Intel Offers Compelling Upside

In a sense, the initial market reaction to Intel's (NASDAQ: INTC  ) latest results tells you what you need to know about the stock. In short, the semiconductor manufacturer gave lower than expected revenue guidance, declared that its customers were cautiously keeping their inventories lean, and delayed production of a new chip due to technical issues. Yet, the stock still went up.

Intel disappoints
Intel's third-quarter revenues of $13.5 billion were in line with company guidance and its gross margins were higher, but this was far from being a positive report. Essentially, the chipmaker is trying to transition its products toward ultra-mobile PCs and mobile devices. Meanwhile, it has to deal with the usual uncertainty of its end demand that bedevils the highly cyclical semiconductor sector. There are four key takeaways from the results, and each of them highlighted Intel's current difficulties in achieving its aims.

First, the midpoint of Intel's revenue guidance for the fourth quarter implies that full-year revenue will come in at around $52.6 billion. This represents a year-on-year decline of 1.4%, when it had previously forecast they would be flat.

Source: Company accounts.

 

The main reasons appear to be that its customers are reluctant to build up inventory due to uncertain consumer demand. Indeed, only a day later Taiwan Semiconductor (NYSE: TSM  ) said its fourth quarter revenue could fall by 11%, due to "softer demand for certain high-end smartphones and inventory correction." This is a worrying comment given that the fourth quarter is traditionally the strongest for the industry.

Second, Intel argued that its mature markets in the US and Europe were stabilizing, while Asia and particularly China remained volatile.

The third takeaway is that production of its 14 nanometer chip Broadwell will now begin at the start of 2014, one quarter later than planned. On the conference call, management claimed that this was "a small blip in the schedule" due to a technical issue which has now been resolved.

Fourth, Intel announced that its Bay Trail processor (aimed at the entry point ultra-mobile device market) had over 50 design wins, and eight to ten of these products will be available by Thanksgiving.

What it all means: FedEx, International Business Machines, and Intel

 From a macro perspective the color given on its customers' behavior was disappointing, but it's in-line with what other bellwethers have been saying. For example, FedEx has sequentially lowered its global 2013 GDP forecast throughout the year. In addition, International Business Machines (NYSE: IBM  ) recently reported weakness in China. IBM's sales were down 22% in China, with its hardware sales down a whopping 40%. IBM blamed a combination of its own execution problems, and delays in public spending caused by the wait for the mid-November release of an economic reform plan. Moreover, IBM doesn't expect Chinese demand to improve until early next year. A warning sign for Intel's fourth quarter?

With regard to its internal execution, Intel's scorecard is mixed. The technical issues with Broadwell appear to be resolved, but the delay now means that products incorporating the chip won't be available until after April. In addition, the design wins with Bay Trail are impressive, but investors could have hoped for more products to be available during the critical shopping season.
All told, it's not hard to see why the full year guidance was lowered.

But does it really matter?

 The fact is that none of these developments represent significant long-term headwinds for Intel. The technical issues with 14 nanometer chip production only serve to highlight that next generation chip production requires huge resources, and very few companies have Intel's financial firepower. Furthermore, Intel is now demonstrating its commitment to penetrating the ultra-mobile device market.

Despite the fall in earnings this year, the stock still trades on a P/E ratio of 12.7 times earnings for 2013, and a dividend yield of nearly 4%. In other words, the valuation is so cheap that Intel can afford to make the odd hiccup from quarter to quarter. Moreover its near 60% gross margins and substantive free cash flow generation (approaching $9 billion on a trailing basis) mean that it can buy its way into the new device market. The company may not be firing on all cylinders, but the valuation provides for plenty of upside if/when it starts achieving its aims.

Time to Invest in Tech Value Plays?

If you favor a value-based, long-term, buy-and-hold investing strategy, then you must have noticed how cheap some blue-chip tech stocks are right now. The easy move is to put a bunch of them in your portfolio and forget about them for 10 years. Unfortunately, tech investing is rarely that easy. So what do you need to know before making a decision?

Tech titans
First up, let's look at a chart of these tech titans. I've included a mature blue-chip stock, Johnson & Johnson by way of comparison. Enterprise value over earnings before interest, tax, depreciation, and amortization, or EBITDA, is used, because EV -- market cap plus net debt -- is a better measure to compare companies. Moreover, EBITDA is a good proxy for underlying cash flow.

IBM EV / EBITDA TTM data by YCharts

All these companies look relatively cheap. Moreover, on a historical basis they are all a good value. In fact, Intel (NASDAQ: INTC  ) , Oracle (NYSE: ORCL  ) , and Cisco (NASDAQ: CSCO  ) are all trading at substantial discounts to their pre-recession valuations. Why is IBM (NYSE: IBM  ) the odd man out?

Adjusting early to structural shifts
IBM adopted a different strategy to the rest. It acted early to adjust to structural changes in the economy. The sale of its PC division to Lenovo in 2004 was a key part of its transition into primarily a software and services company.

Source: Company accounts

Consider how well Oracle's stock performed compared to Intel and Cisco over the last 10 years.

Data by YCharts

The charts demonstrate that over the last decade, goods, products, and services have commanded higher prices based on how "smart" they are. For example, think of the advanced electronics systems being fitted into cars, or smartphones versus landlines. The shift is mirrored in the outperformance of the one software and services company on the list: Oracle. IBM also did very well, precisely because it made the transition to selling more software and services.

Going forward, IBM's strategy is to sell its lower-margin businesses, and increase margin expansion at the expense of revenue growth.

So while its revenues are forecast to be flat from 2012-2014, its EPS is expected to rise 20%.

Oracle now facing challenges
The previous 10 years have been very good for Oracle shareholders. However, there is no guarantee that the next 10 will be the same. The company remains a very good value play, but it also faces its own structural challenge with its traditional on-premise, on-license sales being threatened by cloud-based software providers. Moreover, as cloud-based sales increase, Oracle will find it harder to bundle its hardware solutions with its software.

Accordingly, analysts have Oracle on low-single-digit revenue growth for the next couple of years, with only high-single-digit earnings growth forecast. Oracle is seen as being late to the cloud party, and its future growth depends on making the adjustment.

Intel adjust its business, Cisco tinkers
Intel is the worst performer of the four, and it's also facing some structural challenges. It wasn't the only company caught out by the acceleration in mobile computing at the expense of PCs. Subsequently, Intel has found its core PC processor market to be challenged as PC sales repeatedly disappoint, and ARM core processor designs have won out in the mobile market. Simply put, Intel's refusal to license ARM's architecture in a meaningful way, has hurt the company.

The good news is that Intel has invested in new processors (Bay Trail and Haswell) that should start to penetrate the ultra-mobile market as of this year. Intel will need to do this in order to hit guidance this year.

Cisco's challenges and opportunities are of a different sort. It's switching and routing divisions still generate low-single-digit growth, but it's not enough to get excited about the company. Moreover, its services revenues growth -- services make up around 21% of total revenues -- is really a function of how well it can sell its products into the marketplace. The real question is how well Cisco will invest its cash in growing its peripheral sales.

You can see the point illustrated in the following chart.

 

Source: Company accounts

What you need to look for
Intel will become very attractive if it can establish a strong foothold in the mobile market. You'll want to monitor developments later this year.

Oracle needs to halt declines in its hardware sales and demonstrate that it can shift more revenues to the cloud while retaining margins with its traditional software. However, the stock is very cheap right now, and even stabilizing the company to GDP-type growth should see some good price appreciation.

IBM's story is one of ongoing margin improvements and the execution of its plan. Look for margin expansion. Cisco is intriguing because its sits on more than $34 billion in net cash and investments, while its market cap is $123 billion as I write. In other words, it has the capability to invest wisely and generate growth. Keep an eye on its acquisition strategy.

Each of the four has its own risks and rewards, but a portfolio that contains all four isn't a bad idea for a value investor.

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.

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.