Most of the companies associated with PCs, laptops, notebooks, netbooks, operating systems, hard disks, microprocessors or the accessories used in these computers are not having a good time. The list of such companies includes the behemoths like Microsoft (MSFT), Hewlett-Packard (HPQ), Dell (DELL), Western Digital (WDC) and Intel Corporation (INTC). In this article, we are going to discuss some of the factors weighing down Intel's stock. Let's take a look.
The macroeconomic outlook and the fear of a global slowdown: The fact that consumers and businesses are still tight-fisted, the labor market is yet not reasonably recovered despite QE-1, QE-2 and QE-as-long-as-it-takes, the looming fiscal cliff in the US, the confusion over the austerity vs. Keynesian policies driven stimulated growth debate in the EU and the fear of a widespread global slowdown definitely impact Intel's business but they do not affect Intel alone. Nearly every multinational company is affected. Remember that if you are in the business for the long-term, you have to live with the business cycles (sometimes prolonged) and come out stronger. Intel has survived and has come out stronger from many recessions in the past and we do not see any reason it won't this time too. So in the long-term, we would not worry too much about these factors.
PCs cannibalizing tablets: The PC beyond any doubt is at a terminal decline but it's not dead yet, specially the mobile version i.e. the notebooks. It's common knowledge that the tablet has eaten away the PC's lunch to a large extent but it's not the end of the story.
- First of all, a tablet is not a serious content creation device. My household has two tablets (both are the iPads with the Bluetooth keyboards) but I'm still authoring this article on a notebook. Why, because it's more convenient and because that's where I have the serious productivity tools such as the MS Word editor, Excel spreadsheet, PowerPoint, various research tools and the information and data I need. Yes, I have seen many of the editors available on iPads but No, I shall not pick up an iPad for editing if both an iPad and a notebook are equidistant from me. I love my iPad but I can't type over 2000 words (which are roughly how long this article is) on an iPad even with the Bluetooth keyboard.
- As a consumption device, a tablet is OK for the most people. Most of the commonly used content work is absolutely fine or better on the tablets as a standalone app or as embedded web content. It's true that the content creators, who can afford to create or change their content for the tablet consumption, are doing so at ever-increasing pace; it's equally true that billions and billions of web pages in existence (and some which are still being developed) are designed for the bigger screens. We should realize that not every content creator has the resources to afford the good programmers who can create/convert their content for the smaller screens. I can't speak for everyone but I for one encounter hundreds of web pages everyday where clicking on hyperlinks remains a frustrating exercise, especially on the pages with the navigation menus having multiple links next to/over/under each other. While I don't claim to be Johnny Depp, I do not have fat fingers either so I don't think that I'm the only one suffering from the small form factor of the tablets. To summarize, in the near term I definitely see a need for the devices with a bigger screen especially in the enterprise world where Intel is a proven leader.
- Moreover the tablets for the most part are the developed world phenomenon. Consumers in places like India and China are a lot more price-sensitive. If they find "a" computer which does everything they need it to do, they will not buy an iPad from Apple Inc. (AAPL) or the Surface tablet from Microsoft costing twice as much. Of course, I'm discounting the techies, the affluent and the vocal minority with the penchant for any and all high-end show-off gadgets. These guys do not move the needle much for the device makers and the chip manufacturers. While I am not an expert in the computer shopping behavior of the consumers in India or China. I have lived in India for many years so I do have an advantage of some firsthand experience. It's extremely critical for the multinational businesses and the investors to understand how the consumers in other parts of the world behave, something which Home Depot (HD) learned the hard way. Take a look at the following to understand how unprecedented an opportunity we are talking about here.
Total Population (Millions)
Internet Population (Millions)
Internet Population Penetration
Untapped Population / USA untapped population
Numbers in Millions. Source: internetworldstats.com
As you can see that there is not much penetration left in the US while the users in China and India are just warming up to the vast resources of the internet, the knowledge and the empowerment it brings. In fact the untapped opportunity in India is 16 times and in China it's 12 times of the same in the US. These are mind-boggling numbers and KYC (Knowing Your Customers) can make or break the deal for you.
- And finally, as much as the PC, laptop, tablet makers or the chip manufacturers such as Intel wanted to penetrate the tablet market ever since Apple created it, they were severely hamstrung by Windows 8 unavailability. Apple owns the tablet market while the Android devices, the Kindles, the Nooks of the world are kind of like the "me too devices" and there is nothing beyond these. Windows 8 looks very promising for the tablets and we believe that it may become the strongest competitor for the iOS, if Microsoft can quickly build an ecosystem good enough to stand against Apple's. They already have the largest user base on the planet using any software or the system. They now have to come out with all the guns blazing to retain and win over this huge asset base.
The results and the outlook not meeting the market's expectations: This is as much a universal truth as there may be in the public equity market so no surprise if Intel got beaten up. Remember that the market says: "Hey, you may be a great business, increasing your revenue, income or the cash flow consistently year after year but if you don't meet or beat the expectations or issue the outlook warnings once in a while, you and your investors better hold on to something as I shall give you a rough ride." Just like the information, the money moves very fast in this time and age and once out, the smart money takes its own sweet time to get back in.
Intel has a lot of catching up to do with the chips better suited for mobile computing: This is a clear and present danger for Intel and this is where it underestimated the rivals such as ARM Holdings (ARMH), Qualcomm Incorporated (QCOM), NVIDIA Corporation (NVDA) or Samsung. The good news is that Intel has the IP, scientific know-how, brainpower, resources, industry relationships, scale and most importantly the willpower and execution capability of its management to steer it past the choppy waters.
To summarize, in our opinion the tablets, notebooks, Ultrabook and to a small extent PCs will co-exist for the foreseeable future. In this future, Intel will not be the dominant player in the tablet arena like it had been in the PC-Laptop arena but it will not be a non-player either. In fact with the addition of the patents and the technology from InterDigital (IDCC), QLogic (QLGC), Wind River, Havok, Fulcrum, McAfee and Intel's revitalized R&D in its own mobile technology, we believe that Intel will not only have a strong presence in consumer devices, it will also be a significant player in the tectonic shift towards the cloud based world with its enterprise and data center offerings.
Valuation: Now let's look at some numbers. Is the stock really undervalued? Looking at the following key data, Intel does look grossly undervalued right now. Take a look.
- Intel is trading at a 35% discount to its 5 years average low P/E multiple.
- It's trading at a 50% discount to its 5 years average P/E multiple.
- It's trading at a 25% discount to its 5 years average P/B multiple.
- It's trading at a 25% discount to its 5 years average P/FCF multiple.
- Based upon FY 2012 estimates, P/E multiple is under 10 which is one-third discount to the broad market.
- With Intel's gross margin consistently over 60%, operating margin consistently over 30%, net margin consistently over 20%, return on assets consistently over 17%, return on equity consistently over 26% and $10 billion in the war chest along with significant barriers to entry in the chip design and the manufacturing, the work is cut out for any potential competitor.
- At 4.1%, Intel has one of the largest dividend yields in the market at present, with no question marks over its sustainability. In fact if anything, it actually has ample room to grow, with the payout ratio at a paltry 34%.
- With the Long Term Debt to Capital ratio at 13%, the operating income being 200 times the interest payment and the liquid assets at over $10 Billions, Intel has a rock solid balance sheet.
- Intel is trading at an EV/EBITDA multiple of 4.5 at the moment which means that your cash on cash return is 22% which is 12 times the 10 years T-Bond yield at 1.77%
This kind of valuation is very attractive even from a private or LBO buyer's perspective, only that Intel as whole is too big a fish to swallow for any buyer. For such a mega cap company, the relative valuation is usually an exercise only to see where it stands compared to the other players in its industry. The fact that the whole industry may be over or under valued, in our opinion a better measure is a DCF valuation using the cash flow to the firm or the owner's earnings. We made some conservative assumptions such as the revenue growth rate for the next five years in the 5-6% range which in the years 6-10 wind down to under 2%, WACC in the range of 8-9% for the next 5 years and then inching up gradually every year to finally reach at 10% in the year 10, an effective tax rate of 28%, the 10 year T-bond yield at 1.77%, discounting the operating lease commitments for the next 5 years and beyond to the present value using a pre tax debt cost of 6% and adding them to the debt on the balance sheet and using the diluted number of outstanding shares at 5153 million as reported in the latest quarterly results, to calculate our DCF valuation.
Conclusion: Our DCF valuation shows an intrinsic value for Intel in the range of $30-$35 per share. This indicates an upside potential of 40-60% over the current price of $21.50. Now, even if the price travels halfway, we're still looking at 20-30% upside potential. And as a sweetener to the deal, while we are waiting for the mispricing to correct, we get paid over 4% per year as the dividend.
Additional disclosure: May initiate a long position in INTC in the next few days.