There is an incredible amount of optimism on Seeking Alpha about the prospects of Intel (INTC) as the company begins to become serious about its mobile business. A recent article went as far as to declare a price target of $50 per share, more than double Intel's current stock price and a level not seen for the company since prior to the crash of the dot-com bubble in 2000. As an Intel shareholder, I largely share in this optimism and believe Intel will benefit from its ever-increasing lead in manufacturing technology over its fabless rivals. However, a dose of reality is needed - there is no reason to believe Intel will soon be a $50 stock, or even a $40 stock, as the realistic upside of Intel's mobile business is not nearly enough to propel the company to these levels. Individuals considering a purchase of Intel need to be conscious of whether they are truly investing - purchasing Intel based on its demonstrated earnings power - or whether they are really just speculating - purchasing Intel's stock in hopes of a jump based on the company finally achieving success in the mobile sector.
I attempt to answer two questions - first, is $40 or $50 per share a realistic upside for Intel if the company finally achieves success in the mobile sector? Second, does an investment at the current price level provide an adequate return based on expected earnings from Intel's current, proven non-mobile business - is there a margin of safety if mobile profits fail to materialize?
A Back of the Envelope Calculation
Accurately assessing the earnings Intel will derive from its mobile business is impossible. We have no idea what market share Intel will capture with Bay Trail and its future mobile SoCs, we don't know where ASP/margins will fall, and we don't know how quickly and in which direction the mobile market will expand. But as Intel will gain traction in the mobile market primarily at the expense of Qualcomm (QCOM), taking a look at its profitability can give us a basic idea of how much upside potential Intel's mobile business has.
Qualcomm is currently the clear leader in the non-Apple smartphone/tablet SoC market and will be Intel's main competition in these markets. Qualcomm's mobile computing (QMC, formerly QCT) segment recorded $4.22B of revenue and $738M in EBT in the most recent quarter (Q3 of FY 2013), and has recorded a total of $15.4B in revenue and $2.97B in EBT over the past calendar year.
Intel has yet to achieve profitability in its mobile business - Intel's "Other IA" segment recorded $942M in revenues and an operating loss of $608M in Q2 2013, and has recorded a total of $4.115B in revenue and an operating loss of $1.949B over the past calendar year.
Suppose we make an incredibly optimistic and unrealistic assumption - that Intel can capture Qualcomm's entire mobile chip business and transform its consistent losses in the Other IA segment into the consistent profits of Qualcomm's QCT segment. Across all of its operating segments, Intel has recorded revenues of $52.3B and operating income of $12.2 billion over the past calendar year. Swapping the revenues and earnings of Intel's Other IA segment for Qualcomm's QCT segment would give Intel $63.6B of revenue and operating income of $17.2 billion over the past year. This transformation results in 22% higher revenues and 40% higher operating income for Intel over its actual TTM results.
A 40% increase in operating income is nothing to scoff at - if Intel were able to achieve $17.2B in yearly operating income as a result of success in its mobile business, its share price would increase dramatically. A 40% increase in operating income would likely translate to an increase in net income of about 31% for Intel based on the company's TTM tax rate (TTM operating income was $12.2B vs. net income of $9.49B, so a dollar of operating income translated into $0.78 of net income). Assuming the market continues to value Intel's TTM earnings at the current P/E of 12.1x, this 31% increase in net income would result in a price of $29.40 per share. It is fair to assume, however, that if Intel achieves success with its mobile business, the market will assess a higher multiple for the company. Qualcomm currently trades at 17.8x earnings - if Intel were to increase its earnings by 31% and trade at a P/E of 17.8, the stock price would be $43.24 per share. Of course, assessing a 17.8x multiple to Intel's total earnings also values its PC Client and Data Center groups, which have both seen declines in operating income, at a multiple which is appropriate for a growing business but not for a stagnant/declining one.
So if Intel is able to dramatically turn around its mobile business, capturing all of Qualcomm's business and transforming an operating loss of $1.95B in the segment to a profit of $3B - and, in addition, investors reward Intel's success with a 47% expansion in its P/E ratio - two results which should each be well beyond the expectations of even the most bullish Intel investors - Intel is still only worth $43 per share, falling 14% short of the $50 target that had recently been thrown around.
To be fair, it is likely that Intel will achieve higher margins on its mobile processors than either Qualcomm or Nvidia (NVDA), as Intel will manufacture its chips in-house while Qualcomm and Nvidia rely on external foundries to build their chips. But as Intel makes its first serious entry into the mobile chip business, it's also likely that, if Intel's Silvermont and future processors are competitive, this will drive down prices as competition in the industry heats up.
Let's get even crazier - take the entire market capitalization of QCOM, which includes both the market's valuation of Qualcomm's mobile chip business and its licensing/other business segments- and add this to Intel's market cap of $111.8 billion. With a contribution of $115.2B, we get a new market capitalization of $227B. Divide this by Intel's 4.98B shares outstanding and you get a value of $45.56 per share. Even if Intel could literally swallow its new primary competitor, gaining not only Qualcomm's mobile chip business but also its highly profitable licensing business, a price target of $50 per share is not realistic. Add in Nvidia ($8.78B market cap) and Broadcom (BRCM) ($14.6B) and then finally you reach the $50 per share mark.
The point of this analysis is to understand just how valuable Intel's mobile business will have to be in order to single-handedly propel Intel to $50, $40, or even $30 per share. Even getting to $30 per share, which is well below the target many bulls seem to have in mind, requires a market cap expansion of $38 billion. The chart below shows, assuming Intel's current share price of $22.44 reflects only the value of its non-mobile business, how valuable the mobile business has to be to support a $30, $40, or $50 price target:
Are you prepared to assign $38B of value (and this is assuming that the current share price assigns zero value to the mobile segment) to a business that is bleeding money and has yet to turn a profit? If you are buying INTC based on the hope that its mobile business turns the company into even a $30 per share stock, that's exactly what you are doing.
The Value of Intel's Non-Mobile Business
Given the uncertainty surrounding Intel's mobile business and the difficulty of valuing a non-profitable business, I have chosen to invest in Intel primarily based on what we do know about: Intel's proven leadership in servers and PCs.
Suppose we were to spin-off Intel's Other IA segment - what is a fair value for what remains? Intel's two remaining prominent business segments would be its PC Client Group and Data Center group, with its Software and Services group and other segments generating a small amount of revenue. Excluding the Other IA group, Intel would have recorded $48.2 billion in revenues and $14.2B in operating income over the past twelve months. Based on Intel's TTM tax rate, this would have translated to approximately $11B in net income, or $2.15 per diluted share.
Intel's non-mobile business is in decline, having produced $14.2B in TTM operating income as compared to $18.2B in operating income in the prior twelve-month period, for a decline of 22%. Non Other-IA revenues have declined from $49.9B to $48.2B over the same time period, a decline of 3.4%.
Despite this decline, at Intel's current price of $22.44 per share, my estimation of $2.15 diluted EPS for the non-mobile business provides an earnings yield of 9.6% (or P/E of 10.4). The sharply negative earnings of Intel's Other-IA segment, which drags TTM diluted EPS to $1.85, causes Intel as a whole to look less attractive (8.2% earnings yield, 12.1 P/E) than when examining only the earnings of the company's non-mobile segments.
If we could throw away Intel's mobile unit, or assign it a value of zero, and invest in the remaining business at the current price, is a 9.6% earnings yield attractive enough for a risk-averse investor? On one hand, the 22% drop in TTM earnings over the prior year is an alarming sign and reminds us that any technology business, regardless of its maturity, can quickly suffer declining fortunes even during a period of economic growth.
On the other hand, despite weakness in the PC/server markets over the past year, Intel possesses a near monopoly in these segments. In particular, Intel has a 95%+ market share in the server space. According to Mercury Research, Intel's overall share of the x86 CPU market in Q2 2013 was 83%, up from 81.9% in Q2 2012:
AMD, Intel's only real competitor in these segments, has been relegated to a niche player in the very low-end of the desktop/notebook/server markets and its most profitable market is graphics. AMD does not have the R&D capabilities or will to challenge Intel's leadership in the x86 CPU business. The biggest reason for Intel's insurmountable advantage in these segments is manufacturing - Intel has historically been about a year ahead of AMD in adopting new manufacturing processes, and that gap is now widening to 2-3 years as AMD now relies on GlobalFoundries and TSMC to manufacture its chips.
Intel's manufacturing advantage grants it a strong moat in the desktop/notebook/server CPU segments, guaranteeing that, for the foreseeable future, Intel will retain all but the lowest-margin share of these markets. Of course, this leadership means nothing if PC sales decline to zero, but this will not happen - consumers and business still have a strong need for traditional computers. The traditional CPU business may continue to decline or stay stagnant, and it is no longer the exciting growth business it was over a decade ago, but it is not going anywhere and a return to slow, steady growth as consumers/businesses need to replace their PCs is likely.
Buying Intel's non-mobile business at an earnings yield of 9.6% provides a large margin of safety - investing at these levels, you would earn a rate of return above the current 10-year treasury rate barring a decline in profits greater than 71%. A 10% decline in earnings would still result in an earnings yield of 8.6%; a 20% decline would result in a yield of 7.7%. Based on the current S&P 500 TTM P/E of ~17.9x, and hence earnings yield of ~5.6%, Intel's non-mobile business will provide a return greater than the S&P 500 as long as earnings do not decline by more than 42%. Based on Intel's near-monopoly which is secured by its manufacturing advantage, I am comfortable that the profitability of Intel's non-mobile business will not decline by 42% and certainly not by 71% - declines in the 10-20% range are certainly possible but would leave me with an earnings yield still well above the yield of the S&P 500 and certainly that of risk-free securities.
Based on this analysis, I would be willing to purchase a share in Intel's non-mobile business at the company's current price of $22.44 per share. Therefore, I believe that investors must assign a negative value to Intel's mobile unit in order to rationalize the current share price. While I am not confident enough that Intel will achieve profitability to risk paying a high price for this unproven business unit, given Intel's manufacturing advantage and strong execution (at least in the non-mobile space!), it would be terribly foolish not to accept a call option on this business if it comes packaged for free alongside Intel's proven business.
I am comfortable holding Intel at its current price of $22.44 per share and plan to add to my position if/when the share price becomes even more attractive. Intel retains a solid foundation with a near-monopoly in the x86 server, desktop, and notebook markets - while these are no longer exciting growth markets and PC sales have in fact declined in 2013, conventional computers will remain necessary for the foreseeable future and a return to slow but steady growth can be expected in the long run. Intel has demonstrated consistent earnings power over the past decade and, with a strong moat protecting its position in the PC chip business, an investment in Intel provides an adequate margin of safety if the stock is purchased at a price below the value of this mature and proven part of the company's business. However, purchasing Intel based on a valuation, which assigns significant value to the potential growth of Intel's immature and unproven mobile business is speculative and hence dangerous. As a risk-averse investor, I am confident holding Intel at its current price of $22 is a fair value for Intel's PC business, thus making the considerable upside of the company's mobile business a free bonus. I believe Intel becomes a must-buy at $20 or below, at prices which clearly undervalue its existing and proven business units and assign no value to Intel's mobile growth opportunities. Prices in the upper $20s and above, however, do not become justifiable until Intel can demonstrate that it can turn a profit selling mobile chips, which will not occur in 2013 and likely not in 2014 either. Until then, purchasing or holding Intel at ~$30+ prices will lead to certain loss of capital if Intel's existing business units continue to decline and its mobile business fails to achieve profitability.
Note: All prices/market caps are accurate as of market close on Friday, August 23rd 2013. All figures cited without a source are found either on Intel's and Qualcomm's earnings reports freely available on their Investor Relations pages or Yahoo Finance.