Welcome to 2014! While some people may just be getting back to school or work after a long holiday break, the stock market is getting prepared for another round of quarterly earnings. Chip giant Intel (INTC) will deliver its fourth quarter report next Thursday, the 16th, after the close. Unless a miracle occurs, Intel will report its second consecutive year of declining revenues and earnings. 2012 and 2013 were disappointments for the company, although Intel's stock fared a bit better thanks to the rise in the overall market. Intel's Q4 report next week will be somewhat important, but the real news investors will be looking for is an update to the 2014 forecast. Back in November, Intel spooked the street when it provided the following slide at its Investor Day Presentation.
After a disappointing 2013, Intel was supposed to turn things around, and analysts were looking for 2.1% revenue growth when Intel essentially warned. Shares initially fell on the news, but have since recovered, and are close to the 52-week high set on the last trading day of 2013. With this late 2013 rally, Intel investors will be expecting a bit come next Thursday. Today, I'll break down the numbers and see where Intel needs to guide next week, and what it could mean for shares of the chip giant.
It all starts at the top:
The first line in Intel's guidance will be revenues, which I think are the most important number for 2014. After initially forecasting large growth in 2012, the high single digits percentage wise, Intel ended up with a revenue decline. Intel guided to low single digit growth for 2013, but that forecast appeared to be aggressive as well. Intel has continued to take down its forecasts since the middle of 2012, and revenue guidance for Q4 was much weaker than expected.
Intel cannot take its forecast down when it reports next week. If the company were to forecast a decline in 2014 revenues this early in the year, it would be a tremendously negative sign, and I think shares would sell off somewhere in the 5-10% range, holding all else equal. At the bare bones minimum, Intel must at least reiterate its forecast for revenues to be approximately flat in 2014. That might not even be enough, as analysts are still expecting 1.1% growth.
Intel bulls are looking for signs of life when it comes to revenue growth. While there were some hopes that Intel's CES Keynote might shed some light on the future, SA's Ashraf Eassa called the keynote a non-event, a dud. Intel is looking to get into the tablet/smartphone space in a hurry, because as the company admits, it has been late to the party. To do this, Intel will need to provide significant subsidies, which may limit the company's revenue growth. I believe that Intel's latest rally has Intel investors hoping that Intel was conservative in November with the forecast. That means that Intel needs to basically raise its forecast next week, even if it only guides to low single digit growth.
Gross margins - the first number is key:
Intel guided to a 2013 gross margin midpoint of 60% with its Q4 2012 report. That forecast proved to be slightly optimistic. The company's Q4 2013 guidance midpoint has the company coming in a little light for 2013, at about 59.55%. Intel did take its gross margin forecast down at the Q2 2013 report to 59%, but it looks like it should come in closer to 60%, probably a little under.
So the statement in the slide above "GM approximately flat at the middle of our long term range" is a little vague. To figure out what this means, I went through Intel's financial results via 10-K filings back to the 2006 calendar year. The chart below shows how Intel's gross margins have fared, with the 2013 number being an estimate given Intel's first 9 months results plus the midpoint of Q4 guidance.
The overall range in the chart is 51.49% to 65.31%, with an average of 58.01%. If you take out the first two years as outliers, the average is just over 60%. I think that is the critical number for Intel in 2014, 60%. I think the first number must be a "6" in the guidance forecast, and not a "5". Intel provided a longer-term chart in its Investor Day Presentation, and the chart looks like the company guided to about 60% initially for 2014. With Intel probably coming in the high 59s this year, investors want to see improvement. I'd like to see 60%, but I'm sure Intel bulls will be hoping for 61%. The problem for Intel is if it comes in at 59% or even 58%. I think that would be a disaster because it would show Intel is losing pricing power and shifting to lower margin items. In the end, it would be nice to see gross margins stabilize or even rebound in 2014, instead of declining for the fourth straight year.
Operating expenses / income:
The next big thing to look for is the company's guidance for operating expenses. In 2014, Intel will have four primary operating expense lines on its income statement:
- Research and Development (R&D) expense
- Marketing, General, and Administrative (MG&A) expense
- Amortization of acquisition-related intangibles
- Restructuring and asset impairment charges
The final two items on that list are smaller, only expected to total a little more than half a billion dollars in 2013. The bulk of Intel's operating expenses will come from R&D plus MG&A spending. The company guided originally to $18.9 billion for these two items in 2013, but it reduced that guidance a little during the year. I expect that the company will come in around $18.5-$18.6 billion when all is said and done. The table below shows these expenses since 2006, compared to revenues. Dollar values in millions.
The key here is that Intel is spending more, but there are two levels of spending. First, the actual dollar amount, which is increasing. The second level is the percentage of revenues. Intel is spending more, but revenues have tailed off in the past two years. That's why these expenses have gone from less than 30% of revenues to more than 35% (expected) in two years. Should Intel gain on the gross margin side in 2014, those gains could be wiped out if operating expenses rise.
So that's where we get to guidance for these items. Intel will probably provide guidance for the restructuring/amortization charges too, which will probably total $600 million or so in 2014. The key though is the company's number for R&D plus MG&A spending. It would be nice if Intel could get this number down from 2013 levels, to maybe $18 billion total, but I'd think guidance will be close to what it spent in 2013. I'd start to get bearish if guidance is for $19 billion or more, unless Intel actually plans on growing revenues a little. You don't want to see operating margins pressured too much, and for now, Intel guided for operating income to be roughly flat.
Other items / tax rate:
Intel should also provide guidance for other items like interest income/expense and other items related to its equity investments. These numbers can swing wildly from one year to the next, so they are not very predictable. Investors just need to realize that you'd like to see these numbers be positive instead of negative. A few hundred million here or there will add up in the end.
Another important item to watch for in the guidance will be the 2014 expected tax rate. Obviously, this isn't something Intel has complete control of, but it will have an impact on the bottom line. The chart below shows Intel's tax rate from 2006 to the currently expected 2013 figure based on Q4 guidance.
Sometimes the tax rate gets lost because taxes are near the bottom of the income statement, but it is a very important number. A percentage point swing (100 basis points) in this rate will probably impact Intel's earnings per share by about 2 to 3 cents per year. As you can see in the chart, Intel's tax rate in 2013 was towards the lower end of the recent range. That has helped earnings per share to not fall as much as they could have. Should Intel's tax rate jump back up to say 25% or so in 2014, it could pressure EPS by a few pennies. A tax rate higher than that and you could be looking at a dime or more of impact, comparing 2013's rate to 2014.
When Intel guided to $13 billion in capital expenditures for 2013, investors were shocked. This forecast seemed ridiculously high, and many wondered what Intel was thinking. Well, as revenues have disappointed, Intel has reduced that forecast a bit, with current expectations for about $10.8 billion.
Intel's Investor Day Presentation stated that 2014 capex would be around $11 billion, which I think is a reasonable amount. Hopefully, the company maintains that guidance next week, although I could see management maybe hiking that to $11.5 billion if it really wants to make a push into the mobile space. I think $10 billion would be a little light, and I'd be concerned again if the number is $12 billion or more, because that gets me to my next point.
The dividend and buyback:
I've harped on these two items enough in the past year, so I'll keep this discussion brief. Intel did not raise the dividend during calendar 2013, which has some dividend investors upset. While Intel probably will not announce its next dividend until later in January, it would be nice if that was a raise. If Intel plans on raising the dividend, it would be a positive sign for the business. A lack of raise might frustrate investors even more, and a few more might bail on this stock.
Intel has also slowed down its buyback tremendously in 2013. While the share count is still going lower, Intel needs to repurchase a fair amount of stock to keep said share count from rising, thanks to executive options and other dilutive securities. We'll get the final buyback number in a week or so, but Intel needs to spend at least this much in 2014. It would not be a good sign if the company reduces the buyback further and keeps the dividend where it currently is. The more Intel spends on capital expenditures, the less it will have for both dividends and buybacks.
Comparisons with other tech giants:
Like most of my other tech sector articles, I always do a comparison of the top tier names. When it comes to Intel, I've used a comparison group of Microsoft (MSFT), Apple (AAPL), Cisco Systems (CSCO), and Qualcomm (QCOM) recently. The following table shows some key expected growth and valuation metrics for each name.
*EPS and P/E numbers are non-GAAP.
Right now, Intel is trading at a valuation very close to that of Microsoft, and a premium to Apple. I can't understand how underappreciated Apple is, but that's a story for another day. The key point is that Intel shares have been bid up a bit in recent months, in the anticipation of a solid 2014. I'm not saying here that Intel needs to come in with high single digit growth like Microsoft, Apple, or Qualcomm. But what Intel needs to do a little bit more is separate itself from Cisco as a potential Dow dog. If Intel could just get back to a point where analysts are looking for maybe 2% revenue and earnings growth, the stock and company would look so much better. Additionally, those calling for P/E multiple expansion for Intel need to have some growth behind those claims. I don't see how Intel gets to a 14 or 15 P/E with a third straight year of revenue declines, unless we get a ton of Fed induced QE that keeps pushing the market higher to even more extreme levels. Were it not for the Fed and such easy monetary policy, Intel shares would have been hit hard for the company's weak performance in the past two years.
I know that I've covered a lot of information here today, so I'll provide this basic summary table below for where Intel needs to be with its guidance. These numbers are approximate, so investors shouldn't jump off the roof if R&D plus MG&A spending is $18.7 billion, for example.
But the question is how many of these items really need to be slanted towards the "good" side for this stock to rise? Well, I would think that revenues and gross margin guidance are the two keys, but the other items should not be ignored. As you can see from the chart below, Intel has rallied strongly over the past 3 months. Intel shares shrugged off poor Q4 guidance in October and a bad initial forecast for 2014 at the Investor day.
(Source: Yahoo! Finance)
Those bullish on the name are betting that Intel was being a bit conservative with its initial forecast, and will be looking for some "raises" next week. I am of the opinion that Intel will continue to disappoint a bit as it tries to break ground in the competitive mobile space. My personal guess is guidance for flat revenues, 60% gross margins, $19 billion of R&D plus MG&A expenses, and a 25% tax rate. I think that this will disappoint investors and miss analyst estimates. For that reason, I would consider Intel a decent short above $26 going into earnings, especially if shares head towards $27. But if shares tick down to $25 or below into earnings, expectations might not be as high, and at that point I would be a bit more neutral. Intel has a lot to prove in 2014, and that process really starts next week.
Additional disclosure: Author may initiate a short position into earnings if Intel is approaching $27. Investors are always reminded that before making any investment, you should do your own proper due diligence on any name directly or indirectly mentioned in this article. Investors should also consider seeking advice from a broker or financial adviser before making any investment decisions. Any material in this article should be considered general information, and not relied on as a formal investment recommendation.