By The Valuentum Team
The Intel (NASDAQ:INTC) "story" continues to be misunderstood, in our view. The company is growing, and its traction in mobile has been noteworthy, making ongoing gains against rival Qualcomm (NASDAQ:QCOM). Intel is also navigating the difficult PC market well, and strength in data center, the Internet of Things and programmable solutions will pave the way for ongoing company-wide expansion. Unlike the IBM's of the world where revenue is in free-fall, Intel is not struggling, and its purchase of asset-light, free-cash-flow rich Altera was a very savvy move, even though it has strained the balance sheet a bit. By our measures, long- and short-term debt stood at ~$25 billion at the end of the second quarter, slightly higher than the sum of total cash investments and marketable equity securities (~$23 billion). Management said on the conference call that it expects to improve its net cash balance over the second half of the year, however.
Though restructuring charges associated with layoffs muddied accounting earnings, Intel delivered where it matters. The chip giant hauled in $3.8 billion in operating cash flow in the period, more than 3 times what it paid out in dividends, and the company is buying back its undervalued stock hand over fist. We love Intel's dividend growth potential (it sports a Dividend Cushion ratio of 2.6), and we have no qualms with management scooping up its equity on the cheap. During the quarter, the company repurchased ~26 million shares and still has a whopping ~$7.8 billion remaining dollars authorized for buyback.
Trading at less than 15 times current-year non-GAAP earnings estimates, Intel is a rare bargain in today's overheated equity market and has a nice ~3% dividend yield to boot. The company last upped its dividend payout 8%+ in January of this year, and we expect many more years of dividend increases to come. Free cash flow generation at Intel is tremendous, and management aims to please. We think convergence to our estimate of intrinsic value (found in the 'Valuation Analysis' section of this article) may happen sooner than later at the company, even if it has a few tough trading sessions following these second-quarter results. It could very well hit multi-year highs before the year is up.
Intel's Investment Considerations
• 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 recently completed the acquisition of Altera in a near-$17 billion deal.
• Intel's merger with Altera enables it to compete in new classes of products in its high-growth Data Center and Internet of Things segments. The deal is expected to be accretive to non-GAAP EPS and free cash flow in 2016.
• 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.
• Apple will reportedly use Intel modems in 2016 iPhones aimed at emerging markets, helping Intel take iPhone share from rivals. Intel remains confident in the resurrection of PC demand, as it estimates that it has an opportunity to replace ~1 billion PCs that are >3 years old in the near term.
• The strength of Intel's dividend is noteworthy, even as it posts a yield near 3%. Though the deal with Altera has absorbed some of its cash, Intel's Dividend Cushion ratio remains very healthy and is well above 2.
Economic Profit Analysis
In our opinion, 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 31.8%, which is above the estimate of its cost of capital of 9.2%. 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 grey 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 19.4% during the past 3 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 decreased about 8% from levels registered two years ago, while capital expenditures fell about 31% over the same time period.
Intel's Dividend Cushion ratio is among the best in our coverage after considering the size of its annual dividend yield (~3%).
We're huge fans of Intel's dividend growth prospects, and we include it in the Dividend Growth Newsletter portfolio. The firm recently completed its acquisition of Altera in a near-$17 billion deal, which enables it to compete in new classes of products in its high growth Data Center and Internet of Things segments. These two segments will be areas of focus for the company moving forward, and it expects to continue to allocate additional resources to the divisions as it cuts spending in the areas of software, PC, and phones/tablets. We like the strategy and expect Intel to be able capture future customer needs with ongoing innovations. The firm's tremendous free cash flow generation will continue to be the basis of its dividend strength.
After considering the typical operational risks of a company in such a competitive and rapidly-evolving industry, perhaps the largest threat to material future dividend growth for Intel is its weakened balance sheet. In the first quarter of 2016, the firm's cash and cash equivalents position fell to ~$3.1 billion from ~$15.3 billion, and its net cash position swung to a net debt position as a result of the Altera merger. Though we do not like the deterioration of its balance sheet strength, we continue to have faith in Intel's free cash flow generation, and the Altera acquisition is expected to be accretive to free cash flow immediately. All things considered, we like what the deal does for the company on a long-term basis, even if it may impact dividend health in the near term.
We think Intel is worth $42 per share with a fair value range of $34-$50.
The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance. Our model reflects a compound annual revenue growth rate of 3.4% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 1.2%.
Our model reflects a 5-year projected average operating margin of 27.4%, which is above Intel's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 1.9% for the next 15 years and 3% in perpetuity. For Intel, we use a 9.2% 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 $42 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 were 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 $34 per share (the green line), but quite expensive above $50 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 $42 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 is also subject to change over time, should our views on the firm's future cash flow potential change.
The expected fair value of $51 per share in Year 3 represents our existing fair value per share of $42 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.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.