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Intel: Reward Outweighs Risk

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About: Intel Corporation (INTC)
by: Timothy D Gallagher
Timothy D Gallagher
Long only, value, long-term horizon, growth at reasonable price
Summary

Intel has a strong fundamental business even though growth may be slowing.

The company's shift towards data-centric businesses opens the opportunity for rapid growth in several areas.

At current prices, the reward outweighs the risk involved in investing in Intel.

Investment Thesis

Intel (INTC) is being valued as a slow-to-no-growth stock, but for no good reason in my opinion. The company remains a leader in its PC chip business and continues to invest in developing innovative processors. Meanwhile, it is increasingly directing efforts and cash towards newer, high-growth businesses such as data centers, autonomous driving, and 5G technology. At its current bargain valuation, I believe the risk-reward proposition for an investment in Intel is heavily skewed towards the reward.

Company Overview

Intel was founded in California in 1968 and since its inception has been a worldwide leader in the design and manufacturing of semiconductors and related technologies. For FY 2019, the company posted net income of just over $21 billion on revenues approaching $72 billion. It has been hovering around the $245 billion market cap recently.

The company operates through two main business lines: PC-centric (52% 2019 revenue) and data-centric (48% 2019 revenue). Management's open emphasis on transforming into a data-focused company has steadily shifted the business mix to more quickly growing areas over the last few years, and I expect this trend to continue looking forward.

Within the PC-centric business, the company mainly provides processors for end-user applications, such as laptops, desktops, 2-in-1s, and gaming systems. Revenues for this division have grown at a 4.09% CAGR over the last three years to $37.1 billion in FY 2019.

The data-centric business encompasses a wider variety of markets, with the Data Center Group being the biggest (~33% of total revenue), followed by its memory and storage offerings (~6%), and Internet-of-Things Group (~5%). Its data businesses also include Mobileye (~1%), of which I will talk more later but I consider to be especially promising. Revenues from data applications have grown at a 9.51% CAGR since 2016 to $34.8 billion in FY 2019.

PC-Centric Business And Competitors

Intel estimates its PC offerings compete for a total addressable market of $70 billion, of which it currently holds a significant portion. It primarily competes with AMD (AMD) in the x86 processor market and has lost market share over the last few years due to AMD's introduction of increasingly competitive products and a supply constraint for Intel in 2019, which likely turned some clients over to AMD.

Source: PassMark (x86 processors market only)

Despite the slowing growth in PC markets and the company's decline of market share, Intel is a giant ready and able to defend itself. Revenues in the division have increased each of the last three years - albeit very marginally in 2019 due to very strong 2018 numbers - and operating income has increased at an even faster pace to $15.2 billion in 2019. Additionally, the company generates substantial free cash flow, which it continuously plows back into R&D.

As it has recognized the increasing competition in the market, the company has accelerated the pace of new launches, as shown most recently by the introduction of the 10th Generation Intel Core vPro processors and the world's fastest gaming processor. While I am not specifically tech literate in this aspect and cannot speak to performance specifics, Intel has shown a real commitment to quickening advancements in its products. Together with its massive amount of free cash flow available for investing, I consider this a promising sign for future developments and will not rule out a return to glory in the PC market.

Data-Centric Business And Competitors

The combined addressable market of the businesses Intel operates with regard to data is estimated to top $230 billion, representing a significant opportunity for growth. For simplicity, I will discuss just a few areas that I believe are especially promising long term.

Data Centers

The Data Center Group has posted consistently strong results over the past few years, including 43% YoY revenue growth for Q1 2020. Along with that, segment operating income for the quarter almost doubled YoY from $1.8B to $3.5B. As cloud service and communications providers have upped capacity to meet demand caused by work-from-home policies, Intel has benefitted with strong sales and earnings growth. Looking forward, much of this growth in demand will continue over the long term, even if it slows in the near future, as it reflects a larger theme of increasing data needs. Most importantly, I believe Intel's results specifically are an indication of the company's expanding presence in the space and success in transitioning their focus. As needs for computing, storage, and network platforms increase, Intel will likely continue to see strong results.

In this area, Intel competes mainly with AMD and Nvidia (NVDA), but competition is growing each year as new entrants develop customized platforms for specific needs and current market participants create newer, more powerful products. Despite the fierce competition, Intel's size and established place offer an advantage due to their investing capabilities and embeddedness in the market. With a 50-plus-year history of innovation, I cannot see Intel losing the battle anytime soon.

5G

After divesting its 5G smartphone modem business, the company is now focusing solely on developing modernized network and edge infrastructure for the new 5G network. I believe the divestiture was a good move and shows company leadership is willing to accept a mistake and minimize losses while narrowing its focus to where the company can excel and create strong returns.

The 5G transition is expected to create dramatic improvements in network operating speeds, but with greater need for modernized critical infrastructure. With its expansive suite of products and platforms designed for 5G, Intel is poised to fill this hole, and the company's investments in 5G should pay off handsomely.

Mobileye

Mobileye is the leading provider of driving assistance and automation solutions. The division has experienced explosive growth since Intel's acquisition in 2017, almost quadrupling revenue in the two years since. Mobileye posted $210 million in revenue in 2017 and $879 million in 2019. Most recently, revenue increased $45 million for the first quarter, 21.5% growth YoY as automakers continued to adopt advanced driver-assistance-systems (ADAS). There will likely be a hiccup in this rapid growth due to the delays in car production caused by the coronavirus, but on the whole, I expect continued impressive growth from Mobileye.

As of 2018, the ADAS market was valued at $32.5 billion and projected to grow at a 12% CAGR to $74.5 billion by 2025. Mobileye has already increased market share each of the last two years, and if this trend continues, it could be a huge growth engine for Intel even though it currently represents only about 1% of revenue. In addition to the ADAS market, Mobileye targets the eventual development of commercially-viable robotaxis, the first step in the direction of fully autonomous vehicles. Increased adoption of ADAS and ever-growing investments in autonomous vehicle capabilities should continue to drive growth in Mobileye for the foreseeable future.

Source: Mobileye

Acquisitions And Size Advantage

Intel generates a large and growing amount of free cash flow yearly, which it consistently reinvests in the business to maintain its competitiveness. Intel also uses its size and cash flow to its advantage by purchasing smaller, potentially disruptive companies and either adding their power and capabilities to existing business units or allowing them to operate on a standalone basis.

The most recent example of this is Intel's $900 million acquisition of Moovit. Moovit is an Israel-based Mobility-as-a-Service (MaaS) company that provides an app to find the best route for travelers by combining a variety of transportation options, including ride-sharing, public transportation, and other services. Moovit has been added to the Mobileye business - which was acquired in 2017 - and will fast-track Intel's developments on the MaaS scene thanks to the addition of 6 billion anonymous data points collected daily from an existing user base of over 800 million people.

In 2019, the company acquired Habana Labs for about $2 billion. Habana Labs, also an Israel-based company, develops deep learning programs for data centers. This acquisition greatly enhances Intel's data center offerings, specifically on the artificial intelligence front. Navin Shenoy, General Manager of Intel's Data Platforms Group, had this to say regarding the acquisition:

This acquisition advances our AI strategy, which is to provide customers with solutions to fit every performance need – from the intelligent edge to the data center.

More specifically, Habana turbo-charges our AI offerings for the data center with a high-performance training processor family and a standards-based programming environment to address evolving AI workloads.

Habana Labs will sharpen Intel's products' AI capabilities and place the company in a good position to benefit from computing's move to the edge.

In general, acquisitions have allowed the company to purchase advanced and potentially disruptive technology and employ it in a manner that creates a product greater than the individual sum of the parts.

Financials

Intel has steadily grown its free cash flow, generating $16.9 billion of FCF in 2019 compared to $14.2 billion in 2018 and $10.3 billion in 2017. Intel holds about $12.6 billion in cash and short-term investments compared to about $36 billion in debt after the recent issuance of $10 billion in Q1 2020. The company's cash-generating ability and a Total Debt/EBITDA ratio of 1 make the debt nothing to worry about in my opinion. Intel also has a current ratio of about 1.75. To put it simply, the company is in strong financial shape, both short term and long term.

Risks

The main risk for Intel is, in my opinion, the recent loss of market share caused by the increased adoption of AMD's processors for platform products. AMD has steadily stolen market share by introducing cheaper and more effective alternatives to Intel's existing processors. Although this is a serious risk to the business, Intel operates with a somewhat wide moat as the leader in the industry, and any decline in its PC business will likely be slow and more than offset by growth in its data business. Any further loss of market share will not occur overnight due to the company's products being heavily embedded in the market, and Intel will have plenty of time to develop its own competitive alternatives, as it has recently shown a commitment to doing. Overall, I believe any future loss of market share will happen at a slow pace and, even if it continues indefinitely, will be offset by growth in the data business.

Similarly, the market for chips in general has become increasingly competitive recently, and numerous companies besides AMD could pose a threat to Intel. However, I believe this risk is slightly overblown due to the massive size advantage Intel holds. With regard to the amount of cash available for investing in new products or acquiring potential disruptors, there is no company that comes close. This large and consistent cash flow is the single biggest risk-deterrent factor in my opinion.

Another necessary consideration is Intel's recent struggles with supply and its ability to meet necessary orders from PC makers. However, the Q1 call alleviated some of my concerns on that front as the supply chain seemed to be up and running effectively, even in light of coronavirus-caused manufacturing disruptions. For the quarter, 90% of orders were met on time, which is a solid percentage before considering the exogenous impact of coronavirus, and a downright impressive percentage after. Overall, management seemed to be optimistic on that front, and the company should be able to meet continued strong demand for its products.

Valuation

Intel is valued at a fraction of the multiples of other semiconductor companies, even though it has grown the top line at 7.78% and earnings at an impressive 26.49% CAGR over the last three years. Below is a chart of some relevant valuation metrics for Intel and several peers.

(All data from SA as of May 16, 2020) TTM P/E EV/Sales EV/EBITDA Price/Cash Flow
Intel 11.30 3.51 7.24 7.18
Advanced Micro Devices 127.21 8.67 61.93 99.03
Nvidia 75.14 18.38 62.18 43.88
Qualcomm (NASDAQ:QCOM) 22.24 3.71 9.47 10.22

Although Intel may be experiencing slow growth in comparison to trendy names like AMD and Nvidia, the risk-reward for an investment in one of those names is skewed more towards the risk in my opinion as you are paying up-front for the potential of future growth. Intel, however, trades at a bargain price relative to its current business and operates in a few areas primed for growth in the future. At current prices, the risk-reward tradeoff for an investment in Intel seems to be heavily in favor of the reward.

Putting It Together

Putting all the pieces together, Intel seems to be a high-quality company that has lost favor in the market compared to competitors. Although it has surrendered market share in some operating markets recently and is facing a few headwinds on that front, there are numerous other opportunities for growth ahead, yet investors seem to only be considering the downside case. Intel is a household name that powers much of the world's computing needs, and it will not rapidly be replaced in all aspects of its businesses. As the company fully pivots to a data-centric focus, it will likely continue to excel and deliver results for shareholders. In comparison to the sky-high valuations of competitors, an investment in Intel almost seems like buying the current business at an attractive price and getting the potential for growth free.

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.