Wednesday, January 16, 2013

Intel's Earning Preview

One of the most important tech bellwethers gives results soon, and it's worthwhile taking some time out to look at the underlying trends here. Intel’s (NASDAQ: INTC) results are going to set the tone for thinking about the semiconductor industry this year and as a consequence the consumer electronics industry. It’s time to look a little closer.

What to Look Out For

With Intel it is a combination of fundamental metrics (which are hugely indicative of the overall industry) and the associated commentary and outlook, which will help investors create an overall viewpoint and give some very useful color as to prospects for other stocks.

The two key metrics are Intel’s gross margins and its inventory to sales ratio. I know I display symptoms of the early onset of Asperger’s syndrome over these metrics, but they really are the best indicator of the semiconductor industry cycle. We know things are tough right now, but investors are looking for a trough. Is it time?

Inventory Days Outstanding

Here is the relationship between Intel’s share price and its inventory days outstanding. The latter just represents inventory over the cost of sales and is representative of growing unsold inventories.

INTC Days Inventory Outstanding data by YCharts

It’s not hard to see that there is a mirror image here with a pretty good optical correlation. Ideally investors are looking for a reduction in inventory days outstanding because it is starting to look dangerously high. I appreciate that we are coming into a Microsoft (NASDAQ: MSFT) Windows 8 inspired upgrade cycle, but I would argue that this phenomenon is getting weaker and weaker every time around. PCs are not as important as they used to be and Intel’s traditional strength is being affected.

Frankly I can't see the stock making a significant move upwards unless this ratio starts improving. Over the last month Intel has had a nice move upwards in sympathy with the Nasdaq, but it remains a significant underperformer on a yearly basis. Long term investors won't react to short term movements.

Gross Margins

The second key metric is Intel’s gross margins. I think that they are a pretty good indicator of the economy at large and one of the best corporate metrics for recessions.

Here is how they have trended over the years. Note how the big dips presage recessions.

INTC data by YCharts

Note that the latest recession was not caused by a consumer slowdown or a capital expenditure boom. It was caused by the incompetence and negligence of risk at the investment banks and a calculation (on their behalf) that the taxpayer could always be gamed to save them because they were ‘too big to fail.’ Therefore there was a ‘delayed effect’ before it fed through into Intel’s gross margins. No matter, it did in the end.

The current situation is that Intel has guided downwards towards gross margins of around 57% for the quarter. My suspicion is that Intel may well beat this because it tends to be conservative with guidance and there did appear to be a general tech slowdown in the last quarter. With the fiscal cliff issue now resolved and things looking better in Europe, some pent up sales may have come in. In addition, the political dispute between China and Japan would have surely affected inventory channeling, at least on a short term basis, so I think there are good grounds for some positive surprise here.

However, even if Intel beats its own estimates all eyes will be on its gross margin guidance. If it continues to guide lower than investors will have to conclude that we still haven’t hit a trough yet and history shows us not to buy Intel’s stock when its gross margins are falling.

Intel’s Read Across

Naturally, anyone invested in the PC sector will want to hear what Intel says about the marketplace. In particular, Microsoft investors will want to hear about the Windows 8 push and PC and notebook manufacturers like Dell (NASDAQ: DELL) and Hewlett-Packard (NYSE: HPQ) will want to factor Intel’s guidance into their assumptions. Dell is trying to diversify away from these businesses but it remains a critical factor for them. As for Hewlett-Packard, if there is any company that needs a Windows 8 boost it is HP. The Autonomy debacle has damaged its reputation even more, and the traditional PC and printing businesses are what are supposed to generate the cash flow to enable it to try to restructure and deal with its debt issues.

Another little discussed aspect of Intel’s guidance is data center spending. I noted a subtle change in the last statement where Intel talked of some softening. I suspect the market is sanguine about this because the sector has been so strong in 2012, and indeed Cisco Systems explained some weakness in the last quarter as being the result of a kind of pause for breath. I’m sympathetic to this argument but if Intel suggests that conditions have worsened in the last quarter then it might be time to re-think...

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