Intel: A Safe Dividend And Underappreciated Moat

| About: Intel Corporation (INTC)

Summary

Intel essentially operates as a monopoly in the personal computer and data center processor markets, resulting in substantial free cash flow generation.

The company's dividend scores extremely well for safety and carries above-average growth prospects to go along with its 3%+ dividend yield.

Despite headwinds from lower personal computer demand, is Intel a buy for dividend growth investors?

Intel (NASDAQ:INTC) is one of the most dominant and pervasive technology companies in the world.

The business essentially operates as a monopoly in its core computer and data center markets and has numerous competitive advantages that are virtually impossible to replicate by most companies.

Intel also offers a healthy dividend payment that scores very well for Dividend Safety and Dividend Growth prospects.

While we typically veer away from technology stocks, Intel is the type of business we like to invest in for our Top 20 Dividend Stocks and Conservative Retirees dividend portfolios.

Business Overview

Intel was incorporated in 1968 and is the largest manufacturer of semiconductor chips in the world. Intel's primary products are microprocessors and chipsets, which are two of the most important factors that influence the performance and functionality of personal computers (PCs).

Intel's operating profits are split roughly 50/50 between PCs and data center processors/flash memory chips/"Internet of Things" chips.

Business Analysis

According to Bloomberg, Intel's microprocessors are used in over 80% of global PCs sold each year, and the company has nearly 100% of the market for servers that are built on PC chips.

How has Intel amassed such a dominant share in these huge markets?

Simply put, Intel has consistently invested to maintain the most advanced manufacturing process in the world, enabling it to deliver the best performance and value proposition to customers.

Developing and manufacturing microprocessors is extremely complex and capital intensive.

The manufacturing process requires hundreds of steps in "cleanrooms," which, according to Intel, contain air which is 1,000 times cleaner than a hospital's operation theater. Building a single plant costs roughly $5 billion today and will only increase in cost going forward.

Research and development costs are also astronomical in the semiconductor manufacturing industry. Intel spent more than $12 billion on R&D in 2015, representing about 22% of its total sales.

To maintain its technological lead, Intel must constantly invest in cutting-edge processes to improve the performance and value of its chips.

The company expects capital spending to total $10 billion in 2016, and Intel has spent more than $160 billion on R&D and capital expenditures since 2005.

Not surprisingly, there are very high barriers to entry in this industry. The cost of developing valuable intellectual property and building out competitive production facilities is enormous, especially when the bulk of customers are already dependent on Intel's chips.

Intel's investments have allowed it to consistently introduce the next generation of process technology every two to three years, improving the performance of its chips at a breakneck pace that competitors cannot afford to keep up with.

Intel is also one of the few semiconductor companies that manufacture products using their own facilities (most semiconductor businesses design their chips and outsource manufacturing to save costs and generate more predictable cash flow).

As a result of its scale and vertical integration, Intel exerts more control over its performance optimization and can introduce new products to the market at a faster pace.

With costs to build leading-edge manufacturing facilities rising (it becomes increasingly difficult to build smaller chips), fewer companies are able to compete with Intel's advancements in performance, energy efficiency, and cost.

In addition to spending on manufacturing plants and R&D, competitors and new entrants must contend with the strong reputation of Intel's brand, which recently ranked as the world's 14th most valuable brand.

Altogether, Intel's economies of scale, leading technology portfolio, and cutting-edge manufacturing processes have created a powerful ecosystem with high switching costs for customers.

Intel's architecture has been refined for decades, and the company has funneled well over $100 billion to continue improving it.

As the incumbent technology in PCs and data centers, Intel's processors have effectively locked up customers. For example, when Dell develops a new computer, there is no compelling incentive to switch to a different processor family as long as the previous version worked and the next one offered by Intel is even better. Many legacy applications run on Intel's technology, and switching would be costly.

Inertia is a powerful factor in these markets, making it even more difficult for a real challenger to Intel to emerge.

As the industry's giant and only viable supplier in many cases, Intel largely controls the pricing of its chips and can exert pressure on Advanced Micro Devices (NYSE:AMD), its only competitor in PC microprocessors. As seen below, Intel's market share has risen significantly over the last 10 years at the expense of AMD.

Intel Dividend

Source: CPU Benchmark

With less scale than Intel and a weaker technology portfolio, there is little AMD can do to compete. In response to Intel's pressure, AMD actually spun off its manufacturing business in 2009 in an effort to improve profitability.

Today, AMD is more focused on non-PC markets in pursuit of new areas for growth where Intel isn't as dominant of a force.

Intel's leading PC technologies have also provided the foundation for the company's expansion into the data center and "Internet of Things" markets.

Intel's PC business provides incredible scale with about $35 billion of revenue and possesses substantial intellectual property that translates over into other electronics such as servers. This gives Intel an advantage once again over smaller players with inferior manufacturing processes.

However, it doesn't guarantee Intel's success in dominating these markets either. One move Intel recently made to continue strengthening its position in data centers and Internet of Things devices was its acquisition of Altera for $16.7 billion in 2015.

This deal helped Intel gain exposure to field-programmable gate arrays (FGPAs), a more flexible type of semiconductor chip that could account for as much as a third of the processors in all data centers by 2020.

By purchasing Altera, Intel can stay in front of this potential development and deliver customizable, integrated products.

Overall, Intel's scale, world-class manufacturing processes, long-standing customer relationships, massive intellectual property portfolio, early-mover advantage (in PCs), and strong reputation for quality have helped it essentially monopolize the market for PC processors.

The company is using its advantages in the PC market to successfully extend into data center processors, which it also dominates, and is trying to crack into mobile phones and Internet of Things devices to continue its long-term growth. Intel is certainly a force to be reckoned with!

Intel's Key Risks

The world has changed a lot since Intel incorporated nearly 50 years ago.

For one thing, computers were extremely rare and largely unavailable to the public. The first microprocessor didn't even exist until 1971.

Today, computers are everywhere, and relatively new devices such as tablets and smartphones are beginning to erode total demand for Intel's legacy cash cow - PCs (close to 50% of operating profits). If demand falls faster than expected, Intel's profits could struggle to grow.

Recent data from Gartner showed that global PC shipments fell by nearly 10% in the first quarter of 2016, suggesting that PC headwinds aren't abating any time soon.

Intel benefited for many years from the rapid ascent of computers, which drove strong demand for its microprocessors.

However, the company must now rely on other growth drivers to remain competitive, especially if the market for PCs contracts faster than expected (we don't think it will, but you never know).

As we noted earlier, Intel is already dominant in data center processors, but the company is working to capture a meaningful market share in mobile devices and a broad array of "Internet of Things" devices.

The company is leveraging the scale and intellectual property from its legacy PC business, but that certainly doesn't guarantee its success in gaining a strong and profitable market share in these emerging growth industries.

Intel's push in these industries is also pitting it against competitors and threats it didn't previously face in the PC market.

Perhaps most notably, cutting-edge tech giants such as Facebook (NASDAQ:FB), Apple (NASDAQ:AAPL), and Google (NASDAQ:GOOG) (NASDAQ:GOOGL) have increasingly expressed a desire to make their own chip designs and leverage other suppliers to push back on Intel's pricing.

They are well aware of the monopoly profits enjoyed by Intel and increasingly view hardware as a performance differentiator, increasing the incentive to develop their own intellectual property and processes. Intel already has a large custom chip business, but it's worth remembering this risk factor.

The biggest competitive threat to Intel's data center processor business, which is responsible for driving the far majority of the company's profit growth, is ARM Holdings (NASDAQ:ARMH).

ARM uses a different architecture than Intel and currently dominates the smartphone market, which relies on smaller chips. Unlike Intel, ARM is a chip designer that makes money from licensing and doesn't do any manufacturing.

ARM's first chips for data center servers are expected to ramp up this year. It's hard to imagine that these chips will be able to match Intel's high level of performance, but it's worth monitoring ARM's progress trying to challenge Intel's major profit driver. For now, we believe Intel's incumbency and performance advantages in data center processors will be hard to uproot.

A final risk factor to note is that semiconductor technology is constantly evolving. Microprocessors become faster and more powerful each year while also shrinking in size and cost.

While Intel is one of the only companies with the financial strength and reputation to invest in the best manufacturing processes and R&D, the pace of chip improvements has begun to slow in recent years as the physics of chips has become extraordinarily complex.

If innovating in performance and power becomes increasingly difficult, the competitive gap between Intel and its competitors could begin to narrow. Intel could also begin to realize a lower return from its multi-billion dollar investments.

Dividend Analysis: Intel

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

Dividend Safety Score

Our Safety Score answers the question, "Is the current dividend payment safe?" We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

Intel has one of the best Dividend Safety Scores in our database, which suggests that its dividend payment is extremely safe.

The company's strong dividend safety rating begins with Intel's healthy payout ratios. As seen below, Intel's earnings and free cash flow payout ratios were both about 40% in 2015, which provides the company with plenty of flexibility to continue paying and growing the dividend.

Even if cash flow was unexpectedly cut in half, Intel would have the financial strength to continue paying its dividend (its dividend payout ratio would double to 80%).

Intel Dividend

Source: Simply Safe Dividends

Intel Dividend

Source: Simply Safe Dividends

Another factor we analyze to gauge the safety of a dividend payment is how a company performed during the last recession. Intel's sales fell by 2% and 7% in fiscal years 2008 and 2009, respectively. The company's earnings also dropped by 22% and 16% in 2008 and 2009, respectively. Earnings fell more than sales because Intel has a high amount of fixed costs - the company's multi-billion dollar manufacturing plants had less volume to spread their costs over.

Not surprisingly, businesses and consumers alike cut back on discretionary spending when times get tough, and fewer electronics such as computers are purchased. Intel's stock was also hit fairly hard during the recession, falling by 43% in 2008 to trail the S&P 500 by about 6%.

Intel Dividend

Source: Simply Safe Dividends

Despite its sensitivity to the economy, Intel's business model is extremely strong. As seen below, the company has been a free cash flow machine over the last decade despite its capital intensity. Businesses that throw off predictable cash flow each year are much better positioned to sustainably pay and grow dividends, and Intel is no exception.

Intel Dividend

Source: Simply Safe Dividends

Just like we observed in our analysis of Cisco (NASDAQ:CSCO), Intel's operating margins are excellent, especially for a capital-intensive technology hardware company. High and stable margins usually indicate an economic moat, and Intel's essential monopoly of the microprocessor PC and data center markets has allowed it to command high prices for its technology.

Intel Dividend

Source: Simply Safe Dividends

Intel's balance sheet adds to the safety of its dividend as well. We can see that the company has more cash than debt on hand, and the business generated about $11.7 billion free cash flow last year compared to total dividend payments of roughly $4.6 billion. Intel has plenty of financial strength.

Click to enlarge

Source: Simply Safe Dividends

It's hard not to feel great about Intel's dividend. While demand for the company's microprocessors and chips is somewhat sensitive to the broader economy, Intel is a cash cow with healthy payout ratios, a strong balance sheet, and persistently high margins.

Dividend Growth Score

Our Growth Score answers the question, "How fast is the dividend likely to grow?" It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

Intel's Dividend Growth Score is 69, which suggests that the company has above-average dividend growth potential. Management last boosted Intel's dividend by 8.3% at the end of 2015, and the company's modest 40% payout ratios indicate there is plenty of room for further dividend growth.

While Intel's dividend growth streak is less than five years long, the company has paid uninterrupted dividends since the early 1990s. As seen below, Intel has also increased its dividend by nearly 9% per year over the last five years. We expect mid-single dividend growth to continue.

Intel Dividend

Source: Simply Safe Dividends

Valuation

Intel trades at a forward price-to-earnings multiple of 13.9 and has a dividend yield of 3.3%, which is roughly in line with its five-year average dividend yield of 3.2%.

Intel's reported earnings and free cash flow per share have each grown by 3-4% per year over the last five years. If this trend continues, Intel's annual total return potential would be approximately 6-8%.

Intel believes it can grow revenue at a mid-to-high-single digit pace so long as the PC market does not decline by more than 5% per year. Under this scenario, earnings would likely grow faster than 3-4% per year given the company's relatively high fixed costs.

Overall, we think Intel's stock seems very reasonably priced and is certainly factoring in at least some of the uncertainty surrounding the PC market's long-term growth profile.

Conclusion

Simply put, Intel dominates its markets and arguably operates as a monopoly in the PC and data center markets. The company's heavy investments in factory equipment, manufacturing processes, and R&D have helped it stay years ahead of its competitors and enjoy excellent pricing power and margins.

While Intel's legacy computer market appears stagnant at best, the boom in data consumption and connected devices is driving strong demand for data centers and plenty of emerging "Internet of Things" applications.

Intel's dominant market share and excellent profitability will certainly keep the company in the crosshairs of competitors, especially in technology. That's just the way capitalism works.

However, given what we know today, Intel's hold on the market continues to look very strong. Intel is one of our favorite blue chip dividend stocks and appears to have plenty to offer dividend investors seeking safe income and at least moderate income growth.

Disclosure: I am/we are long INTC.

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.