Thursday, April 25, 2013

Intel Can Fight Back

Investing in Intel is a bit like betting on an old and slightly out of shape, but hard hitting fighter. Mr. Market keeps landing quick jabs and slows his opponent down. The odd cheeky hook to the body gets slipped in, and your fighter starts to slow and look out of place. He is way down on points by the middle rounds, so, he starts throwing haymakers, and commentators scoff about the superior mobility of the other guy.

The quicker opponent comes out confidently in the eighth round, throws a few jabs, and then gets caught square on the chin by an overhand right from your guy. Ten seconds and a medic later, the ringside journalists start re-writing their reports to reflect how ‘clever’ Intel was with its strategy.

Intel fights on

Frankly, the company has had its fair share of jabs in the last year and I looked at some of them recently.

  • Weakening PC demand has hit its core market and negatively impacted capacity utilization and inventory. Ultimately, gross margins have taken a hit too.

  •  Intel found itself behind the curve in adjusting to the shift towards tablets, ultrabooks, and smartphones.

  • A slowing consumer electronics market, plus weaker than expected demand pull from the release of Windows 8 affected its growth expectations

The end result is falling margins, as inventory gets cleared and Intel shifts investment to newer technologies and end markets. Indeed, Intel had to lower revenue forecasts throughout 2012.

It’s easy to make after-the-event criticisms of a management when these sorts of transitions occur, but it’s also hard not to feel a certain amount of sympathy. Those that can predict industry trends (let alone macro) can throw the first stone. Indeed, the market clearly ‘gets’ that Intel has had difficulties because the stock has been marked down accordingly. The question now is whether its adjustment plans will work?

Reasons to be cheerful

Before considering the investment case for Intel, it’s worth reflecting on a couple of issues that will govern the investment decision. The first is that irrespective of the secular shift to tablets etc., the semiconductor market is highly cyclical. Indeed, Intel’s forecast of a better second half is based on an economic improvement. 

The second is that in the long-term, there is the threat of ARM Holdings' core processors winning out over Intel. Intel confirmed that it wouldn’t take on any competitor-based business within its growing foundry business. In other words, buying Intel tends to imply a positive outlook on global growth and confidence in its long-term future against ARM. Intel’s problem is that ARM-based architecture dominates the mobile phone market.

Turning back to the secular issues, Intel will launch its Haswell processors, which will enable it to benefit from growth in tablet, ultrabooks, and convertibles. This is all part of Intel’s drive to be more relevant in a declining PC world. There was more good news with the announcement that it was now making LTE-based phone shipments, while its tablet and smartphone bases sales are growing well. The problem is that it has a significant amount of PC-based sales to replace.

In addition, the negative surprise with PC sales has caused overcapacity issues. Gross margins have been falling…

INTC Gross Profit Margin Quarterly data by YCharts

…and they came in at a lower than expected 56% for the current quarter.

So again, it is a question of jam tomorrow with Intel, but at least it is not lowering revenue forecasts as it did last year. On the contrary, with the new Haswell processors and data center revenue (already around 20% of total company sales) growing in double digits, prospects look better for the second half. I also suspect the Windows 8 disappointment is already fully understood by the market, and Intel looks better positioned from a product portfolio perspective than it did last year.

Another area of growth is likely to come from increasing foundry activity. The Altera deal highlights the potential for Intel to generate some value from its older production technology. It is also good news for Altera, because it secures its chip production from a world class manufacturer that is looking to generate long-term relationships with value-based solutions.

However, this developing aspect of Intel’s activities is not good news for Taiwan Semiconductor The leading semiconductor foundry has seen its gross margin decline over the last few years, and the last thing it needs is Intel muscling in on the market. Altera is a long-term client of Taiwan Semiconductor, and the Intel deal cant have been good news for it. It's margins (at less than 50%) have never been as high as Intel's.

The bottom line

In conclusion, I think there is a lot to like about Intel. Its valuation is now levels not seen since the recession…

INTC Price / Sales Ratio TTM data by YCharts

…and a 4%+ dividend yield is a fine income to enjoy while you wait for a turnaround.

Macro matters are always a concern with such a cyclical stock, and ARM’s strength in mobile does overshadow Intel. But, if you are sanguine on these issues, then I think Intel has good prospects. It’s a heavyweight and still packs a punch, and at some point it is going to remind the market of it.

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