- Intel may strike a licensing deal with AMD upon the expiration of its current deal with Nvidia.
- This will have some favorable impact on cost savings, but the cyclical nature of Intel’s profitability will most likely continue.
- This has very little impact on Nvidia, but will be a big needle mover for AMD stock.
Intel (NASDAQ:INTC) has a deal with NVIDIA (NASDAQ:NVDA) to license some of its integrated/workstation graphics technology from Nvidia, which is set to expire in 2017. In a lot of sell side models, there’s zero assumption of renewal of the licensing deal with Nvidia, and according to recent reports, Intel is leaning towards AMD (NASDAQ:AMD). To be fair, AMD’s graphics technology is at least competent when compared to Nvidia in mid to high-end models, which implies that the patent portfolio of AMD is at least passable and would provide enough IP for Intel to create a compelling chip for its Xeon-Phi line-up of server co-processors and Intel embedded graphics chips.
Intel licensed this technology from Nvidia after settling a lawsuit with a $1.5 billion licensing agreement between 2011 and 2017. This amounts to $66 million in revenue per quarter for Nvidia, which translates into direct profit as there are no overhead costs to collecting royalties from its graphics patent portfolio. However, Intel upon the expiration of this licensing deal could expect to get a better deal from AMD, and reduce its expense of paying $264 million per year to Nvidia.
However, the cost of licensing graphics technologies is peanuts to Intel as it has averaged operating margins of 25% or so over the past couple of years. The operating margin fluctuates between 20% and 30% depending on the launch cadence of next generation parts. More specifically, Intel’s profitability is heavily dependent on the timing of CAPEX for its next-generation fabrication technology, which carries higher cost due to lower yields from wafers and timing of amortization from PP&E (Plant, Property & Equipment) investment made for next generation parts.
I foresee Intel’s profitability to be negatively impacted in FY’18 as Intel’s first generation 10nm parts will have lower yields plus the depreciation and amortization schedule is most elevated in the first generation part following a node shift. Therefore, I anticipate that Intel will report lower gross margins in the first half of 2018. Profitability will remain elevated in the next fiscal year or two, because Intel’s 14nm technologies are “mature” meaning that yields are optimized and the depreciation/amortization schedule tends to level off in the second generation of a transistor node.
Therefore, Intel’s profitability metrics won’t improve by much in FY’17 upon moving a licensing deal over to AMD. The same cyclical nature of profitability will continue, and while management likes to remind us at every analyst day that they have some miraculous way of reaching sustained operating margins above 30%, the small stuff like reducing mobile R&D, or renegotiating licensing deals will only provide so much cost recapture. In other words, for Intel to recover, there would need to be a meaningful improvement to desktop/laptop shipments or a shift in product mix to high-end SKUs, which seems less likely following various supply chain reports. The broad weakness in consumer electronics also extends to PCs and laptops, which implies that shipment growth will continue to decline on aggregate. I believe Intel will mitigate some of this impact with ASP improvement, and gross margin improvements, but it’s really hard to get really aggressive on Intel stock here without a more meaningful catalyst to earnings and sales.
However, if AMD is able to bid low enough, it can stave off its current cash burn, which has averaged -$54.3 million free cash flow over the trailing five-year period. Even an incremental $100 million to $150 million in free cash flow for AMD would be a huge needle mover, and would allow the company to remain financially solvent to pay its upcoming bond notes or continue bond issuances to pay the previous bonds. The company has $2 billion in long-term debt and $785 million in cash/equivalents so upon the maturity of its current bonds, it would need to issue more bonds to pay back its previous obligations. However, upon returning to free cash flow positive, the company would secure a higher credit rating, which will reduce its debt service cost thus freeing up additional resources for R&D and SG&A (Selling General & Administrative expenses). Therefore, there are enough immediate upside catalysts for AMD stock to make it a compelling consideration. I don’t foresee shares tripling or quadrupling, but over the near term, I see shares trading at $4 on sentiment alone, which would imply 43% upside from its current levels (March 24 close price).
On the other hand, Nvidia’s loss of licensing revenue to Intel is fully priced into the current Nvidia stock price. Analysts don’t anticipate Nvidia to renew its license with Intel. Furthermore, I view the upside to its high-end graphics business to be far more meaningful, as the launch of its Pascal family of GPUs will create a wave of replacement demand, which should be enough to offset declines in licensing revenue to Intel. I also believe its autonomous driving platform and efforts to earn licensing revenue from patents pertinent to mobile GPUs will help to fill the gap in licensing revenue from Intel. Hence, the impact on Nvidia stock price was limited and the stock, in fact, rose 3% following Bloomberg’s report whereas AMD shot up by 4%. Intel’s share price increased by 2% following the report.
The move in Intel stock price was driven by sentiment rather than fundamentals. Needless to say, Intel stock is heavily undervalued and reversion to the mean was likely to occur at some point, but the recent momentum isn’t tied to the Bloomberg report. I also believe confirmation of Nvidia’s loss of Intel licensing revenue doesn’t classify as good news, but confirmation of what’s on the minds of buy/sell side analyst doesn’t hurt. The big winner, following the Bloomberg report, was AMD and its recent momentum can at least be supported with fundamentals. Over the near term, I believe AMD stock will perform the best out of its peer group.
I reiterate my buy recommendation on Intel, Nvidia and AMD. I currently have a price target of $38.79, $43.15 and $4.00 respectively for Intel, Nvidia and AMD stocks.