Wednesday, April 16, 2008

Dissecting Intel's quarter.

The investment thesis in Intel consists predominantly of :

1. Competitive wide moat 45 nm strategy, and aggressive pursuit of Moore’s law.
2. Low cost differentiator due to economies of scale.
3. Margin expansion due to lower ongoing costs and operating expenses.
4. Potential growth by targeting new markets like Consumer Electronics (CEs), Mobile Internet Devices (MIDs) and Ultra Mobile PCs (UMPCs).
( Discussed in a later post. This post discusses their current quarter)

Intel posted mildly positive results, which was good enough given the lack of optimism. Intel breaks out their results into the digital enterprise group (servers, PCs) and the mobility group(notebooks, netbooks).

Revenues came in at $9.7 billion, with a net income of $1.5 billion. Revenues were impacted by a higher tax rate, and asset impairment charges. Company guided to a $9 – 9.6 billion revenues for Q2, and gross margins of 56%. For 2008, the company’s expects $5.2 billion in Capex, $6 billion in R&D and $5.9 billion in SG&A expenses.

Let’s dig a little deeper.

North America: Strongest growth this quarter (up 17%), thanks to a strong demand for high end 45 nm server chips. Their new quad core is their competitive strength here, (helped with the delay in Barcelona). Flat ASPs (average selling prices) in microprocessors.

Growth drivers in this segment were large internet datacenters and infrastructure build out for cloud computing. The important question to ask is this: Will the IT spending in the US remain resilient? If a business slowdown in the latter part of the year/next year occurs, any effect in IT infrastructure budgets could potentially impact sales in this segment. A justification was made based on the return on investments because of the energy efficient solutions, but color me skeptical. It can also be argued that in a slowdown, IT spending would go up because of productivity gains. It didn’t happen the last time around, and IT spending remains correlated with business spending. It’ll be interesting to see if virtualization and cloud computing have any effect on sales of microprocessor chips.

Margins: One reason margins were higher was because of higher utilization of factories for inventory buildup.The 45 nm ramp in shipments was predominantly in the high-end server segment.

Margins for the desktop group ticked up because of high end server chips, while the mobility group saw a decline in their margins. Since mobility comprises an increasingly larger part of Intel’s revenue source, they will also shoulder a bigger chunk of the cost of production. Moreover, there was an increase in advertising for the mobility (Centrino) based product line. Mobility has had sharp ASP declines, and this trend should continue or accelerate with the introduction of their mobile internet devices/ Ultra-mobile PCs. Intel is pursuing a cost reduction strategy in this segment by introducing a lower bill of materials solution. It needs to do this in order to maintain it’s margins.

Shift of expenses from SG&A to R&D for qualification of 32nm could depress gross margins in coming quarters. This is possibly the biggest reason I could be negative on Intel, and adopt a wait and watch strategy for at least two quarters. I see limited upside if they can’t use their operating leverage. Caveat here is that their cost reduction turnaround has produced good results so far. Also, in the ramp to qualify their earlier process technology in 2006 (45 nm), they were locked in a bitter price war with AMD, which really affected their profitability. Will history repeat? I don't think so.

Buybacks: Intel has had a strong buyback for the past few years(it bought back $2.5 billion this quarter). Unfortunately, the buyback hasn’t shrunk the share count yet, because of stock dilution caused due to employee stock options. Given that Intel started awarding more stock based incentives sometime in 2005/2006, I would expect that going forward 18 months or so, buybacks would actually start shrinking share counts, and be accretive to the EPS figures.

Currency affects: Intel gets 75% of their revenues from outside the US. A strong Euro/Asian currencies and a weak dollar is good for Intel. Since their components are priced in dollars, it simulates demand in the European economy, and is responsible for the above trend growth there.

Emerging markets: For emerging markets, appreciating local currencies drive PC and notebook penetration by making Intel’s products more affordable to a wider population. Increasing wage growth in India and China should accelerate this trend as well. Laptops are a fashion accessory (all across the world actually).

Restructuring: Intel’s restructuring program is producing good results. Employee head count is down to 84 thousand. They are conservative on Capex, R&D and SG&A. This should help in mitigating costs while they qualify 32nm.

Volume growth: Since notebooks have a quicker replacement cycle than PCs, this should drive volume growth, offsetting the ASP erosion. This trend towards volume growth should accelerate with Intel’s foray into new markets, more than offsetting the ASP declines.

Netbook launch: Should open up new markets with their aggressive price points. Most sales will be in mature markets and tier one cities in places like China. This needs a separate post. I’ll just add that in this segment, the wireless connectivity solutions and added functionality, and not the microprocessor strength, is what will drive adoption rates. Intel has been going down the WiMax route. We could see a sharp deacceleration of growth or even a decline in the notebook segment should these $200-$300 products catch on. This market is not the duopoly like the notebooks/PC markets were. Is Intel’s microarchitectural strength a valid edge here? (I’ll address this in another post)

Intel needs the new markets. PCs are in a decline. Laptops will be increasingly replaced by smaller form factor wireless mobile devices. Like the notebook became the replacement for the desktop, I view their Atom line as a replacement to their notebook products at some level. Only difference is that notebook chips were low volume high ASP, while the UMPC segment will be at a lower ASP. It would be nice if going forward they broke out that revenue segment in a separate category.

Technicals: I like Intel’s chart. It looks neutral in the intermediate term, given that it’s below 200 day MA, and broke it’s upward trend channel. However, it’s been consolidating for a few months now. There looks like a long term support on their chart going back to 2002, and a potential double bottom. MACD is ticking up to a potential crossover, but I’d hold off for now.

Conclusion For long term investors, I like the risk-reward situation with Intel. Given its generous yield, share buybacks and competitive moat, the company has maybe a 10-15 % downside in the worst case situation, and plenty of upside with new markets, international growth and operating leverage. That’s an attractive proposition in this volatile environment. Intel remains one of the best names for new money in the blue chip investment universe.

Disclosure: No positions in any securities mentioned above.