While I do pride myself on a better-than-average grasp on the English language, I find myself unable to really express my frustration whenever I see comments such as the following with respect to Intel's (INTC) tablet strategy:
It's not a "win" of a slot, when Intel essentially gives the part away. "Win" implies competition on the merits. "Contra revenue" is a humorous marketing/accounting creation, synonymous with "unable to compete on the merits."
So, this is a pretty common misconception that I feel needs to be better explained to the investment community.
Repeat after me:
Intel isn't giving away its "Bay Trail" chips to win tablet share.
The "Contra Revenue" Thing
So, right off the bat, it's important to understand just why Intel is providing subsidies for its mobile platforms. Rather than explain it myself, I will defer to Intel CEO Brian Krzanich, who explained it beautifully on the most recent call:
Sure. This isn't a price reduction as normal price reduction would be; it's not where you are just simply reducing. It's truly a BOM cost equalizer and remember a lot of our 40 million tablets in '14 will be based on Bay Trail. Bay Trail was originally designed for Atom-based PC segments and the upper end tablet. And so it's what we are doing here is doing a BOM cast delta relative to the what the mid and lower end tablets require. And so those are things like Bay Trail may require more layers of a printed circuit board for the board itself, more components on the board and tighter power management controls and things like that. We have a whole program to reduce those throughout the year. So that gives us confidence that as we go through the year, the BOM cast [sic] delta will shrink, but if the volume didn't show up for some reason and I am not going to say that, that's what's going to happen, but I am confident it will, but if it didn't it's on a per unit basis. And so the spending on that contra would be reduced equivalently.
Got it? Intel isn't selling its chips "below cost" or even "at cost" to try to gain share. Bay Trail was originally designed as a netbook chip and only mid-way through its development (probably iPad launch did the trick) did Intel decide to do a tablet-oriented SKU. It's obvious given the lack of integration in the SoC that this is the case, and it makes sense that the platform surrounding it would be pretty expensive and more notebook like.
Anybody who tells you that Intel is "unjustly" winning designs by "giving them away" is simply being intellectually lazy and not giving you the whole picture. If you're going to invest your hard earned money in individual securities, you absolutely cannot afford to be misled like this. With technology companies, especially one as hated by investors and competitors alike, such FUD is very easy to spread since most people will just accept the "easy" headline as truth.
Now, am I trying to say that the fact that Intel is in a position of needing to provide contra-revenue support is a good thing? No, as a shareholder I'm actually beyond irritated that we have to incur this hit. However, putting aside emotions, there is a very real silver-lining here when thinking about 2015 financials.
The Silver Lining
Let's assume that Intel's contra-revenue gig works out and the company ships "over 40 million" tablet chips during 2014 (we'll say the range is between 40 million - 60 million, since I've seen the 60 million number floated around quite a bit).
We know the following:
- Intel has stated that Broxton (a part that Intel has claimed will eliminate the BoM delta) will have a BoM that is $20 cheaper than Bay Trail's. So Intel is providing about $20 of contra-revenue support for its Bay Trail parts (depending, of course, on how low/high end that part is).
- The tablet market is growing and Intel is likely to continue to gain share over the next few years
- SoFIA and Broxton will eliminate the BoM cost delta and 2015 should be free-and-clear of this contra-revenue business
- Intel guided to $4B in sales in Other IA, under the assumption that Bay Trail will provide roughly zero net revenue during the year
With that in mind, we realize that in 2015, the following happens:
- The BoM cost delta that impacts gross margin by 1.5% goes away and all Atom parts for tablets/phones will be accretive to gross margin dollars
- Intel will likely ship anywhere from 60-100 million tablet chips, all of which gross margin accretive
- Intel's tablet platform costs likely come down in addition to the lack of contra revenue thanks to the 14-nanometer process providing a significant die size/cost improvement
So, some quick, back-of-the-envelope math suggests that Intel could recognize (assuming tablet chip ASP of $20 and per-chip production cost of $8) the following:
- $20 * 60-100 million = $1.2B - $2B
- Gross margin of 60% (selling price =$20, production cost = $8)
- Gross profit = $720M - $1.2B
Now, it is my belief from the current annual losses in Other IA that opex (MG&A + R&D) comes in at about $3 billion/year for the division. I therefore believe that it would take a $6 billion/year run-rate at 50% gross margin for Intel to break-even in Other IA and to completely wipe clean the $3B/year loss that we are about to see in 2014.
I think that in 2015, Intel could actually bring this division to breakeven on the following drivers:
- Assume 80 million tablet chip sales at $20/chip
- Assume "Intelligent Systems" sales at about $2.5B (this is pretty high margin business, by the way)
- Assume that Intel sees baseband revenue (remember, Intel will be well into the ramp of XMM 7260) of $1B (this would require the sale of 66 million basebands at ~$15/pop...very achievable)
- Assume that Intel sells 50 million smartphone apps processors at $20/unit
This all works out to $6.1B in net revenue. Assuming now Intel can do this at 50% gross margin, and assuming operating expenses of $3B, and viola, our operating loss vaporizes!
What Would Intel Shares Be Worth, Then?
I assume that Intel will deliver on its flat operating profit guide in 2014 for PCs, and I assume that this will persist into 2015 (although I am hopeful for a recovery to growth, I don't want to bake it in). I also assume that DCG growth will be 11% in 2014 over 2013 and then 10% in 2015 over 2014 (sorry, Intel, but I really don't buy your 15% CAGR nonsense).
This leads me to the following operating income numbers for 2015:
- $11.8 billion for PCCG (flat y/y)
- $5.73 billion for DCG (+12% Y/Y)
- $0.00 billion for Other IA
- $150 million for software and services
- ($2.25 billion) for all other <--- this is a wild guess...if foundry is kicking in by 2015, then this GROSSLY overestimates the operating loss.
Netting this all out, I get an operating income number of $15.43B. Assuming a 27% tax rate, this gets me to $11.26 billion in net income (EPS of $2.27).
Assuming that the market is willing to pay 15x (likely for an Intel that can actually execute in mobile as I am assuming here) EPS, then this works out to a share price of $34, achievable by early 2015 once full-year guidance is given. Further, once Intel is breakeven (or better) in Other IA, there is plenty of leverage to be had and as 2015 progresses, 2016 estimates (especially if PC sales do come back) would point to earnings per share much closer to the $3/share level.
Intel has so much potential to really drive operating income up if it can just execute in mobile and keep PCs flattish to slightly up. I have no doubt that Intel will eventually succeed, but no investor lives forever. I am more than willing to stay on board as long as I see Intel building a solid design win base from which to launch profitably into 2015, but if it becomes clear that Intel is still having problems in 2015, then I really do think it'll be time to throw in the towel.
However, that time is not now, and I remain long - albeit much more cautiously optimistic over the next year. At any rate, don't believe the nonsense and the lies that Intel is "giving away" tablet chips. This contra-revenue support will go away likely by 2015, and then there will be a pretty significant uptick in profitability from that point on, assuming that the designs that Intel won in 2014 are refreshed with Intel silicon in 2015.