I own Intel (INTC) stock. I first bought in the $13/share neighborhood during the financial crisis, and added sub-$20 to $24/share in the last couple of years. In this article, as in all of my recent articles, I am reviewing the status of a current holding to determine whether it's a buy, a hold, or a sell, and what its value is. I conclude I still think Intel is a good buy -- despite the challenges, while cognizant of the risks, and even after the recent share-price appreciation.
Fads and Trends Galore: I think it is best for me first to orient you on my thinking about the tech space in general. As I detailed more fully here in my bullish call on Microsoft (MSFT), one of my present major investment theses is that the market has turned against all major tech companies in general, due to a faddish belief that none can have a moat, and a related conviction that all of these campanies are all about to be destroyed at any moment. Like all intellectual fads, this one arises from a grain of truth: in this case, the seeming fate of Apple in the late 1980s, what has happened to Nokia (NOK) and Research in Motion (RIMM), and the lingering hangover from the tech bubble.
This intellectual trend is overblown though. Also, what I call the Total Destruction Conviction is contradictory because, of course, these companies cannot all destroy each other --there have to be some winners. And, in fact, I think (in my totally inexpert way) that amongst the larger tech companies at least -- both hardware and software companies -- there is enough macro market room for pretty much all of these companies to be winners to varying degrees, RIMM excepted. (Even RIMM will probably limp along until somebody buys it for its patent portfolio, or until its iPhone imitations gather a little more steam.)
You may recall, 20-25% ago in share price appreciation, that the more particular faddish thesis about Intel was that Intel and Microsoft were going to be destroyed by Apple (AAPL). Apple, by the way, is a company I also love and recommend. This faddish view neglected, among other things, Intel's dominance in data centers, including the new ones being built by Facebook. This view also neglected Intel's actual numbers (more below) and Intel's powerful push into smart phones, and the growth it is experiencing internationally.
More importantly, keep in mind, per that above-referenced Apple article, that Apple, too, is priced, every single quarter, as if it will only grow like an old-line stalwart stock! Coke as of this writing trades at higher P/E (20.4) and forward P/E (17.1) ratios than Apple does (13.8 and 10.2, respectively). That is nuts, people, and it is in line with my general thesis. I'll say it again: for the past few years the market has priced this entire sector as if there can be no long term winners. Fads and trends galore.
Look at the Ratios and Numbers: I think what's important is to look first and foremost at the numbers. Then one can check the numbers against one's gut-based, fad-based, or fear-based thesis. The numbers have simply never, ever told a story of imminent decline for Intel, and do not do so today. Most of Intel's key numbers and ratios for the last decade can be found here.
The numbers tell a story of generally increasing revenue (including recent record revenue), expanding gross margins, a doubling of operating margin, exploding operating income, a quadrupling of net income in less than a decade, dividends up 9x in less than a decade, a major reduction in share count, higher asset turnover, higher returns on assets, higher returns on invested capital, and free cash flow up by 125%. Also, returns on invested capital are at all-time highs, and returns on invested capital have consistently exceeded Intel's WACC (when ROIC does not exceed WACC, a company is destroying value). Don't forget to look at the numbers. That is all I am saying.
Tablets and iPad Worries Are the Anchor: This is not to say Intel does not have problems and real worries facing it. I just finished reviewing this quarter's earnings call transcript and Q&A. As always with conference calls, the Q&A was better than the presentation. Anyway, I found a few of the questions and answers highly illuminating (if not exactly surprising) about what is weighing down Intel's stock still, even as it has appreciated in the last twelve months:
- Vivek Arya - BofA Merrill Lynch, Research Division: "It's clear the emerging markets have been driving a lot of PC growth. I'm curious, longer-term, do you think these emerging markets go more towards Ultrabooks or towards tablets? And what implications will that have on Intel's pricing?"
- CEO Answer: " I don't think anyone in the world knows the answer to that question, Vivek. I think a lot of that has -- has to depends on -- if you look at people buying tablets today, particularly in the iPad arena, there are people that have started out PCs and very often still use PCs. And it's a complimentary device. How that unfolds 2, 3 years from now, I don't think anyone knows...."
- Vivek Arya - BofA Merrill Lynch, Research Division: "....Paul, secondly, on your smartphone and tablet strategy, I mean, if I look at the industry, it's clear that Apple and Samsung are now accounting for an increasing number of units and even more, almost half of the industry sales. So does that leave enough room in the market for you to go after and have an impact on your sales and profitability? Is it enough potential for you to go after this market?"
- CEO Answer: "Well, sure. I mean, any numbers that we look at going forward has smartphones, going from sort of $450 million to close to $1 billion as smartphones, as most phones become smartphones. And even if you take out half of the market, which I would be loath to do, but even if you take it out, it's still a very large number. I'd point out, too, that those are both companies that we are continuing to have dialogue with in terms of our product line. And Samsung doesn't universally use its chips in its phones. They use other vendors, and that's certainly an account we would love to win for phones. And I can't ever speak for Apple, but we know where they are and they know where we are."
- James Covello - Goldman Sachs Group Inc., Research Division " [His second question.] Okay. And then if I could ask for my follow-up, relative to the view that Ultrabook adoption will pick up steam as the price points get down to a "mainstream price point," if I look at consumer activity today, the iPad 3 is already at a higher price point of where Ultrabooks are today and obviously, had tremendous adoption almost immediately. So how do we get comfortable that it's really a price point issue and not a product preference issue?"
- CEO Answer: " I don't think -- I'm not a subscriber that it takes mainstream price points to get us to high volume. I mean, I think this is -- that just helps. And what you're going to see is an incredible amount of differentiation from $699 to $1,299. And I love that. People are doing different experiments with different screen sizes. I talked earlier about convertibles and hybrids and slide-out keyboards and things like that. Some people are putting touch in, which is a cost adder. I really don't see the need to get to those price points to deliver the value proposition. The price points make everything work better because it lowers the bill of material's cost on some of these previously very expensive niche components."
I have a few notes on those questions and answers. First, they really articulate the issue Intel faces with regard to its long term growth. The other analyst questions were basically about nitpicking questions about operational issues local to this year. In other words, those questions (in addition to a JPMorgan question I have left out for the sake of brevity) were the good questions.
Second, the CEO of Intel admits we cannot really know the extent to which tablets (where Intel is not dominant) will replace PCs or even harm new Ultrabook adoption. He believes they are complimentary devices. I am not so sure. I can buy that a smart phone is complimentary with a notebook. I can buy a tablet is complimentary with a desktop PC or with a smart phone. But I am not sure I buy that a tablet is complimentary with a notebook computer, whether it is labeled an Ultrabook or not. Therein lies the rub. However, it is important to note Intel is a formidable competitor, and this is why I am watching so closely their attempts to take share in this market.
Third -- and this gets to the discussion of Samsung and Apple -- so far, Intel has not succeeded with the above attempts. 2012 is a critical year to see if Intel does so, given its new low-power, high-performance chips. So far it has not really happened.
Finally, Covello's question is my favorite. Essentially, he is saying the following: "What if you are a dinosaur? What if the Apple brand is simply too much for you and your problem has nothing to do with pricing, but has everything to do with the fact that years and years of so-called "Wintel" laptops have had crappy battery life and have failed to demonstrate innovation, and people are just sick of it, and will not be interested in your tablets either, because they don't trust you."
But of course he is saying it very politely. Note that the CEO, Otellini, actually stutters in the transcript before answering it. Note also that Otellini does not really answer the question. Rather, he says he does not think reducing the price of Intel-based form-factors will be determinative. His answer here contradicts, at least thematically, what he had said earlier on the call, about how he was excited that lower prices would spur more sales.
I read this as basically an admission (which is not at all surprising) that the Ultrabook advertising/branding campaign has not yet created a premium brand. In other words, Wintel still must compete primarily on price & performance, which is not as attractive as what Apple competes on, which is lust. Wintel lacks "pricing power," period. In my view, this does not make Intel and Microsoft a bad buy, and it does not mean these two companies are going to go extinct. Microsoft and Intel are just different from Apple -- strong in their own ways, and weak in their own ways. No company is perfect. But any buyer needs to be aware that the CEO admits this is true.
What's The Value Now? As I have stated in all of my prior articles, I am most interested in discounted free cash flow analysis as a mean of valuing a company. Here is my latest sheet, which includes cash flows through 12/2011. Intel has had 9.72% annualized free cash flow growth over the past nine years. Measured over the past four years, that growth has slowed to 7.54%. These are using standard measures.
Measured by Joel Greenblatt's alternative measure used for growth companies, free cash flow is actually up from an annualized 7.43% over the past nine years, to 17.50% over the past four years. Yes, you read that last number correctly. (You get there by deducting depreciation/amortization, instead of capital expenditures, from operating cash flows.) Since Intel's capital expenditures, especially in the last year, have been HUGE, the Greenblatt method gives much higher free cash flow growth.
Personally, I am not entirely comfortable with either method here. The standard method gives Intel not enough credit for investing in hew growth. But here, I am also not entirely convinced that the Greenblatt method is perfect either. That is because I think a lot of the capital expenditures Intel is making is catch-up spending -- spending it has to do in order to maintain its present position, because of prior failures and the problems discussed above. I think this is true even though a lot of that spending goes way above its depreciation/amortization expenses. So I would not be comfortable -- at all -- with crediting Intel with anything near high-teen free cash flow growth, and certainly not for any appreciable amount of time.
As far as my discount rate, I always use the company's WACC now. This site says Intel's WACC is only 10%. Using this website, which uses an alternative method, I get 12%. So I'm compromising with 11%. I'm starting my current free cash flow in between the levels I get based on the two different methods (standard vs. Greenblatt) for calculating past free cash flow growth.
Under these assumptions, Intel is fairly valued today if you assume it will grow free cash flow at only a 4% rate for the next ten years, followed by my standard 2% perpetuity growth that I give to all stocks.
That 4% annualized growth is less than half what it managed over the last nine years, even using the more conservative calculation of free cash flow. If you think as I do, that part of Intel's recent capital expenditures have been investments in new growth that will pay off, and that the Greenblatt method is therefore at least partially appropriate, this assumption is only one-third of what the company's true free cash flow has been in the last four years, through the greatest recession since the Great Depression.
In other words, I think the market is essentially pricing in stagnation related to the questions I quoted above from the conference call.
Blending my various measures of historical growth, I am assuming Intel can grow at an 8% rate for the next decade. The sheet currently reflects this assumption, which in my view is reasonable, given Intel's previous growth, and given the much higher recent free cash flow that the Greenblatt model indicates over the past four years. Using this measure, Intel is currently worth between $28.33 and $42.49 per share, with a targeted valuation of $35.41. Based on that targeted valuation, the stock is a buy today, as it is under $28.33, providing a greater-than-20% margin of error to my best considered guess as to the true value of the company.
Conclusions: I hope I have both clearly articulated the reasons for my bullishness on Intel, as well as the reasons why I worry about it. All investments should be thought of in terms of valuation, and risk of loss. In my view, Intel still presents an extremely compelling risk/reward profile at these prices, just as it did two years ago, and three years ago.
This puts me at odds, note, with both S&P and Morningstar, both of which only rate Intel as a three-star hold. So do your own diligence! I would like to note, however, that in their latest research notes, neither of those esteemed organizations appears to premise their valuation analysis on a discounted free cash flow analysis. Rather, Morningstar and S&P are performing market-comparative valuations versus the rest of the sector. In other words, they are using the relative appraisal method, looking at things like sector P/E ratios.
This is similar to appraising a house by comparing it to nearby houses, versus appraising a house by estimating how much rental cash flows it could produce. A "relative appraisal method" just does not work if, as I believe, the entire sector is undervalued, just as relative appraisals of houses were totally meaningless during the recent housing boom, since the entire universe of comparables was overvalued. I think we all remember how that turned out.
P.S. One final thing to note. On April 19, 2012, CEO Paul Otellini exercised options for and then sold $53 million in stock. That is a pretty serious slug of money, folks. That is not something you want to see a CEO doing. Note that it took place two days after the April 17, 2012 earnings call....
I sure hope the "real" analysts ask about that in the next conference call! Famed fund-manager Peter Lynch always says that it is very standard for executives to exercise stock options and sell them. He does not view exercises and sales as particularly negative. He does however view purchases of large amounts of stock by insiders to be wildly bullish. I am choosing not to treat this as a big negative, but I really am not pleased about it either, not at all.