Recently I've written several articles about large prominent tech companies which have fallen out of favor in recent years. In this article I'll take a closer look at another one of these companies - Intel Corporation (INTC).
Intel is a solid business with large competitive advantages that is currently trading near 52 week lows. The company has a trailing P/E of only 9.57, which is at the bottom of its 5 year range. Certainly this alone makes it an intriguing value play worth a deeper look. On top of this I believe the risks to the core business are overdone and the company is poised to start taking market share in mobile processors. Below I have outlined my thesis.
As of the end of 2011, Intel organizes its business into 5 main units:
- PC Client Group
- Data Center Group
- Other Intel architecture operating segments
- Software and services operating segments
- All other
The company is best known for its microprocessors running in desktop and laptop PCs both for consumers and businesses. This traditional core business falls mostly under the "PC Client Group", which currently makes up 66% of revenue. As shown below from the latest 10-K, the PC Client Group is by far the largest part of the business in terms of revenue. It should be noted though that the company continues to diversify, and is now making a more serious push into mobile architectures, which falls under the "Other Intel Architecture" group. As a result, the percentage of total revenue for the PCCG group has decreased from 71 to 66% in the past 3 years.
Percentage of Revenue by Major Operating Segment
(Dollars in Millions)
The following table shows the breakdown of operating profit for each of the 4 main business units in 2011:
|PC Client Group||Data Center Group||Other Intel Arch||Software and Services|
The largest divisions of Intel (PC Client Group, Data Center) are also the most profitable by far.
It should also be noted that if you look at the past few years prior to 2011, the whole business did very well since 2009, growing substantially after the great recession. During this period operating income increased from $5.7B all the way up to $17.5B - a more than 300% increase in only 3 years.
What Are The Risks To Intel's Business?
Although Intel has done quite well over the past few years as revenues and profits have increased, one of the most often cited risks to Intel is that the company was late to the whole mobile revolution. The processor market for tablets and smartphones is largely dominated by competitor ARM Holdings (ARMH). You won't find Intel processors in any of Apple's (AAPL) iPhones.
In addition to this, now in 2012 there is well documented softness in the PC market, which has a direct impact on Intel's core business. Both IDC and Gartner have recently said that PC sales dropped 8% year over year in September, which was the largest drop since 2001. Going forward there is continued uncertainty, as the growth of tablet sales continue to have some cannibalizing impact on PC sales.
Despite these risks, Intel remains in a very strong position going forward. I think that the company should definitely not be underestimated in its ability to grow market share in tablets and smartphone processors. In the past the company had always focused on building more and more powerful processors which in tern were quite power consuming. Smaller devices such as smartphones require much lighter and less power consuming chips. This change has required a fundamental shift for the company. The company has taken this seriously, and the CEO Paul Otellini hired Mike Bell in 2010 to take on this challenge (Bell is a former Apple insider). Bell has worked tirelessly the past 2 years to make the first viable phones running Intel chips. The single-core chip Medfield that is currently used has worked well. As of yet it has not caught up to offerings from Nvidia (NVDA), Qualcomm (QCOM) or Samsung (SSNLF.PK), but the company is working hard on the next generation. In 2013 they are expected to release a chip with roughly double the processing power. In 2015 a new chip about half the size of Medfield potentially four times as powerful and efficient. This is where competitors need to be worried - Intel's strength has always been its ability to outpace the competition with relentless R&D skill. Intel has always been unmatched at process technology - making designs faster, smaller, and more efficient in very short time cycles. I think it is only a matter of time that Intel will catch up and start to take meaningful market share.
This risk to the business is therefore in my opinion overblown, and has created a very good buying opportunity. A double bonus here has been the short term fears of PC sales that has helped to dropped the share price to 52 week lows.
Intel is Shareholder Friendly
With any potential investment, I always assess how friendly I believe the company management is towards shareholders. Even if the general business prospects seem good, it is important to check aspects such as this before committing your investment dollars. In the case of Intel, there are several points to like here:
- Intel has a juicy dividend yield of 4.0%.
- The payout ratio is only 37%. The company has also raised the dividend the past few years, increasing it about 40% from 2009 to 2011.
- The company has consistently repurchased stock. Outstanding shares have been reduced about 25% in 10 years, from 6.58B to 5.0B.
Intel's Competitive Moat
Intel has traditionally held a dominant market share in platforms used in desktops and laptops. The only serious competitor is Advanced Micro Devices (AMD), however in recent years they have become less of a threat. AMD peaked in the mid 2000s where they had more than 40% market share, but they have since dropped back into the high 20s in 2012.
Clearly this huge market share has led to competitive advantages. Indeed, Intel has a gross margin that is significantly higher than its peers - 64% vs. 28% for the industry as a whole.
In the smartphones and tablets space, as mentioned previously ARM is by far and away the market leader in chip design. The primary manufacturers are Qualcomm, Nvidia, and Texas Instruments (TXN). Here Intel clearly doesn't have a strong competitive position yet. However I think what's important to realize is that their moat is so strong in the established PC and server business, that this gives them a continued strong level of cash flow for years to come. Although PC sales may be weak, in no means is the PC "dead", and Intel will continue to make loads of cash from this part of the business. This cash they can easily channel into their world class research facilities to quickly gain an edge in bringing their mobile chips to a competitive position.
Intel is Conservatively Financed
Another reason to like Intel is that the company is in excellent financial health. The following table summarizes key balance sheet figures:
|Total Cash (mrq):||10.46B|
|Total Cash Per Share (mrq):||2.10|
|Total Debt (mrq):||7.16B|
|Total Debt/Equity (mrq):||14.52|
|Current Ratio (mrq):||1.93|
(Source: Yahoo! Finance)
With a debt/equity ratio of only 0.1452, Intel is in no danger of financial problems. This lowers downside risk on the company, and gives them even more time to transition their business to be able to profit more strongly from the mobile revolution.
Intel's Earnings Are Much More Predictable Than its Peers
One thing to be aware of is that the semiconductor industry has been notoriously cyclical. As the PC refresh cycle typically lasts a few years, the earnings of companies in this industry have largely risen and fallen with this cycle. One of the strengths of Intel is that it has such a dominant market share and a diversified enough business that it has been much less susceptible to these cycles. Earnings and FCF have been relatively consistent with steady growth the past few years, even when earnings growth in the industry actually declined. Here are a few figures which show this:
- EBITDA has grown an average 21% over the past 5 years.
- Free Cash Flow has grown an average of 15.7% over the past 5 years.
- In the same 5 year period, 64% vs. 28%.
The last point I want to make on Intel is that the company is clearly trading for an attractive price. I think this is especially true now that the company is trading near the bottom of its 52 week range. To illustrate this I have performed a simple DCF. I have used the following inputs:
- Current EPS: $2.31
- Earnings Growth Rate over 10 years: 5%
- Growth rate after 10 years: 0%
- Discount Rate: 6%
This gives me an intrinsic value of $37.40/share.
I think that 5% EPS growth is quite reasonable, especially considering the company has grown earnings over 17% in the past 10 years. I expect growth will slow significantly in the PC segment in the future, but there will remain strong demand in the enterprise server arena and Intel will gain market share in mobile. Combining this I think that 5% is a safe bet. Indeed, analysts have almost 12% growth estimates for the coming 5 years, and I always err on the side of conservatism when reviewing analyst estimates. With a current market price of $21.95/share, there is a margin of safety of 41% from my intrinsic value. The company P/E ratio of 9.57 being at the bottom end of the 5 year range, and a PEG of 0.87 are attractive as well.
I think Intel is definitely a buy at current prices. The company's strengths in R&D, and in particular process technology will make it a formidable competitor for mobile processors. In addition, Intel remains strong financially, and is a shareholder friendly company which pays a very nice dividend to help cushion any downside.
Now that Intel has successfully developed the Medfield chip, they will do what the company does best - perfect the process and make the next generation chips smaller, more energy efficient, and much more powerful. To the rest of the competitors which think they have Intel beat, I would caution them to look out, as I think the "sleeping giant" has woken up and is poised to come roaring back in a big way.
Disclosure: I am long AAPL.