Intel’s 1Q13–another transition quarter

the report

Intel (INTC) reported 1Q13 earnings after the close on Tuesday.  Revenue came in at $12.6 billion, down 2.5% year-on-year.  EPS, however, were $.40, down 25% vs. 1Q12.  The latter figure was slightly below the Wall Street consensus of $.41.

INTC believes this is a low point for its business, expecting revenues to show slow but steady improvement as the year progresses.  It expects earnings to advance at a faster rate.  Brokerage house analysts as a group are a bit more cautious, projecting 2Q13 EPS of $.39.

Consensus earnings per share for the full year are $1.88, a number I have no quarrel with.  INTC’s dividend yield is just over 4%.

What I find most interesting is that INTC shares, one of the worst performers of 2012, have been rising since the company’s earnings report, in an overall shaky market.

How so?

I think it’s because INTC is now a qualitative “big picture” stock, not one that will be driven by near-term earnings.

details

First, some housekeeping stuff from the report.

Servers, which comprise about 20% of INTC’s business, were a strong point.  High-end and cloud models are growing at 30%+.  Generic corporate servers, purchases that rise and fall with GDP, are up a little.  Overall server revenues were up 7.5% yoy during 1Q13.

PC chip sales were down 6% yoy.  INTC’s customers have continued to work down their PC inventories from already lean levels, so end user demand is a bit better than INTC’s sales would indicate.  At some point, one would expect PC makers to rebuild inventories to more normal levels.

The transition away from old school heavy, clunky laptops–epitomized by DELL or HWP offerings–toward ultrabooks and other “post-PC” devices (think: Samsung or Asus) is going faster than INTC had expected.  This has several consequences for the company:

–older chip-making machinery is going out of service faster than anticipated, meaning extra depreciation charges,

–clients are asking for larger numbers of test models for INTC’s newest chips, where production isn’t still super-efficient, again meaning higher costs, and

–some older machinery can be reconfigured for use in cutting-edge chips, saving INTC $1 billion in capex this year.

The first and second items non-recurring.  Together, they’re the reason for the 1Q margin deterioration that led to the sharp decline in operating earnings on only a very small decrease in revenues.  As I mentioned earlier, INTC believes the worst on this front is behind it.

the big picture, according to INTC

INTC thinks that the chips it’s starting to ship this quarter will spark a quantum shift in the market for mobile computing devices.  By next year, we’ll have more powerful, touch-screen ultrabooks with better graphics and longer battery life selling for around $500.  Don’t need sleek or instant-on?   …then $400.

Tablets will see big power improvements and  maybe a $300 price for an iPad clone.

New form factors will emerge, too.

The disappearance of the huge price gulf between ultrabook and tablet will shift demand toward the former. That’s good for INTC.  Chips that use less power and generate less heat mean INTC has a chance to be a real presence in the tablet category for the first time.

can this happen?

Yes.  I think it will, and maybe even in time  for the holiday selling season this year.

The only real question is whether INTC can maintain its dominant market share in PC-like devices and displace ARMH offerings in some tablets (smartphones are only a possible INTC story in, say, 2016).  I like INTC. I hold the stock.  I think they have a very good shot at doing what they say.

as an investor…

…I think the rewards outweigh the risk that INTC finds itself the odd man out in an ARMH-dominated mobile world.

Why?  It’s valuation.

–arguably, INTC’s server business as a stand-alone is worth than the current market cap of the entire company.

— INTC has by far the best chip manufacturing operations in the world.  They’re certainly better than TSMC’s, the king of the third-party foundries.  Ignoring its intellectual property, were INTC valued solely for its manufacturing capabilities on the same basis as TSMC, INTC shares would be well over $30 (yes, gross margins would be lower, but so too would R&D and marketing expenses).  TSMC also has a much more cyclical earnings record).

So I’m content to wait.

commodities cycles

commodity rhythms

agricultural

The co-owner of one of the smaller investment companies I’ve worked for was a farmer.  He made me realize that there are no long cycles for most agricultural commodities.  If prices for a particular crop are high, farmers will plant more–usually a lot more–the following season.  That virtually guarantees that prices will either level out, or more likely fall.  The opposite happens–supply falls, and prices subsequently go up–if prices are currently low.

Considering that many crops have two or three growing seasons in a year, price adjustment comes swiftly.

metals

Metals mining, especially base metals mining, is just the opposite.  Mines tend to be gigantic projects, costing billions of dollars and designed to last 20 years or more.  Most of that money is spent up front:  for the mine itself, for all the drilling machines and other earth moving equipment, for the ore processing plants, for the roads or rails to tap into a country’s established transport infrastructure, and maybe even for new sources of electric power.

Because the optimal project size is “humongous,” mines tend to spew out very large amounts of output when they open.

Because–unless you’re very unlucky–the running costs are low relative to the initial investment, projects seldom shut down once they’re up and running.  They normally don’t even consider doing so unless the output price falls below out-of-pocket extraction costs.  And even then a mine may not shut down.  Miners always identify pockets of especially rich ore that they set aside for a rainy day.  So the first response to weak pricing it to turn to these high-grade areas in order to keep going–and spewing even more price-depressing output on the market.

In addition, some emerging countries run their mines to create employment and get foreign exchange.  Because whether they make money or not is a secondary concern, such mines almost never shut down.

The result of all this is a supply/demand dynamic somewhat like the farm one I sketched out above.  When times are good and metals prices are high, miners generally spend their cash developing new mines.  This creates periodic overcapacity when supply outstrips global industrial demand as all the new mines open at once.  But, unlike the case with soybeans or corn, excess capacity doesn’t disappear come winter.  Instead, it can stay for a decade.  What cures the oversupply is the eventual expansion of the world economy to the point where it can use all the raw materials being produced.

an example

I was a starting-out analyst when a supply-demand imbalance sent base metals prices skyrocketing in 1980.  I remember copper briefly hitting around $1.40 a pound and bringing previously loss-making capacity back onstream.  The price almost immediately fell back.  It took nine years for demand to expand to the point where it absorbed all available supply–and for the price to regain that 1980 high ground.

Another wave of new capacity pushed the price back down in the mid-1990s, where it stayed again until sharply climbing demand from China absorbed all the new output.  The price began to rise again in 2003.

For most metals, this pattern of feast and famine is common.  It’s not alone.  Chemicals and shipbuilding are the same way.  The common threads are:  commodity industry; long-lived assets with most of the capital in up front; capacity additions coming in large chunks.

Try to find a copper chart that goes back to the 1980s.  It isn’t that easy–suggesting to me that commodities traders aren’t as up on their history as they should be.

investment significance

I think that for base metals, and maybe for gold as well, we’re deep in the end-game transition from fat years to lean.  It has less to do with the state of demand in China than the state of supply among mining companies.  If I’m correct, time–and the accompanying gradual world economic expansion–is the only cure.

I’ve updated Current Market Tactics: price action this week has made me a bit more cautious

I’ve updated Current Market Tactics, based on recent price action of the S&P 500.  If you’re on the blog, you can click the tab at the top of the page.

J C Penney (JCP) just borrowed $850 million…why?

the 8-k

Yesterday, JCP announced in an 8-K filed with the SEC that it has borrowed $850 million on its newly expanded $1.8 billion bank credit line   …even though it doesn’t really need the money right now.  It also said it’s looking for other sources of new finance, which I interpret as meaning finding someone to purchase new bonds or stock.

My guess is that as the company needs seasonal working capital finance it will borrow more on the credit line rather than deplete its cash balances, which should now amount to around $1.8 billion.  This despite the fact that paying the current 5.25% interest rate on the $850 million will cost the company $44.6 million a year.

Why do this?

We know that the Ackman/Johnson regime inflicted terrible damage on JCP.  Part of this is actual–the stuff about lost sales and profits that we can read in the company’s financial statements.  Part of it is psychological–we don’t know how deeply JCP is wounded, how long it will take for the company to heal, nor even how much healing is possible.

a psychological plus

By borrowing the money now, JCP is in a sense buying itself an insurance policy on the psychological/confidence front by establishing several things:

— it now has enough cash to be able to weather two more ugly years like 2012, rather than one.  This gives it much more breathing room to negotiate any asset disposals, to say nothing of getting customers back into the stores.

–it has lessened the possibility that its banks will withdraw or reduce the credit line if sales continue to deteriorate.  After all, they now have their $850 million that’s in JCP’s hands to protect.

–it demonstrates to suppliers that the company has ample cash to pay for merchandise.  JCP will likely get better payment terms with the money on the balance sheet than without it, although it’s not clear to me that payables still won’t shrink this year.   More important, in my view, is that suppliers won’t restrict either the quantity or selection of merchandise they deliver to JCP for fear they won’t be paid.

–it avoids the negative publicity (see my 2011 post on Eastman Kodak) that would likely have been generated were JCP to wait until it genuinely needed the funds, or until its banks might be getting cold feet.

so far, so good

So far, Wall Street is taking the move in stride.  The stock showed no adverse effect from the announcement.  And in pre-market trading today, it’s up.

a falling gold price–what does it mean?

Back in the day, I was, among other things, a gold mining analyst.  That period left me with an enduring fascination, not about the yellow metal itself, but about gold “bugs”–the people who are obsessed with gold and who buy it as an “investment.”  I have the same complex mixture of feelings about gold bugs that I have about survivalists, Civil War reenactors, model railroad buffs and people from Brooklyn.  It’s not exactly “There but for the grace of God…”, but that’s the general direction.

I really don’t get gold as an investment.  Yes, it’s shiny and there may actually be gnomes in Zurich.  Until the mid-1970s, gold did serve as a kind of money worldwide.  But no longer.  One exception:  developing economies where either there are no banks for businesses to use, or where people don’t want/trust banks to know about their finances.

Contrary to what I think is popular belief in the US, virtually all the demand for gold comes from the developing world.  The US accounts for 5% of purchases, the EU 10%.  Japan is a non-factor.  Last year, as usual, India was the #1 buyer of gold, at 28% of the total.  Greater China took 25%.

Before the Great Recession, the large bulk, maybe 3/4th, of the world’s demand for gold was for jewelry (although much of this did double duty as chuk kam 99.9% gold trinkets). 10% was for technology or dentistry.  The rest was gold bars and coins bought as an “investment.”  The bulk of that demand was supplied by mine production, with the rest coming from recycling and steady selling by central banks in developed countries.

The GR changed that pattern, in two ways.  Demand for gold bars and coins more than tripled.  Central banks in the developed world stopped selling, while their counterparts in emerging economies began to buy gold like there was no tomorrow.  Between 2009 and 2011–which appears to have been the peak of this activity–the gold price doubled in US$.

Gold ETFs?  They peaked in 2009 at about 17% of world gold demand.  By 2011 they had shrunk to 4%.

What’s happening now?

The gold price has been slowly declining for two years, without attracting much attention, as panicky buying by gold bugs has waned.

What’s new is India.  The biggest drain on India’s growing trade imbalance is its citizens’ continuing demand for gold–both for jewelry and because the country’s banks don’t work.  New Delhi has decided to deal with the steady flow of cash out of the country by taxing gold imports.  At least to some degree, this will put the metal’s chief buyer on the sidelines.  That won’t stop mines from churning out the stuff, however, until/unless the gold price drops below their cash cost of production.  That’s a looong way down.

Elsewhere, “investment” demand appears to be waning.  Less significant in the short term, Chinese tastes seem to be slowly shifting away from chuk kam to fashion or statement jewelry with lower gold content.  And, of course, more dentists are using ceramic teeth and PC demand is slowing.

In other words, the supply/demand picture for gold is looking less favorable for prices.  The price decline has nothing to do with inflation fears in the US or EU subsiding, or renewed faith that either area is suddenly on a sounder economic footing.

parity party on the calendar–the yen and the penny?

parity–almost

Two days ago the Japanese yen reached a low where US$1 could buy ¥99 in the foreign exchange markets.  That’s extremely close to parity between the US penny and the yen.

What makes this level shocking is that last September, one greenback would only get you ¥77.  So the exchange value of the yen has dropped against the US$ by 22%+ in a little over half a year.  Stuff like this doesn’t usually happen with the national currencies of large developed world economies.

On the other hand, there aren’t normal times in the Land of Wa.

Japan’s problem

Japan has been struggling economically for almost a quarter century, plagued by a toxic combination of next to zero real economic growth + Deflation.  A falling price level means takes more of your income to repay debt, so no one borrows.  Things will always be cheaper tomorrow, so everyone postpones spending.

This stagnation is not an accidental occurrence, as I see it.  It’s the result of deliberate policy decisions by Tokyo aimed at preserving the social and cultural milieu of the 1970s-1980s–as well as the power of the aging and hidebound executives/bureaucrats/ politicians who came to power in that era.

How so?      The Japanese workforce is shrinking as the population ages, but immigration to replace those workers is not allowed.  Moribund companies are not permitted to die.  Instead, they’re kept alive by financial infusions from suppliers, customers and local financial institutions.  Nor are such firms encouraged to streamline or refocus so they can make money again.  Quite the opposite.  The government even protects inept or indifferent managements from any shareholder attempts to compel them to do so.  In many cases–the auto companies are one shining exception–zombie-like firms destroy the profitability of entire industries.

the inflation “solution”

Faced with severe voter discontent, the recently-elected new government has decided to “cure” the economic malaise by increasing the money supply until doing so creates inflation.  That’s the main economic plank the Liberal Democratic Party ran on, so arguably the ballot box shows the measure has popular approval.  Unfortunately for Japanese citizens, however,…

…there’s little reason to think that this will do lasting good

Textbook theory says an acceleration in money growth will lower interest rates and weaken the currency.  That gives the economy a temporary boost, which will gradually subside–leaving the country with the same real growth rate as before but with higher inflation.

A whiff of inflation is nothing too horrible in Japan’s case, since the country is suffering the ills of deflation–except for the risk that domestic interest rates will rise.  That could make it far more difficult for the government to finance the country’s huge debt burden.

In some ways, we’re in uncharted waters here, however.  Textbook theory is formulated from general economic principles buttressed by observations from practical experience.  Most of that experience comes either from small economies or from a much simpler pre-globalization (no BRICs) world, however.

So far, the announcement of Tokyo’s intention to create inflation has weakened the yen by a (to me) startling 22.5%.  That represents an extraordinary loss in national wealth.  It also means that dollar-denominated items–like food, clothing, fuel–that Japanese consumers buy on a regular basis now cost almost 30% more in yen than they did six months ago.  Yes, this is inflation, but not the healthy kind–wage increases driven by rising industrial productivity;  rather, this is a substantial fall in the Japanese standard of living.

Will the loosening of money policy lead to improvement in profits for Japanese industry?  In the case of commodity-like machinery output, the short-term answer is “Yes.”  Both the EU and the US have recently expressed strong concern that Japan is attempting to export its industrial woes through hostile currency devaluation.  This means that basic industry in both areas is already being hurt by Japan’s move.

On the other hand, will you now pick a Sharp TV over a Samsung, or a Sony smartphone over an iPhone/Galaxy S4 just because the price of the former has gone down a bit?  How many more boomboxes or Walkmen will you buy?

Perhaps most distressingly, for much of Japanese industry a lower currency will only make it easier to ignore their lack of innovation and their weak general management for a while longer.

The damage done to Japanese consumers is real and it’s today.  An industrial renaissance due to looser money is unlikely, in my view, while the government defends the status quo.  As the White Queen in Through the Looking Glass said, it’s “jam tomorrow.”