the results

Thursday January 13th, INTC reported its 4Q10 results.  The firm earned $3.4 billion (a company record), or $.59 per diluted share, on revenue of $11.5 billion (another record).  This compares with the Wall Street consensus of $.50.

For the full year 2010, INTC posted eps of $2.05 on revenue of $43.6 billion (more records).  The figures compare favorably with the brokerage house median estimate in late 2009 of about $1.25.

Management also said the first quarter won’t show its normal seasonal revenue decline, but will be about the same as 4Q10.  Despite  all the good news, and a prospective dividend yield of 3.45% (higher than the 10-year Treasury), the stock traded down in an up market on Friday–a day in which the IT sector as a whole was up almost a percent.

the details

unusual items

Earnings for 4Q10 were $3.4 billion vs. $2.3 billion in the comparable period of the prior year.  4Q09 results were depressed by a $1.3 billion (before a $438 million tax benefit) settlement with AMD; 4Q10 expenses were about $200 million higher than forecast, due to a new cross-licensing agreement that settles litigation with Nvidia.

The tax rate for 4Q10 was 24% vs. guidance of 31%, due to retroactive reinstatement of the US tax credit for R&D.  The tax rate for 4Q09 was 12%, or half the rate of 4Q10, as INTC made year-end adjustments for having a larger than expected percentage of earnings in low tax rate areas.

Operating income, ex the AMD settlement, for 4Q10 was up 16% vs. 4Q09.  This figure gives a better indication of the true growth in INTC’s profits.

the business

Revenues were up 3% quarter on quarter in a period when sales are normally up 8%.

Why?  The server business–both conventional servers and cloud computing–was strong, at + 15%.  But the consumer business–a much larger segment for INTC–was flat, both at the high end and for Atom as well.  The US and Japan showed typical seasonal strength, while Asia was weaker than usual.

INTC’s analysis of the poor consumer outcome is that computer makers reduced inventory of older INTC chips while they waited for the introduction of the company’s new Sandy Bridge line of processors.  A rebound in the consumer business as more Sandy Bridge chips become available is part of the reason for INTC’s confidence in the strength of 1Q11.  Wall Street, for good or ill, seems to be reading the consumer shortfall as a loss of business to tablets.  We’ll see.

2011

Cross currents galore.

INTC seems to think revenues will rise by at least 10% in 2011–the chairman said 20% in his remarks but was promptly told by the CFO that the official guidance was 10%.

Gross margins will likely decline by about one percentage point, as startup costs for new 22 nanometer capacity, a key to INTC’s future, more than offset the positive effects on margins of higher unit volume and revenues.  In addition, the company plans to boost R&D spending by about $1 billion more than usual.  It will also lay out $9 billion on new capital equipment in 2011 vs. $5.2 billion in 2010–implying depreciation will also rise by about $1 billion this year.

Mix that all together and a 15% revenue increase would translate into an 11% rise in pretax income.  Assuming, as INTC does, a constant tax rate at 29%, that would imply around $2.30 in eps. My impression is that INTC is hoping for at least that. This compares with a Wall Street consensus before company guidance in the 4Q earnings report of a bit less than $2 and a post-results consensus of $2.11, which is the figure you’d get by assuming sales go up by 10%.

INTC is planning for significant growth in demand…

…as evidenced by the large increase in R&D and the aggressive capital expansion.  Reasons?

–emerging markets, where most of the world’s population is and where PCs are only now becoming affordable to the average person

–the enterprise server business is booming, and cloud computing–a big new user of servers–is in its infancy

–the “Internet of Things,” which will require huge numbers of embedded processors

–INTC design wins in tablets and smartphones, which will soften the blow of any switching (lots of speculation but I don’t think any has yet been seen) by consumers to these devices and away from laptops and netbooks.

…Wall Street is dubious

Based on brokerage house analysts’ estimates for 2011, INTC’s stock is trading on a price earnings ratio of about 10x–which is 75% of the market multiple and about half that of the median tech stock.  The last time INTC traded this cheaply was about fifteen years ago. The analyst’s estimates I’ve seen show no earnings growth to speak of in any of the next three years.

my thoughts

I own a modest amount of the stock, which tells you what conclusion I’ve come to.

INTC is an interesting case, though.

On the one hand, imagine what would happen if a private equity firm gained control of INTC (not that this could happen) and began to run the company for cash.  It would quietly cut R&D and capital spending, with the intent of generating eps of maybe $3 a share for three or four years.  It would likely also do something like what MSFT did a few years ago, bring in a cost-cutter from a mature cyclical industry, to reduce overall spending.  Say these efforts generate $14 a share in total.  INTC, as it stands now, has about $4 a share in liquid assets on the balance sheet, after repayment of debt.  Private equity would remove that.  Plant and equipment is on the books at about $3 a share.  Say the firm does a series of sales and leasebacks that raise operating costs but put another $3 in cash in its hands.  What would be left?    A business–maybe just the server business–capable of generating $1 a share in cash for a number of years.  Let’s say that could be sold for $6 a share.  $14 + $4 + $3 + $6 = $27.

$27 might not be the right number.  It might be $24–or it might be $30.  But I think a reasonable case can be made that INTC dead or broken up is worth much more than $21.  Ordinarily, we’re regard that as downside protection.

But that’s not the INTC management’s strategy.  Instead, the company is upping R&D and capex this year by a total of about $5 billion vs. 2010 levels.  And it’s spending a lot of the idle cash parked on its balance sheet on McAfee and a division from Infineon.  It’s doing so to exploit the growth opportunities, enumerated above, that it sees.  the company also clearly thinks it can be a viable competitor to ARM in smartphones and tablets–although I don’t yet see evidence in favor of the opinion.

That’s the bet.

Wall Street–and the stock price–are implicitly saying that the INTC management is going to destroy shareholder value in its attempt to become a growth company again.  Of course, no analyst is going to put this idea down in writing–fearing being cut off from access to management and having his firm left out of any investment banking deals that might come along.

I’m taking the other side.  Why?  …I think:

–expectations are low;

–the stock looks cheap to me;

–I regard INTC’s management is much more competent than Wall Street is giving it credit for–although whether it can make ARM-competitive products is open to question; and

–the worries that we have entered a post-PC world that doesn’t include INTC have been around for a long while and, I think, are mostly factored into today’s price.

–I think the negative judgment about INTC has been made before conclusive evidence is in.

The stock clearly needs to be monitored closely for evidence that the bear story has more merit than I think.  But for me the combination of what I see as large potential upside and limited downside make it worth holding.