INTC: 4Q11, prospects for 2012

the report


After the close of trading in New York on Thursday January 19th, INTC reported 4Q11 results.  Revenues came in at $13.9 billion.  Profits were $3.4 billion, eps $.64.  Both figures were down slightly quarter on quarter during what’s normally the company’s seasonally strongest period.  Eps surpassed the Wall Street consensus of $.61, though.  Wall Street’s habitually somewhat downbeat stance toward INTC was certainly influenced by the firm’s early December warning that near-term orders for its PC chips were being cancelled by device manufacturers who are unable to get enough hard disk drives to make new PCs.

On a non-GAAP basis (adjusting for acquisition-related goodwill),  eps came in at $.68.

Investors were pleased with the results.  INTC shares rose by about 3% in a flat market on Friday.

full year 2011

During 2011, INTC achieved lots of all-time financial highs, including:  revenues at $54 billion; net income at $12.9 billion; eps at $2.39 (non-GAAP, $2.53).

one-time factors

There are two:

–Historically, INTC has used the week as the basic time period for its accounts rather than the month.  Because  52 weeks x 7 days/week = 364 days, or not quite a year, this approach requires the company to have occasional 53-week years to keep their accounting in sync with the calendar.  2011 was one of those “extra-week” years.  That probably added $.05 to 2011 eps.

(By the way, INTC has just shifted to the month as its basic time measure, so the “extra week” adjustment will no longer be necessary.)

–Thailand produces about 40% of the world’s hard disk drives. Massive flooding there during 4Q11 took many HDD factories out of commission.  In early December, unable to build PCs without storage, device makers began to cancel orders for the INTC chips slated to go into those machines.   INTC thinks we’re now passing the worst of the HDD shortage and that Thailand will be back at full HDD production late in 2Q12.  INTC is adamant that component supply, not a falloff in demand, is the problem.  Assuming the company is correct–and I see no reason to doubt it–the result of the cancellations has probably been to shift $.10 – $.15 a share in earnings for INTC from 2011 into 2012, as well as to make the firm’s 2o12 eps more second-half loaded than normal.

prospects for 2012

INTC expects another up year in 2012, with revenues advancing by “high single digits” and gross margins expanding by 1.5 percentage points to around 64%.  Despite a massive increase in R&D spending to $10.1 billion this year (up by 21% from the 2011 level) this company guidance probably implies eps on a GAAP basis of $2.60 ($2.75, non-GAAP).  If we correct for the one-time factors I’ve cited above, I read the guidance as being for flattish eps on, say, 5% revenue growth.

my thoughts

down Memory Lane

At the peak of the internet bubble in 2002, INTC was a $75 stock.  It traded at 36x eps (a relative multiple of 2.4x the market) and yielded .1%.  After a decade of wretched relative performance, the stock is now trading at less than 10x 2012 earnings, yielding 3.4% and at a price earnings multiple discount to the market of about 25%.

If you think that’s bad, in early October 2011 INTC was trading at 7.3x 2012 eps and yielding 4%+, more than the 30-year Treasury!  Interestingly, despite Wall Street skepticism, INTC shares are enjoying their longest period (and one of only a few) of relative strength in the last decade.

where to from here?  (I wrote this on Sunday January 21st)

I think there are four potential positive points to the INTC story:

1. valuation.   …low PE, high dividend yield, massively cash generative operations

2.   demand for PCs.   …that emerging markets have reached wealth levels where average citizens are able to afford PCs.  According to INTC, two-thirds of PCs worldwide are currently being sold to customers in emerging economies.  None of these markets are as yet well-penetrated.   So this business, INTC’s biggest by unit volume, appears to me to have much better growth prospects than is commonly thought.  Ultrabooks, using reference designs supplied by INTC, may well be an added plus.

3.  servers/the cloud.   …the continuing evolution of the internet is creating strong demand both for the INTC chips that drive sophisticated servers for the cloud and for those used for general corporate purposes.  These tend to be advanced (read: expensive and high-margin) chips.

4.  INTC’s immense technology investments.     …in 2012, INTC plans capital expenditures of $12.5 billion, in addition to R&D outlays of $10.1 billion.  In 2011, those figures were $10.8 billion for capex and $8.3 billion on R&D.  The two-year total comes to $41.7 billion!

Three possible consequences:

–increasing INTC’s already large technological lead over other manufacturers

–creating chips that will be accepted by makers of cellphones and tablets.  For instance, Lenovo has announced its first INTC-powered smartphone for the mainland Chinese market.

–creating an environment for collaboration on design of increasingly complex multi-function chips, either with independent design firms or with device manufacturers.  In other words, INTC would use its advanced chip fabs to attract and lock in customers.     …like AAPL?

It seems to me that at $20 a share, Wall Street was factoring into the INTC stock price a belief that:

–none of its turnaround efforts would be successful,

–that the parlous state of the PC market in the US and Europe is indicative of the global market for these devices,

–that INTC parts will be displaced by ARMH components, and therefore

–that INTC will gradually go out of business.

the stock

To buy the stock at $20 a share, you’d only have to believe that stories of INTC’s demise have been greatly exaggerated.

At the current $26 or so, in contrast, it seems to me the price already factors in a grudging acceptance that the PC business may not be on its deathbed.  I don’t think, however, that the value of the server business is fully reflected.  Nor is there anything, in my view, for the possibility that ultrabooks may expand the PC category or that INTC will have any success cracking the smartphone or tablet market.  Wall Street analysts are merrily downgrading the stock, meaning they don’t want to be seen as endorsing any of these possibilities.

$30 a share seems to me to be the next price objective.  At that level, I think the idea that the current business, PCs and servers, is viable would be in the quote.  But I don’t think there would be very much for new products.  In addition, I don’t think that very many have considered the thought that, after more than a decade of foundry success, the economic winds may be shifting in favor of integrated design/manufacturing firms like INTC or Samsung.

My bottom line:  INTC is no longer the one-way street it was in October, but I think it still has very attractive prospects.  I have no desire to sell any of the stock I own.  On the other hand, given the strong run it has made over the past four months, the size of my holding, and the possibility that good news probably won’t arrive before 2H12 begins, I don’t feel a powerful urge to buy today.  I do think the stock will outperform the S&P over the coming year, though.

I’ve just updated Current Market Tactics

I’ve just updated Current Market Tactics.  If you’re on the blog, you can also reach the CMT page by clicking the tab at the top of the page.

Men working!!

I’ve decided that it’s time for me to overhaul PSI so it looks better and it’s easier to access past information.  I’m not going to be posting on Sundays while my repair work is under way–unless, of course, there’s some piece of investment information that’s so urgent it can’t wait a day.  So far, in my thirty years of involvement with stock markets, nothing like that has ever happened–but you never can tell.

what is a carried interest?

Mitt Romney’s taxes

Mitt Romney’s partial disclosure of his tax situation has reopened debate on the issue of how private equity managers and some hedge funds use carried interest as a device to shelter their earnings from tax.

Since Mr. Romney left the private equity business a decade ago, it seems to me that he isn’t currently using carried interest as a tax shelter.  In all likelihood, it’s some combination of itemized deductions, like charitable contributions or state and local taxes paid, and the favorable treatment of long-term gains on investments that’s producing his low tax rate.  But he was a prominent figure in the private equity community, so the press–and his political opponents–have made the connection anyway.

Powerful lobbying efforts by the private equity industry have defeated repeated attempts to close the tax loophole it uses to lower its executives’ tax burden.

I wrote about this topic in mid-2010.  But I haven’t read anything, wither in the current discussion or in the past, that explains exactly what a carried interest is.  Hence this post.

carried interest

A carried interest is a participation in an investment venture where the holder gets a share of the cash generated by the project (profits or cash flow) without having to contribute anything to the venture’s costs.  The holder of such an interest is “carried” in the sense that the other venture participants pick up the burden of his share of project expenses.

Carried interests aren’t just a private equity phenomenon.  They’re very common in the mining industry, which is where I first encountered them thirty years ago.  But they also occur in lots of other industries, particularly those where highly specialized experience or skills, or possession of crucial physical resources are key to a project’s success.  In the extractive industries, holders of mineral rights may be carried.  The fund raisers or organizers of any sort of projects may be carried, as well.  So, too, famous actors or holders of key intellectual property.

variations on the theme

As with everything in practical economic life, there are myriad variations on this basic idea.  For example,

–a party may not be carried for the entire life of the project, but only up to a certain point–say, when cash flow turns positive.

–the other parties may be entitled to recover the “extra” costs they’ve paid to subsidize the carried interest before the carried interest receives a dime (there are also lots of variations on the cost recovery theme), or

–the carried interest may only be paid if the project exceeds specified return criteria.

In plain-vanilla projects, the carried interest receives a portion of the recurring revenue that the venture generates.  This is ordinary income and taxed as such.  The private equity case is different.

private equity and carried interest

Private equity raises equity money from institutions or wealthy individuals, arranges financing of, say, 3x -5x that amount, and uses the assembled war chest to make acquisitions.  It targets mostly badly run companies.  It spruces them up and resells them a few years later.  There’s no conclusive evidence that this process adds any economic value, although it certainly sets the process of “creative destruction” in motion in the affected company–but that’s another issue.

Private equity companies appear to me to act as a blend of business consultants and managers of a highly concentrated (and extremely highly leveraged) equity portfolio.  What’s really unique about them is their pay structure.

Private equity charges its clients a recurring management fee of, say, 2% of the assets under management plus a large performance bonus if the turnaround projects they select are successful.  This bonus is structured as a carried interest (an equity holding) in each individual project.  Because the projects last several years and result in an equity sale, the bonus payments are capital gains, not ordinary income.  This means the private equity executives’ tax bill is much less than half what it would be if the payments were income.

my thoughts

You’ve got to admit that turning investment management income into capital gains is a clever trick.  Should the loophole be closed?  When I first wrote about this I thought so.  I still do.  But I’d prefer to see more comprehensive tax reform that achieves this result rather than specific legislation that targets the private equity industry.  I also find it somewhat disturbing that private equity political contributions and lobbying allow them to “own” this issue in Congress, despite the fact that private equity’s taxation is clearly different from other investment managers’, from management consultants’ and from corporate executives’ for basically the same activities.

prospects for fixed income in 2012 (III): conclusions

This is the final installment of three that contain a bond market analysis by money manager Strategy Asset Management, LLC.  (Installment I, Installment II)

Risk and Return

Bond investors will face some difficult choices in the months ahead.  Our base case for 2012 includes a modest acceleration of GDP growth accompanied by an improvement in employment and personal income.  US housing prices will finally stabilize and inflation, as measured by the Consumer Price Index less food and energy costs, will continue to rise.  (This inflation measure bottomed at 0.6% year over year in October and now stands at 2.2%.)  The Federal Reserve, however, is likely to keep short term interest rates at virtually zero.  All this points to a significant rise in government bond yields.

The current yield curve for government bonds looks strikingly similar to that which prevailed at the close of 2008.  Based on the improving domestic economy and our assumption that the European debt problems will be contained (admittedly, not a universally held point of view), we think the changes in bond market yields will be very similar to those which occurred in 2009.  If so, it implies interest rate increases in excess of 150 basis points for US Treasury securities with maturities of five years or more.  That translates into a near 12% price decline for ten year government securities.  To avoid these possible losses, investors would need to shrink the average maturity of their portfolios to two years or less and accept current returns of 0.25% versus the 2%-plus yields now available on longer dated investments.

Mortgages, normally a refuge for investors in a rising rate environment, pprobably won’t be a good port of call in 2012.  The market prices of high coupon mortgage securities are astronomical–GNMA pass-thru mortgages with coupons between 5% and 7% are being valued at 110% to 115% of par value.  These premiums are much higher than during previous low yield episodes; for example, GNMA 7% coupons never traded above 106 until mid 2010.  The current mortgage market bubble has occurred because mortgage refinance activity in these premium coupon mortgages has been exceptionally low, limiting prepayment losses for investors.  Borrowers have been unable to refinance because they are underwater on their existing mortgages and lack the equity to meet requirements on new mortgages.  That could all change with the stroke of a pen.

It is rumored that President Obama wants to replace the acting Federal Housing Finance Agency head with a more activist chairman and push for a multi-trillion dollar refinancing plan.  It would permit current borrowers in the government agency guaranteed programs to refinance into lower coupon mortgages with no requirements other than being current on the existing mortgage.  No appraisals, no income verification, no upfront payments.  This is actually a great idea.  It would save consumers tens of billions of dollars a year, increase housing demand and lift home prices, and boost economic growth–in an election year no less.  The losers under the plan would be holders of high coupon mortgage securities who would probably see the market value of their investments drop at least 5%.

While a change in the rules could hurt high coupon mortgages, their lower coupon cousins–the mortgage pass through securities with 3.5% to 4.5% coupons–would be crushed if interest rates rise.  Given the already inflated prices of even these securities, their upside appreciation potential, even in a declining interest rate environment is very limited.  (And we could see that further reduced if government actions unleash a flood of new low coupon securities.)  Meanwhile, they would suffer sizeable price declines and negative total returns if interest rates rise.

Making choices

As we begin 2012, most of our accounts are 20% to 30% below their benchmark maturity targets.  This is at the outer end of our usual duration bands and represents a significant call on the direction of interest rates.  During the fourth quarter of 2011, we added to our holdings of short term US Treasury notes.  We are generally overweight US Treasury securities compared with mortgages.  Nonetheless, a large rise in market yields would result in losses for most of our portfolios.  Accordingly, it is possible in the months ahead we may adopt an even more defensive maturity stance if the economic and political scenario we envision begins to materialize.

In closing, we thank you, our clients, for your support during 2011 and we will continue to work to merit your loyalty in the year ahead.  We wish you a healthy and prosperous New Year.

Note:  The Market Environment reflects the vies of the Investment Advisor only through the date of this report.  The Investment Advisor’s views are subject to change at any time based on market and other conditions.  December 31, 2011.

Thanks again to Strategy Asset Managers for allowing PSI to publish “Bond Market Environment, Fourth Quarter 2011.”