Intel: Chips Above the Rest

Stronger sales of PCs, competitive technological advances, and an enticing valuation should push the company's shares higher

From Standard & Poor's Equity ResearchThe semiconductor industry is in the early stages of an upturn, and we believe that accelerating PC growth will provide Intel (INTC; recent price $24.45) strong growth opportunities. We think Intel has a key competitive advantage with its technology, which should lead to market share gains and better profitability.

That's why we have Standard & Poor's highest investment recommendation of 5-STARS, or strong buy, on Intel shares. Essentially, we think that a very favorable demand environment, competitive technology advantages, improving company fundamentals, and an enticing valuation are catalysts for the stock to outperform.

According to market researcher IDC, worldwide PC shipments have recently risen above expectations, rebounding from single-digit growth at the end of 2006 to 11% growth in the first quarter of 2007 and 12% in the second quarter. Growth was supported by strong sales of mobile computers, which advanced 29.5% in the second quarter from the same quarter last year, compared to a 2.3% increase in desktop computer sales for the same period.

With mobile shipment growth expected to remain strong over the foreseeable future, we believe this trend and an increase in corporate spending for desktops, mobile, and servers will support healthy double-digit computer growth through 2009, similar to IDC's expectations. Considering that there's a large correlation between PC shipments and Intel's sales, we see the anticipated computer sales growth providing Intel with a substantial growth opportunity.

"Tick-Tock" Strategy

A few years ago, when Intel was focusing on creating faster microprocessors, Advanced Micro Devices (AMD; ranked hold) went a different direction and focused on creating chips that were not only fast but also power-efficient—a quality that became increasingly attractive to businesses with large energy bills because of computing activities, and to laptop customers who faced short battery lives, among others. AMD quickly attracted new customers for its speedy and power-efficient chips; between 2005 and 2006, the smaller chipmaker gained an additional 10% of market share.

Losing ground, Intel fought back with a new strategy based on introducing a new line of microprocessors that were both fast and power-efficient, and advancing its process manufacturing capabilities so that it could create better performing chips and/or lower per-chip costs. Now, over a year after implementation, we think the strategy has helped Intel regain the technological lead and gain market share from AMD.

Intel refers to this strategy as "tick-tock," aimed at creating and sustaining technology leadership by increasing the cadence for new chip releases and for process technology improvements. Essentially, the strategy calls for releasing a new line of better-performing chips every single year. The "tock" portion of the strategy began in 2006, when Intel released chips with the Core microarchitecture, which gave it a leg up in performance against AMD's offerings that year. For 2007, the "tick" represents the release of chips using the Core microarchitecture, but produced on a much more advanced (45 nanometer) process technology that's expected to increase chip performance while reducing the chip size, allowing for higher-scale production and lower per-chip cost.

In 2008, the cycle repeats again with the "tock" representing chips using a new and improved microarchitecture. Considering AMD's current product road map and history of execution problems, we think it will have a hard time keeping pace with Intel's technological advances and chip cadence.

Marked by End-Markets

While AMD is reporting quarterly losses, heavily using cash, and increasing debt to support working capital and finance capital expenditures to remain competitive, Intel has a sound balance sheet and an improving income statement.

In addition to observing sales through Intel's six operating segments—Digital Enterprise Group, Mobility Group, Flash Memory Group, Digital Home Group, Digital Health Group, and Channel Platform Group—we derive our sales forecast by first looking at the company's products by end-markets (desktop, mobile, and server), projecting unit volumes for each market by incorporating company guidance and independent forecasts, and then applying expected market share and average selling prices. This approach allows us to better understand the key dynamics and drivers, particularly unit growth and pricing, for products in each important end-market.

Desktop is Intel's largest market by volume. Over the last couple of years, unit growth declined while mobile computers increased in popularity. Making matters worse, Intel was entrenched in a vicious price war with AMD and ended up on the losing end for several quarters. Intel's desktop-segment market share fell from around 80% in early 2005 to 71% in late 2006. Against the ropes, the company shored up distributor relationships, priced chips more competitively, and attracted customers with its supply of new chips; it was thus able to turn the tide and improve its desktop segment market share to 72% in early 2007.

We expect increasing desktop sales in emerging markets and an acceleration in the PC refresh cycle to provide growth opportunities over the next year, and we see Intel gaining market share as its Core-based chips migrate to the lower end. Although Intel's plan to remain competitive in the lower-end desktop market implies more competitive pricing in the near term, we think sales of higher-end systems starting in the second half of 2007 will help balance desktop segment average selling prices (ASPs) ahead.

Mobile and Server Segments

Mobile is the second-largest volume contributor and the fastest-growing segment by both volume and revenues. Similar to the woes in the desktop space, Intel's mobile ASPs and market share suffered in 2005-06. However, substantial growth in the mobile market helped the company increase unit sales by 20%, while simultaneously losing notable mobile-segment market share in 2006. By early 2007, the company recaptured some lost segment share, which currently stands at around 82%.

Although we think that AMD will continue to aggressively pursue business in the lower-end mobile-PC market, which will likely pressure prices in the near term, we see a better pricing environment in the midterm as mid- to high-end notebook sales from enterprise spending increases. Combined with market research firm IDC's forecast for double-digit mobile-computer growth over the next five years, and our view of Intel extending segment market share along the way, we see the mobile segment contributing significantly to future revenue growth.

Although server is by far the smallest end-market by volume and revenue, it's also the most profitable. Differing from that of desktop and mobile, prices for server chips have held up due to the high-performance requirements for these chips. As Intel executes on its technology road map, we expect ASPs to rise moderately over the next couple of years. Furthermore, we expect server chip unit growth to increase with the accelerating growth for blade servers and for servers with added features due to virtualization.

Although Intel's market share for server chips fell 20% in 2005-06, unit growth rose on underlying segment market growth. Intel has since gained some market share, which is currently 87%, and should continue to benefit from expected server market expansion and stable pricing, by our analysis.

Barcelona vs. Penryn

Over the next few months, we see an interesting battle brewing as AMD releases its first quad-core offering, nicknamed Barcelona, and Intel launches a competing line of chips, nicknamed Penryn. There have been no formal head-on performance tests to compare the two offerings, but if Barcelona lives up to the hype, we believe AMD could temporarily gain the performance lead. Ultimately, however, we think Intel will be very hard to beat as it executes its "tick-tock" strategy, releasing faster and more power-efficient chips and extending its technological lead.

Desktop, mobile, and server microprocessors comprise two-thirds of the company's total revenue, with the remainder coming from complementary products, such as motherboards and chipsets. We believe that PC growth will also benefit these nonmicroprocessor products, and see their growth following that of microprocessors. With our view of increasing unit growth and stabilizing ASPs, we anticipate sales gains of 6% and 12% in 2007 and 2008, respectively.

Intel's cost of sales is approximately 70% larger than operating expenses, which is why investors closely watch the gross margin line as an indication of earnings growth and stock movement. The main factors that affect gross margins (ASPs, sales mix, unit costs, and startup costs) are becoming more favorable; and while gross margins narrowed over the last couple of years, we believe they hit an inflection point last quarter and will now begin to widen.

As previously mentioned, intense competition for lower-end business may lead to pricing pressure over the near term; but we see longer-term relief from higher-end products providing a better sales mix and supporting a more favorable blended ASP.

Margins, Expenses, and Earnings

With our view of increasing unit demand, we see rising plant utilization rates helping to spread fixed costs over a larger number of chips, essentially reducing unit costs. Furthermore, Intel is quickly increasing production of new chips on its latest 45-nanometer process technology, which will likely increase lot sizes, further reducing unit costs. Last, although 2007 first-half margins were hurt by startup costs related to building its 45-nanometer production capabilities, the company stated that these costs will decline in the second half, which should contribute about 2% to the gross margin line starting in the third quarter. Considering these factors, we see gross margins widening from 47% in the second quarter of 2007 to 55% by the end of 2008.

Regarding operating expenses, Intel recently divested unprofitable product lines and finished cutting approximately 10,000 jobs, about 10% of Intel's workforce, to improve profitability. As a result, recent quarterly operating expenses fell 15% from the comparable quarter last year. Including our sales and gross margin view, we project operating margins of 22% in 2007 and 26% in 2008. Our projections do not include Intel's plan to exit the unprofitable NOR flash business, which presents more opportunity for margin improvement.

Our 12-month target price of $30 is based on a blend of our price-to-earnings (p-e) and price-to-sales (p-s) analyses. Applying a 21 multiple to our 2008 EPS estimate of $1.41, we derive a value of $30. This multiple is below Intel's historical p-e average, but slightly above the peer-based average of approximately 20, a premium justified, we believe, given our assessment of the company's growth and risk.

We see earnings growth of over 20% and are projecting similar levels of sustainable growth over the midterm, assuming gross margins in the mid-50% range, moderate improvements in operational efficiency, and a long-term capital structure similar to that of the present. Even though our growth forecast for Intel is about even with our normalized, midterm net income growth view for the broader semiconductor industry, we believe that Intel deserves a higher multiple because of its lower risk profile. We think the company's business, financial, liquidity, and systematic risk is lower than those of the aggregate semiconductor group.

Healthy Projections and Speed Bumps

We also apply a 4.3 multiple to our forward 12-month sales per share estimate of about $7 to obtain a $30 price. This multiple is near the midpoint of the historical average but is a premium to the peer average of 3.5. We believe the premium is warranted since Intel's revenues are less variable than those of the industry. Considering the company's large market share, its commitment to creating technological innovations, and expanding computer growth across the world, we see healthy sales growth for years to come.

As for corporate governance, we have a favorable view on certain aspects of Intel's practices. A notable majority of the company's board is controlled by independent outsiders and all stock-based incentive plans have been approved by shareholders.

On the negative side, we are concerned that shareholders do not have cumulative voting rights in director elections. Furthermore, we are somewhat concerned that shareholders do not have cumulative voting rights in direct elections.

Risks to our recommendation and target price include the possibility of a sharp global and national economic slowdown, slower-than-expected enterprise spending on computers, AMD's Barcelona offerings leading to substantial market-share gains, the pricing war deteriorating average selling prices above our projections, and Intel running into problems executing its technology road map and strategies.

In the end, we see significant opportunity for share appreciation driven by our view of healthy growth for computing products, competitive technological advances providing highly competitive products while enabling unit cost reductions, improving fundamentals, and attractive share valuations. With our target price implying potential appreciation of about 20% from recent levels, we have a strong buy recommendation on Intel stock.