Intel (NASDAQ:INTC) has been in the 'dog house' for years, but the firm is finally back on track. Let's look at the upside potential in Intel's shares, which we tally to be ~20% on the basis of the high end of the fair value range, and evaluate the firm via the Valuentum style.
Intel's Investment Considerations
• Intel's business quality (an evaluation of our ValueCreation™ and ValueRisk™ ratings) ranks among the best of the firms in our coverage universe. The firm has been generating economic value for shareholders with relatively stable operating results for the past few years, a combination we view very positively.
• Intel designs and manufactures advanced integrated digital technology platforms, which are used in PCs (including Ultrabooks), servers, tablets, smartphones, automobiles, automated factory systems, and medical devices.
• Intel has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 17.3% in coming years. Total debt-to-EBITDA was 0.7 last year, while debt-to-book capitalization stood at 18.8%.
• Though many fear Intel will be left behind by the mobile revolution, we think those worries are overblown. Intel will spend billions on research and development in the coming years, and we expect the company will become a viable competitor in the mobile space.
At the Computex conference in Taiwan, Intel revealed the most energy-efficient processor in history -- its Core M line of processors. The goal of the Core M, which is based off of the Core i3, i5, and i7 processors, is to enhance processor performance (with less power consumption) in mobile products, and we think the firm will make a big splash with the new chip.
In recent past, Intel has faced myriad challenges in its efforts to gain traction in mobile against rival Arm Holdings (NASDAQ:ARMH), which dominates the market. However, the Core M has changed all of this, and in our view, represents the first of many steps Intel will inevitably take to gain share in mobile. Most Intel 'bears' feel that Intel will fail in mobile, but we think the Core M throws cold water on that thesis. The new chip will be in tablets before the end of this year (just in time for the holiday season), and we're looking forward to a number of new data points in coming months to assess the firm's progress.
On a fundamental level, Intel announced June 12 that it had raised its second-quarter and full-year revenue and gross margin expectations thanks to stronger than expected demand for business PCs. The chip giant now expects second-quarter revenue to be $13.7 billion, plus or minus $300 million, compared to the previous range of $13 billion, plus or minus $500 million. Raising and tightening the guidance range is always a positive, as it signals strong business performance and greater visibility. Intel also noted that it expects the mid-point of the gross margin range in the period to increase by one percentage point, to 64%, plus or minus a couple percentage points. Though it made a couple tweaks higher to its expected R&D plus MG&A spending expectations and its tax rate for the quarter, the increased top-line and gross margin expectations are well-received.
On a full-year basis, Intel will return to top-line expansion, versus its previous outlook calling for flat performance. The firm also noted that the strong second-quarter gross margin will favorably impact full-year performance, driving the measure to the high end of its yearly guidance range (61% +/- a few percentage points). Intel expects to provide a new full-year gross margin range when it reports second-quarter results July 15 (as it receives a few more data points regarding the sustainability of business PC demand for 2014). R&D plus MG&A spending and its tax rate will also be a bit higher than previous expectations for the year. However, the top-line and gross margin news are far more important as it relates to materiality.
The Valuentum Buying Index
For those that may not be familiar with our boutique research firm, we think a comprehensive analysis of a firm's discounted cash flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. We think stocks that are cheap (undervalued) and just starting to go up (momentum) are some of the best ones to evaluate for addition to the portfolios. These stocks have both strong valuation and pricing support. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best.
Most stocks that are cheap and just starting to go up are also adored by value, growth, GARP, and momentum investors, all the same and across the board. Though we are purely fundamentally-based investors, we find that the stocks we like (underpriced stocks with strong momentum) are the ones that are soon to be liked by a large variety of money managers. We think this characteristic is partly responsible for the outperformance of our ideas -- as they are soon to experience heavy buying interest. Regardless of a money manager's focus, the Valuentum process covers the bases.
We liken stock selection to a modern-day beauty contest. In order to pick the winner of a beauty contest, one must know the preferences of the judges of a beauty contest. The contestant that is liked by the most judges will win, and in a similar respect, the stock that is liked by the most money managers will win. We may have our own views on which companies we like or which contestant we like, but it doesn't matter much if the money managers or judges disagree. That's why we focus on the DCF -- that's why we focus on relative value -- and that's why we use technical and momentum indicators. We think a comprehensive and systematic analysis applied across a coverage universe is the key to outperformance. We are tuned into what drives stocks higher and lower. Some investors know no other way to invest than the Valuentum process. They call this way of thinking common sense.
At the methodology's core, if a company is undervalued both on a discounted cash flow basis and on a relative valuation basis, and is showing improvement in technical and momentum indicators, it scores high on our scale. Intel posts a Valuentum Buying Index score of 6, reflecting our "fairly valued" DCF assessment of the firm, its neutral relative valuation versus peers, and bullish technicals.
The Valuentum process is somewhat unique in that it is not a trading system, though numbers can change upon each update. When a firm registers a high rating on the Valuentum Buying Index, our analyst team considers adding it to the Best Ideas portfolio (or in instances of it having a strong, safe, and growing dividend) to the Dividend Growth portfolio. If our team likes the company, it is added to the portfolio(s).
Once it's in the portfolio, we may make tactical trades around the position, as any money manager would do, but we generally don't remove shares until they register a low score on the Valuentum Buying Index. A low score would be a 1 or 2. This allows us to capture the entire pricing cycle of the stock, from when it is undervalued and just showing strong pricing support (a 9 or 10) to when it is overvalued and showing weak pricing support (a 1 or 2). Fairly simple, no? Most members like to follow along with ideas in the Best Ideas portfolio and Dividend Growth portfolio in such a way. The ideas in the Best Ideas portfolio and Dividend Growth portfolio are our best ideas at any given time.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Intel's 3-year historical return on invested capital (without goodwill) is 41.5%, which is above the estimate of its cost of capital of 9.3%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Intel's free cash flow margin has averaged about 14.3% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Intel, cash flow from operations decreased about 17% from levels registered two years ago, while capital expenditures expanded about 10% over the same time period.
Our discounted cash flow model indicates that Intel's shares are worth between $24-$36 each. Shares are currently trading at $30 each at the time of this writing, implying upside at the high end of the fair value range. The margin of safety around our fair value estimate is driven by the firm's LOW ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers.
The estimated fair value of $30 per share represents a price-to-earnings (P/E) ratio of about 15.9 times last year's earnings and an implied EV/EBITDA multiple of about 7.7 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 2.6% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 6.5%. We think a stabilizing PC market coupled with improvements in its mobile position will help drive revenue higher in coming years. Our model reflects a 5-year projected average operating margin of 24.2%, which is below Intel's trailing 3-year average. Despite improvements in higher-margin PCs, we think the company will still face some pricing pressures across its product line-up, and we factor this dynamic into our valuation of the company.
Beyond year 5, we assume free cash flow will grow at an annual rate of 2% for the next 15 years and 3% in perpetuity. For Intel, we use a 9.3% weighted average cost of capital to discount future free cash flows. We think these forecasts are reasonable. We would expect Intel to grow modestly during phase II of our discounted cash-flow model, and the 3% growth rate in perpetuity is a universal assumption we apply to all stocks in our coverage universe (they can't grow faster than GDP forever). The discount rate is consistent with a firm of Intel's size and risk profile.
We understand the critical importance of assessing firms on a relative value basis, versus both their industry and peers. Many institutional money managers -- those that drive stock prices -- pay attention to a company's price-to-earnings ratio and price-earnings-to-growth ratio in making buy/sell decisions. With this in mind, we have included a forward-looking relative value assessment in our process to further augment our rigorous discounted cash flow process. If a company is undervalued on both a price-to-earnings ratio and a price-earnings-to-growth ratio versus industry peers, we would consider the firm to be attractive from a relative value standpoint. For relative valuation purposes, we compare Intel to peers Texas Instruments (NYSE:TXN) and STMicroelectronics (NYSE:STM), among others.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $30 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Intel. We think the firm is attractive below $24 per share (the green line), but quite expensive above $36 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Intel's fair value at this point in time to be about $30 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Intel's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $36 per share in Year 3 represents our existing fair value per share of $30 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements
In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score as it relates to firms in the Best Ideas portfolio. Past results are not a guarantee of future performance.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: INTC is included in the Best Ideas portfolio.