Intel (INTC) is the world's largest chip maker, although recent news now suggests that two smaller competitors may be on its heels and gaining market share in newer and faster technologies. Intel currently holds 70% of the market for processors and historically has had a strong partnership with Microsoft (MSFT) supporting the Windows operating system.
On April 17th, Intel reported first quarter results and a strong outlook for the second quarter. Although Intel is already a giant of a company with a market cap of $128 billion, the company shows no signs of slowing growth and has a massive R&D budget to fund new technologies. Intel's ability to leverage this research budget will be the key to Intel's ability to maintain its status as a growth stock.
First quarter numbers show that Intel increased its R&D spend to $2.4 billion, which was 18.6% of its quarterly revenue. Intel also announced that in the second quarter of 2012, the company would launch Intel's first batch of chips designed for smart phones as well as ship a higher volume of products based on its 22 nanometer Tri-Gate technology. Success in the 22 nanometer space is critical if Intel is to be able to compete effectively against ARM Holdings (ARMH) for share in the rapidly growing business of smart phone chips.
The company also released forward projects for the company's general and administrative expenses for the second quarter 2012 of $4.6 billion. Assuming the ratio of R&D to MG&A remains the same in the second quarter as in first quarter, then the research and development spend would be an estimated $2.52 billion or the same 18.6% of revenues that was spent in the first quarter. Although the company is not ramping up research and development, it reducing it either. I believe this is a sign that the company is comfortable with its ability to compete and is not concerned about its pipeline of new products.
This week will be an exciting week for tech-savvy investors as the Computex trade show begins next week in Taiwan. Intel is expected to officially announce its new processing platform, code named Ivy Bridge, which is designed to work with new ultrabooks and to support Microsoft's highly anticipated Windows 8 operating software.
Ultrabooks are the newest version of laptops, bridging the gap between laptops and tablets and Intel has taken the lead in this segment. Many ultrabooks coming into the market are expected to have touch screens that fold back into a tablet format. Tablet computers are also expected to be among the highlights of the Computex show and are divided into two campuses: those that run on Microsoft's Windows and those that run on Google's (GOOG) Android operating system.
No competitor has released a product that is expected to dethrone Apple's (AAPL) iPad dominating market share in the tablet space. Intel is devoting increasing shares of its research and development dollars to this critical segment. Intel's new energy efficient Atom processing platforms such as the Cedar Trail and the Clover Trail will support Windows 7 on these thin machines.
Advanced Micro Devices (AMD) also has a new energy efficient platform called Brazos that can support Windows 7 and Android systems in tablet computers. I have to believe that competitors over time will simply not be able to spend at the level needed to maintain their technological lead over Intel. Intel's primary business remains personal computers and laptops and it controls a 70% share of the market.
Intel's personal computing business makes up approximately two-thirds of Intel's revenue. This stable stream of cash provides Intel some serious competitive advantages. The most important of which is that Intel does not need a first mover advantage. It can simply be second and then outspend the competition and eventually take the market if it so desires. In time, this is the likely path for smart phone chips and even Apple may find Intel to be a suitable partner.
ARM chips currently power Apple iPhones and iPads and reported 1.1 billion mobile phone chips shipped in the first quarter of 2012. Intel has not exactly ignored this space, but until recently it was too small to justify the research and development dollars. Intel has grown so large, that small niche businesses regardless of how successful simply will not move the profit needle.
The smart phone and tablet market has finally reached a size that justifies investment. Additionally, predicted growth rates in the tablet space make this a growing segment as well. Gartner predicts that global PC and laptop shipments will grow by 4.4% in 2012, while other estimates indicate that tablet computers sales will nearly double in 2012.
While AMD is a fraction of Intel's size and lacks the scale to significantly impede upon Intel's dominance of the microprocessor market, the company is focusing their own efforts on the tablet computer and ultrabook market. AMD recently announced it was launching a new series of chips designed specifically for super-thin and light laptops that are similar to Intel's ultrabooks, but with one marked difference - these new "Trinity" chips are significantly less expensive than Intel's new third generation chip.
Intel's high price point has been a sticking point for many computer manufacturers. It remains to be seen whether AMD is trying to start a price war in the personal computing space with its Goliath competitor or whether the company will focus on the low end of the market and target price conscious consumers.
I estimated Intel's equity value using two approaches: a dividend discount model and a relative value analysis. Intel's current dividend is $0.84 cents per share, which equals a dividend yield of about 3.30%. This is equal to a payout ratio of approximately 20% of operating cash flow and results in a value of $28 per share.
The company also aggressively repurchases shares of stock which is one method to return capital back to shareholders and increase the stock price. To determine the net effect of these repurchases on the equity value, I also took into account the issuance of stock as employee compensation and determined that the company is actually returning closer to 78% of the operating cash flow back to shareholders. I do not believe that this current rate of return of capital to shareholders is sustainable in the long term.
Intel currently trades at roughly a 10.66 price to earnings ratio. The stock has fallen along with the rest of the market. Its stock price is down 14.11% from its 52-week high. Assuming Intel would trade at a similar price to earnings multiple as the S&P 500, a 14 price to earnings ratio seems more reasonable and when based on 2011 earnings translates into a $34 per share value. However considering Intel's lackluster first quarter earnings year-over-year and a likely weak second quarter based on uncertainties in the US and Euro-zone, I believe this $34 valuation is high especially for a value investor.
There is some risk associated with Intel as future success will depend on continued R&D investments to innovate as the lead player in the market and stay ahead of the technology curve. Intel is currently trading at the mid-point in its 52-week range, close to $26 a share and I would be comfortable purchasing Intel at a 20% margin of safety to the $28 price estimate, which translates into a target purchase price of $22.40.