Intel: A Value Play In A Growing Industry

Summary

• The semiconductor industry has very good growth prospects, both from cyclical factors (the chip shortage) as well as secular growth trends.
• Intel is underperforming its peers and this is not expected to change soon, while its recent push for the foundry business may succeed in the medium term.
• Intel has a higher dividend yield than peers and a discounted valuation, a good combination for long-term investors.

Photo by JHVEPhoto/iStock Editorial via Getty Images

Intel (NASDAQ:INTC) is not currently a growth company, but its valuation seems to be too much depressed and more similar to value sectors, such as financials or energy. For long-term investors that are willing to wait for a turnaround of its business, Intel may offer good value in a time frame of 3-5 years.

Business Overview & Strategy

Intel was founded in 1968, has a market capitalization of about $230 billion and trades on the NASDAQ stock exchange.

The company reports its business mainly in two segments, namely PC-centric and Data-centric businesses. The company has agreed in 2020 to sell its memory business to the Korean company SK Hynix, which means that it will be only focused on the logic chip segment in the future, where long-term growth prospects are stronger.

Intel is quite strong in the PC desktop market, but this is a segment that is in structural decline while growth comes mainly from new areas like artificial intelligence, high-performance computing, 5G network transformation, beyond other new technological developments. This means that demand for chips should remain quite strong for many years and Intel is adapting its business from a CPU to a multi-architecture xPU company.

This secular growth trend was accelerated by the coronavirus pandemic, with demand for smartphones, tablets, laptops and other products increasing rapidly, while supply is not exactly catching up leading to the current chip shortage. This is something that may take some time to balance as new factories take time to build but, beyond the current shortage, demand for chips is expected to remain strong over the next decade, leading to a recent strategic change from Intel.

While the company scaled back the production of chips some years ago, it has now decided to return to the foundry model, which means that instead of relying on third-party suppliers to produce some of its chips it will now also produce chips for itself and for customers. In this foundry segment, it will be in competition with the market leader Taiwan Semiconductor (TSM), but Intel is years away from TSM from a technological standpoint which raises some questions about this strategic move.

Indeed, as I’ve analyzed previously on “Should You Buy Taiwan Semiconductor Stock?”, TSMC is the most advanced manufacturer in the world, with technology capable of producing the smallest chips nowadays, 7-nanometer (nm) and 5nm nodes, while Intel’s technology is only at the 10nm nodes and has suffered some setbacks in the 7nm process. Moreover, TSMC is already developing its 3nm process and expects to start mass production of this technology in the last months of 2022, while Intel expects to reach 3nm only by 2025.

This means that Intel doesn’t seem to be capable of competing with TSM for a few years, especially in the smartphones and high-performance computers segments which represent the vast majority of TSM’s production, and is targeting more the automotive sector for chip production. This makes sense from a cyclical perspective, as the automotive sector has been especially hit by the chip shortage, but also from a strategic point because it would make Intel to directly compete with companies like NXP Semiconductors (NXPI) or Infineon Technologies (OTCQX:IFNNY), having therefore a higher probability of success.

Nevertheless, this push from Intel to become a global foundry player also seems to be politically motivated, as both the U.S. and Europe want to increase their market share of semiconductor production over the next decade, and the company is expected to receive significant incentives and subsidies to build its factories. Therefore, even though Intel has announced a $20 billion investment in two factories in the U.S. and is also pushing for a factory in Europe, the net cost of these investments should be lower for the company, making this push quite interesting from a financial standpoint as the risk is clearly shared with the different governments.

Taking this backdrop into account, Intel’s strategy seems to make sense, even though I don’t expect it to become a leader in this field for at least the next 4-5 years, but it has tailwinds from a growing industry and the timing seems to be right due to the current chip shortage. However, I don’t expect this foundry push to lead Intel to become a high-growth company, but should have a positive impact on its revenue growth by 2023 and in the years ahead.

Financial Overview

Regarding its financial performance, Intel has a positive track record given that it has reported positive growth figures and a good level of profitability over the past few years, even though it has underperformed the overall semiconductor industry growth. Intel’s compounded annual growth rate (CAGR) from 2016-2020 was 7%, while revenue CAGR at its data-centric business was 9% and should continue to be the segment with higher growth rates in the near future.

Source: Intel.

More recently, Intel’s revenues amounted to $77.9 billion in 2020, an increase of 8.2% from the previous year. Even though the company also benefited from the stay at home move, its revenue growth was lower than the overall semiconductor industry growth (+10.4% YoY), due to its large size and product mix.

For instance, Intel has a very good position in desktop PCs, but this is a segment that is declining as consumers prefer laptops or tablets, explaining why its revenue growth was much weaker than compared to some of its peers, given that Advanced Micro Devices (AMD) reported annual revenue growth of 45% YoY or NVIDIA (NVDA) that reported revenue growth of 53% YoY.

Its gross profit was $43.6 billion, representing a gross margin of 56%, the lowest level in the past five years. This is a worrisome trend, considering that Intel’s gross margin was close to 62% in 2018, showing that gross margin has deteriorated considerably in recent years. The major headwind for Intel’s gross margin in 2020 was the higher platform unit cost from increased mix of 10nm products, a similar trend compared to 2019.

Its recent push to become a global foundry player will not help its gross margins, taking into account that TSMC has lower gross margins than Intel right now, thus its recently created Intel Foundry Services division should report below-average gross margins within the group. Therefore, gross margins should remain under pressure for some time and a return to 60%+ margins is not likely in the next few years.

Regarding costs, Intel invests a lot on research and development (R&D), which is key to maintain technological leadership over the long term, with R&D expenses amounting to $13.6 billion in 2020, or 17.4% of total revenue. This R&D budget has not changed much in recent years and is likely to be maintained at these levels, or even be increased, in coming years.

Source: Intel.

Its net profit was near $21 billion, practically unchanged from the previous year, as lower gross margin offset the company’s revenue growth. Its EPS was $.94, an increase of close to 5% YoY, due to a lower number of shares outstanding.

During the first quarter of 2021, Intel’s revenues were $18.6 billion, flat compared to the same quarter of 2020, while its gross margin was 58.4% (vs. 64.4% in Q1 2020). Its operating margin declined to 39% (vs. 43% in q1 2020) and its EPS was $1.39, down 1% YoY. These are relatively weak numbers during a good period for the semiconductor industry, which clearly show that Intel is struggling to grow its business, especially in the PC and notebook segments that are reporting weak pricing. Even its data-center group reported lower revenues (-20% YoY), which has been its major growth engine in the recent past.

Growth & Capital Returns

This weak operating momentum is not expected to turn around soon, given that Intel’s guidance is for revenue decline of 2% in Q2 2021 and gross margin of 57%, while for the full year expects revenue of $72.5 billion (-1% YoY), gross margin of 56.5% (-3 percentage points excluding the NAND division) and EPS of $4.60 (-10% YoY).

This means that Intel’s business prospects are weak and, according to analysts’ estimates, are not expected to change much in the next couple of years. Revenues are expected to be around $73 billion both in 2021 and 2020, while only by 2023 is it expected to achieve the same level of 2020 (about $76 billion). By 2023 is when theoretically its recent push to the foundry business should start to bear fruits, as fabs take some two years to build, and revenues should ramp up thereafter to $81 billion in 2024 and $85 billion by 2025.

Regarding its balance sheet, Intel has a good position and a very good cash flow generation capacity, enabling it to return the vast majority of its earnings to shareholders. Indeed, its free cash flow amounted to $21.1 billion in 2020 and the company returned $19.8 billion to shareholders, through $5.6 billion in dividends and $14.2 billion in share buybacks.

Source: Intel.

This means that one of the most positive factors of Intel’s investment case right now is its shareholder remuneration policy, particularly its dividend that is clearly safe and should continue to grow gradually over the coming years, despite its higher capital expenditures expected in the near future, with the company repurchasing a lower amount of its own shares during its upcoming investment phase.

Intel’s current quarterly dividend is $0.3475 per share, or $1.39 per share annually, which at its current share price leads to a dividend yield of about 2.42%. Even though this is not a high-dividend yield, it is above-average within the semiconductor industry (1.12% on average for its peer group) making Intel an interesting income play in its sector.

Conclusion

Intel is struggling to grow its business and this is not expected to change much in the next 1-2 years, only by 2023 its recent strategic push into the foundry business should start to boost its top-line and profits. Considering that the semiconductor industry is currently facing a very good momentum due to the chip shortage, Intel is not clearly one of the main beneficiaries of this cyclical growth.

This explains its discounted valuation, considering that Intel is trading at very low multiples compared to its closest peers. Intel is trading at only 14x forward earnings (GAAP earnings), a very undemanding valuation, at a 55% discount to its peer group.

Source: Seeking Alpha.

Therefore, for long-term investors, Intel can be an interesting value play expecting its business to turn around in the coming 3-5 years, while earning a higher dividend yield than compared to most technological companies.

However, for me personally, I think TSMC and ASML (ASML) are better choices in the semiconductor industry, benefiting both from cyclical and secular growth trends, plus enjoying technological leadership in their businesses that are strong supports for many years of above-average revenue and profit growth.

These two companies represent some 35% of my personal portfolio and for the time being I’ll pass on Intel, even though it will remain on my ‘watch list’ and may enter a position as a turnaround play in the coming months, if its operating momentum starts to show signs of improvement.

Analyst’s Disclosure: I am/we are long ASML, TSM. 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.