We are fans of Intel (NASDAQ:INTC); INTC has been the undisputed semiconductor leader and one of the largest wealth creators of the PC era. The glow has reduced over the last decade or so, initially because of Athlon/x86-64, competition from Advanced Micro Devices (NYSE:AMD), followed by the Y2K bubble, followed by the onset of the tablet era.
For the better part of last decade, we have primarily held INTC for the value of its dividends and covered call option income (we currently are short January 30 covered calls against our entire position). Over the years, we have used the proceeds of INTC dividends, options income and stock assignments as a source of funds for other investments. In essence, we have treated the INTC investment as our favorite high-yielding money market fund. This portfolio choice was based on the belief that INTC is an x86 cash flow powerhouse at an exceptional PE multiple. We continue to view INTC as a decent dividend/income play for the near-term, but we are increasingly pessimistic about INTC's role in our portfolio going forward.
Our thesis on INTC is simple; what has driven INTC in the past and what is driving INTC today is the historical inheritance of the x86 riches. Industry observers are aware that INTC has tried hard for over two decades to find new business sectors with high margins and high volumes comparable to the x86 chips. After years of investments in many technology areas, both in-house and external, INTC has very little to show in terms of successes. Its acquisitions to date have largely been hobbies and wealth destroyers.
The experience of the last two decades in the semiconductor industry teaches us that it is unlikely that INTC, or anyone else for that matter, can create a semiconductor niche that will repeat INTC's history of high ASP, high margin, and high volume x86 business. Qualcomm (NASDAQ:QCOM), with its strong CDMA IP, comes a distant second, but we digress. With passage of time, INTC's management has come to accept this reality and started looking at other avenues for growth.
INTC's management has come to believe that the most realistic growth option going forward is to use the strength of its manufacturing operations to create a foundry play. INTC started this effort several years back, but the success so far has been limited. More recently, INTC has reaffirmed its commitment to make foundry a big part of its business. In spite of the lack of much success with the foundry business in the past, one could argue that INTC is a financial juggernaut, is more focused now, and that time is on INTC's side.
On paper, this would seem to be true. INTC's best-of-breed competition, Taiwan Semiconductor Manufacturing Company (NYSE:TSM), has substantially fewer financial resources compared to INTC. For 2013, INTC reported full year revenues of $53.3B. TSMs revenues, on the other hand, were $19.8 billion. INTC's profits, similarly, tower over those of TSM.
However, current revenues and profits are just one way to look at this picture. One of INTC's problems historically has been that its management tends to focus excessively on "gross profit margins" while we believe the more meaningful metric to focus on would be "net profit margins." It is here that INTC's primary competition in the foundry space, TSM, shines. TSM's profits as percentage of sales are dramatically higher than INTC's. And, what is astonishing, is that TSM is able to deliver this level of profitability with a capital spending level that is far in excess of INTC's when measured in percentage of sales.
Part of the reason for the lower profit margin is that INTC's constant drive to stay ahead of the process performance curve has led to high process costs, asset write-offs, and fab underutilization. INTC has reduced the underutilization problem somewhat by building chipsets and other less process-sensitive chips in its older fabs. But in spite of that tactic INTC continues to have underutilization problems.
So, what does the massive spending on process buy INTC? While opinions vary on the subject, it is generally agreed that INTC has an advantage over all other players in the industry in terms of CPU process technology. One would hope so, given the margin by which INTC has outspent TSM and every other competitor in the industry in each of the last 20 years.
Regardless of where one stands on that process advantage debate, the real question is not if INTC has an advantage, but if this advantage does anything to INTC vis-à-vis its prime competitor in the foundry business. Overwhelming data suggest that INTC's process advantage does not buy INTC much in terms of the foundry business. Most of TSM's customers neither need nor care to fabricate products on an advanced process of the type that INTC has. The key issues in the foundry business are cost, simplicity, consistency, and time-to-market. It is unlikely that INTC will come close to TSM on these metrics in the near future. It does not help that many companies in the CPU or SoC business see INTC as a competitor and are more likely to stay with pure foundries such as TSM than switch to INTC.
In the best-case scenario, it is likely that INTC will continue to be approximately a single manufacturing node ahead for the next one or two nodes, but it is also likely that the advantage will NOT manifest into a significant advantage against TSM.
Setting aside the process discussion, the much bigger problem for INTC are the overall industry trends. INTC's core PC business is under threat and declining. On the other hand, TSMs customers are producing cell phones and tablets and other attractive devices that are going through a massive growth spurt. The growth in web-based devices like Chromebooks is likely to further marginalize the importance of an x86 CPU. As the phone and tablet market mature, and there are signs that this is already happening, innovation levels reduce and cost becomes an increasingly important issue. In this environment, INTC's leading edge processes are of no advantage to its customers, except at the very high-end where the volumes are likely to be small.
The result of the market place dynamics is that TSM will continue to grow and INTC will likely stagnate or shrink or, at best, grow very slowly. The net result is that within 5 years, TSM will likely be a more profitable company than INTC, and in less than 10 years, TSM will be larger than INTC in terms of revenues. Given that TSM's capital spending rates are substantially higher than INTC's, any advantage INTC would have in terms of process spending would likely dissipate in about 5 years.
Looking at a different component of INTC's and TSM's net profits, one would note that INTC also has a higher SG&A compared to TSM. One can argue that part of this is due to the nature of x86 business and due to the fact that a large percent of INTC's workforce is in high salary locales. One could also argue that INTC's organization is bloated.
The problem with INTC is that it is a stodgy high-margin company that thinks it wants to take on the commodity foundry business. With its large organizational inertia, INTC is going to find out that its x86 PC culture will not let it thrive in the foundry business. For INTC to return to a growth path and succeed in the foundry business, INTC needs to invert the company focus. It needs to see itself as a foundry company with a captive x86 business - that is extremely hard to do. INTC also needs to evolve the SG&A of the company so that it is comparable to TSM's, at least on the foundry side. Without such radical changes, INTC is unlikely to make much of a headway against TSM.
We do not believe that changes of this magnitude are likely at INTC in a short period of time, and we fully expect TSM to replace Intel as the semiconductor industry leader within the next five years.
In summary, we believe that, INTC, as a growth play, has definitely come to an end with the onset of tablet computing. INTC's revenues in the next five years are far more likely to shrink than grow. We expect the management to reduce costs to keep the EPS in check, but the company itself is likely to be in turmoil for years to come as it comes to grips with its new role in the semiconductor industry. On the other hand, we view TSM as uniquely-positioned to become the top semiconductor company in about five years.
In our portfolio, TSM has replaced INTC as the semiconductor growth component several years back. The only question to us at this point is how long we can continue to keep INTC as a high-yield money market play.
Disclosure: I am long TSM, 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.