Intel (NASDAQ:INTC) is one of our favorite companies. The firm is a holding in both newsletter portfolios, and we think its M&A pipeline is robust, with Altera (Pending:ALTR) being at the top of the list. We're big fans of Intel's capital allocation plans as it generates incremental value by scaling back capital spending, which coincidentally supports its robust dividend and yield. It's hard to bet against the firm in mobile, and recent news has suggested it is making inroads against dominant player Qualcomm (NASDAQ:QCOM) in Apple's mobile platforms. But what we most like about Intel is its dividend growth potential. The firm's Dividend Cushion ratio is a robust 2.4, and we think the company has years of dividend growth ahead of it. We don't think Intel's acquisition program will threaten payout expansion as it focuses on cash-rich entities.
Why We Think Intel Still Wants Altera
Note: The following is a modified excerpt from Valuentum's Tumblr page. Technical material is sourced from Altera's regulatory filings:
Important things you need to know:
- Merger talks between Intel and Altera appear to be ongoing, according to the New York Post. There are a few reasons why this would be a strategic win for Intel.
- Altera is one of the top standard cell ASIC (application-specific integrated circuit) suppliers in terms of revenue. Due to the rising cost of transistors, however, the ASIC and ASPP (application-specific standard product) models have come under pressure as of late.
- Altera's response has been to position itself as one of the two largest manufacturers of field-programmable gate arrays, FPGAs, a sub-segment of programmable logic devices (PLDs) that have much better economics than either ASICs or ASPPs and are poised to displace legacy technologies, almost across the board (ASSP, ASIC, DSP, MCU, CPU, and GPU).
- By most estimates, the ASIC and ASSP replacement opportunity alone offers growth that's twice as fast as the overall semiconductor industry, something Intel wants.
- Altera brings to the table a complete FPGA portfolio (Generation 10), from the Max 10 (refresh CPLD/low-end) to the Arria 10 (mid-range markets) and the Stratix 10 on the high end. Altera estimates that the PLD (FPGA) market was nearly $5 billion in 2014, but the combined portion of the ASIC and ASSP markets that was accessible for PLD displacement was over $50 billion, revealing the tremendous growth potential of PLDs (FPGAs). Altera's Stratix Series already cooperates with Intel 14nm Tri-Gate technology, offering customers double the performance gains in most cases.
- In a recent Intel presentation, the tech behemoth showcased the significant cost per transistor savings in its 14bnm TriGate technology. The new HyperFlex core fabric architecture results in a level of performance and power efficiency that's unmatched by any existing FPGA architecture, according to the firm.
- As for Altera on a standalone basis, the company's economic returns have been great as of late, with the company's operations registering a very attractive Economic Castle rating. From a financial standpoint, free cash flow is robust, and the company is targeting healthy gross (67%-70%) and operating (33%-34%) margins over the next several years.
- Altera's cash flow from operations has expanded to ~$670 million at the end of 2014 from ~$590 million at the end of 2014 while capex has hovered around $40-$60 million. The firm's total cash stood at ~$2.6 billion at the end of 2014, relative to total long-term debt of ~$1.5 billion.
- Altera's strong financial health is exemplified by the fact that it has raised its dividend three-fold since the end of 2008. The strong cash-flow generation and excess cash would help pad Intel's dividend growth prospects.
Intel's Investment Considerations
• Intel's business quality (an evaluation of our ValueCreation and ValueRisk ratings) ranks among the best of the firms in our coverage universe. The firm has been generating economic value for shareholders with relatively stable operating results for the past few years, a combination we view very positively.
• Intel designs and manufactures advanced integrated digital technology platforms, which are used in PCs (including Ultrabooks), servers, tablets, smartphones, automobiles, automated factory systems and medical devices. The company has been rumored to be interested in buying either Altera or Broadcom (BRCM).
• Intel has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 21.6% in coming years. Total debt-to-EBITDA was 0.6 last year while debt-to-book capitalization stood at 19.7%. The firm's dividend growth potential is solid, in our opinion.
• Though many fear Intel will be left behind by the mobile revolution, we think those worries are overblown. Intel will spend billions on research and development in the coming years, and we expect the company will become a viable competitor in the mobile space. Look for the firm to dislodge Qualcomm in a number of new wins.
• Intel recently decided to scale back its capital spending, and we think the move offers nice support to our cash-flow-derived intrinsic value estimate. Its gross margins have been holding up well, and server growth has been solid.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Intel's 3-year historical return on invested capital (without goodwill) is 31.2%, which is above the estimate of its cost of capital of 9.4%. As such, we assign the firm a ValueCreation rating of EXCELLENT.
In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid gray line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Intel's free cash flow margin has averaged about 18% during the past three years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Intel, cash flow from operations increased about 21% from levels registered two years ago, while capital expenditures fell about 9% over the same time period.
Our discounted cash flow model indicates that Intel's shares are worth between $30-$46 each. The margin of safety around our fair value estimate is driven by the firm's LOW ValueRisk rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $38 per share represents a price-to-earnings (P/E) ratio of about 16.4 times last year's earnings and an implied EV/EBITDA multiple of about 8.1 times last year's EBITDA. Intel is trading at $33 and change, so we see upside based on our fair value estimate.
Our model reflects a compound annual revenue growth rate of 3.2% during the next five years, a pace that's higher than the firm's 3-year historical compound annual growth rate of 1.1%. Our model reflects a 5-year projected average operating margin of 28.1%, which is above Intel's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2% for the next 15 years and 3% in perpetuity. For Intel, we use a 9.4% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $38 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk rating sets the margin of safety or the fair value range we assign to each stock.
In the graph above, we show this probable range of fair values for Intel. We think the firm is attractive below $30 per share (the green line) but quite expensive above $46 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Intel's fair value at this point in time to be about $38 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Intel's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes also is subject to change over time should our views on the firm's future cash flow potential change. The expected fair value of $46 per share in Year 3 represents our existing fair value per share of $38 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way but from the upper and lower bounds of our fair value estimate range.
In the spirit of transparency, we reveal the performance of the Valuentum Buying Index, our stock selection methodology in a case study of the ratings spanning September 2013 through September 2014. Past results are not a guarantee of future performance.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: INTC is a holding in both newsletter portfolios.