The Semi-Conductor Space - Part 2: Focus Intel

Mar.23.14 | About: Intel Corporation (INTC)

Summary

We look at companies, and try to see how they are perceived by different stock selection styles adopted by market participants.

We look at companies, and try to see how they are perceived by different capital allocation styles adopted by market participants.

Growth expectations for Intel implied by current market prices are too low. This identifies an opportunity to capture potential alpha.

In ran the first part of this series which looks at the semi-conductor space recently. In part 2 of this series, Intel (NASDAQ:INTC) is the focus stock, for which I present the value case. For those who read part 1 of the series, jump on ahead to "The Case for Intel" section of this post, for the earlier part is a repeat of some of the information included in part 1 of the series. Do forgive the repetition, I repeat myself so that this post can be read as a stand-alone post by those who did not read part 1. For those of you who did not read part 1, if the semi-conductor industry interests you, it may be worth reading part 1, which has some information on industry participants not included in this post.

At present, I am long Intel, and follow Qualcomm. I own Intel because I like to receive a fairly substantial part of my return through dividends: that makes me responsible for allocation of my capital, and so reduces the risk of bad capital allocation by the company. I like Qualcomm too and am often perplexed as to why I don't own it. The reason is simple: I can't possibly own every stock I like.

Quantitative analysis of the behavior of market participants

A couple of years ago, I had written some code to facilitate stock selection. It would help if you read about the build-out of that system here, as that will allow you to appreciate the model output later in this post better. Recently, some of the output of the Alpha Omega Mathematica [AOM] model is being published online, and you can see a list of the top and bottom 20, large, mid, and small cap stocks here. You can view additional information for any specific stock here . You may find differences between the data displayed below in this post and the data on the website: this is because I run the model for a coverage universe of all stocks listed in US with a market capitalization of over $100 million, whereas the website uses a different coverage universe.

I am presenting data and the model output for Qualcomm, Taiwan Semiconductor, Texas Instruments, Intel, Marvell, Nvidia, and Advanced Micro. And at the end of the post, I have run through how I value Intel.

Let's start with some AOM Over-all Score's. As you can see, the AOM model likes Qualcomm, Taiwan Semiconductor, Texas Instruments, Intel, and Marvell, and is relatively less impressed by Nvidia, and Advanced Micro.

In the table below, you can have a look at the data to determine how you feel about each company relative to the others.

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Source: MaxKapital Archives using data from Financial Visualizations

Intel AOM Overview

People select stocks to a personal style bias and so we have value, growth, momentum, balanced style investors and agnostic investors, who follow no specific style. This table below gives you information to help you determine whether your stock selection style bias is satisfied by the stock in question.

For Intel, value and return quality is impeccable, while growth and momentum scores are somewhat disturbing. Ownership quality is sound with substantial institutional holdings, but insider ownership is low.

Intel has been hurt by the absence of a strong entry into the mobile space. And skepticism on whether they will be able to make inroads into this market remain. There is also concern that going ahead, the return quality will deteriorate as margins shrink. Much of this is priced.

Intel has also been hurt by the deterioration in the PC market. What is not priced is that the rate of deceleration is decreasing. The PC has been disrupted and displaced in homes. However, the PC remains critical for industry. That smaller market continues to exist and grow. Once the decline in the PC for home market stops, earnings will grow from a smaller base, and the slowing in the rate of declaration in that market suggests that the end is near. Ultimately, in my view, Intel's earnings are near a trough from which they will grow. In addition, there is upside first from Broadwell, and next from Cherry Trail: don't write Intel off. I guess what I am saying, is that Intel's overall AOM score has potential to rise a lot further as growth expectations get realistic, and momentum returns in anticipation of that change.

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Some investors like to select what they see as the best stock in a sector. Others prefer to select what they see as the best stock in an industry. And there are yet others, who simply want to own what they see as the best stock available, without regard to the sector or industry in which it operates. These are the three main capital allocation styles. This table below helps you determine if the stock in question allows you to satisfy you capital allocation style.

For Intel, the model output suggests that the stock is very attractive for value investors, particularly those allocating capital at sector, or with no sector/industry allocation bias. It is also attractive to balanced investors allocating capital at sector or with no sector/industry allocation bias, and to value investors allocating capital at industry level. For the rest it is a hold.

With the main interest in the stock being from value style stock selectors, there is plenty of scope for the stock to gain interest from the several stock selection and capital allocation combinations available. And as a stock gains buyer interest, sometimes interesting things can happen to the price.

Could we see Intel follow Microsoft, into changing from a widely hated stock to one which is very appreciated by all market participants? Today, AOM says everyone loves Microsoft, with some affection being held back by growth investors who allocate capital at industry or coverage universe level.

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The Case for Intel:

Why look at Intel now?

Firstly, Intel is a mega cap stock. This gives it a defensive character, which appeals to me when I perceive the markets are expensive. Secondly, the stock has a low beta. This adds to the defensive characteristics and protects downside during weak markets. Thirdly, the stock delivers a generous yield of 3.7%, which is a premium to the market yield. This too adds defensive characteristics to the stock. The absence of dividend growth does take away some of the defensive character, and with Intel expressing a preferred dividend pay-out ratio of 40%, no hike is likely for the next two years, even if earnings after the impact of buybacks grow at 7%-8% per year. Finally, Intel as recently priced, includes potential alpha. Alpha is the difference between actual returns and risk adjusted returns an investor should expect from a stock. When a low beta stock includes potential alpha, downside protection is provided by the low beta, while upside total return potential is not compromised, because we earn returns from alpha in addition to the lower upside beta driven gains associated with low beta stocks.

However, I believe that we are now either in, or fast approaching the late or mature phase stage of the economic expansion. As I mentioned in a recent post, during such periods, the technology sector has displayed a historic tendency toward under-performance: it might make sense to wait. Having said that, this time might be different - the technology valuations outside a small band of internet based companies are quite reasonable.

Analyst price expectations

Recently Intel traded at $25.02. From Yahoo Finance we know that thirty-five analysts expect an average price target of $25.05 (median $25.50), with a high target of $32 and a low target of $16. This is a pretty wide dispersion in expectations. The wide dispersion in high and low price estimates suggests that the risk is somewhat high. However, so far, neither the bulls, looking for $32, or bears looking for $16, have the upper hand.

Valuation

We might believe that Intel is attractive. But thus far its attractiveness has been viewed relative to other stocks in its sector, industry, or the coverage universe. We do not know whether the stock is priced to deliver a long-term return in-line with our expectations.

Mathematically, the worth of Intel is estimated as [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate].

What is our long-term return expectation for a stock with a beta of 0.95, a long-term risk free rate of 4.50% and an equity risk premium of 5.75%? This beta of 0.95 differs from the beta on table 1 of this post, because it is based on a five-year regression of weekly closing prices of the stock, relative to weekly closing prices of the market, adjusted for beta's tendency to converge toward one. You can read more about where I get my estimates for long-term market returns and equity risk premium here. It is calculated as Risk Free Rate plus Beta Multiplied by Market Return less Risk Free Rate. Thus for Intel, we should be targeting a long-term return of 9.9625%. Is the stock priced to deliver that return?

Earnings tend to be volatile from year-to-year over the course of the economic cycle. When I speak of sustainable earnings, I mean the level of earnings that can be expected to occur over the course of an economic cycle, which can be grown at estimated growth rates over a long period of time. I believe sustainable earnings can be estimated as the six year median earnings per share. Thus cyclically adjusted earnings per share of $1.97, is an estimate of sustainable earnings for Intel.

The adjusted payout potential is that part of sustainable earnings that we can expect the company to return to shareholders via dividends and buybacks, net of dilution. I expect Intel will payout approximately 55% of earnings via dividends and buybacks (40% via dividends and another 15% via buybacks) over the long-term.

If we use a very long-term growth expectation of 5.4%, Intel is worth $25.02. Intel Value = [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate] = 105.40% * $1.97 * 55% / (9.9625%-5.4%) = $25.02. At this price it is likely that an investor with a return expectation of 9.9625% will be satisfied.

The growth estimate implied by the current market price of 5.4% is low. In my view, Intel can be expected to grow at a faster rate: an 8% growth rate in line with potential real Global GDP growth of 4.2% and global inflation of 3.8% should be achievable. Since I am somewhat wary on whether a trough in earnings following the death of the PC has been reached, I will reduce the growth estimate to 6.5%. In recent times, Intel's earnings have grown earnings at long-term annualized rates of 6.5%: 8.3% per earnings per share growth, less the 1.8% of per share growth which was driven by buybacks net of dilution. If I am right, the spread between the 5.4% growth priced by markets, and a 6.5% growth expectation, is 1.1%: this represents potential long-term alpha. Alpha is the difference between actual returns and the risk adjusted return expectation. Since we have a risk adjusted return expectation of 9.9625% for Intel, a long-term investor targeting a risk adjusted return of 9.9625% will end up earning a return of 11.0625%. I do feel the potential alpha of 1.1% could rise rapidly to 2.5%, but to consider that I would want to see Broadwell, and Cherry Trail delivered, and have a sense on how they will be received.

An investor with a shorter time horizon might do quite well too. A price target of $32 implies confidence in long-term earnings growth rising to 6.4% from 5.4% at present. And a 6.4% long-term growth rate expectation is very modest. Intel Value = [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate] = 106.40% * $1.97 * 55% / (9.9625%-6.4%) = $32.

I like Intel because it's got potential alpha, and scope for that potential alpha to grow. In addition, if Intel successfully enters the mobile space, chances are that the change in product mix will lower the beta somewhat. Buying potential alpha, with prospects for growth in potential alpha, together with buying low beta, with potential to go lower yet, can have a profound impact on long-term returns.

The formula above helps to compute a fair value for a stock. It is simple, and you can use it to calculate a value based on your expectations, as opposed to mine. But if you do so, be cautious.

If you alter your risk free rate assumptions, you will need to evaluate how that will impact market return expectations, and the equity risk premium. You will also need to think about how the risk free rates will impact long-term growth. If you alter the adjusted pay-out assumptions, think about how that might impact the growth assumption and the capital structure. For instance, higher growth may signal a need for fresh equity or debt. And if the capital structure changes, so will beta. When you alter growth assumptions, think about how it might change the operational mix, and the impact that might have on the stocks beta, and stock return expectations.

There is a high degree of inter-connectivity between beta, growth, adjusted pay-out ratios, risk free rates, and market and stock return expectations. And reading the inter-connectivity wrong will result in an answer that ranges from absurd to obscene: this model comes with warts. To avoid falling into this trap, here are some ideas which I hope will help.

1. Since valuation is about what you are willing to pay for a stock, perhaps the most important consideration is the growth risk premium: that is Long-term Return Expectation minus Long-term Growth Rate. The question to ask yourself is that if you expect a stock to grow at a certain rate, how much over and above that growth would you want by way of a stock return expectation, to compensate you for the risk that the long-term growth rate might not be in line with your expectations. This spread will be low for a fast growing stock, where there is great confidence in forward growth expectations, and higher for stocks where the confidence in growth is low. In the very-long term, the growth risk premium has tended towards 4.5% for the market.

2. When you look at sustainable earnings for a growth stock, you need to look at where you expect earnings to be a few years down the road. And then discount that number to its present value using your stock return expectations to obtain today's sustainable earnings

3. When you look at long-term growth rates, remember it is not the next years' growth, or the next five years growth you are looking for. You are looking for a composite long-term growth rate expected over the life of the company. This will be made up of foreseeable growth rate for some years, reversion to market growth rates, and finally a terminal growth rate. The terminal growth rate used by many is the risk free rate. I tend to use the very long-term market growth rates, since if the terminal growth rate is below market growth rates, I as an investor have the option to exit and enter the broad market. The life-expectancy of a typical Fortune 500 company is 40 to 50 years: you can read more about this here. So we can consider using a five year forward rate, and then assume growth shall revert to being in-line with market growth expectations for the following 45 years. What this signals is that I am willing to pay a premium for currently foreseeable growth expectations, but after that period, I expect to share fully in the reward of growth over market growth rates. On excel you can calculate a composite growth rate for a company growing at 15% per year for five years, followed by growth at 8% for the following 45 years as 8.68% [=POWER(1/1*115%^5*108%^45,1/50)-1].

4. Test your adjusted payout expectations. Take your growth rate and divide it by 1 minus the pay-out ratio. The result will estimate the return on equity implied in the model for the company. Review the return on equity to see if it is broadly consistent with the return on equity for the industry over the long-term. If it is high, review the return on equity in the context of the leverage employed by the company. A levered company will have a higher return on equity, and so a high return on equity for a company may be perfectly justifiable in some circumstances. However, higher than industry leverage implies higher financial risk and this implies a higher beta, and a higher market return expectation. If you see a low beta with higher than industry leverage, you may want to compute a bottom up beta for the company, instead of one generated using regression analysis.

Disclosure: I am long INTC. 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.