Intel (INTC)

Key Statistics

EV/EBIT = 8.96x

FCF/Price = 7%

Debt/Equity = 49%

Return on Equity = 29.5%

Dividend Yield = 2.53%

The Company

Intel is the world’s dominant manufacturer of chips for PC’s and servers.

Intel was founded in 1968 by Gordon Moore and Robert Noyce. They left Fairchild Semiconductor to form their own company. They positioned themselves at the forefront of the new industry and sought to have the fastest chips in the market.

Gordon Moore coined “Moore’s law”: the number of transistors doubles on a chip every two years. The law became a target for the company and Intel has frequently had the fastest chip in the market. Intel itself has been the driving force behind Moore’s law becoming a reality. They have sometimes been outpaced by their competition, but they have always been able to regain their dominant position.

Over time, demand for chips has increased and Intel’s business grew with it. They developed close relationships with PC manufacturers, and this tight relationship along with strong R&D made them the dominant chip company.

Intel’s dominance has its roots in their development of x86 architecture, which was pioneered by Intel in 1978 and is still used by most PC’s and servers. Most PC software was written for the x86 architecture, giving Intel a sticky position in the PC market. AMD also makes x86 chips, but Intel remains the dominant player.

Below is the growth of Intel’s business over the last twenty years. In the last 10 years, EPS has grown at a 19.9% CAGR through a combination of growth in the business and buybacks.

Does this look like a falling knife?

My Take

Intel has high ROE, an incredible track record, secular growth prospects (we’re going to need more chips 10 years from now today than we do now). Why is it selling for a 8.96x EV/EBIT multiple?

The stock is cheap for two reasons: 1) Intel has recently fallen behind its rivals technologically. 2) The market prefers companies that outsource chip manufacturing and focuses more on chip design, a capital-light business.

Technological decline

In recent years, Intel has fallen behind the technological curve. I think this is temporary. The market seems to think it is permanent.

In July 2020, Intel announced that their 7-nanometer chips (nm – nanometer is a metric for measuring the size of transistors on the chip & smaller is better) were behind schedule and wouldn’t be released until 2022. In contrast, Samsung and TSMC have already transitioned to 5 nanometer manufacturing, making it clear that Intel is falling behind the curve. The delays mean that Intel will temporarily fall behind rivals AMD and Nvidia, who will likely gain more market share in the next couple of years. After the announcement, Intel shares fell by 9%.

Additionally, Apple announced that they are ending their reliance on Intel chips. Apple computers have used Intel chips since 2005. Apple is going to start using its own chips. Microsoft is making a similar move and announced that they are going to use their own chips in their products.

The perception in the market is that Intel is falling behind, squandering their cash flow on buybacks while they lose their competitive position, mirroring the similar decline of IBM.

Meanwhile, Intel spent $13.3 billion on research & development in 2019. This compares to $2.8 billion for Nvidia, $1.5 billion for AMD, and $3 billion for Taiwan semiconductor.

For all of the concerns over Intel’s loss of their competitive position, they still spend more on R&D than anyone else. They aren’t squandering their future to buy back stock and pay dividends, which is the popular narrative. This R&D spend has obviously been misspent – but the cash is available to make better chips.

Additionally, revenues, earnings, and cash flows have not declined. Through all of this, Intel has been consistently growing. 2020 was actually an excellent year for Intel, as lockdowns boosted demand for PC’s and Laptops.

Intel still has the dominant position in the PC market. Their revenues massively outpace that of any of their rivals.

They are pushing for faster and better chips. They aim to create 1.4 nanometer chips by 2029. Chip design & manufacture is an arms race and the key driver of that arms race is the money spent on R&D. I think that the company spending 375% more on R&D than the next rival will eventually be able to make a better chip.

In-house fabrication vs. a focus on design

Intel designs & fabricates computer chips.

The market prefers chip companies that don’t fabricate their own chips, like Nvidia, who outsources their manufacturing. Designing chips is a more profitable business than manufacturing them.

This is why Nvidia is rewarded with an EV/EBIT multiple of 86.2 and Intel with 8.96. This vast difference in valuation shows a simple narrative: Intel is a dying company and Nvidia will eventually dominate.

Even with the “bad” business of chip fabrication, Intel sports excellent margins. It currently has an operating margin of 32.8%, compared to Nvidia at 26.1%. With that said, Nvidia has significantly higher ROIC because chip design is more capital-light. Nvidia’s ROIC is 51.7% vs. Intel’s 21%.

This is why the market wants Intel to focus more on design.

Dan Loeb has recently announced a significant position in the stock and is pushing Intel to make strategic changes. This is why the stock went up 5% after Loeb’s activism was announced.

Management was already moving in the direction of outsourcing more production. Bob Swan is relatively new and is changing course from the management of the last decade, which oversaw the erosion of Intel’s competitive position. Management indicated recently that the “Ponte Vecchio” graphics chip may use outside factories, for instance. They also announced that they plan on outsourcing more manufacturing to TSM, another chip stock that has gone parabolic in 2020.

If that’s why they wanted to do, anyway – then I think Loeb’s activism will easily push them in a positive direction.

Prospects

I think it’s a fairly safe bet that Intel will pursue a strategic change, particularly considering that it was already considering going in a different direction.

It also seems unlikely to me that the company spending 375% more on R&D than its next competitor will remain behind the curve for long.

In addition to making faster chips for x86 style PC’s and servers, Intel is also acquiring smaller companies. Mobileye, for instance, is an important subsidiary. Mobileye is focused on self-driving car technology. Intel is also making significant investments in artificial intelligence, covered in this article by Fast Company. Nvidia has positioned itself as the AI leader, but I think Intel can catch up.

The incentives are strong to turn this situation around and Intel has the cash to make it happen.

They have fallen behind technologically and management has failed to execute over the last five years, but I don’t think that any of this is fatal or permanent.

Moat

Does Intel have a moat that defends it from competition?

I believe it has a moat. With that said, it isn’t as strong as other companies I have purchased recently like General Dynamics. The moat is also currently under attack, which is why the stock sells for a such a cheap price.

Intel’s moat is derived from its scale and tight relationships with the dominant manufacturers of PC’s.

Even with its recent manufacturing issues and the upcoming loss of Apple, it remains the top chip company. Intel did $71 billion in revenue last year. In contrast, AMD did $7.1 billion and Nvidia did $10.9 billion. TSM, which focuses on the manufacturing process, produces $35 billion in revenue. Intel is overwhelmingly the dominant player.

Competition is nothing new for Intel. It has battled AMD for decades. The sheer scale of Intel’s design & manufacturing capabilities gives it a cost advantage over its rivals and usually this results in Intel’s victory. Additionally, because x86 is the primary architecture for most PC’s, Intel’s dominance gives it a foothold there.

The recent worries over Intel losing customers is another major reason that the stock is down. Apple, for instance, used Intel chips in their PC’s and will use their own chip design in the future.

With that said, Intel still has relationships with the dominant sellers of PC’s. As of 2019, Apple represented only 7% of the PC market and is a relatively minor player. The big ones are Lenovo (24%), HP (22.2%), and Dell ( 16.8%). A bulk of all of these products run on Intel chips.

Of course, Intel can’t rest on that dominant position, as the world is subject to rapid technological change. Intel needs to use its scale and cash flow to solidify its future.

Recent manufacturing issues aside, I think that Intel is committed to maintaining its competitive position in the future. This is probably best reflected in its R&D budget.

The scale and vastly superior size of Intel’s R&D budget gives it an advantage over rivals. The stock is now selling for a cheap price because this is in question, but I fail to see how Intel’s overwhelming $13 billion annual spend on R&D won’t eventually result in them winning. This is a war and the company with the most troops (dollars) should ultimately win. Any innovation in this industry is going to be quickly commoditized. It’s a constant fight to develop the best and fastest chip. Intel’s R&D spend ought to get them there, even though they’re suffering temporary setbacks.

Intel’s acquisition of AI and self driving businesses also shows a commitment to their future: like Mobileye and Habana Labs.

This is not a company squandering its competitive position on buybacks, which seems to be the consensus view in the market.

Quantitative Considerations

Intel has a high degree of financial quality. The Z-Score is 3.54, implying that they have practically zero chance of going bankrupt in the near future. Debt/equity is only 49%. Return on equity is 29.5% despite the low leverage. With an M-Score of -2.88, there are no signs of earnings manipulation.

It seems unlikely that the stock will deliver negative returns over the next 10 years, unless they are completely overtaken by competitors.

Shareholder yield is high. The dividend yield is currently 2.53% and share count was reduced by 5% last year. They also have the margins and cash flow to sustain this yield that without ruining their business.

Intel isn’t operating in a declining industry. They are simply losing ground to rivals. It seems likely that semiconductor demand will be higher in 10 years than it is today.

Between EPS growth and shareholder yield, it seems likely that Intel stock could deliver a 10% CAGR over the next 10 years without any multiple appreciation.

With that said, at a 8.96 EV/EBIT multiple, I think a multiple re-rating is likely. Companies like Nvidia trades at 83x and AMD trades at 99x because they have temporarily leapt ahead. TSM trades at 27x. If the multiple re-rates, then the CAGR should be a lot higher than 10%. A 20x multiple seems reasonable for a high ROIC company with a dominant competitive position.

All of this said, I don’t have any special insight or knowledge into the chip industry. What I do understand is that 1) the incentives are there to turn this around (Bob Swan just became CEO in 2019 and seems determined to change course. The company is now attracting activists like Loeb), 2) the money is there to turn this around, 3) chip demand is not an industry in secular decline, 4) despite its trouble, Intel remains the dominant chip manufacturer with overwhelming financial resources to stay dominant.

Intel strikes me as a wonderful company at a wonderful price.

There is a leap of faith involved here. Faith is needed to believe that Intel will be able to turn around a deteriorating situation. I think they have the resources to do so. I think the incentives are there to do so. There is new management and activists are involved. The wonderful price is a result of the uncertainty. By the time that the uncertainty is gone, it will be 20x EV/EBIT and the opportunity to purchase a company of this quality will be gone.

Also, I think it’s worth noting that I looked at Intel back in October and I actually passed on it. Loeb’s involvement changed my mind. Now that it is attracting activists like Loeb (and Intel is listening), I think that the risk/reward is compelling. I think it’s a situation comparable to Microsoft in 2012 or Apple in 2013. It’s a strong company with a lot going for it, but it has been mismanaged for a few years and will benefit immensely from some activism & change. It has the resources & incentives to turn things around.

Checklist

  • Can the stock deliver a 10% CAGR for the next decade? The dividend yield is currently 2.5% and it is sustainable. Intel consistently buys back shares and share count is down 5% in the last year. Revenues grew over the last decade at a 7% rate. Even if that declines, a low growth rate combined with the shareholder yield could easily result in a 10% CAGR. Currently, the free cash flow yield is 7% and free cash flow is likely to grow in the future. At a P/E of 9, multiple appreciation on top of the growth & yield seems likely. It is easy to imagine how the stock could deliver a 10% CAGR for the next 10 years, if not more. Pass.
  • Has the business delivered consistent results over a long period of time? Despite the recent troubles, Intel has been able to consistently grow sales, cash flow, dividends, and earnings over the years. It is free cash flow generative. Pass.
  • Does return on equity consistently exceed 10% without the use of heavy leverage? Intel has averaged a 21.5% return on equity over the last decade with minimal leverage, passing my 10% hurdle. Pass.
  • Is management sketchy? Management has been transparent about the problems facing the company. The recent trouble has nothing to do with dishonesty or fraud. They aren’t shifty promoters or grifters. They aren’t obsessed with short sellers. Bob Swan strikes me as a competent and transparent leader who is committed to fixing the current situation. Pass.
  • Is the company financially healthy? Intel has a debt/equity ratio of 49%, which is low. The Altman Z-Score is 3.52, so no bankruptcy risk. M-Score is -2.88, so there are not any signs of earnings manipulation. Interest coverage is robust at 31. WACC is estimated at 4.5% and ROIC has averaged 19% for 10 years, so the company is not a net destroyer of capital. Pass.
  • Has the company consistently generated returns for shareholders? Is the industry in secular decline? The company has consistently generated positive returns for shareholders. Intel has generated a 11% CAGR since 2010. It returned only a 3% CAGR since 2000, but was in a bubble at that point. Chips are not an industry in secular decline. We will need more of them 10 years from now than we do today. Pass.
  • Has the company survived previous recessions? Intel did not report losses in earnings or negative free cash flow during the last two recessions. Cash & earnings declined slightly, but the company was never in any dire trouble. The stock drawdown was serious in the early 2000’s (80%), but this was due to the overvaluation of the stock, not the performance of the business. Pass.
  • Does the company have a moat? Intel has a moat in terms of its dominance of the still-dominant x86 architecture and tight relationships with PC manufacturers. Its scale also give it cost advantages over competitors. It has an overwhelmingly larger R&D budget than its competitors. However, Intel’s moat is under attack. With that said, I think that Intel has the financial resources to survive the current assault on its moat. With new management and activist involvement, it is likely that they shift their strategic direction. The current troubles are also a source of the compelling price. If I wait for the issues to be resolved, the “wonderful price” will likely be gone by that point. Pass, with reservations.
  • Is the stock cheap on an absolute and relative basis? EV/EBIT is currently 8.96, the P/E is 10, and the forward P/E is 11. The free cash flow yield is 7%. These metrics are cheap on an absolute and a relative basis. Pass.
  • If I was forced to hold the stock for 10 years, would I be terrified? I wouldn’t be terrified if I was forced to hold this company for 10 years. The industry isn’t in secular decline and the company is not a mall-retailer or Kodak-style melting ice cube. Intel is financially healthy, so I think the possibility of a bankruptcy in the next 10 years is approximately zero. They’ve shown resilience in past recessions, so I would be comfortable holding through a nasty recession. The stock isn’t expensive, so I don’t think it can be destroyed by multiple compression if interest rates go up or if the broader market embraces reason. While they could see their moat erode over the next decade, I don’t think that this is an investment which could result in a permanent loss of capital or suffer a catastrophic drawdown. Pass.

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