Intel (NASDAQ:INTC) used to be a huge growth story. Investors expected advances in processor technology and the thirst for faster devices to drive Intel's profits for years to come. However, the last few years have made investors worry that Intel has lost its way. With slowing PC demand and soft results, Intel was being questioned left and right about its strategy. However, the company's most recent quarter seems to be a solid answer to the company's critics.
Understanding the business
One of the main criticisms of Intel has been the company's heavy reliance on the PC business. The consensus seemed to be that as tablets and smartphones become more prevalent, PCs would become obsolete. Microsoft (NASDAQ:MSFT) has been plagued by the same concerns. By contrast, ARM Holdings (NASDAQ:ARMH) dominates the mobile chip business. The company has been growing annual revenue at a faster clip (revenue up 10% vs. 8% at Intel), and has been more popular than Intel with investors.
However, based on Intel's earnings, it appears that the PC business is actually a cyclical business instead of being in a permanent downturn. If you think about it, this makes good sense. Tablets are great for consuming information, but when users want to create content, they use a PC. Smartphones are convenient, but their limited screen size means users need something more if they expect to get real work done.
The end result is, customers don't need a new PC every year or even every two years. They can wait until their PC either crashes or too many components fail. Intel and Microsoft will still sell PC chips and operating systems, but at a slower pace and in a cyclical fashion. Intel's PC business growth in the last three months was a shock to many investors, but it shouldn't have been.
The first way Intel is defying its critics is, the company's PC business isn't in a long slow decline as many expected. Instead, the company's cyclical sales will generate opportunities for informed investors.
Declining in a good way
The second way Intel is defying its critics is, the company's diluted shares are going to decline in the next quarter. Compared to the past three months, Intel spent about $2 billion on share repurchases, yet diluted shares actually increased year-over-year.
In a similar fashion, Microsoft spends billions on share repurchases, yet shares were down less than 1% compared to last year. ARM Holdings is growing faster, and its share count increased over the last year. The point is, Intel generates billions in free cash flow and doesn't use all of it on dividends, so why is the diluted share count stagnant?
The answer is, Intel uses its shares for compensation as well as for purchases of other companies. The good news for investors is, Intel is already committed to buying back $4 billion in shares next quarter. Given that this is double the amount spent last quarter, it seems almost certain that the company's share count will fall. Obviously, with less shares outstanding, even mediocre results will appear better.
A huge improvement in the most important area
The third way Intel is defying its critics is, the company's cash flow situation is far better than it was even one quarter ago. If investors were nervous about Intel's growth one quarter ago, they also might have worried about the company's dividend.
Unlike Microsoft, which has transitioned into a devices and software company, or ARM Holdings, which focuses on licensing its technology for chip design, Intel seemed to be in real trouble last quarter. Just six months ago, operating cash flow was down, and even more important, core free cash flow didn't cover dividend payments.
This quarter, Intel's operating cash flow increased by 26%. More important to investors, the company's free cash flow payout ratio came in at 61%. By comparison, ARM Holdings' operating cash flow declined, and its dividend is so small that a payout ratio isn't an issue. Microsoft witnessed a slight decline in operating cash flow, but its payout ratio was just 40%.
The bottom line is, Intel's revenue will grow, just not in a straight line. Second, with a decline in shares upcoming, Intel's earnings growth should improve. Last, with better free cash flow, Intel's dividend appears safe again. If investors doubt Intel, they may need to think again; this company has several surprises up its sleeve.
Disclosure: The author is long MSFT. 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.