediate danger of having to try and conserve cash for its dividend payments. However, I'm suggesting that if you are long the shares, you should take a closer look at exactly what you're buying. As I stated earlier, Intel's FCF payout isn't too high right now but it has been rising substantially in the past three years. However, it hasn't even reached the 70%+ value of 2009 yet. The problem is that the possibility exists that if Intel can't grow its cash flows, at some point in the future, the dividend or buybacks will need to be reduced. Again, I want to stress that we are not there yet, but some warnings signs are starting to show.

In addition, it is important to note that this analysis ignores the cash that Intel is spending on its buybacks. Intel has a very generous buyback program that eats up billions of dollars in cash flows each year, meaning that Intel is using up far more than 60% of its cash flows in returning capital to investors.

The bottom line is that while Intel is very profitable and very generous in returning cash to shareholders, investors that buy the stock for the yield need to keep a close eye on the amount of cash Intel is producing in relation to how much it is returning to shareholders. The ratio isn't dangerously high today but if it continues to creep up, more debt issuances could be in Intel's future as a financing band aid or the buybacks may have to be cut or arrested. While this is an extreme scenario today, it may not be as far off as some are thinking. With Intel in a cutthroat and (some would say) dying industry, cash flows may begin to diminish in the coming years. If that happens, there are better choices for dividend investors. I'm not suggesting this is a certainty but it is more of a possibility with Intel than I think a lot of investors realize; it is something to be aware of.

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.