Despite Setbacks in Mobile, Intel Is Undervalued

(This is a highly-abbreviated version of a full SumZero report republished with the author's consent)

Contributor: Mike Curran.
Firm: Cush Capital Management. Hedge Fund.
Location: Overland Park, KS.

Recommendation: Long Shares of Intel (Nasdaq: INTC).
Timeframe: 1 to 2 Years
Recent Price: $25.85
Target Price: $32.00
Strategy: Value

Disclosure: The author of this report had an active position in this security at the time of its posting.

Quick Thesis:
What is the market missing about this story? Why is the investment mis-priced?

Intel has faced negative headlines as it is tied so closely with the PC market. Rightly so as it has 80% market share of the microprocessor market. As negative headlines hit for HP, Dell and PC’s in general, this affects Intel’s stock price.

Intel has been late to the party in terms of chips for the tablet and smartphone markets. That has definitely played in to their stock price being depressed. Although security is seen as playing a big part in this market going forward, Intel’s purchase of McAfee in 2011 was also seen as a negative because of the premium that Intel seemingly paid for McAfee. Intel paid $7.68B or $48/share for a company who was trading at the time at just under $30. As they work through this acquisition, as well as many others they have taken on in the last few years, their investors will remain cautious and conservative.

Although capex spending and especially R&D spending has been way ahead of Intel’s competitors, this does hold back the company's stock price. At some point you have to make dollars off of all this spending. Intel has spent $13.8B in the last fiscal year on capex and the 1st quarter R&D spending hit $2.4B alone. The company has 3 new 22nm factories ramping in the 2nd quarter 2012 with 1 more coming on in 2H 2012.

Our speculation is that these factories will be used for the increased capacity needed for “cloud” expansion as well as Intel’s processors starting to make their way back in to Apple products, both computers and cell phones. We have a call into management to ask about this. Intel’s new Ivy Bridge chips (22nm) are rumored to be in the new MacBook refresh which is just starting. There must be several factors that caused them to ramp up 4 new fabrication factories.

Two additional points:
• We stipulate that Intel can grow in the 7-8% range annually for the foreseeable future.
• Management’s guidance for the short-term is conservative with gross margins ranging between 60-65% through 2013 and they have left their previous guidance unchanged.

Intel’s stock price does not reflect PC growth in emerging markets, cloud computing, and corporate spending on data-center infrastructure, including storage, networks and servers. Intel is rightly getting very little credit for their move in to mobile but this is also discounting any major move with any of their new products in this area.

Valuation
MC/LFCF = 131.16B/6.37B= 20.59. This number is high but we are comfortable with that seeing how they have spent an inordinate amount of capex on their four new factories that are ramping up in 2012. Obviously not all of the money was allocated this year but each factory costs roughly $5B.

OCF/MC= 19.92B/131.16B = 15.2% FCF yield
OCF/EV= 19.92B/121.71B= 16.37%
P/B= 2.72; F P/E=9.7; Beta=1.07; PEG= .77
EV/EBITDA= 5.17
Cash on hand: $13.75B
Debt: $7.52B

We expect Intel to have EPS in 2012 of $2.50 which is in-line with management guidance. If we expect growth on the lower end of the range, 7%, then by 2017 we expect EPS to hit $3.50. If we put a 10 multiple on that then we are looking at a $35 stock. There is also a case to be made that the P/E should be equal to or higher than the current P/E for the S&P which is around 15 . A $9 move on a $26 stock gives us a 35% capital appreciation over the next 5 years plus a 3.3% dividend yield.

Business Expectations
The next two logical questions are why we think they can grow at least 7% per year and why we think they can maintain margins in the current 60-65% range?

• As the cloud expands and adoption of tablets and smartphones continue to increase, it will require substantial build-outs to create infrastructure necessary for the cloud. This will provide LT tailwinds for growth of Intel’s server processor segment, the firm’s most lucrative business.
• Strong emerging market growth in the BRIC (Brazil, Russia, India and China). They have seen double-digit growth in the last few years.
• Over 100 designs are in the pipeline currently in 2012.
• Estimated that Ultrabooks will hit mainstream by Christmas time and will represent 40% of all the PC’s shipped in the US in 2012.
• They have a new partnership with Visa for mobile payments, a growing segment.
• McAfee held up against the Day Zero Crydex worm attack; missed by many of their competitors. Security will continue to be ever more important as we move forward.
• Data-center revenue has doubled over the past decade and accounts for about 20% of total revenues. As internet data traffic explodes, so does the need for computers servers and storage.
• They have new partnerships with Lenovo and Motorola in mobile phones.
• Ivy Bridge could be a very big revenue driver.
• The hard disk drive shortage has just about worked itself out now.
• The mass proliferation to the tablet market will help Intel, regardless of how Intel fares against ARM.
• Mobile revenues are being helped by the 2011 acquisition of Germany’s Infineon Technologies, which is expected to report $4B in revenue this year and projected to grow over 30% in 2013.

One area we really have not expounded on in this report is internet security. Intel obviously thinks this can be an important area of growth going forward with their purchase last year of McAfee.

Risks
• The semiconductor industry is cyclical. Intel must continue to innovate in order to keep its lead and dominant position in the microprocessor market.
• Clearly the US PC market is in a decline and this is where Intel has been the dominant player for years. This will cause a headwind if they can’t replace this business with other products.
• AMD and ARM Holdings have become formidable competitors, especially the latter as they own a significant share of the mobile device market.
• There are obviously numerous others risks but these are the main ones we are focused on in the short to medium term.

Conclusion
Our analysis tells us that the company is worth north of $32 and that in order to satisfy our margin of safety we should buy it below $26. Even our pessimistic viewpoint yields a price target of $24. We stress-tested our model with declining revenues and up to 800 bps in margin compression and we still have a price target of at least $30. At this price and dividend yield, we can afford to be patient as this plays out over at least the next 5 years.

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