On November 21, 2013, Brian Krzanich hosted his first annual investor meeting as the CEO of Intel (INTC). In retrospect, this event may prove to be the Best of Times and the Worst of Times at Intel. Certainly, technology geeks and investors are well familiar with Moore's Law, which specifies that the number of working transistors that may fit upon one integrated circuit will double every other year. Over time, computing devices will become increasingly powerful, yet smaller and more energy efficient. Ironically, Moore's Law may continue to wreak havoc on the Intel business model, as the balance of power shifts away from personal computers and towards mobile device sales.
Intel foreshadowed that company revenue would flat line through 2014, in comparison to this year. Investors promptly dumped Intel stock to $23.87, for a 5.4% loss on the November 21 trading session. Wall Street then rationalized the flat revenue projection as an admission that billions of dollars in mobile investments have failed to pay off for Intel. In response, Intel has pledged to open up its foundries to outside semiconductor businesses. Taiwan Semiconductor (TSM), of course, is the 800-pound alpha gorilla sitting in this room, where Apple (AAPL) looms large as the main prize. Ironically, Intel as a foundry may be yet another Catch-22 proposal that shall be interpreted as a concession of defeat.
Intel PC Bread and Butter
For the sake of making comparisons, please be advised that fiscal years at Intel and Taiwan Semiconductor both largely coincide with calendar time. In recent years, Intel has classified its businesses according to PC Client, Data Center, Software and Services, and Other Intel Architecture operating segments. The Other Intel Architecture was designated as an umbrella classification largely above mobile chip sales. Through the first nine months of 2013, the Intel PC Client Group generated $8.4 billion in operating profits off $25.5 billion in segment revenue. In all, Intel posted $8.7 in operating income upon $38.9 billion in total net sales through this same time frame. Intel has been historically revered for its fat gross margins of 60%, or more.
High margins at Intel, of course, are largely attributable to the vertical integration of powerful chip design, assembly, and distribution to PC and server companies. The PC Client Group alone often generates roughly two-thirds of all sales activity at Intel. For the sake of comparison, the Other Intel Architecture division racked up $1.8 billion in operating losses upon a mere $3.0 billion in revenue between Q1 2013 and Q3 2013. Meanwhile, Taiwan Semiconductor posted a respective $7.3 billion in gross profits upon $15.2 billion in net revenue through the same time frame. Gross margins at the world's largest independent foundry have generally ranged between 45% and 50%. Again, factory work, if you can get it, is a bit less profitable than selling off popular and vertically integrated chip technology. Intel bulls should not assume that an American company would match the low costs and profitability of the Taiwan-based outfit.
In 1999, near the peak of the personal computer revolution, Intel spent a mere $3.1 billion on research and development, out of $29.4 billion in net revenue. During prior years, Intel was to allocate less than 10 percent of total net sales to research and development. By 2012, Intel was directing roughly 20% of net revenue towards research and development. In terms of cash flow, Intel has already used up $7.8 billion in cash for additions to property, plant, and equipment, through the first nine months of this year (Intel generated $14.7 billion in Q1 2013 to Q3 2013 operational cash flow). To date, Intel has literally attempted to buy its way into the mobile market, through aggressive capital spending. All recent reports out of research firms Gardner and IDC have confirmed a secular shift out of personal computers and into mobile devices. IDC has projected annual mobile unit shipment growth rates above 70% through year 2017.
Apple is The Big Fish
In addition to Moore's Law, prospective Intel investors must also acknowledge the Law of Large numbers. In terms of market capitalization, Intel is a $118.9 billion operation. Again, the company sinks billions of dollars into capital spending, each year. Expensive foundries must therefore be running at full capacity, in order for Intel to profitably leverage its fixed costs and generate real shareholder returns. Leading mobile chipmaker and rival Qualcomm (QCOM) is not likely to hand its business over to Intel. To no avail, Intel has nearly wasted two years of time in an attempt to outflank the ARM-based (ARMH) Qualcomm Snapdragon as the go-to engine that drove premium Android, and even Windows, handsets and tablets. For all intensive purposes, Intel must win Apple chip manufacturing contracts, in order to economically justify Santa Clara's foray into the foundry business. In 2013, ARM-based A-Series chips helped move more than 150 million and 70 million Apple iPhone and iPad shipments, respectively.
To date, the highly secretive Apple has contracted out the bulk of its chip manufacturing orders to rival Samsung (GM:SSNLF). The working relationship between these two unlikely bedfellows, of course, has been frayed by a seemingly endless parade of patent infringement lawsuits and billion-dollar judgments. The dysfunctional Apple-Samsung relationship has all the markings of codependency, as Apple has relied upon Samsung's manufacturing prowess to solidify its own iPhone and iPad supply chains. According to Mark Newman, Sanford Bernstein analyst, Samsung has filled roughly $10 billion worth of Apple component orders, over the course of the past year. Samsung, of course, will reinvest this money back into the company to roll out its own smartphones and tablets that compete directly against Apple.
Enter Taiwan Semiconductor. For years, the rumor mill has been abuzz with speculation that Apple was making moves to dump Samsung as a manufacturer, in favor of striking deals with either Taiwan Semiconductor, or Intel. On July 1, 2013, The Wall Street Journal confirmed rumors that Taiwan Semiconductor had inked a deal to share the load with Samsung, and produce 20nm Apple A8 chips, beginning in 2014. Ironically, Intel and its spearhead 14nm manufacturing capabilities, will be the odd man out as a foundry throughout the course of the next eighteen months. A recent deal to manufacture ARM-based chips for Altera will barely budge the bottom line needle at Intel.
The Bottom Line
Intel bulls, notorious for doggedly harping upon technical specifications, should also acknowledge that a long-term alliance with Taiwan Semiconductor grants ever more authority for control freak Apple to throw its weight around. Apple closed out its latest 2013 fiscal year ended September 28, 2013, with $146.8 billion in cash and securities on the books. Going forward, Cupertino could be laying the groundwork for a direct investment into the $90 billion Taiwan Semiconductor, in order to build out a wing of this company specifically designated to crank out Apple parts. Taiwan Semiconductor Founder and CEO Morris Chang, 82, may be open to closing out a megadeal for his company, before riding off into the sunset.
On November 27, 2013, Intel stock closed out the trading session at $23.90 per share. Again, this performance calculated out to $118.9 billion worth of market capitalization. Intel may close out this 2013 fiscal year with $10 billion in net income, at best. At this rate, Intel would trade for an estimated 12 times current earnings. This valuation is somewhat of an expensive price to pay for a deteriorating business model. Intel brass has already foreshadowed flat revenue figures through 2014. James Covello, Senior Analyst, Goldman Sachs, recently went on to dismiss even these flat revenue projections as 'aggressive.' Covello has also described his feelings towards Intel as an investment as the 'exact opposite' of bullish. Earlier this month, on November 22, 2013, investment bank Goldman Sachs reiterated its sell rating and $16 price target for Intel shares.
Financial engineers may argue that Intel can simply slash capital spending and direct these savings to buy back additional shares of outstanding stock, in order to immediately improve earnings per share. Intel managers, of course, have proven unwilling to kowtow to the financiers. Short-term financial engineering may effectively gut long-term prospects at Intel. At this junction in time, Intel must take a gamble on mobile, in order to avoid even further fallout from what appears to be the inevitable decline of the personal computer industry. As such, prospective investors should recognize that the fortunes of Intel are caught between a rock and a hard place, and walk away. Intel stock ownership is a losing proposition.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)
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