Intel (INTC) announced last week that it expects weaker third quarter results. It said that it expects third quarter revenues of $13.2 billion, lower than the original management's expectations that range from $13.8 billion to $14.8 billion for the quarter. The giant chipmaker has been battling with declining demand in laptop computers as consumers shift their spending to smartphones and tablets. Intel is not ready to succumb to these pressures. It responded with a heavy campaign to promote its new line of products called Ultrabooks.
Despite these efforts, Ultrabook sales have been disappointing. According to this BusinessWeek article, the Ultrabooks accounted for 5% of all laptops sold for the second quarter. The key issue here is the cost of producing one Ultrabook already accounts for 25% of the total costs. This has driven its prices to above $1,000 per unit, resulting in lower sales.
There are speculations that consumers are waiting for the Ultrabooks and tablets under Microsoft's (MSFT) Windows 8 platform. The operating system is expected to be available in October. But, some analysts have noted that Intel should be seeing decent demand ahead of the launch and the Ultrabook units that goes with it. I believe that companies are holding off their purchases until Microsoft launches its newest platform. It could be too early to assume if the slowdown is permanent unless I see actual figures in third and fourth quarter.
Inventory in the second quarter were at a multi-year high, suggesting lower factory utilization and gross margins in the coming quarters. Intel confirmed that its customers have been reducing inventory in the supply chain notably in the enterprise PC market segment. Moving forward, the PC makers like Dell (DELL) and Hewlett-Packard (HPQ) are expected to cut their prices on old inventories. This will definitely translate to better unit sales and overall profitability despite lower margins. For example, Dell recently dropped the price of Inspiron to $700 and Lenovo have decided to price its super thin laptops at $720. As soon as their sales pick up, there is no reason for suppliers such as Intel to ramp up its production.
Short Term Pain for Intel
While the tough macroeconomic environment appears to be causing short term headwinds for Intel, this slowdown is temporary and cyclical. The microprocessor industry has been inherently cyclical. Intel has successfully proven that it can survive the ups and downs of its industry. Its steady financial performance through the years is a testament to its ability to withstand any stresses in the current environment.
It has grown its sales by 7.36% for the last 10 years. This translates to operating margins increasing to 32.4% in 2011, significantly higher than its operating margins of 16.4%. The increasing operating margins are due to a duopoly industry with Intel cornering 80% of the total market. The remaining 20% of the market goes to its competitor Advanced Micro Devices (AMD).
AMD have grown its sales by 5.37% for the 10-year period. Its operating margins have started to turn positive only in 2009. Since then, operating margins have averaged between 5% to 12%. The difference between AMD and Intel is manufacturing as AMD is now using a "fab-less" design house. This resulted in lower costs and improved overall profitability. AMD has also shore up its balance sheet and stabilized its margins. This has resulted in better prospects for the company. Despite these improvements, there are still challenges moving forward. Intel is a strong competitor with huge economies of scale. It also has 8 times higher research and development spending than AMD, which leads to better product differentiation for Intel.
The silver lining is the strong performance of its server processor segment and data storage business. It has revenue growth of more than 15% a year from the demand of high-volume storage and better information technology infrastructure. Intel continues to invest in advanced technologies such as the first 3-D Tri-Gate transistor, which results in better performance at lower energy usage. This will translate to a sustainable competitive advantage of Intel over its future competitors. Also these segments will be the main key driver of the company given the drive towards cloud infrastructure, propelling the demand for the company's server chips.
Having said this, I expect that the softness in PC market appears a temporary situation. I also believe that the PC business is not dead given that the global PC demand has continued to grow in emerging markets. The average selling prices for microprocessors have risen by more than 9% in 2011. This is the highest level since 2007.
Intel Valuations Suggest Weakness Are Priced In
Intel is currently trading at 9.4 times forward earnings and 2.5 times book value. It also carries a dividend yield of 3.5%. On a historical perspective, this is significantly lower than its 5-year average earnings multiple of 17.1 times and dividend yield of 2.9%. At the current levels, the market is not valuing any growth on the company at all. I also believe that the market has already priced in a worst case scenario for the company. Investors are willing to pay up 1.2 times for its future earnings growth.
Other technology stocks are trading higher. Microsoft trades at 15 times earnings and carries a dividend yield of 2.6%. A closer comparison, IBM (IBM) is valued at 12 times earnings and has a dividend yield of 1.60%.
Meanwhile, AMD has lower valuations at 7 times earnings. But, this seems close to Intel. In terms of future prospects, Intel has better revenue growth this year and superior operating margins. It also has far more advanced technology and better strategy in the future. I believe the market is mispricing Intel at these levels as it has been bearish on the entire industry. Moving forward, demand will normalize and manufacturers will still go to Intel for the supply of its components. At present, investors are rewarded with modest dividend pay-out while waiting for these catalysts to happen.