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The investment thesis
This article explains why we hold Intel Corporation (NASDAQ:INTC) in our retirement portfolio, and in particular, its near-term profit drivers and some of the key catalysts.
First, a bit of background of our overall strategy. As detailed in my earlier article, contrary to the popular advice of building "a" retirement portfolio or "the" perfect retirement portfolio, we always hold two portfolios. And we suggest you do the same at any stage of life. The issue with one portfolio is that, no matter how perfect it is, it's a big risk in itself. Always build two portfolios - one for short-term survival (e.g., a visit to the ER next month) and one for the long-term growth (e.g., take care of things when we are 90 years old and estate planning for kids and grandkids). Survival and growth risks are never the same and shouldn't be mixed up. Delineating these risks with a barbell model is diversification at a survival level.
Under this general background, INTC is a holding in our short-term portfolio (and our time frame for holdings in this portfolio is a few years). First, it generates an attractive and reliable current dividend income (the dividend yield is more than 2.8% as of this writing). Secondly, as you will see, INTC earns a very competitive return on capital employed (“ROCE”) at a fundamental level. Its profitability is projected to further accelerate based on the DuPont framework. And finally, its near-term profit drivers can benefit from some of the key catalysts (such as the fab initiative and the Mobileye IPO), offering very favorable odds for a potential annual return in the double-digit range.
The DuPont framework
The DuPont framework is a tool for analyzing profitability at a fundamental level. In practice, a few modifications are needed to make the original DuPont method applied to many modern businesses. These modifications are detailed in my earlier writings and summarized below to facilitate easy reference.
The original DuPont method is developed to analyze return on equity (“ROE”). And the first modification is that I will use the framework to analyze ROCE instead of ROE for two main reasons. The first one is that ROCE is more fundamentally important than ROE. And the second one is that ROE is not applicable to many modern corporations where their share equity is very small or even negative. And for this same reason, the second modification that I made here is that I defined leverage as the ratio between total asset divided and total capital employed, instead of the total asset divided by share equity.
With these modifications, through simple math, we can show that ROCE is just the product of three things, i.e.,
ROCE = PM x ATR x leverage
Where PM stands for profit margin and ATR for asset turnover ratio. These are the three knobs that management can turn to drive up ROCE.
INTC’s profitability drivers
Based on the above discussions, the following three charts show the three knobs for INTC over the past decade. As can be seen from the first chart, the profit margin has stabilized for INTC in recent years starting from 2017 in terms of operating cash. It has been very stable around the ~39% level. On average, the profit margin for the overall economy fluctuates around 8% and rarely goes above 10%. Of course, this is an average across all business sectors. Nonetheless, as a rule of thumb, 10% is a very healthy profit margin and 20% is a very high margin. So INTC’s near 40% is among the very high end compared to the overall economy. To put things into perspective, Apple (AAPL) “only” features a profit margin of ~30% in recent years.
Source: Author and Seeking Alpha data.
The second chart shows the ATR driver. The ATR measures how efficiently a company uses its assets to generate revenue. The higher the ATR, the better the company is performing, since higher ratios imply that the company is generating more revenue per dollar of assets. As seen, INTC’s ATR has been higher at the beginning of the decade, near 0.75. However, the ATR gradually declined to the current level of 0.5. Not only a far cry from its peak value but also lower than the historical mean of 0.57. It also lags other large-cap stocks. To put things into perspective, the ATR of Apple is currently at about 0.9 under Tim Cook’s leadership, a CEO known for his tremendous experiences and insights for streamlining operations. And the ATR for Amazon (AMZN), another business that relies on large-scale efficient operation, is about 1.2 in recent years.
However, ATR is a knob that management can consistently tweak to suit its operations. And as aforementioned, I am optimistic that INTC’s many new initiatives can help to improve its operational efficiency.
Source: Author and Seeking Alpha data.
This third and last chart shows the effective leverage. As seen, INTC’s effective leverage has also been quite stable around an average of 1.9 over the past decade. The leverage fluctuated in a relatively narrow range between 1.7 and 2.0 most of the time. This is also a range that is normal to tech companies. To put things into perspective, the effective leverage for AMZN is about 1.8x in recent years.
Source: Author and Seeking Alpha data.
Projected profitability
Now with the above understanding of the fundamental profit drivers, we make projections about future profitability and long-term returns. The following table summarizes the two profitability scenarios based on the above DuPont analysis.
- The base case assumes the profit margin to maintain at the current level of 40%, the ATR to stabilize around the historical average of 0.6, and the leveraged also at the historical average of 1.7. in this case, the projected ROCE will be 46% - essentially the current level of ROCE for INTC.
- The bull case assumes a profit margin of 40% also (again 40% is also a very high margin) but a higher ATR of 1.0, closer to the average level of its large-cap peers. In this case, the projected ROCE will be about 76%. Many catalysts afoot could support such a bull case scenario, including the initiative to gain back INTC's manufacturing superiority. The shift in people’s working habits caused by the pandemic could be helpful too due to the increase in demand for laptops and other electronic devices powered by INTC chips.
Such levels of ROCE are very competitive as shown in the next chart in this section. This chart compares the projected ROCE against the FAAMG stocks – a group of quintessential examples of capital-light and high return businesses. As can be seen, both the base case (i.e., the current level) of 46% to the bull case of 71% puts INTC at a very competitive position among this group of overachievers.
Source: Author and Seeking Alpha data.
Source: Author and Seeking Alpha data.
Projected return
With the above understanding of business fundamentals, we can project returns. For a time frame reasonable long, say a few years, so that price volatilities are averaged out, projecting the return is relatively “simple”. It is the sum of two parts: the owner’s earning yield when we made the investment (“OEY”) and the growth rate (“GR”) of the owner’s earning. That is:
ROI = OEY + GR
And the growth rate is given by:
GR = ROCE * Reinvestment Rate
The reasons for the simplicity are primarily twofold. The first reason is that all price fluctuations are averaged out in a reasonably long time (all luck even out). Second, it doesn't really matter how the business uses the earnings (paid out as a dividend, retained in the bank account, or used to repurchase stocks). As long as used sensibly (as INTC has done in the past), it will be reflected as a return to the business owner. That is why valuation metrics like PE do not appear in this framework at all.
So as a long-term business owner, the puzzle of our return consists of three pieces: OEY, ROCE, and the reinvestment rate. And the table below summarizes these pieces for INTC for the base case and bull case mentioned above. A few notes about the assumptions that I made here. First, I used the free cash flow ("FCF") as the owner's earnings. It is conservative in the sense that rigorously speaking, the owner's earnings should be free cash flow plus the portion of CAPEx that is used to fuel the growth (i.e., the growth CAPEx). Second, the reinvestment rate was obtained by analyzing the difference between maintenance CAPEx and total CAPEx expenditures with R&D expenses adjusted as capital expenditure.
From this analysis, we can see that a potential return in the double-digit range can be expected in both the base case and the bull case given the current valuation of the stock and the business fundamentals.
Source: Author and Seeking Alpha data.
Catalysts and risks
Several near-term catalysts afoot could support such a bull case scenario, including the Biden administration’s determination to gain back US manufacturing superiority, INTC's fab initiative, et al. Here, I will list a few that I think are the key. First, the shift in people’s working habits caused by the pandemic could be helpful too due to the increase in demand for laptops and other electronic devices powered by INTC chips. Second, Intel's initiative in the fabrication business could further drive up profitability. For example, its asset over turnover rate currently is lower than Taiwan Semiconductor Manufacturing (TSM), a pure fabrication player. When its fabrication business becomes online and starts contributing, it could close the gap and further enhance profitability. Lastly, Intel has announced to spin off Mobileye in 2022. The spinoff will be sizable (estimated to be more than $50B). The capital raised from this spinoff hence could fund a large portion (or even all of it depending on how much stake INTC decides to maintain) of its fab growth plans.
Investing in INTC also involves risks too. At the macroeconomic level, an element of uncertainty involves the ongoing chip shortage. Such a shortage could limit the growth of both the top and bottom line of INTC. And in the end, the situation ultimately relies on the development of the pandemic, or more precisely the recovery of the global economy and logistic chain from the pandemic.
Specific to INTC, its heavy investment in the fab business represents a large uncertainty. The success of the foundry business is just simply uncertain at this point. Although there are a few tailwinds to support an optimistic view. The foundry sector is expected to enjoy strong secular growth. It's expected to grow into a $100 billion market over the next five years from about $87 billion today. INTC’s investment in foundry also enjoys support from the U.S. government. The Biden administration had recently pledged $52 billion toward building out domestic production and supply of semiconductors and reestablishing America’s “chip supremacy” from Asia. But in the end, the outcome wouldn't become clear until a few years later
Conclusion and final thought
INTC is appealing as a candidate for retirement accounts seeking current income and short-term appreciation potential, for several good reasons.
- INTC earns a very competitive ROCE in recent years, and its profitability is projected to further accelerate based on a DuPont analysis. In a bull case scenario, where a higher ATR of 1.0 is assumed, the projected ROCE will be about 76%. And many catalysts afoot could support such a bull case scenario. Such levels of ROCE will put INTC among the top tier when compared against the FAAMG stocks.
- Based on the understanding of the business fundamentals and its current valuation, its potential return in the next few years is projected to be in the double-digit range (11% to 15%).
- A key to materializing the bull case is to improve ATR. And fortunately, ATR, unlike innovations, is a knob that management can consistently tweak to suit its operations. I am optimistic that INTC’s many new initiatives can help to improve its operational efficiency, such as its initiative to gain back its manufacturing superiority.
Marketplace launch coming soon
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