- Due to a tough PC environment I’m revising my stance on Intel.
- Key-trends in PCs will drive some recovery, but sales acceleration is more of a 2017 theme.
- After a comprehensive financial overview, the stock seems fairly valued at around $31.56.
I’m going to start this article by stating, “I’m sorry guys.” I got Intel wrong back in 2015. I figured that at this point, cyclical trends would start to take over and PCs would recover. Instead, I have to revise my stance quite considerably from prior-year, as I believe the upside potential in Intel (NSDQ:INTC) is quite limited, and feasibility of a market recovery has diminished given key trends in the PC market, and reduced pricing for enterprise products. I believe these factors are already reflected in the stock price, so even if investors were to abandon their long position, it’s not like the stock will move considerably higher from here in 2016. So, you won’t miss out on much this year, and many could potentially revisit a decision to buy Intel shares at a later point.
I also believe that the stock will perform a lot better by 2017, but patience is key here because Intel’s efforts in the datacenter side of the business won’t materialize into meaningful sales acceleration until the adoption of server-class CPUs for telecom network workloads.
The High-Level overview
Given the management commentary, we’re likely to witness stabilizing CapEx trends, as the company has optimized itself at keeping it at levels of $9 to $10 billion over the next two years. This is a shift from historical patterns of CapEx build ahead of a node shift. The transition to a tick-tock, tock, tock cycle has allowed Intel to spread its investment spending, and it’s likely that the next node shift to 10nm will likely occur within the 2017 timeframe, and volume production will happen in the second half of 2017 reaching consumers by either Q4’17 or Q1’18.
Furthermore, Intel will release Kaby Lake, its 3rd generation 14nm family in Q4’16, which might spark some demand in PCs. However, the back-half results will only counter-balance what has been a poor start to the first half of 2016. Net-net, I still anticipate the CCG (client computing group) to report declining sales in FY’16, which I will elaborate on in more detail.
At a recent Bernstein technology conference, Bryan Krzanich (CEO of Intel) mentions that PC refresh has elongated further from the average of four years to perhaps five to six years. This implies that the cyclical growth driven by upgrades will take longer to materialize, and it may happen either this year or the next couple years. Hard to tell, but we might capture a bit of a tailwind in 2H’16 due to the summer release of a true next-generation MacBook family and VR becoming a more coveted functionality that penetrates deeper into the consumer PC market. It’s hard to really tell at this point, but with IDC revising its full-year shipment growth estimate from -5.3% to -7.3% y/y, the market will likely remain in the doldrums.
Decline in PC shipments doesn’t fully translate into Intel’s revenue for the current year, as the company is transitioning away from contra-revenue support for mobile OEMs, which drove the ASP figure higher thus diminishing the negative impact from shipment decline in the client computing group.
Now as you may know from prior Intel articles, I mentioned that Intel’s inventory trends remain a lot more elevated. So, it’s hard to articulate the specific drivers, but management commentary implies a shift amongst OEMs with inventory burn a key factor. So there was some build-up on Intel’s end. Furthermore, we can observe that Intel’s inventory also increased due to the integration of Altera, which added roughly $500 million to the figure according to RBC Capital Markets. Now, Skylake processors are still “in”, so we know that even if build-up is occurring we can also point to mid-2016 refreshes as contributing factors to abnormalities in the inventory figure, and why it might decline following the summer launch of PCs and with Stacy Smith stating, “I think you'll see the same impact as we forecast a roughly seasonal second quarter; that we'll continue to see those customers burning off inventory. We think that doesn't repeat in the back half. So that's a little bit of a tailwind.”
In a report released on May 30th 2016, RBC analyst Amit Daryanani made some salient observations:
Furthermore, June-qtr demand expectations at OEM level are muted with aggregate revenues expected to decline by 2% q/q (vs. seasonality of 2% growth). Much of the softness is within enterprise IT and AAPL from a sub-segment basis at the OEM level.
There’s no denying that Apple mentioned that they’re reducing inventory in their channel on the prior earnings call. After all, Apple would want to reduce the channel inventory ahead of major launches in the Mac segment, so… we have to wait for Q3’16 and Q4’16 uptick before getting aggressive on client computing results, which then balances out to perhaps a 5% decline in revenue, as the ASP improvements offsets unit declines of perhaps 7% to 10%, which is based on IDC commentary and the weak results in Q1’ and Q2’16.
Furthermore, Intel’s spread of Capex spending across three-years for the major node transitions doesn’t actually reduce Capex, but instead spreads investment into other areas. The other investment opportunities are in capacity and node transitions to 16nm at its Dalian fab, which manufactures the memory and storage products used in the datacenter and consumer products. This category is still growing and adds incrementally to DCG results by roughly 3 percentage points in annual growth, so it’s worth noting that this particular investment is roughly estimated at $5.5 billion over three years before Intel has to retrofit the facility again for another node shift. Furthermore, it operates at 16nm, which means that its Optane and SSD products will be running off of a different cadence.
According to Stephen Chin from UBS the investment into its Dalian facility totals out to approximately $1.55 billion this year:
We estimate etch was 45% of its purchases last month, CVD (chemical vapor deposition) was 20%, PVD (physical vapor deposition) was 10%, and implant, inspection and lithography were each around 5%. We estimate Intel's China total capex spend is now $450M, which suggests there is another $1.1B of capex left to spend this year if Intel stays on schedule. We estimate 55% of Intel's China fab total capex of $5.5B will be etch and CVD tools.
Investment has rapidly accelerated in the past couple months at the Dalian Facility, which implies upside in Intel’s memory solutions group, as they’re building the capacity at pretty quick pace to address end-market demand by 2017, which becomes a needle mover for DCG results, and may pivot us from slowing growth in the segment.
Financial Model Revision
I’m revising my EPS estimate and revenue estimate lower in this specific article. All of the aforementioned factors drive my assumptions on revenue this year. The addition of Altera and core growth in some of its smaller product segments will start to drive revenue, but the net impact from the non-performing PC segment is what’s forcing me to revise my rating on the stock. Furthermore, I anticipate gross margin to remain stable at around 62%, which is due to higher yields from wafers paired with less impact from contra-revenue in the mobile segment. The gross margin will probably do better than 62%, but I’m going to remain more conservative and stick with the consensus view here.
I also factor in the cost savings on OpEx from the Q1’16 earnings call as well and anticipate similar tax rates to prior-year. This all balances out to 4.86%, 2.73% and 4.95% y/y revenue, net income and diluted EPS growth respectively. My diluted EPS estimate is roughly $.04 higher than the consensus figure, so I’m slightly more optimistic, so there might be room for upside to figures, but not much.
Intel is going to slog its way through a tougher environment this year, so expect minimal upside to the stock price. I revise my price target lower from $38.79 to $31.56, and also downgrade the stock from buy to hold.
Investors will want to shop elsewhere, but next year may provide enough uplift to results due to ramping growth in some of its smaller segments, and return to perhaps mid-teen revenue growth in the datacenter segment. I think the long-term dynamics are a little more compelling, but since they’re not going to materialize anytime soon its best to stay on the sidelines for now. I don’t think there’s any more downside left, so I wouldn’t go so far as shorting the stock either. Also, if you’re a long-term dividend investor, Intel’s dividend yield of 3.26% is somewhat attractive, but you’ll get a better dividend and stronger recovery plays in the oil and gas space.