How Did Intel Do This?

By Stephen D. Simpson, CFA | October 24, 2011 AAA

The word "surprise" is a given whenever it's time to talk about earnings season, but Intel (Nasdaq:INTC) went above and beyond this quarter. Is Intel's robust growth, in spite of sluggish shipment data from leading PC makers, a sign that U.S. computer companies are more significant than ever before, is it a sign that Intel is gaining shares or is it a sign that dangerous levels of inventory may be building up in the channel? While Intel looks too cheap, no matter what the answer may be, the degree of volatility in this stock may hinge on the answer.

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A Surprising Third Quarter
To be fair, it's not as though Intel left the Street thunderstruck; revenue rose 28% from last year (and almost 9% from last quarter), and that was about 2% higher than the average analyst estimate. PC Group's revenue rose almost 22% this quarter with strong double-digit sequential growth in the notebook unit. The server group was no slouch either, with 15% growth, and the company's acquisitions of McAfee and Infineon's wireless business seem to be paying off.

Profitability was more mixed. Gross margin did improve nicely from the second quarter, but fell two and a half points from last year. Intel lost more momentum through the operating items, and while operating income rose 16% from last year, the margin fell almost four points.

Where Is the PC Growth Coming From?
Intel management, among others, has long maintained that there is more growth potential in non-U.S. PC makers than many seem to realize. It's pretty clear that the PC growth at Dell (Nasdaq:DELL) and Hewlett Packard (NYSE:HPQ) can't support this level of growth, so maybe it really is a case where ASUS, Acer and Lenovo (LNVGY) are picking up the slack. Along the same lines, maybe Intel is just pounding Advanced Micro Devices (NYSE:AMD) all over again and taking share.

Here's the rub - if conditions are so good for Intel, why aren't they good for memory makers like Micron (Nasdaq:MU), Sandisk (Nasdaq:SNDK) or Hynix? Why aren't conditions so good for LCD players like AU Optronics (NYSE:AUO)? After all, how do you build and sell PCs without memory or screens? The threat, then, is that there is too much inventory building in the channel, and that such a buildup has simply pulled revenue forward into this quarter.

Have Profits Peaked?
There is a broader worry in the markets today that U.S. businesses have been operating at, or near, peak margins, and that investors need to stop assuming further incremental margin improvement. Now one quarter, even one year, is not even close to enough data to make such a proclamation about Intel. Still, it looks as though the company has to spend more on sales and marketing to maintain its sales momentum, and the equipment from vendors like Applied Materials (Nasdaq:AMAT) and ASML (Nasdaq:ASML) is not getting cheaper.

Still a Threat from, and to, the Newcomers
Perhaps Intel feels it needs to ramp up its marketing spending in order to better compete with chips based on ARM Holdings (Nasdaq:ARMH) technology (like those that go into Apple (Nasdaq:AAPL) products)), or to keep a fence around Nvidia (Nasdaq:NVDA) as it tries to expand beyond its historical core graphics chip business.

At this point, Intel still has a lot of work to do if it wants to grab shares in the new mobile computing world and replicate its dominance from PCs and servers. By the same token, this is Intel - few companies on Earth can devote as much money towards chip research and development as Intel, and if participation in new products like smartphones and tablets really is vital to Intel's survival, it would be dangerous to bet against them.

The Bottom Line
Nobody wants to give Intel any real credit with respect to future growth. In fact, if Intel simply maintains a level of free cash flow conversion on par with its past 10 years and grows at a mid-single-digit rate, the stock is at least 20% undervalued. Now, bears can argue that margin pressures are going to reduce that free cash flow margin or that even mid-single-digit revenue growth may be ambitious, but that seems like an aggressively negative position to take given the results that Intel has been producing. (For additional reading, see The 4 Basic Elements Of Stock Value.)

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