As a hedge fund analyst, my livelihood depends upon being able to understand companies' financials. Thus, I rarely rely on media headlines to tell me how much money a company is making or not making. The wonders of GAAP accounting mean that companies that are quite profitable sometimes don't look that way. As an example, do you remember a year ago when the headlines said HP (NYSE:HPQ) lost $9 billion in a quarter? Every sophisticated investor knows that it was a goodwill writedown that didn't in any way impact the billions of cash that they minted. In fact, if you bought the stock around that time (which I did), you'd be sitting on a very healthy profit.
And then a few hours later, CFO Stacy Smith provided financial guidance for 2014. Flat revenue ($52.6B is the current consensus for '13), flat GM (60%), flat SG&A, and flat profit as a result.
The media will pick up this headline and proclaim that Intel has yet again failed, and its capital expenditures weren't worth it, and PCs are dying, and-and-and...
No. Stop. Here's what the media's going to miss: what Stacy said right after that.
GMs will take a 150 bps hit due to contra revenue and NREs related to their massive ramp of tablets.
What does this mean?
First, a bit of background for those who didn't listen in on the webcast or are still getting caught up. Intel's plan is to increase tablet shipments by a factor of four next year. Their goal is to get tablet shipments to 40M by the end of next year, and if it doesn't happen, heads may roll, the way Intel management was talking. They're not just going for high-end premium tablets either - they talked about price points well below $150.
Now, here's the deal. Customers are excited about Intel's roadmap, which demonstrates a clear advantage on costs and perf/watt (aka energy efficiency), but as most people know, there are two things that ARM chips have going for them right now:
- They have a majority position in the market, meaning most designs are engineered for them.
- Low-end ARM chips are cheaper compared to Intel's chips.
So customers were in the interesting position of wanting to get on board with the clearly superior SoC vendor, but not wanting to sacrifice near-term margins, or spend money on reengineering in case Intel didn't deliver on their roadmap.
Thus, Intel has to do two things. First, they need to help customers reengineer their designs. Second, they need to provide discounts to help the OEMs lower their Bill of Materials to be competitive with current ARM chips. When Intel rolls out Broxton in '15, they will have a substantial cost advantage across the spectrum due to die size. (Currently, they win at the high-end but are still behind at the low-end.)
Consequently, Intel is essentially agreeing to bear these costs to incentivize OEMs to switch to Atom chips. If I understood Stacy's commentary correctly, then in return, these OEMs agree to use Intel chips in future designs.
This is very similar to what Dell did recently; Mason Hawkins had some good comments which you can read here. The key point: while discounts necessary to "buy" market share may depress short-term results, they shouldn't be viewed as indicative of poor results, but rather as an investment into the future.
And that's exactly what Intel is doing here and why I believe that sophisticated investors should look beyond the headlines. Just as capital expenditures should be depreciated over their useful life, I believe that this investment by Intel should be viewed in the same manner.
It's instructive to look at what Intel's "real" revenue and gross margin would be if not for the one-time contra revenue and non-recurring engineering expenditures (which Stacy made clear would not persist beyond '14). Using what I call seventh-grade math and what Stacy calls 'manager math', we derive the following:
GM = gross margin, GMexC = gross margin ex-contra, NR = net revenue, C = contra (assuming all NRE is counted as contra revenue, which is probably incorrect, but useful for the purpose of quick analysis)
GMexC = GM + C = 0.615(NR + C)
(Gross margin ex-contra equals gross margin plus contra and also equals 61.5% of gross revenue, which is net revenue with the contra addback.)
GM + C = .615(52.6) + .615(NYSE:C)
31.56 + C = 32.349 + .615C
0.385C = 0.789
C = 2.04935
Here's what it looks like in Excel:
|FY 13||FY 14||y/y|
So if you strip out the one-time contra revenue and NRE expenditures, revenue actually grows 4%, and GM grows 6.5%... and due to operational leverage, operating income grows even more since SG&A will remain flat.
Now, it's worth noting that unlike HP's accounting charge, Intel's contra revenue and NRE are real expenses. What period should they be "depreciated" over? Say three years, since things move pretty quickly in tech. That still means that revenue and GM grow. It's also worth noting that my numbers are quick and dirty and reality is probably different depending exactly where it gets classified on the P&L (since I lumped two separate categories together). However, 2% growth (roughly half of what the algebra problem suggests) is a lot different input in a DCF than 0% growth.
Put differently, if Intel is selling 4X as many tablets, turning in low-teens growth in DCG, selling a few less PCs, and seeing growth in NAND and a bunch of other areas... how can their real revenue be flat?
It doesn't add up because of the very large contra revenue charge.
This is not intended to be a full analysis of Intel's financials. I've done that before in a previous SA article and may circle back if I get a chance to update my model and modify a few assumptions. My belief is that Intel continues to be materially undervalued. It has an undemanding valuation on depressed near-term earnings; much of the current SG&A expense is treated as a period cost but should really be viewed as an investment into new markets like tablets, etc where Intel is already showing very strong results. Strip that out and look at the underlying earnings power, and you have a company with a very strong leadership position trading cheaply.
However, what this is intended to be is a caution. If you hold a position in Intel, long or short, you have to realize that GAAP accounting can often distort the truth. The headlines will say that revenue is flat next year, and on paper it will be, but that doesn't mean the business hasn't gone anywhere. It just means they have to invest to achieve market leadership in another area. Just as they did in servers and PCs, they will achieve substantial technology leadership, and profits will follow.
For Intel or any other company, don't let the headlines and reported numbers sway your decision. Analyze the underlying business and determine what's really going on.
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.
Disclosure: I am long INTC, HPQ. 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.