Wednesday, December 5, 2012

Time to Buy Intel?

Intel (NASDAQ: INTC) did what Intel does and managed to report results above the high end of its recently lowered expectations. However, I doubt this will be enough because anyone looking for an early sign of recovery in the semiconductor market will have been disappointed.

Microsoft (NASDAQ: MSFT) investors should note that PC demand certainly isn’t going to be propelled by Windows 8. In summary, this report was saying that industry conditions are going to get worse short term. What it is not saying is that Intel is necessarily a bad buy at the moment.

Intel Reports and Guides Weaker

Much hope has been placed on Windows 8 driving PC sales but the likes of Hewlett-Packard (NYSE: HPQ) and Dell (NASDAQ: DELL) are likely to have to downgrade expectations even more after Intel said that the Q4 PC business looked set to grow at half the normal seasonality.  This is not good news at the best of times and certainly not what investors would have been hoping for at the start of the year where most analysts were predicting an upturn in semiconductor demand.

Neither was there any good news for the semiconductor capital machinery as Intel lowered its capital expenditure plans in the light of weaker end demand. This is bad news for companies like Applied Materials or KLA-Tencor (NASDAQ: KLAC). KLA-Tencor previously talked of industry CapEx being down by 10-15% in 2012 but with Intel lowering its spending guidance it is likely that KLA-Tencor and others will have to lower their top line expectations accordingly.

There was even some disappointing commentary on data center spending. At the start of September Intel released a statement and lowered Q3 expectations, but it also said that its data center business was performing in line with its expectations. However Intel is now saying that the corporate server market segment softened during the course of the quarter. In other words, we have a broad-based slowdown on our hands here. While this is not unexpected from a macro perspective the market still seems to be taking hard when companies inevitably lower guidance and I don’t think Intel is any different.

Longer-Term Picture

The key point is to keep matters within a long-tern perspective. The all important metrics with Intel are always gross margins and inventory. What usually happens is that inventories start rising as sales are lower than expected and then gross margins come down as Intel and the rest of the industry struggles to lower inventory levels.

This chart demonstrates it well.


INTC Inventories data by YCharts

What the chart is not telling you is that gross margins for Q3 came in at 63% and that Intel guided margins for Q4 to come in at 57%. Inventory grew by $400 million in Q3 and investors can expect average selling prices to be under pressure in Q4.

Of course this type of analysis doesn’t include any discussion of the underlying trends and this is unfortunate because there are some important changes happening. PC demand is maturing (even within emerging markets) and it is hard to imagine that this is not partly due to the growth in usage of smart phones and tablets as internet-enabled devices. As such Intel is under pressure to change its product development in line with end demand and it is doing this, but to argue – as some inevitably will -- that Intel can generate contra cyclical growth as a consequence of engineering this shift in the types of processors it develops is a deluded idea.

The simple fact is that if you are going to invest in Intel you are going to take bet on the semiconductor industry cycle and in turn the macro environment. The companies that are being hit by the shift in the makeup of internet-enabled devices are the likes of Dell and Hewlett-Packard. They are both fundamentally challenged business and this report does not auger well for them. Nor does it say much about Microsoft's prospects with Windows 8.

Where Next for Intel?

It’s not the end of the world. Consumers will still buy PCs, mobiles, tablets and anything else that Intel’s processors get position in. If you believe that the company is correctly readjusting to sales shifts then on a historical basis the stock looks good value.

INTC Price / Sales Ratio TTM data by YCharts

Throw in a 4%+ dividend yield and you can bet that yield chasers will start moving in at some point. Short term, I suspect things are going to get worse and markets surely don’t like downgrades and earnings misses, so any buyer needs to be able to stomach near-term volatility. However in the long term, Intel looks decent value down here. Cautious investors (I'm one of them) might prefer to wait until the inventory situation starts to demonstrably get better but at some point it surely will.

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