Intel – Pay Today To Grow Tomorrow

By Stephen D. Simpson, CFA | January 23, 2012 AAA

For better or worse, software giant Microsoft (Nasdaq:MSFT) and Intel (Nasdaq:INTC) are still tied together in many investors' minds. Both are former leading lights of the tech universe brought low by the perception that the evolution of new technologies will permanently cripple their growth prospects.

With a growing addressable market in areas like security and data, Intel's ability to flex its R&D and manufacturing muscle may well be underestimated by the Street today.

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Beating Lower Numbers for the Fourth Quarter
Intel reported a fourth quarter that was broadly better than published estimates, though still shy of where most analysts had been on the stock a couple of months ago. Revenue slid more than 2% sequentially, but jumped 21% over last year as Intel had little choice but to endure the disruptions to the PC market brought on by the flooding in Thailand (and the subsequent issues with hard disk drive supply).

Growth in the core PC business fell 4% sequentially (and rose 17% versus a year ago), while the start of Romley shipments led the data center business to 8% sequential growth. Intel's software and services segment saw nearly 7% sequential revenue growth.

Gross margin improved about a point sequentially (and was basically flat from last year). Increased R&D spending weighed on operating income, though, and operating income fell 4% sequentially (and rose 14% from the year-ago quarter), leading to about a half-point of operating margin compression. (For related reading, see Understanding The Income Statement.)

Spend Today to Win Tomorrow?
One of the bigger sources of volatility in Intel shares has often been the company's guidance on capital spending and, to a lesser extent, R&D. The question here really comes down to short-term thinking (what can boost earnings and cash the most right now) versus long-term success.

Intel's R&D spending in 2011 was greater than the market capitalizations for other chip companies like ON Semiconductor (Nasdaq:ONNN), STMicroelectronics (NYSE:STM) and very nearly Nvidia (Nasdaq:NVDA) as well. While it may be true that there has never been a one-to-one correlation between R&D spending and results, I have to believe that such a level of development activity gives Intel multiple chances to get back in the game on mobile and expand into other markets like networking and security.

Capex, too, can offer under-appreciated leverage. Capex does drain away capital that could otherwise be paid out to shareholders, and increases depreciation expense. But capex also can lead to better gross margins and the ability to literally make things that other companies cannot. Capex can also give a company more flexibility - Texas Instruments (NYSE:TXN) recently made major investments in capex and is using the margin leverage that has provided to start competing in market segments that were previously less interesting from a profit perspective.

As an aside, with Intel upping its spend, that's good news for equipment vendors like Applied Materials (Nasdaq:AMAT) and KLA-Tencor (Nasdaq:KLAC) that sorely need a rebound. It could also work out well for ASML (Nasdaq:ASML) - although Nikon has been a strong supplier to Intel in the past, ASML's R&D advantage may serve to force Intel's hand more towards ASML in the future.

The Bottom Line
Like Microsoft, Intel is not at all conceding the mobile market to the new generation. It will take time to grab share and shift the market, but Intel clearly has the resources to devote to this market.

All of that said, Intel doesn't jump out as a huge bargain. The relatively quick obsolescence cycle of semiconductor equipment limits future free cash flow leverage, and even an assumption of 10% forward compound free cash flow growth does not leave a lot of appreciation potential in the shares. Intel is certainly a solid company (and pays a good dividend), but there are better ways to make money in chips today. (For related reading, see Free Cash Flow Yield: The Best Fundamental Indicator.)

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At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.

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