Intel's (INTC) weak 2014 guidance has stirred up a hornet's nest and tanked the stock, off 5% to trade in the $24 area. As a contribution to the discussion, I start by asking readers to consider a very simple concept: a company should be valued on what it does for shareholders, and what it does to create value. These are the outputs, by this line of thinking.
Intel pays a dividend, and attempts to create value by heavy investments in capex and R&D. Capitalizing the dividend at 5%, and R&D and capex at 15%, here's what the company is worth:
The analysis is simple, and not necessarily intuitive. I use it when the outcome of the expenditures for R&D and capex is not immediately clear by looking at EPS. It's driven by the assumption that management is capable and spends on the items involved in ways that are calculated to increase value. I left out buybacks, which have averaged 2.5% annually over the past 8 years. $46 is very high, compared to recent prices in the $24 area.
Homing in on the Key Questions
The market is telling us that Intel's R&D and capex are a waste of money. It should be noted that ROE and ROIC, at 18.1% and 14.8% TTM, are in the area of long term averages of 18.% and 17.3%. Historically, R&D and capex have been effective.
The benefits of increased R&D will lag the expenditures. Similarly, Intel's rapid depreciation schedule may impact earnings if the benefits of capex don't manifest in the same time frame. Working with the numbers, a plausible argument can be advanced, that the benefits of these investments will show up in EPS in 2015 and later. Management has already told us they won't be apparent in 2014.
After first quantifying the increased capex and R&D, I will turn to the key questions: 1) where are these investments being directed? and 2) will they create profit going forward?
Capex, Depreciation and Free Cash Flow
Looking at Intel's financials, capex jumped in 2011 from $5 billion per year to approximately $11 billion for 2012 and 2013, and is guided at that level for 2014. The outcome of these investments is not known, and has sparked considerable debate.
For depreciation, Intel uses the following estimated useful lives: machinery and equipment, 2 to 4 years, buildings, 4 to 25 years. The obsolescence cycle runs rapidly in the industry. I checked a few competitors and found that Intel depreciates these items faster than Advanced Micro Devices (AMD) and Taiwan Semiconductor (TSM).
The heavy capex will result in heavy depreciation which will reduce earnings and increase cash flow going forward. If and when capex abates free cash flow will surge, assuming the capex was directed at profitable opportunities.
R&D has increased by about 10% annually over the past 5 or 6 years. The cycle of innovation in the industry runs rapidly.
Where is Intel Investing?
From a recent presentation:
They're going after tablets in a big way. Intel had 80% of the traditional PC market in 2010, and in 2014 will have 20% of very a broadly defined computing universe. The company has the resources to compete for this business, and they are doing so, aggressively.
Intel Quark is not a household name. Nor is the internet of things a common usage for the concept it embraces. Here's some explanatory material from the company's website:
From datacenters to ultra-mobile devices such as tablets, phones, and wearables, computing segments are undergoing exciting and even game-changing transitions. Intel is developing new products for each of these dynamic markets over the next year and beyond, including a new, lower-power product family.
Intel Quark technology is designed for applications where lower power and size take priority over higher performance. Products derived from the Intel Quark processor family will develop innovative solutions for ubiquitous computing markets and the Internet of Things, from automotive to industrial to wearables.
The first product in this new roadmap family is called the Intel Quark SoC X1000. Products like the Intel Quark SoC X1000 will bring flexibility for higher levels of integration, lower power and lower cost for the next wave of intelligent connected devices while maintaining Intel architecture instruction set compatibility.
With the addition of the Intel Quark SoC X1000, Intel's enhanced product portfolio will bring integrated, scalable products from the device to the cloud, driving data acquisition and analysis to unleash the value in the Internet of Things.
Will These Investments be Profitable?
From the standpoint of an investor, the question is whether Intel can penetrate the mobile/cloud universe sufficiently to overcome the diminishing role of the traditional PC. The analysis involves long-term projections by segment. Nobody has visibility for the time frames involved. There are four segments relevant to this effort: PCG (PC Client Group), DCG (Data Center Group), OIA (Other Intel Architecture) and SSG (Software and Services Group). Here's a spreadsheet:
For PCG, the company sees revenue down 5% for 2014, and operating margin flat. Long term, I use -10% as a conservative guesstimate. For DCG, management sees low to mid teens revenue growth for 2014, then 15% CAGR going forward. Running numbers for these two segments forward, and assuming margins remain stable, 2014 is flat, as per guidance. Looking out to 2017, at that point both revenue and profits will be growing. Using a combination of guidance and conservative estimates, the two largest segments will stabilize with a low growth profile.
SSG - expect low double digit revenue/move from breakeven to profit.
OIA is the key here. The three main sub-segments are tablets, multi-comms and intelligent systems. Guidance is optimistic, but not possible to quantify.
- tablets - expect to rapidly grow share in 2014
- multi-comms - revenue down slightly in '14. Steep ramp of LTE in 2H.
- intelligent systems - For '14, expect revenue growth in the mid-teens.
OIA is expected to show a 2.5 billion operating loss for 2014 based on increased investments. It's not possible to quantify "rapidly" and "ramp." I used 100% for 2014, and 25% thereafter for tablets. For multi-comms I used 25%, and 10% for ISG. I'm using a linear gain on the operating margin, $1 billion improvement annually.
Under these assumptions, for Intel as a whole, profits start increasing in 2015, and revenue starts increasing in 2016. Profit growth would be 5.6% annualized over the next 5 years, expanding to reach 8.6% in 2018.
Putting all this through the blender, I'm investing on the basis that the share price will reach $35 by the end of 2015, returning in excess of 20% annualized. This target price relies on performance in the OIA segment. Clarity will develop over the next year, as quarterly results come in.
Strategy and Tactics
At this point I question the suitability of INTC for dividend growth or buy and hold investors. I like it as a speculative value play, on the grounds the potential upside exceeds the downside - risk/reward is good here.
The company provides segment performance information quarterly. It's important to monitor as it becomes available and compare results to projections. As the market digests it, prices may swing rapidly, with much discussion and comment.
The objective would be to bring the position up to full size if and when it becomes clear that OIA performance is strong enough to support growth for the company as a whole of 5% or better going forward. If the situation develops unfavorably, I plan to eliminate the exposure when it becomes apparent that OIA is not performing at a level that justifies the investment.
Additional disclosure: I have a small position in my Synthetic Dividend Growth portfolio. I have a larger position in my Speculative portfolio, by means of a bullish risk reversal.