Thursday, August 1, 2013

What Intel Needs to do in the Second Half in Order to Hit Guidance

One of the most fascinating things about investing is how you can find yourself faced with the same sort of questions over and over again. In the case of Intel (NASDAQ: INTC), you're coming up against some classic propositions. What if you like the long term value of the stock, but are concerned about the near-term risk? Moreover, you might like the forward guidance, but how much do you believe in it?

Intel lowers guidance, again

It’s no secret that Intel’s core PC market has been weakening for some time, and the company has-- by its own admission-- been slow to react to the changing trend towards ultra-mobile PCs and smart phone devices. Indeed, it recently lowered its expectations for PC sales in 2013, but raised them for ultra-mobile devices.

Furthermore, the market didn’t have to wait long before Microsoft (NASDAQ: MSFT) confirmed these trends by reporting a decline in its Windows business, as the new device market takes precedence over traditional PCs.  In fact, Microsoft’s Windows revenue declined 5%, while it estimated that the consumer PC market was down a whopping 20%.

In the good old days, the release of a new Windows operating system was like a red rag to a tech bull, particularly for Microsoft and Intel investors. Unfortunately, those days are gone. Microsoft’s Windows 8 has hardly set the world on fire, and some analysts have blamed its release for slowing down PC sales. Consequently, Microsoft is struggling to remain relevant on new devices such as smart phones.

Turning back to Intel, its lowered expectations for PC sales (the PC client group currently makes up more than 63% of sales) caused it to lower full-year revenue guidance to ‘approximately flat’. Equally importantly, it lowered its full-year gross margin forecast to 59% from 60% previously.  On a more positive note, Intel also demonstrated its ability to adjust to weakening sales by lowering its capital expenditure forecast by $1 billion, to $11 billion.

I want to focus on gross margins, because this metric has tended to guide the share price.

INTC Gross Profit Margin Quarterly data by YCharts

It’s not a failsafe indicator, but generally speaking, you would want to buy Intel after its gross margins have bottomed. The good news is that on the conference call, management guided towards gross margins improving to 61% in the third quarter (Q3) and “at or maybe a little bit higher” for the fourth quarter (Q4).

So is it now the time to buy Intel?

The answer depends on your level of belief in the guidance. In order to graphically demonstrate this, I’ve created this chart from company accounts, using the latest guidance given by the management. Intel forecasted $13.1 billion in revenues for Q3 and full-year revenues to be flat.

Clearly, the guidance assumes a return to growth in Q3 & Q4. Furthermore, note that these two quarters tend to be the most important for Intel. In other words, the second half performance will be critical to Intel hitting its guidance.

A few bullet points on what bulls might look for:

  • The second half will see the launch of the Bay Trail processor, aimed at the entry-point ultramobile device market.

  • The energy-efficient Haswell processor should start to see sales ramp up as manufacturers integrate it into their new devices.

  • LTE-phone-based sales will start to accelerate.

  • Intel predicts its data-center-based revenues will grow in the low double digits for the full year.

  • The company is starting to lap weaker comparables from last year.

  • Management forecasts that an improving macro environment will lift Intel’s sales.

The key factors will probably be how well Haswell and Bay Trail are adopted by original equipment manufacturers (OEMs). Intel is trying to muscle its way into the ultra-mobile market currently dominated by ARM Holdings(NASDAQ: ARMH) processor designs. This is becoming an ever-more-important battle because -- as demonstrated above -- the trend towards mobile devices is accelerating. So far, the refusal to license ARM-based architecture for its chips has seen Intel struggle to compete against competitors like QUALCOMM (NASDAQ: QCOM) in the mobile device market.

In the end, the key decision makers in the Intel vs. ARM battle are going to be the device makers. If the latter are confident that they can create commercially viable products via shifting to Intel, then the battle will start to be won. Moreover, you can form your own view by looking at which tablets, ultrabooks, and mobiles are starting to be released with Intel chips.

The bottom line

In conclusion, the second half promises to be a better one for Intel -- and it needs to be, for the company to hit its guidance.  Thinking longer-term, even if Intel does fail to establish itself in the ultra-mobile device market, it could always change tack in future and start to license ARM's core technology. This is something for investors in ARM (positively) and Qualcomm (negatively) to ponder.

However, the near-term risk is if Intel misses the targets outlined above. Frankly, I think Intel will have challenges to hit these targets. But in any case, its valuation of around 12 times earnings will make it attractive to value investors who can stomach near- to mid-term volatility.

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