Introduction
Despite a decrease in earnings for 2012, Intel (NASDAQ:INTC) remains a great company that is priced as a mediocre one. They have an operating margin of 29%, and a ROI/ROA of 26% and 18%, respectively. Given those great numbers, one would expect a high P/E, but the truth is that Intel is actually trading at a discount compared to its peers, as the P/E ratio is only 11.1 compared to the industry average of 15.
Thus, in the below analysis, I will argue why Intel is not only undervalued on a multiple basis, but on a DCF basis as well.
Methodology
In this analysis I will value Intel through a discounted free cash flow model. I estimate 5 factors:
- Future revenue growth
- Adjusted operating margin
- Tax rate
- Sales/capital ratio
- WACC
The future revenue growth and adjusted operating margin are estimated by a detailed analysis of the operations of the company, historical growth rates, and estimates by analysts and management. The adjusted operating margin is calculated as: "Accounting operating margin + Depreciations", as depreciations are purely an accounting number and not particularly relevant in valuation.
To calculate the free cash flow I deduct the capital that the company invests each year from the after tax operating profit. I estimate the capital invested by assuming an appropriate sales to capital ratio that the company will obtain in the future, where capital is calculated as: "Equity + Debt - Cash + Accumulated depreciation". This ratio tells us how much revenue the company generates in relation to how much capital (both working capital and long-term capital) the company has invested. A capital to sales ratio of below 1 tells us that for each $1 invested in capital, revenue rises by an amount less than $1.
The tax rate is typically set equal to the historical effective tax rate, and WACC is calculated through the CAPM method.
Revenue growth rate
Click to enlarge images
Source: Morningstar.com
Intel has averaged a CAGR of 7.94% in revenues from 2002-2011. Most of that growth actually came from the 2009-2011 period (where revenues increased by 53%). The primary driver behind the growth (the below graph) was increased sales in the Asia-Pacific region.
Source: Intel, 10K 2011
In the below tables I have listed the net revenue on a division basis.
Source: Annual reports, own calculations
The PC Client Group was able to increase its revenues primarily due to higher platform notebook unit sales and higher average selling prices. In 2012, the growth rate has (so far) slowed significantly down to only 3% a year.
The Data Center Group experienced higher revenues in 2011 due to significantly higher server unit sales and higher selling prices. It seems that the Group has continued its momentum in 2012 (Q1 + Q2), as revenues are up by 14%.
Revenue for the Other Intel Architecture Group includes Mobile Communication, the Intelligent systems Group, the Netbook and Tablet Group and the Ultramobility Group. The increase in revenue is primarily due to the acquisition of Infineon in 2011. This increase was partially offset by lower unit sales in the Netbook and Tablet Group. In the first half of 2012, revenue has so far increased by 3%.
The software and service division was almost a non-factor prior to the acquisition of the security technology company McAfee in 2011. This acquisition should be viewed as an important part of Intel's mobile wireless strategy, as it assures customer and consumer's security concerns.
Combined outlook for 2012
Management estimates that revenues will increase by 3-5% in 2012. This seems to be a slightly conservative estimate, as revenue so far (in 2012) has already increased by 5.1%. I estimate that Intel will grow revenues by 4.5% in 2012.
Combined outlook for 2013-2021
Determining the outlook for an 8-year period always presents a challenge. Will Intel come out on top in the competition against ARM Holdings (NASDAQ:ARMH)? Can Intel expand their business to new segments through acquisitions like they did with McAfee? What about the macroeconomic environment? Management has been primarily "blaming" the disappointing macroeconomics for not reaching double digit growth in 2012-but is double digit growth even realistic after 2012?
Regarding the last question, I highly doubt so, as I believe the market for notebooks and PCs has topped out. Therefore, if Intel wants to increase revenues, they need to do very well in producing chips for Mobile devices. Intel definitely has the resources available to be a big player in the future, but there are a lot of uncertainties (currently, critics of Intel mobile chips argue that the life of their batteries is too low). Therefore, I would prefer relatively conservative estimates.
I estimate that Intel will grow around 5% a year from 2013-2021. In the terminal period I calculate that revenues will increase by the same rate as the risk free rate: 2.5%.
Operating margin
Source: Morningstar.com, Annual reports, Own calculations
The average margin from 2007-2011 was 38%, and the margin improved significantly over the last 3 years. In 2012 (Q1 and Q2), gross margin improved to 63 %, and is expected to be 64% at the end of the year. But R&D and marketing expenses have gone up as well, which lowered the adjusted operating margin to around 40% in the first half of 2012, from 43% in 2011.
I estimate that Intel will have an operating margin of 41% in 2012, and 41% also seems to be a fair estimate for 2013. The ratio will decline gradually from 2014 to 2021, where it will be 30%, which is the ratio I use for the terminal period. The relatively low margin for the terminal period can be explained by my expectations of more intense competition in the future.
Fair value of Intel
Assumptions
- WACC = 10.22%
- Tax rate = 27%
- Future Sales to capital ratio = 0.8
As one can see in the below table, I estimate that the fair value of Intel is 32, which is around 25% above the current price.
Terminal value | 218992 |
PV(Terminal value) | 82731 |
PV (CF over next 10 years) | 79678 |
Sum of PV | 162409 |
Debt | 7300 |
Cash | 14837 |
Value of equity | 169946 |
Number of shares | 5308 |
Estimated value /share | 32 |
Price | 26 |