Intel Corporation (INTC) is the world's largest chipmaker with revenues in excess of $54 billion, and a gross profit margin of that routinely tops 60%. Founded in 1968 by Gordon Moore and Robert Noyce, the company originally focused on the manufacture of dynamic random access memory (DRAM).
Foreign competition, especially by Japanese electronic manufacturers, led the company to change strategy and focus on the development and manufacture of microprocessors, the "brains" of computers. The rise of the personal computer, as well as savvy marketing such as the "Intel Inside" ads, allowed the company to dominate the business for PC microprocessors.
This dominance alongside Microsoft's (MSFT) Windows operating system allowed Intel to become one half of the somewhat infamous "Wintel" tandem of the 1990s. Maintaining growth to justify relatively lofty valuations became a key concern of Intel in the 2000s. For equity investors, Intel remains a stalwart technology company, but the company's ability to adapt and grow remains the most important thing when considering whether the stock should be included in most portfolios.
Current Situation
Intel reported first-quarter 2012 results on April 17, 2012. Revenue was $12.9 billion, up slightly from Q1 2011's $12.8 billion. Earnings disappointed vs. Q1 2011, but there was much to be positive about. Gross margins improved to 64% from 61% in Q1 2011. Operating margins improved to 30% from 29% in Q1 2011. Intel did report lower earnings vs. Q1 2011, but the results are not as bad as the press release would indicate. Extraneous factors explain a large portion of the difference, and research and development spending most of the remainder.
Intel's effective tax rose from 27.7% for Q1 2011 to 28.2% for Q1 2012. Additionally, there was -$254 million swing in interest, intangible amortization, and investment gains that pulled down Q1 2012 vs. Q1 2011. Total diluted shares decreased from 5.6 billion to 5.1 billion, which help the overall earnings per share, but earnings per share were still 53 cents vs. 56 cents for Q1 2011. Intel elected to invest in R&D vs. higher earnings in the short term. R&D increased to $2.4 billion, representing 18.60% of revenue. Although this held down operating margins and earnings for Q1 2012, the investment should bode well for the future as those R&D dollars get translated into new products and revenue.
Intel's primary business remains personal computers and laptops. Gartner predicted that PC and laptop shipments would grow by 4.4% in 2012 vs. 2011. Intel's market share is roughly 70%, and Gartner estimates PC and laptop sales at 368 million units. This equates to Intel selling the microprocessors in an astonishing 257.6 million machines.
Competitors
In Intel's primary PC business, which makes up approximately two-thirds of Intel's revenue, the only significant competitor is Advance Micro Devices (AMD). Advanced Micro Devices is a fraction of Intel's size and lacks the scale to significantly impede on Intel's dominance of the microprocessor market. Advanced Micro Devices's market share in the microprocessor market is less than 30%, and the company is struggling to determine a strategy that will allow it to compete effectively. The company is likely to focus on the very low end, allowing it to pick off Intel's value-conscious purchasers. Intel may elect to abandon this market to avoid a price war. Maintaining Advanced Micro Devices as a legitimate rival is in Intel's interest as it allows it to avoid distractions related to regulatory and antitrust concerns.
Intel has diversified the span of products it produces for the PC market. In addition to microprocessors, Intel produces video cards, where it has approximately 6% of the market. Its largest competitor in the video card market is Nvidia (NVDA). In 2011, Intel cross-licensed its non-microprocessor patents with Nvidia, which should benefit each company by avoiding costly patent fights and improving each company's competitive position against ATI, a division of Advanced Micro Devices.
In 2011, Intel purchased McAfee, a software developer with a focus on security software. That will allow Intel to further broaden its efforts to control more of the consumer spend on PCs. The purchase of McAfee brought Intel a tough new competitor in Symantec (SYMC). Symantec did roughly $6 billion in sales during 2011 and may face difficulty competing against Intel should Intel elect to invest heavily in its newly acquired security division.
Intel's success in the PC market has not translated well to mobile devices. Intel largely avoided this market in past, but the explosion of smartphones and tablets have led Intel to spend increasing sums to catch up to market leader ARM Holdings (ARMH). On March 13th, ARM Holdings announced the release of the world's most energy efficient microprocessor, named Cortex -MO+. Although ARM Holdings has led in the smart-device market to date, a portion of Intel's increased R&D is likely being directed at ARM Holdings' core business. Intel will not likely catch ARM Holdings in the next generational release, but has a solid opportunity to catch it one generation out should ARM Holdings fail to produce a new breakthrough technology. Intel's cash flow from its legacy PC business allows Intel to far outspend ARM Holdings on R&D and makes it unlikely that ARM Holdings can maintain its lead indefinitely.
Valuation
Intel dominates the market for PC microprocessors and this business still generates the bulk of Intel's cash flows. Placing a value on the company's equity is tricky as the degree to which tablets and smartphones will eat into PC sales is an open question. Much of Intel's future value relies on its ability to innovate not only in PC microprocessors, but also in the power conscious smart-device arena. For valuing Intel, I use two forms of discounted cash flow and relative value. I am increasing the low end of my valuation for Intel to $28 from $27 and maintaining my high-end estimate at $34 dollars a share. Although Q1 2012 earnings disappointed vs. Q1 2011, I believe that Intel's election to increase R&D spending will generate positive cash flows for investors going forward.
My low-end estimate remains based on a dividend discount model approach with an estimated value for Intel stock of $28 a share, based on the 2011 dividend rate of $0.84 cents a share. The company continues to buy back shares, which is likely to remain the primary approach to returning capital to shareholders and is included in my baseline valuation. Although Q1 2012 earnings were below 2011's earnings, I believe the easing of the global shortage in disk drives and Intel's aggressive marketing will allow the company to make up the difference over the remainder of 2012. A 14 times price-to-earnings multiple seems reasonable to me for both the S&P 500 and Intel, which equates to an Intel share value of $34 a share based on 2011 earnings. Using a full pro forma model of Intel resulted in a slightly improved valuation of $29 per share vs. my previous estimate of $27. This is contingent on Intel's ability to garner more significant market share in the smart-devices space in 2013.
Intel's decline in earnings from Q1 2011 to Q1 2012 will likely continue the discount in price to earnings vs. the S&P 500 that Intel has been suffering. Intel recently traded at close to $28 a share. The risk to purchasing Intel today is the limited upside in fair value vs. the current share price, as well as the risk that increased R&D spending does translate quickly into new revenue and market share. There is a reasonable amount of risk associated with Intel given that it operates in a rapidly changing business that requires significant capital outlays and a high conversion rate for R&D to innovation. Intel's beta is close to 1, which I believe likely fails to capture all of the risk that Intel's equity entails.
I would be comfortable purchasing Intel at a 30% margin of safety to the $28 price estimate, which translates to a target purchase price of $19.60. Although Intel seems fully valued at today's share price, Intel is a stock that investors with a moderate ability and willingness to take risks should continue to monitor. Any pullback to the target purchase price or below should be viewed as a strong opportunity to purchase this leader in the technology space at a reasonable risk-to-reward ratio.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
