INTC’s 1Q11: strong earnings, not enough (in my opinion) Wall Street reaction

the results

After the close of New York trading on Wednesday, INTC reported its highest-ever quarterly revenues, $12.8 billion, for 1Q11 and earnings per share of $.59, up 37% year on year.  This compares with brokerage house analysts’ projections of up 7%.

The company suggested that 2Q11 will be a carbon copy of 1Q–which would mean a year on year earnings gain of 15% or so– and voiced its expectation that the second half would show its usual seasonal strength.  INTC  also reiterated its full-year 2011 guidance for revenues (and, in my opinion, earnings–though INTC didn’t say) of up 20%+.  This would imply earnings per share of $2.40 or better for the twelve months (actually 53 weeks, because INTC is adjusting its financial reporting to the calendar year).

This contrasts sharply with analysts’ forecasts averaging $2.03–a mere 2% gain over 2010 actuals.  In fact, analysts have been projecting that earnings comparisons for INTC will be turning negative right about now.

Yes, INTC’s shares did rally almost 8% in trading yesterday.  That brings the stock just barely (+1.8%) into the plus column, year to date, compared with the S&P 500 gain of 5.8%.

The move also raises INTC’s price-earnings ratio from 8.3x 2011 earnings to 8.9x.  The latter figure is about two-thirds of the multiple on the S&P 500, half that on the typical semiconductor stock and 40% of the multiple the market has awarded INTC in the recent past.

the details

Starting with one-time factors Wall Street was worried about:

–INTC appears to have suffered no damage to its production plants, and very little disruption to supplies, from the Japanese earthquake/tsunamis.

–You may recall that INTC found a glitch in the earliest runs of its new Sandy Bridge processor.  The company estimated that 1Q11 revenues would be depressed by about $300 million because of the time needed to fix the problem, reramp production and replace defective chips.  It turns out the company worked quickly enough that there was no negative revenue impact.

–the acquisitions of McAfee and Infineon’s former wireless division have closed.

Two areas are responsible for INTC’s strong performance:

1.  Demand for servers is exceptionally strong:

a)  The more important reason why is the rapid growth of devices that connect to the internet.  They are sparking exceptionally strong demand for data centers to service them, including providing “cloud” applications and storage.  These servers are virtually all standardized on and powered by high-end (read: high profit) INTC chips.  This new market will likely end up being as big as the total traditional enterprise server market within a few years.

b)  In the traditional corporate market for servers, INTC’s offerings are so much better/cheaper that replacing existing equipment pays for itself.

2.  Well over half INTC’s business is now in emerging markets.  Corporate demand for PCs in China, Latin America and Eastern Europe is booming.  In addition, the combination in these areas of rising incomes and falling PC prices has made computers affordable for large portions of the population for the first time.  So consumer demand for PCs–even desktops (!)–is strong there, too.

The only area of weakness for INTC is the consumer PC business in the US and the EU.  Strong replacement buying through the recent recession, weak current economic growth, maturation of the netbook market and the appearance of tablets have all conspired to put the Western consumer on hold as far as buying PCs is concerned.  The bad news is that these markets are at present declining gently.  The good news is that they comprise only a third (my guess) of INTC’s business and the other two-thirds is performing going gangbusters.

where are the INTC smartphones and tablets?

This is Wall Street’s biggest worry.  So far, there’s not much to write about, because processors made by ARM Holdings have a stranglehold on these markets.  INTC’s offerings to date are thought of as too big, too power-hungry, too inflexible.

the stock

Many investors seem to believe what analysts’ numbers are showing–that the traditional PC market is in immediate, terminal decline, with personal computers being replaced in most uses by smartphones and tablets.  From this premise, which I think is incorrect, they draw the conclusion reflected in  analysts’ numbers–that INTC, too, is a company of the past.

Even after Wednesday’s sharp rise, INTC shares have underperformed the S&P 500 by more than 20 percentage points over the past year, despite stellar earnings performance.

The two issues:

1.  Can the market for INTC’s x86 chips be as strong as the company says, while third-party technology consulting firms predict much slower growth for the industry?

This was the topic of more than one analyst’s questioning on the company conference call.

INTC had several points:  the third parties have their best insight into the consumer markets of the EU and US, which is where all the weakness is.  They have less visibility into the corporate market and almost none into the emerging economies that make up the bulk of INTC’s business and almost all of its growth.  This is not the first time the third parties have been wrong.  Last year they underestimated the market growth as well–and for the same reasons. 

I’m willing to believe INTC.

2.  Where are the smartphones…?

INTC has a new chip for tablets.  It has shaken up its mobile business. It hints at great things from its “revolutionary” next generation of chips–details in early May.

But no one really knows whether INTC can be successful with mobile client devices.  The company does point out, that tablets and smartphones are not so tightly wedded to a given processor as PCs are.  So a potential switch from an ARM chip to an INTC one could be made in a given model relatively easily.  So if INTC can manufacture an acceptable chip, it could gain design wins quickly.  Let’s see one, though.

On the other hand, a lot of damage based on this worry has already been done as the PE of INTC’s stock has shrunk from from 21+ to 10-.  At the risk of being too simplistic, if INTC’s consumer business in the US and EU were to vaporize tomorrow, what would remain would likely be a 12 multiple stock with 30% growth in prospect for a number of years–plus a big play on emerging markets.  INTC would seem extremely cheap. 

In other words, I don’t think there’s much downside in holding the stock (remember, I own it) and waiting either for Wall Street to work out that the company’s business is booming, or for some positive development on the smartphone/tablet front.  The greatest near-term stumbling block I can see is that sell-side analysts, who appear to be very wrong about INTC current earnings prospects, are notorious for their unwillingness to admit their mistakes.  And they’re the ones many investors turn to, if not for advice, at least for factual information and industry analysis.

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