Is Intel Overvalued?

May.20.14 | About: Intel Corporation (INTC)

Summary

The trend in Intel fundamentals is negative and its transition from the PC/Server business to the mobile and new device business is fraught with risk.

The current stock price exceeds its average trading range over the past decade even though the fundamentals would indicate otherwise.

The stock has more downside risk than upside potential and is most likely overvalued.

Over the past decade or so Intel stock has followed a now familiar pattern: Intel stock trades in the mid-twenties > the economy takes a hit > Intel gets hammered > stock drops to the mid-teens > stock price recovers and rises to the mid-twenties > pattern repeats. I have been buying Intel in the mid-teens and selling it in the mid-twenties over the past ten years. You might not be able to time the market, but for some reason you could always time Intel.

The curious thing about the price of Intel stock today is that Intel's fundamentals are trending negative yet the stock still trades in the mid-twenties ($26.42 as of this writing). The question becomes: Is Intel overvalued?

To answer this question let's take a stab at getting to the intrinsic value of Intel stock today. Valuation techniques range from old wives' tales such as "This is a great company so the stock must be a great investment" to technical analysis (nonsense?) to relative valuation (dangerous?) to fundamental analysis. Fundamental analysis is the only method that gets you to the intrinsic value of an asset. If it's good enough for Warren, then it's good enough for me!

Table 1 below presents summary data for Intel over the last three annual reporting periods (Source: 10K for year ends 2013, 2012 and 2011). Note that the trends are negative in that revenue is decreasing, earnings per share is decreasing, pre-tax margin before R&D is decreasing, R&D as a percent of revenue is increasing, and capital investment (excluding cash) as a percent of revenue is increasing.

Table 1: Summary Data

Reporting Year End

Dollars in millions except where noted

2013

2012

2011

Revenue

52,708

53,341

53,999

Earnings per fully-diluted share ($)

1.89

2.13

2.39

Pre-tax margin before R&D

44%

47%

48%

R&D as a percent of revenue

20%

19%

15%

Investment as a percent of revenue (1)

83%

78%

68%

Income tax rate (2)

27%

26%

28%

Notes:

1) R&D is not capitalized (per GAAP) so this ratio is understated.

2) Excludes the R&D tax credit, which most likely is temporary.

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Given the decline in the PC and server business, Intel is moving in another direction. The Company's 10K notes the following:

Company Strategy - We are transforming our primary focus from the design and manufacture of semiconductor chips for personal computing (PC) and servers to the delivery of solutions consisting of hardware and software platforms, and supporting services across a wide range of computing devices.

Competition - We are a relatively new entrant to the segments for tablets, smartphones and similar mobile devices.

Prospects - Looking ahead to 2014, we expect revenue and gross margin to remain flat.

Table 2 below presents revenue composition over the last three annual reporting periods (Source: 10K for year ends 2013, 2012 and 2011). For all the talk about transitioning from the PC to mobile devices, the composition of revenue has not materially changed. From the table below we can see that revenue is not increasing and revenue composition is not materially changing.

Table 2: Revenue Composition

Reporting Year End

Dollars in millions

2013

2012

2011

PC Client Group

33,039

34,504

35,624

Percent of total revenue

63%

65%

66%

Tablet, phone, new devices

4,092

4,378

5,005

Percent of total revenue

8%

8%

9%

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To come up with some candidate values for Intel stock we will utilize two rather straightforward cash flow valuation models.

Base Case Model - Values the stock assuming that Intel's current fundamentals do not change. The assumption is that there is no revenue growth and the composition of margin and investment does not change.

Optimistic Model - Values the stock assuming that revenues show some growth, margin improves and capital investment declines.

Table 3 below presents the valuation assumptions for our Base Case and Optimistic models.

Table 3: Model Assumptions

Base Case

Optimistic

Annualized revenue ($ in millions)

52,700

52,700

Margin on old business

44%

44%

Margin on new business

44%

48%

R&D as a percent of revenue

20%

15%

Investment as a percent of revenue

83%

70%

Cash as a percent of revenue

5%

5%

Income tax rate

27%

27%

Revenue growth rate

0%

3%

Discount rate (i.e. cost of capital)

11%

11%

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Model notes:

Intel has excess cash that is not needed for current operations. This cash can be used to acquire another company that generates a positive risk-adjusted return, retire debt or dividend cash to stockholders (includes stock buybacks).

The average annual total return (dividends and capital gains) on the S&P composite since the end of WWII has been in the 10% to 11% range. Given the risks that Intel faces (the market for PCs is declining and the company is a latecomer to the mobile device market) a discount rate of 11% would appear to be very generous.

After-tax R&D is capitalized and then amortized over an average revenue life of approximately three years.

Table 4 below presents the model results.

Table 4: Model Results

Base Case

Optimistic

+

Enterprise value

88,373

143,746

+

Excess cash

19,962

19,962

+

Debt tax shield

1,691

2,360

-

Debt

13,400

13,400

=

Value of common equity

96,726

152,668

/

Fully-diluted shares (#)

5,100

5,100

=

Per share value ($)

18.97

29.93

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Table 5 below presents return on investment given that R&D is capitalized and not expensed when incurred.

Table 5: ROI

Base Case

Optimistic

Return on investment

13.29%

22.75%

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Return on investment is important in that it tells you if revenue growth is adding or destroying value and by how much. If ROI is less than the cost of capital, then growth destroys value. If ROI is greater than the cost of capital, the growth creates value. Note that in the Base Case Model some value would be created (13.29% is greater than 11.00%) but not much of it. Changing the model assumption from no-growth to positive growth will not materially change the outcome. For the Optimistic Model, value is being created but one may question whether the company can generate returns greater than two times the cost of capital in perpetuity.

Conclusion: Financial valuation models should never be used to determine "the price" but they do provide you with critical input to the decision making process. It is my opinion that Intel stock price has a lot more downside risk than upside potential and at minimum the stock is fully-priced and may very well be overvalued.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.