Description
Note: 2015/16 numbers are drawn from consensus.
Short INTC
Summary: Intel (INTC) is an incredibly impressive business that is in the process of downshifting from great to good. We believe PC declines are inevitable over the next several years in both volumes as well as ASPs and the company's growth area (data centers) simply cannot grow enough to keep profitability up. Even if the decline is only mild, we do not see how this business deserves more than its current market multiple and so we view the asymmetry in this investment as very high.
Intro: Intel is one of the great business success stories of the computing revolution. It is a literal textbook example of how to establish competitive advantage as well as being a prodigious cashflow generator. It is also, in our opinion, a victim of its own success that is now on the horns of several important interlinking dilemmas and is a correspondingly compelling short as these dilemmas force it to transition from great to good.
Basic Facts: Several other VIC contributors have done a good job discussing INTC's business itself in detail so we will be brief. While it has other businesses, from a profitability standpoint, Intel is the world's dominant designer and manufacturer of microprocessor units for computing devices - especially PCs and servers - where it often enjoys market shares well in to the high-80% range. It is a high-fixed cost business that requires continual reinvestment which has historically been a great strength of the company. The stock is eminently transactable: $160bn mkt cap, ~$1bn ADV, 2.8% of the shares sold short and with a ~2.9% dividend yield.
Dilemma #1: PC Unit Decline [PC units % of consumer business vs declining PC sales and very high market share]
PCs, I think we can agree, are not a growth industry - in 2013 unit shipments were down ~-9% from 2012 and ~-13% from their 2011 all-time peak. In 2014, PC shipments look to have declined again (~-2.1%) despite an ongoing PC refresh cycle spurred by Microsoft discontinuing updates for its XP platform (historically, the obsolesence of a Windows platform prompted a new wave of PC buying). [Note: All PC shipment data from IDC]
A fact: ~90% of INTC's net operating profitability comes from its PC business (this is after including INTC's loss-making Mobile division but management has flagged most of this spend as non-discretionary). That may not be such a surprise and the pushback might be that while PCs may not grow, surely enterprise PC unit declines will be mild. But there's a second fact: 60% of INTC's PC business today is actually consumer-focused. Not that no consumer is going to buy PCs in 5 years but what aspect of the PC business seems more likely to shrink over time than that (and, indeed, has been shrinking)? The average PC now costs a bit more than $500. For that amount of money you can buy a top-of-the-line smartphone without a carrier subsidy and that smartphone will fulfill effectively all of the average non-business user's needs while also providing greater portability.
Again, even with a PC refresh cycle ongoing, IDC observed declining PC shipments for 2014. Yes, INTC managed to grow units but that came entirely from market share gains. INTC was already in the high-80% range for PC share and even a company this well-run can't avoid mathematical inevitability and get over 100%! We would argue that it is pretty clear what will happen when the refresh cycle abates (as MSFT said definitvely has happened in its most recent quarterly earnings).
Incidentally, this industry decline is also a classic argument for further PC manufacturer consolidation. This is precisely what has happened - the top 5 vendors have gone from 58.8% to 65.3% of the market in the past year alone. This consolidation will have the side effect of giving the vendors more clout when negotiating with INTC.
This brings us to.....
Dilemma #2:PC ASPs [% of bill of goods and profitability of a PC vs ASPs and margins]
We mentioned that that the average PC sold now costs ~$500. Of that, ~20% of the price is represented by the average price of an Intel PC processor. That's up from less than 15% 4-5 years ago!
Meanwhile, as you probably know, the PC manufacturers have been getting relentlessly squeezed as ASPs decline and compeition intensifies. The problem is pervasive throughout the industry but let's use HP (2nd largest in CY13 at ~16% of the market) as an example. As recently as 2011, it earned ~$37/PC before tax. In 2013, that was down to ~$18. Meanwhile, INTC has gone from $46/PC before tax to $39 during the same period, more than double HPs profit! On preliminary estimates, INTC looks to have actually increased its pre-tax profit per PC in 2014! This is indicative of the industry as a whole.
While it's not a surprise that a crucial IP holder and quasi-monopolist extracts more profitability than the commoditized manufacturers, this magnitude of difference is clearly not a sustainable state of affairs when the vendors are barely profitable on a net basis and consolidating in response. Additionally, the marginal non-enterprise customer for PCs comes from emerging markets and is less performance-sensitive to boot. All-in, Intel's ASPs simply must come down.
.....Which appears to be starting to happen, 2014 looks to have been the first full year of a new decline in Intel's PC unit ASPs as they've begun falling this year in a sustained way for the first time since the financial crisis. This sort of decline actually has happened once before in recent memory (between 2005-2009) and margins suffered accordingly (gross margins reached a low of <52% vs. ~64% today, almost an all-time high), but Intel was able to get ASPs up again in recent years. That trend turning negative once again will weigh heavily on sales and margins, especially with manufacturer consolidation. Remember that this is a high fixed cost business and so it is very sensitive to volume and ASP declines.
Dilemma #3: Milking the business vs competitive positioning
Of course, if you accept the first two dilemmas, you could argue that INTC can attempt to preserve margin dollars by milking pre-existing designs and PP&E. But the problem there is that, while it will certainly preserve some gross margins dollars in the near-term, it gives rivals the chance to catch up with Intel and potentially even steal a march on them. The manufacturers have no love for Intel but Intel today has its massive market power and the switching costs are quite high. A situation where Intel is milking the business and cutting-edge performance is less of a factor to the incremental PC consumer gives an opening for the vendors to search for alternate solutions and generally erodes INTC's competitive positioning over time. In short, we think INTC cannot slow down its spend and that INTC management knows it.
Dilemma #4: New businesses vs margins
Finally, INTC could try to re-accelerate growth by winning business in new computing forms, most notably mobile. It's certainly trying to do this but has so far failed spectacularly with effectively zero revenue coming from its mobile division in the most recent quarter (due to substantial contrarevenue - that is, subsidizing vendors to use their chips) leading to a >$1bn loss. Yes, some tablet sales are grouped in the PC unit but those numbers don't appear to be particularly substantial. We think the ship sailed long ago for INTC to gain substantial mobile share and, even if it is able to buy its way into sustained share in tablets, the margins are vastly lower than what INTC is accustomed to given the highly competitive mobile environment.
INTC could again save money in the near-term by cutting its mobile bleed but INTC has flagged most of this spend as nondiscretionary and, then it again, INTC risks being meaningfully outflanked over time as other architectures gain sufficient scale in the ever-mutating world of computing. It's also not obvious that cutting down on mobile would be quite so accretive given that it would lower INTC's overall production volumes. Cognizant of this, management seems determined to stay the course on mobile and has actually opted to combine its mobile and PC divisions in an attempt to mask its operating challenges
So, in summary, we think we are looking at a stunningly successful company that has reached the logical extremes of its competitive niche as the world has moved on. We don't think it has any good outs from this situation. You may feel this is well understood but, if so, why is this stock trading at a market multiple (~14x consensus fwd P/E) and still up ~40% over the last year? We think the stock is highly asymmetric at this valuation as both the results and the multiple are likely to decline meaningfully over the next couple of years. INTC may still be a solid company that we'd be happy to buy at the right valuation, but that valuation is not anywhere close to here.
Valuation: This is a high fixed-cost business and, as explained, things could go quite badly for INTC in several different ways. So, instead of seeing just how bad it could get, let's instead look at the recent past for a reasonable - and maybe even mild - scenario. When the PC decline was front and center on the market's mind, INTC traded with a 9x - 13x forward multiple for almost all of 2010 through 2013. That was not that long or that many negative PC unit sales reports ago. When negative unit sales again hit alongside negative ASPs, we think the stock will rerate quickly as fundamentals deteriorate. Using the 12x fwd average from that period and better-than-trough margins (16%) we think you're looking at more than (40)% downside when you start getting some multiple compression combined with EPS declines.
Meanwhile, we struggle to see how this company manages to grow its multiple or results much further so we really like the asymmetry.
Other Considerations:
- Note that CapEx continues to outpace D&A which will be another drag on earnings
- Apple has been rumored to be considering cutting out INTC's chips in its laptops and instead use its own internal solutions. Certainly not a guarantee, but is another incremental challenge for INTC and represents some of the pressure it will feel as customers fret about such an important sole supplier
- The popularity of Chromebooks and other lower-performance offerings suggest that a large portion of the PC buying public is more price-sensitive than performance-sensitive which will create further pressure.
Risks:
- INTC's PC business does not decline or declines very gradually
* Certainly possible but, since they don't have the ability to grab much additional market share (and the vendors will not tolerate a single supplier if they can possibly avoid it) INTC is at the whim of the PC end market and that is currently projected to be flat to down in 2015 plus ASPs appear to be on a continued downtrend
* Even management's guidance for FY15 includes a forecast of for flat units and a decrease in ASPs.
* Recent management disclosures have shown utilization at or near all-time highs which will cap the upper limit of further margin improvement
- The Data Center unit (DCG) makes up the loss in profitability from PCG
* Possible, as DCG is another market that INTC almost solely owns, but PCG represents 2x the revenue and 80% more OpInc. Even at management's projected growth rate for DCG (+15%), it will struggle to make up the gap if PCG's margins decline
* DCG is also a chunkier business with low visibility and so will likely command a lower mutliple
* INTC is even more dominant in data centers than in PCs and customers are eagerly looking for another supplier, several of which are mooting an entrance (including Qualcomm). Just the threat of entry will moderate INTC's ability to extract better prices.
* Even in the event that DCG does manage to make up the difference, we believe the stock is unlikely to rerate positively.
Bottom Line: We have a great deal of respect for INTC but believe the current valuation simply capitalizes INTC's recent excellent results at too high a rate as the various elements of INTC's dilemma we have highlighted here become more obvious.
Most Recent IDC Data: http://www.idc.com/getdoc.jsp?containerId=prUS25372415
Disclosure: We are currently short INTC.
I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.
Catalyst
- Earnings and estimates around PC volumes and prices
- Further evidence of the end of the XP-driven refresh cycle
- Potential entrants in either of its core markets
- INTC gives back some of the share it took near the end of FY14