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Long only, value, hedge fund analyst
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Introduction

Being a good investor is a bit like being a good parent: you have to ignore the noise and focus on what's material.

Defenders of the efficient market hypothesis insist that the market automatically and immediately prices in all relevant information, but in my experience, the market can occasionally become fixated on information that's not truly relevant, leading the market price to reflect a somewhat skewed view of reality. A not-so-brief analogy: have you ever met those parents who focus so heavily on whether or not their kids' hair is parted just so that they're completely oblivious to the fact that aforementioned kids are getting drunk and joyriding in the neighbor's car every Thursday night? Don't laugh, it's a true story; perhaps not coincidentally, I just had a very interesting conversation with one of the smartest investors I know. He was talking about how he wants to make sure his kids understand the concept of materiality. Namely, everyone makes mistakes, and it's okay to make little ones; just don't screw the big things up. And for the love of puppies and all else that's nice in the world, don't traumatize your kids over irrelevant trivialities.

Sadly, the world occasionally tends to miss the ocean for the water drops, and that's exactly what's happened with Intel (NASDAQ:INTC). Many market participants - even some very sharp, very bullish Seeking Alpha contributors - have become overly focused on Intel's Silvermont architecture and its advantages/disadvantages compared to ARM-based SoCs for the low-power mobile chip market. While this discussion is undoubtedly of some relevance to Intel investors (I myself have been keeping a close eye on it), I'd posit that mobile should be viewed as optionality for Intel. Many sell-side analysts (as well as Seeking Alpha authors) seem to completely miss this. The keystone for the INTC thesis is continued growth in the company's Data Center Group. Conservative projections and valuation models suggest that the company is materially undervalued.

The thrust of this article will focus on why mobile doesn't matter and why DCG is the real story at Intel. It will be a primarily qualitative analysis and contain little in the way of projections or valuation analysis. A subsequent article will provide a thorough look at projections and valuation via multiple avenues. If you're interested in reading the follow-up, please click "follow" under my profile to be alerted when it's published.

Background: Clouds Aren't Water Vapor

It was the often-hyped "big data" and "mobile" trends that initially led me to look into Intel. If you look around you, you'll notice that people tend to use computing resources more rather than less every year; this suggests that (broadly speaking) people in the data business are in a good place. Further, it's pretty clear that a lot of this data usage going forward will be in the "cloud".

So what is a cloud anyway? The way most people talk about it, it's made out of magic and puppies. If you ask a third grader (a nerdy one anyway), they'd say clouds are made out of water vapor. That's true in the sky, but not in the world of data.

The interesting dichotomy a year ago (and, to a lesser but still existent extent, today) was the disparity in valuations between software and hardware providers. Again, panting with broad strokes here, if a software company can find a way to work "cloud" and "SaaS" into its business description, it was rewarded with a stratospheric valuation and the accompanying adoration of the sell-side (we can debate the chicken and egg of those two later). Yet even the sexiest, chic-est photo sharing app (which one are kids using now anyway?) is nothing without a network of servers to back it up. So given that everyone believed in the growth trends of data, and the fact that companies public (won't name names here) and private (cough Instagram cough) were gettin' some valuation lovin' that would make Chef jealous, why were hardware companies like Cisco (NASDAQ:CSCO), EMC (NYSE:EMC), Intel , HP (NYSE:HPQ), Dell (NASDAQ:DELL), Seagate (NASDAQ:STX), and others trading at bargain basement valuations?

To be entirely fair, beating the market isn't as simple as buying the lowest P/E quintile; many cheap stocks are cheap for a reason, as the saying goes. That being said, there seemed to be an utter disconnect in the valuations of hardware and software companies which in theory should have had similar growth opportunities when viewed as a basket. Why? Lower margins and higher capex? Maybe, but not to the extent I was seeing.

So I dug into it a little further, and it turned out that many of these companies were in fact undervalued. I bought most of them. Some I sold; others I kept. Intel is one that I believe is still materially undervalued.

Why Mobile Doesn't Matter: The Iceberg Hides Underneath

Some people can play the game of figuring out which UI users will prefer for fifteen trillion otherwise equivalent applications, or perhaps the game of figuring out which company's phone will be picked up by the masses and revered as the next hot brand. Some people can probably make a lot of money playing that game. I, however, am quite willing to admit that my strengths do not lie in determining what people will or will not find cool/hip/sexy (I still don't understand Dubstep for the life of me). Given this unfortunate weakness, then, I preferred to find the beneficiaries of the obvious "mobile" and "big data" trends that the rest of the market was paying less attention to.

As a brief aside here, I should note that I don't believe in the efficient market hypothesis; however, that doesn't mean I think that markets are radically inefficient either. I think they can be, and I've certainly exploited several instances thereof for profit, but if you want/intend/expect to beat the market over the long term, you'd better have an edge or variant view. It's also helpful to look where other people aren't looking… as a shell collector, I can attest that my best finds have been on remote beaches only accessible by 4x4 or good ol' hiking boots; if you're looking for good shells on a touristy beach in Miami, well, good luck. Anyway, since 1) I had no definable edge in evaluating apps/software platforms/consumer phones and 2) that's where everyone was looking, I figured that bigger opportunities lurked on the back end.

The very simple qualitative (okay, maybe semi-quantitative) argument for why mobile doesn't matter for Intel goes something like this: for every 120 tablets sold, or 20 surveillance cameras, or 20 digital signs, you need one server to power the back-end for the respective devices. I've seen these numbers vary quite a bit depending who you talk to, but the idea remains the same. Since ASPs for server chips are generally somewhere between one-and-a-half and two orders of magnitude higher than those of tablet chips (or whatever chips go into surveillance cameras and digital signs), you're generally going to do pretty well on the back end if the mobile/big data trends continue. You with me so far? Yeah? Okay, good.

If we accept this premise, then we come to a clear conclusion about Intel's mobile efforts: they don't matter. As in, they're not critical to the investment thesis. I view them as "nice to have" but not "essential", a little bit like those tasty mints they serve after lunch at Olive Garden.

Sell-Side Analysts Coming Around: Is Intel The Best Alpha Generation Opportunity in Semis?

I usually don't read too many sell-side reports, but Jefferies' analyst Mark Lipacis recently called it "one of the best alpha generation opportunities in semis". Equally interesting, a recent note by Credit Suisse caught my eye. It was (with apologies to the undoubtedly large number of other interesting reports that preceded it) one of the first I'd seen that actually focused on DCG. Their "bottom line" concluded that even if the market values the rest of Intel's (non-DCG) business at zero, Intel is worth $30-40 a share in the next 3-5 years.

Think about that for a second. That's essentially saying that the (supposedly dying) PC business is worth little despite its ability to be a cash cow in the near-term, and that Intel's mobile efforts are also worth nothing.

While I think Credit Suisse's estimates are perhaps a tad bullish, I agree with the core sentiment - mobile design wins don't necessarily matter for Intel because of the strength of their server opportunities. Intel's recent Q3 report (much maligned on SA by a few contributors) provided substantiation that this growth opportunity is still in place.

Conclusion

I realize this proposition needs quantitative support. My follow-up article will include my valuation model, projections, and specific justifications. However, don't overlook the qualitative aspect of investing - understanding the business model is more than half the battle. Just as you wouldn't judge a Ferrari by its ability to haul a boat, you wouldn't judge an F-150 by its ability to win on the track. If you want to beat the market, you need to figure out where the market is judging the wrong thing - and then figure out if they're misjudging it by enough to make it a worthwhile investment (whether on the long or short side).

In the case of Intel, the market is completely ignoring DCG, even though that's the core of the opportunity going forward. Don't believe me? Take a look at how many mentions of "PC" and "mobile" there are in coverage of Intel, and compare it to how many mentions of "DCG" and "servers" there are.

As I said, numbers to follow. Sneak peek - Intel's materially undervalued.

Disclosure: I am long INTC, HPQ, DELL, EMC. 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.

Additional disclosure: Disclaimer: This is solely my opinion, not an investment recommendation or solicitation, and may not represent the views of my employer(s), associates, or other related parties. No guarantees made to accuracy or completeness. I am long the companies mentioned in the disclosure and may change my position at any time without notification. Please see the full disclaimer in my profile, and do your own due diligence before making any investment.

Source: Intel: Why Mobile Doesn't Matter