- Intel remains well valued even after the recent run up in price.
- The stock as priced offers at least 40 basis points of growth alpha, which translates to an 11.25% gain potential to my estimate of fair value.
- Once at fair value, investors can expect a total long-term return of 10.25%.
In a prior post I looked at Intel (NASDAQ:INTC), when it was trading at $25.02, because I saw it as a value opportunity hiding in plain sight. And it was hard to believe that this value would not be recognized. With the price now nearing $30, I am looking at whether Intel might still be suitable for the alpha hunter.
How do different market participants view Intel?
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.
AOM Statistical Scores
The AOM statistical scores are a statistical evaluation of thirty-eight key indicators for the company, grouped into value, growth, quality, and momentum categories. It illustrates how the key indicators for the stock perform in comparison to the market capitalization weighted scores for the market, the stock's sector and the stock's industry of operation.
Intel scores high on value and on quality across the board, regardless of whether we compare the stock with the market, other stocks in its sector of operation, or other stocks in its industry of operation. The score for growth remains poor, thus conviction in growth has not built along-with the price rise: though I believe growth scores will improve as analysts revise estimates following Intel's recent revision to revenue and gross margin expectations. And the momentum is now strong in comparison with where it was a few months ago: momentum investors are likely recognizing improvements to growth potential.
AOM Model Recommendation
This stock now appeals strongly to most investor stock selection styles, except for growth investors. This includes value style stock selectors. It also appeals to the balanced investor who considers value, growth, quality and momentum equally. It also appeals to momentum investors and to investors with no stock selection style bias. And it appeals to most of the typical capital allocation strategies adopted by investors in that the stock has appeal to all, regardless of whether they allocate capital at sector, industry, or with no sector/industry bias. I expect that as analysts revise growth expectations upwards, we will see the GetAOM algorithm revise growth style stock selectors to buy.
Overall, after analyzing fifteen stock selection and capital allocation strategy combinations, the system assigns an AOM Score of 78%, and an AOM Buy recommendation for Intel.
The AOM statistical scores for each of the fifteen strategy combinations are unique and not comparable with each other. The AOM Score is very different from AOM Statistical scores: it evaluates and rates the AOM Statistical scores for each of the fifteen strategy combinations, and uses a unique technique to make the statistical scores across the strategy combinations comparable. The output is the AOM Score: a quantitative assessment of the output from the fifteen strategy combinations. The AOM Recommendation is a plain English recommendation based on the quintile the AOM Score falls in.
I'll hasten to add that this is a package aimed at generating ideas, it does not intend to, and nor does it replace the due diligence we must do as investors. It is a tool that uses quantitative techniques to understand the behavior of different market participants, and then brings that data together so that users can hear the voice of the market through the noise. The AOM system can guide you where to look, but make no mistake about it - it cannot look for you.
The Case for Intel:
Why look at Intel now?
While Intel is no longer as cheap as it was when I last posted, valuation remains a good reason to look at Intel now. The stock trades at a trailing twelve month P/E below the market P/E. The P/E for 2015 is at a level that suggests that there is gain potential from earnings growth, as well as from an expansion in the multiple. With the five-year forward growth expectation expected to strengthen in the coming months, I expect the elevated PEG ratio to decline somewhat.
And the stock still offers an attractive dividend yield, well ahead of market yield, and yield offered by stocks in Intel's sector and industry of operations. This is great when considering the additional $550 million value typically returned to owners via buybacks each quarter in recent times.
Source: Intel Investor Relations
Intel scores poorly on key growth criteria. While earnings growth over the past five years has been healthy, growth in the current year has been poor. And the growth expected in the coming year and five years are poor too. It takes a leap of faith to allow growth expectations to rise, but Intel's recent revision in revenue and gross margin expectations is a positive. Besides, low-growth expectations are fine as long as they are priced, which in my opinion, they are in the case of Intel.
Intel also continues to display characteristics consistent with a high-quality company. Return on assets, equity and investments are all strong in comparison to the industry, as are gross, operating and profit margins. Institutional ownership which is well over market and sector averages provides a positive signal of sound owner quality. But it is disappointing that institutional ownership significantly lags industry averages. Insider ownership is low too, but that is something of a curse of the value mega-caps.
Of late, momentum has been positive, though it does look like the stock is somewhat overbought in the short term.
Is Intel a suitable pick for alpha hunters?
Analyst price expectations
Recently Intel traded at $29.93. From Yahoo Finance, we know that thirty-seven analysts expect an average price target of $29.64 (median $30.00), with a high target of $40 and a low target of $17. This is a wide dispersion in expectations, which suggests risks are high. So far, the bulls are clearly in control.
One of the classic conundrums for value investors is that value stocks tend to go from being very cheap to being rightly valued and back to being cheap. When a stock is rightly valued, it is priced to hold. When it is cheap, it is priced to buy. And one way to determine whether it is cheap or not is to estimate the alpha available with the stock as currently priced.
Alpha is the difference between actual returns and risk adjusted returns an investor should expect from a stock. So we will really never know the extent of alpha created until the actual return is earned. But we can always try to estimate alpha.
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]. If you do use the above formula, please read this explanatory note.
So let us have a closer look at the different parameters used to determine value.
Beta, co-efficient of determination and alpha intercept considerations
Value Line reports a beta of 0.95 for Intel. The Value Line beta is calculated as 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 towards one. Value Line also has a 2017-2019 price range of $40 to $45: this clearly suggests that they expect that there is much to play for.
I calculate the raw beta based on the five-year regression of weekly closing prices of the stock, relative to weekly closing prices of the S&P 500 at 1.00, and I leave it unadjusted as it already reflects the beta's tendency to converge towards one. This low beta adds defensive characteristics to the stock, which is always nice in what is perceived as an over-valued market.
The coefficient of determination for Intel is 43.16%. This suggests that only 43.16% of the price movement in Intel is explained by movements in the market: the residual price movement is based on company-specific factors. This average coefficient of determination suggests that the market related risks are average. And because company specific risks can be diversified, Intel is a great pick for most portfolios at the present time.
Disappointingly, Intel has an alpha intercept of (0.02%), which means that if the S&P 500 returns 0%, the stock can be expected to return (0.02%). But because of the average coefficient of determination, the raw beta and alpha are less meaningful.
Over the past five years, the average weekly price change on Intel has been 0.29% (median 0.26%). The standard deviation over the period has been 3.27%. Thus for Intel, the range of normalcy (average plus or minus one standard deviation) for weekly returns is between a gain of 3.6% and a loss of 3%. In the week of 6/9/14 we saw a price spike of 6.03%. While this fell outside the range of normality, it was driven by news of upwardly revised expectations. More importantly, the rise did not reflect a two standard deviation event, which would have occurred with a weekly price move of over 6.8%. In my view further gains with normal volatility are possible: even likely.
Source: MaxKapital Beta Calculator
We might believe that Intel is attractively valued. But thus far, its attractiveness has been viewed relative to other stocks in its sector, industry or the coverage universe in the analysis of the perception of different market participants. We also know that Intel is cheap relative to the broad markets. What we do not know is whether the stock is priced to deliver a long-term return in line with our long-term expectations on a standalone basis and regardless of broad market valuations.
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 1.00, a long-term risk free rate of 4.50% and an equity risk premium of 5.75%? 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 10.25%. 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. This chart below displays normalized trailing-twelve-month earnings over the past five years, together with analyst expectations for the current and coming three years. It also shows Intel's historic revenues and sales estimates for the current and coming fiscal years.
I am very comfortable with $1.90 marking a bottom in earnings, and expect growth to accelerate with a pick-up in the global economic cycle and the PC replacement cycle.
Forty-four analysts included on Reuters data estimate average earnings of $2.01 (High: $2.21, Low: $1.76) during the year ended December 14, with forty-four analysts estimating that it will rise to an average of $2.11 (High: $2.51, Low: $1.57) for the year ending December 15. Four analysts assess long-term growth rates at 7.6% on average, with a high estimate of 12% and a low estimate of 3.4%. I expect these estimates will be revised upwards in response to Intel's recent upward guidance.
I am comfortable with $1.90 as a fair and conservative representation of sustainable earnings.
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 on account of employee and other issuances. I expect Intel will pay out approximately 60% of earnings via dividends and buybacks (approximately 40% to 60% via dividends and another 0% to 20% via buybacks) over the long term. An adjusted payout ratio of 60%, assuming nominal earnings growth of 6.4%, implies a return on incremental equity of 16%: the 40% of earnings retained, invested at a 16% return on equity, delivers the required 6.4% (40% * 16%) growth. This return on incremental equity is not unreasonable to expect, considering that the recent return on equity is 17.40%, and it has averaged 20.83% over the past five years.
If we use a very long-term growth expectation of 6.2%, Intel is worth $29.93. Intel Value = [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate] = 106.2% * $1.90 * 60% / (10.25%-6.2%) = $29.93. At this price, it is likely that an investor with a return expectation of 10.25% will be satisfied.
The growth estimate implied by the current market price of 6.2% is low. And until the recent guidance revision, it has been low with good reason.
Alpha is estimated as the difference between actual returns and the risk-adjusted return expectation. If we accept analyst estimates of forward five-year growth of 7.60%, we get a composite very long-term (fifty-year) growth rate of 6.4% assuming that following five-years growth at 7.60%, growth reverts to a 6.25% growth rate for the next forty-five years. If Intel grows at a long-term rate of 6.4%, we have growth alpha of 0.2%. And an investor buying at present levels can expect a long-term return of 10.45%.
There is however a small matter of an expectation of revisions to earnings growth following Intel's updated guidance. If we expect the forward five-years growth estimate to converge towards today's 12% high estimate, and we assume that growth reduces to 6.25% for the following forty-five years, we get a composite very long-term growth rate of 6.8%, growth alpha of 0.60%, and the total long-term return expectation goes to 10.85%.
A 12% growth estimate for the forward five years is possibly too optimistic to expect. And so I will use a 9.8% forward five-year growth estimate. This represents the mid-point of the present average and high analyst expectations of 7.6% and 12% respectively. And based on this I get a composite very long-term growth rate of 6.6%, growth alpha of 0.40%, and a total long-term return expectation of 10.65%.
Intel is capable of sustaining a composite very long-term growth rate of 8%, which is essentially in line with global potential nominal GDP growth rates. But to achieve this they must retain their competitive advantage through innovation, and they must succeed in the mobile, tablet and phablet market. And we cannot presume that they will. Thus, I will go with a composite very long-term growth rate of 6.6%, as calculated above.
If we use a very long-term growth expectation of 6.6%, Intel is rightly valued at $33.29 [106.6% * $1.90 * 60% / (10.25%-6.6%) = $33.29]. So at present, we have 0.40% of long-term alpha, which translates to an 11.25% upside to "rightly valued", after which you can expect a very long-term total return of 10.25% from the stock.
I don't believe a $33.29 fair value estimate is overly optimistic. The fair value estimate ($33.29), together with a 7.25% (Total Return Expectation of 10.25% less 3% via Dividends) annualized three-year return results in a projected value of $41.06 by mid-2017, which is at the low end of the Value Line range of $40 to $45 for 2017-19.
While Intel remains well valued for the alpha hunter, for those of you who took aggressive over-allocations to Intel when it represented value hidden in plain sight, the time to eliminate those aggressive over-weights and return to allocation is near, if not here. The easy money has been made.