A good friend of mine and I were in the midst of discussing IBM (IBM) as a name that has been excellent at improving the bottom line through a combination of cost cutting and share-buybacks, despite a stagnant top-line. Intel (INTC), on the other hand, has seen its bottom-line drop dramatically despite a stagnant top-line as a result of heavy investment. While many shareholders complain about Intel's profit decline, the key is to understand just why it has declined as it has. It's not just because PC sales are faltering, but because spending on all of the new "growth" areas - smartphone/tablet SoCs, cellular baseband and RF, and so on has far outpaced sales growth in this segment.
It is my view that as the new product cycles begin to kick in the mobile space, and material revenue growth can be achieved, Intel stands to see substantial operating leverage. Assuming Intel can keep the data-center growing at a rate of ~10-15% annually, and assuming that the PC space can find a bottom sooner rather than later, Intel is set to become significantly more profitable.
Illustrating The Operating Leverage
Here's a snippet from Intel's most recent quarterly financial table,
In the most recent quarter, Intel's "Other Architecture" group (this includes the modem/RF division, tablets, phones, embedded, and service provider products) posted a loss of $608M (this translates into a drag of $0.12/share on the bottom line). Now, that's not to say that it's worth ignoring that the PC Client Group and the Data Center Groups both saw Y/Y declines in their net income, but it's key to note that without the heavy investment in the mobile efforts, Intel could add over $2B to the bottom line.
However, cutting these expenses would be very foolish - even once the PC business bottoms (and there's no telling where/when that will be), Intel will still need to grow in order to drive meaningful share price appreciation. So, Intel's only choice is to actually drive profitability in these segments if it is to return to being a growth business. However, the nice thing here is that these divisions don't even need to return to "profitability" per se - simply getting to breakeven would be enough to drive substantial gains on the bottom line. Assuming a ~$2B annualized operating loss on "Other IA" currently, then a simple return to profitability buys shareholders ~$0.40/share on the bottom line. Any additional profitability from there would be gravy.
So, how do we get there?
Getting Back To Even
In 2012, "Other IA" did about $4.4B in sales. I expect 2013 to be lower as 3G baseband sales have dropped, netbook sales are pretty much gone, and Bay Trail will, at best, prop up Q4 enough to keep 2013 flat to 2012. At a $4.4B revenue run rate, Intel lost $1.38B in 2012. Now, assuming 50% gross margins (slightly pessimistic, but realistic), this suggests that opex for the division comes in at about $3.5B ($2.5B R&D, $1B SG&A according to 2012 investor day).
Looking to 2014, here are the positives that will be in play that were not during 2013:
- Full year of having a competitive, high end LTE smartphone platform available on the market (this helps both apps processor + baseband/RF revenue)
- Full year of having a competitive lineup of tablet chips ("Bay Trail" during Q1/Q2, "Cherry Trail" during Q3)
- Full year of having competitive embedded/intelligent systems chips based on the Bay Trail-I platform
So, let's say that at 50% gross margin, Intel is able to:
- Capture 5-10% of the smartphone market with its apps processor + LTE modem/RF
- Capture 20% of the cellular baseband market
- Capture 20-30% of the tablet market
- Grow its "Intelligent Systems" business from a $2B baseline (according to 2012 estimates from Deutsche Bank's Ross Seymore) by 15%
The smartphone apps processor market was a $12.9B one in 2012, and probably a $17B one in 2014 (assuming 20% Y/Y growth in 2013 and then 15% growth for 2014). Intel actually owns 12% of the cellular baseband market currently with its 3G chips, and I would expect that significant market share gains are likely as the XMM 7160 (LTE) chip has begun rolling out now (and its LTE-Advanced successor is set to roll out in 1H 2014). This is an ~$18B market and is likely to be a $20B market in 2014.
So with all of these assumptions in place for 2014, I could see revenues by sub-segment coming out to the following:
- Smartphone apps processors: $850M - $1.7B
- Cellular baseband: $4B
- Tablet: $1B - $1.6B (est. 270M unit TAM, 20-30% share @ $20 ASP)
- Intelligent Systems: $2.5B
Summing this all up, we get $8.35B - $9.8B. Assuming opex of $4B (up from $3.5B in 2012), and assuming 50% gross margin, and we are at $670M - $900M in operating income. Of course, there are a lot of variables here, but the point remains that 2014 has the potential to be an excellent year for "Other IA" based on some fairly reasonable assumptions.
Intel has been in "investment mode" when it comes to smartphones and tablets over the last several years, and it's now finally time for investors to reap the fruits of this labor. 2014 should see a full year of competitive smartphone and tablet offerings, and as a result of the underlying growth of the market as well as share gains, should help to get Intel to profitability in these segments that have been a significant drag on the bottom line. Should these initiatives pay off, the data-center continue to grow, and the PC market stabilize (some are even calling for growth, but I'm not sure I'd be ready to call for that), 2014 should be an excellent year for Intel investors as we finally near the end of 2013 which has been a transition year. Assuming Intel doesn't miss for Q3 (that is, a miss enough to warrant a warning), and assuming that the Q4 guide looks strong, Intel investors should be near the end of the pain-train that has gone on for the last year.