Intel Working Through A Difficult Transition

By Stephen D. Simpson, CFA | Updated April 11, 2014 AAA

Chip giant Intel Corp. (Nasdaq:INTC) continues to work through a challenge that most leading tech companies face at some point in their corporate lives – what do you do when your bread-and-butter market has fundamentally changed? Santa Clara, Calif.-based Intel's efforts to engineer a second act have consumed considerable shareholder capital but have yet to show a lot for themselves, as the company's fab efforts are still sub-scale and the company lags San Diego's Qualcomm Inc.(Nasdaq:QCOM) in the mobile world.

The good news for Intel is that reports of the demise of PCs and servers are likely significantly exaggerated, meaning that Intel can harvest years of rich cash flow while other businesses gain scale. Intel is not likely to emerge as a winner in mobile, but the shares are still priced to generate reasonable returns from today's level.

Will Intel Get Squeezed Out of Mobile?

Despite excellent chip manufacturing and process capabilities, Intel has struggled to gain any real traction in mobile despite generous incentives to original equipment manufacturers. Qualcomm has staked out a leading position on the high end of baseband and mobile app processors and has hardly looked back since. While Intel continues to talk a strong, optimistic game, the reality is that adoption continues to lag and the company is churning through quite a lot of capital in trying to catch up.

A lot of companies are likely to see that ongoing operations in the mobile chip market just aren't a good long-term use of capital and that it is too difficult to carve out enough market share and revenue to make the ongoing R&D demands viable. On the opposite end of the spectrum sits Hsinchu, Taiwan-based MediaTek Inc. (TWSE:2454), a provider of chips for low-end and mid-range phones produced primarily by Asian OEMs. MediaTek has a cost structure that makes competing on the low end worthwhile; Qualcomm and MediaTek may basically squeeze out the other players.

Intel certainly has the capital to stay in the game longer than Santa Clara, Calif.-based Marvell Technology Group Ltd.(Nasdaq:MRVL) and Nvidia Corp. (Nasdaq:NVDA), or Irvine, Calif.-based Broadcom Corp. (Nasdaq:BRCM), but without meaningful design wins and share gains in the next 18 months or so, it will be increasingly hard to justify the spending.

Fabs Could Still Be a Good Opportunity

It was once thought that Hsinchu, Taiwan's Taiwan Semiconductor Mfg. Co. Ltd. (NYSE:TSM) was practically untouchable in the fab space, as the company always managed to stay a step (or more) ahead of other chip fabs. In recent years, though, Intel has significantly stepped up its game in line with transitions and chip structures, seriously challenging TSMC for technology leadership and the premiums that go with it for leading-edge capabilities.

There has been some debate lately as to whether TSMC's 16nm “FinFET Plus” has closed the gap. Even if Intel's lead isn't quite what Intel wants the market to believe, the fact remains that there is a lot of uncommitted potential at Intel for this business. San Jose, Calif.-based digital circuit maker Altera Corp. (Nasdaq:ALTR) is already on board as a fab customer, but there could be substantial opportunity here- particularly if Intel is willing to take on ARM licensees like Marvell or Nvidia.

Can PCs and Servers Bridge the Gap?

Intel's mobile efforts are likely to prove disappointing over the long term, but there is meaningful potential in further expanding the fab business. In the meantime, there are the large PC and server chip businesses to consider.

On one hand, it's easy to argue that Intel's share in these markets (over 80% in PCs and over 90% in servers) has nowhere to go but down. In the case of servers, there is a threat of oncoming competition with ARM-based microserver chips from Sunnyvale, Calif.-based Applied Micro Circuits Corp. (Nasdaq:AMCC), ​San Jose, Calif.-based Cavium Inc. (Nasdaq:CAVM), Marvell and Qualcomm, though the microserver market could take longer to materialize. On the PC side, while there has been some significant damage to this market, there is still a core base of demand that can provide ample revenue and cash flow for Intel, albeit not with much (if any) growth potential.

The Bottom Line

Weighing out the long-term challenges in PCs and servers against the prospects for growth led by mobile chips and fab services, I model long-term revenue growth for Intel of around 3% (against a trailing growth rate of 5%). On the FCF side, I expect Intel's margins to improve as the company better leverages past R&D investments and scales up the fab operations, leading to growth of around 3% to 4%. Discounted back, that works out to a fair value of over $26. At today's price, Intel does not look notably cheap, but it does look priced to generate mid-to-high single-digit annual returns (capital appreciation plus dividends). That's not remarkable, but it's not terrible relative to the market and it does still allow for some upside from the mobile efforts. 

Disclosure: At the time of writing, the author owned shares of Broadcom.

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